- Inflation may have peaked, but that won't necessarily be any help to stocks, Morgan Stanley says.
- Stocks could falls as companies deal with lower pricing power and high staffing amid a hot labor market.
- "It won't be good for profits – i.e., be careful what you wish for," analysts wrote on Monday.
Inflation is starting to fall, but it's too soon to say the bear market in stocks is over, Morgan Stanley strategists said on Monday, warning that companies will soon start to grapple with falling prices and high labor costs at the same time, weighing on profits.
That sets up a trap for investors, many of whom have been encouraged by the stock market's recent rally and believe cooling inflation will boost the market and the economy.
"The rally in stocks has been powerful, and has many investors believing the bear market is over. However, we think it's premature to sound the all-clear simply because inflation has peaked," the bank's strategists said, adding that falling inflation would drag on corporate profits in exactly the opposite way rising inflation boosted them.
"Just like most underestimated the positive effects of inflation on operating leverage, we think they are underestimating the negative effects from inflation falling," the strategists said.
They noted that July's hot jobs report, which showed 528,000 jobs were added last month, means that companies are still spending large amounts on their labor forces, and will be saddled with those operating costs as the prices they charge to customers begin to fall.
"The next leg lower may have to wait until September when our negative operating leverage thesis is more reflected in earnings estimates. However, with valuations this stretched, we think the best part of the rally is over."
The bank said it is a possibility that recession would actually be necessary to get the market through the deleveraging cycle.