Traders are overestimating the lasting impact of corporate tax cuts — and Morgan Stanley says one crucial corner of the market is particularly at-risk
- Morgan Stanley chief US equity strategist Mike Wilson says capital spending is about to slow down, creating a big challenge for companies that make sell goods to other businesses.
- Wall Street experts have been projectinga slowdown in corporate earnings, and Wilson says they are forecasting stronger business investment at the same time. He warns that the combination doesn’t make sense.
- Wilson warns that one sector crucial to the market’s overall health is particularly vulnerable.
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Mike Wilson, the chief US equity strategist at Morgan Stanley, says investors are overlooking a growing threat to technology- and business-focused companies.
They’re the same firms that benefited — and saw their stocks climb — in the wake ofthe Tax Cuts and Jobs Act in 2017. The law reduced corporate taxes, changed accounting rules, and encouraged companies to bring back cash they were keeping outside the US. That resulted in corporations plowing a great deal of that money back into their businesses.
Those investments — called capital expenditures, or capex — are critical for companies in the tech and industrial sectors among other areas.
But corporate profits for the S&P 500 are expected to slip in the current quarter, and Wilson says companies won’t spend as much money on items like machinery and software if their earnings are weak.
“Tax reform ignited the capex boom that began in early 2017, but the boom is likely to slow with the earnings recession,” Wilson wrote in a recent note to clients. “Net income growth should decelerate over the next 12 months, and that’s a bearish signal for capex growth.”
Wilson adds that there is a second problem: forecasts for spending growth are actually going up, even though earnings forecasts are coming down.
The chart below shows the growing divergence — one that Wilson says simply doesn’t make sense because companies that aren’t making as much money can’t ramp up investments in their business at the same rate.
FactSet, Morgan Stanley Research
That could be a problem for companies including software and hardware makers, as well as companies that manufacture machinery and other equipment used in making goods for busineses, rather than for consumers. The further that capex spending declines, the more those stocks are likely to suffer damaging turbulence, according to Wilson.
To illustrate that point, Wilson uses this chart to show the inverse: that those types of companies tend to beat the rest of the market when capital spending picks up, and struggle when that spending weakens.
Morgan Stanley Research
For Wilson, this is a warning sign about wide swaths of the technology sector, which goes against the flawed investor expectation that relatively few cyclical stocks will be harmed.
“The actual risk is likely to be broader and affect software and services stocks, too,” he said. “We are also skeptical that the rebound will be as robust as now expected by the cyclical tech stocks — i.e. semiconductors and hardware.”
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