Stocks are headed for a 'boom-bust' fallout as falling inflation sparks an earnings recession, Morgan Stanley's CIO says

• Stocks are still headed for a sharp earnings recession, Morgan Stanley's Mike Wilson said.
• The chief investment officer and equity strategist pointed to falling inflation hurting corporate profits.
• Corporate earnings could slide as much as 16%, strategists previously warned.

Stocks are still headed for a sharp earnings recession as falling inflation chokes corporate profits, Morgan Stanley's chief investment officer Mike Wilson warned in a new client note.

Wilson, who has sounded the alarm for an profit recession for months, reiterated his view that the market is in the midst of a boom-bust cycle. That's because the expansive fiscal policy of the pandemic led inflation and asset prices to soar (the boom), and tight monetary policy enacted over the last year to control inflation has weighed on asset prices (the bust), with the S&P 500 sinking 20% in 2022.

But for the time being, the market appears to be shrugging off boom-bust risks, with more investors piling into stocks as inflation cools and the economy remains strong.

That strength is largely due to robust fiscal spending, which has allowed the economy to grow faster than expected this year, Wilson said. But investors still have reason to be concerned, as fiscal spending could wind down and falling inflation soon could eat into corporate profits.

"We think the even bigger takeaway for investors to consider is if fiscal spending must be curtailed due to high political or funding costs, the unfinished earnings decline that began last year has further to fall as inflation doesn't just stop at 2 percent," Wilson and his team of strategists said in a note on Monday. "Our boom/bust framework would suggest inflation as it relates to cooperation earnings (i.e. pricing falls toward zero or even below)." 

Falling inflation is already beginning to hurt sales and earnings growth, the leading indicators show. The Producer Price Index, which the bank calls its "favorite leading indicator" of inflation in relation to corporate earnings, has fallen rapidly over the past year, with final demand prices increasing just 0.1% in June.

The Congressional Budget Office has also predicted government spending will slow this year, with its estimate for annual discretionary outlays falling $29 billion from its prior estimate in February.

"If fiscal spending begins to be curtailed as the CBO is projecting, this deflationary pressure on businesses is likely to show up in sales growth, which would call into question the accelerating growth narrative," Wilson's team added. 

Corporate earnings could slide as much as 16%, strategists previously warned.

Wilson is among the most bearish Wall Street voices at the moment, as other forecasters have pointed to the resilient economy supporting the rally in stocks. The S&P 500 could be a new secular bull market, RBC said in a recent note, predicting the benchmark index would triple to 14,000 by 2034.