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Morgan Stanley says the stock market is ‘disconnected from reality’ and it’s going to hit bottom this Spring

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US stocks are ripe for a selloff after prematurely pricing in a pause in Federal Reserve rate hikes, according to Morgan Stanley strategists.

“While the recent move higher in front-end rates is supportive of the notion that the Fed may remain restrictive for longer than appreciated, the equity market is refusing to accept this reality,” a team led by Michael Wilson wrote in a note. 

Wilson — a staunch Wall Street bear who correctly predicted last year’s selloff when US equities posted their worst performance since 2008  — expects deteriorating fundamentals, along with Fed hikes that are coming at the same time as an earnings recession, to drive equities to an ultimate low this spring. “Price is about as disconnected from reality as it’s been during this bear market,” the strategists said.

Last week, yields on US two-year notes exceeded 10-year yields by the most since the early 1980s, a sign of flagging confidence in the economy’s ability to withstand additional rate increases. Meanwhile, US equities have seen one of the strongest starts to a year on record, though the rally has started to cool as Fed Chair Jerome Powell’s outlook for further rate increases weighed on sentiment.

US inflation data could be a catalyst to bring investors back to reality, and get stocks in line with bonds again, if prices rose more than expected, Wilson said, while noting that expectations for such a result have been growing. The data on Tuesday is predicted to show consumer prices increased 0.5% in January from a month earlier, spurred by higher gasoline costs. That would mark the biggest gain in three months.

Wilson sees the S&P 500 ending the year at 3,900 index points, about 4.7% below where the gauge closed on Friday, with a rough ride to get there. He expects stocks to fall as earnings estimates come down, before rebounding in the second half of the year.

“The risk-reward is as poor as it’s been at any time during this bear market,” Wilson wrote. “The reality for equities is that monetary policy remains in restrictive territory in the context of an earnings recession that has now begun in earnest.”

Other strategists are less pessimistic. Goldman Sachs Group Inc.’s Christian Mueller-Glissmann raised global stocks to neutral from underweight over the next three months citing less upside risk for bond yields and more confidence in a US soft landing.

That said, he remains selective as “higher valuations and more optimistic growth sentiment increases the risk of equity drawdowns.” While there’s limited room for Wall Street equities to rally further, “we still see attractive upside to non-US equities,” Mueller-Glissmann wrote in a note. 

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