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Economy, Trading  | January 16, 2019

Enjoy the market calm for now. Morgan Stanley thinks another storm is coming.

The S&P 500 will soon suffer a retest of the lows from Christmas Eve because of shrinking earnings estimates and mounting economic concerns, the investment bank warned in a Monday report titled "Don't fear a potential recession; Embrace it."

"Should the hard data deteriorate further, as we expect, we think the market will quickly return to pricing in a recession and rate cuts," wrote Michael Wilson, Morgan Stanley's chief US equity strategist.

Wilson was among the few on Wall Street who correctly predicted the recent market downturn, though even he was surprised by how quickly it happened.

The Dow has spiked more than 2,100 points, or about 10%, since Christmas Eve. Fears of a recession have faded thanks to progress on US-China trade talks, soothing words from the Federal Reserve and a very strong December jobs report.

Even though stocks have rebounded nicely, some red flags persist. For instance, numbers released on Monday show China suffered its biggest drop in exports in two years in December as global growth slowed. Germany's economy grew last year at the weakest pace since 2013.

Meanwhile, the once-booming junk bond market has slowed to a near-halt. And last week Macy's (M) suffered its worst day of trade ever after reporting weak holiday sales and dimming its outlook.

"We think the odds of an earnings and economic recession have increased materially," Wilson wrote in his report.

An earnings recession occurs when S&P 500 profits decline for consecutive quarters. That hasn't happened since 2016, when crashing oil prices wreaked havoc.

And the United States hasn't suffered an economic recession -- typically defined as two straight quarters of negative GDP growth -- since the Great Recession in 2008. In fact, if the current US economic expansion continues through the summer, it would become the longest in American history.

Sixty Percent of Investors Expect Growth to Slow

Still, even though the US economy remained strong in the third quarter, Wall Street started to freak out last month about a looming recession due to slowing global growth and the US-China trade war. Those concerns were amplified by a weak manufacturing report released January 4 showing US factory activity declined at the fastest pace since 2008.

Sixty percent of global fund managers expect global growth will weaken over the next 12 months, according to a survey released on Tuesday by Bank of America Merrill Lynch. That's not only the dimmest outlook on the world economy since July 2008 -- it's also below the survey's weakest point in the 2001 recession.

All of this raises the stakes for fourth-quarter earnings season, which kicked off Monday. Wall Street has hammered companies that have reported news. Apple (AAPL), for example, plunged 10% on January 3 after blaming slowing growth and China for soft iPhone sales.

Companies that reported negative earnings surprises for the fourth quarter have experienced an average plunge of 10.2% in the two days prior to results through two days after, according to FactSet. That's a far steeper decline than the five-year average of 2.6%.

'Sharp' Slide in Earnings Growth Looms

Even companies that have reported earnings beats are getting hit, FactSet found. Those companies have suffered an average price decline of 5.2%, compared with the five-year average gain of 1%.

Looking at S&P 500 earnings outlooks at large, Goldman Sachs is calling for a "sharp deceleration" in the index's earnings growth: just 6% in 2019, compared with 23% in 2018.

While an earnings recession "appears unlikely," Goldman Sachs chief US equity strategist David Kostin wrote in a report published late Friday that recent "weakness in the macro landscape" could cause S&P 500 earnings growth to dip a bit further than anticipated.

Morgan Stanley's Wilson is more bearish.

He said the United States is "in the midst of a fairly steep and broad" negative earnings revision cycle and 2019 margin estimates have already contracted by the most for this time of the year since 2008.

"The fundamentals remain murky at best with earnings visibility deteriorating," Wilson wrote.

Sellers' 'Trap'

So does all of this mean that the United States is headed for a recession that should cause investors to flee?

"We don't know if an economic recession is coming or not," Wilson wrote. However, he said that if there is a recession, it will likely be "shallow and brief" like the 1990 downturn.

Not even the biggest bears on Wall Street see the ingredients for a repeat of the Great Recession.

But by the time investors agree that the United States is in a recession, it will likely be too late for them to dump stocks. That's why Wilson is urging his clients to treat a retest of the S&P 500's December closing low of 2,351 as an opportunity.

"That's the trap and the time to buy, not sell," he wrote.

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