The stock-market rally that's jumpstarted 2023 is about to fade as the Fed reasserts its resolve in fighting inflation, Morgan Stanley's top stock strategist says

• Stocks are off to a "surprisingly good start" in 2023, but the upside momentum looks set to fizzle, Morgan Stanley said Monday.
• This week's FOMC meeting may remind investors of the cardinal rule: "Don't Fight the Fed," said strategist Mike Wilson.

The surge in stocks at the start of 2023 should run out of steam as investors will soon be reminded that the Federal Reserve is continuing to tighten financial conditions to ease still-high inflation, Morgan Stanley said Monday.

"While there have been several positive developments, we think the good news is now priced, and reality is likely to return with month end and the Fed's resolve to tame inflation," Morgan Stanley chief equity strategist Michael Wilson said in a Monday note to clients about the "surprisingly good start" for stocks this year.

The S&P 500 has risen by more than 5% so far this year, ahead of the final trading session of January on Tuesday. The Nasdaq Composite has jumped more than 9%. The indexes in 2022 sank by 19% and 33%, respectively.

Investors have attributed the strong start to China's reopening of its economy after tough COVID lockdowns, a retreat in inflation from recent peaks, the softening of the US dollar's value, and a potential pause by the Fed from aggressive rate hikes.

"We think the recent price action is more a reflection of the seasonal January effect and short covering after a tough end to December and a brutal year," said Wilson.

He said recent price action in stocks has prompted investors to participate more actively as they fear missing out.

"The reality is that earnings are proving to be even worse than feared based on the data, especially as it relates to margins," said Wilson. "Secondly, investors seem to have forgotten the cardinal rule of 'Don't Fight the Fed'. Perhaps this week will serve as a reminder."

The Federal Reserve on Wednesday is expected to deliver its eighth straight interest rate increase, while further downshifting the size of its tightening to 25 basis points to put the fed funds rate at 4.5%-4.75%.

In December, the Fed hiked rates by 50 basis points after four consecutive increases of 75 basis points.

Morgan Stanley said cost growth is rising faster than sales growth for about 80% of S&P 500 industry groups. It also noted that EBIT margins for 2023 have fallen 1.2% since the end of 2022.

The bank is now leaning more toward its bear case of per-share earnings of $180 for the S&P 500, based on margin degradation so far and what its earnings models are projecting.

"We think it's important to note that typically when forward earnings growth goes negative, the Fed is actually cutting rates. That's not the case this time around...an additional headwind for equities," said Wilson.

The final leg of the bear market should materialize when the Fed signals a dovish stance on monetary policy and when investors stop mispricing the worst earnings recession since 2008, he added.