'Winter is here' is here for stocks and investors should stop focusing on the Fed and start playing defense, Morgan Stanley's equities guru says

• The recent downturn that US equities are seeing does not come as a surprise to Morgan Stanley's Michael Wilson.
• "The current deceleration in growth is more about the natural ebbing of the cycle than the latest variant of Covid," he said.
• Looking ahead, Wilson touted defensive stocks relative to cyclical stocks.

The recent downturn that US equities are seeing does not come as a surprise to Morgan Stanley's Michael Wilson who has repeatedly expressed his reservations about a stock market that has been breaking one record after another.

"Winter is here," the equities guru said in a note Monday, calling on investors to pivot their focus from the Federal Reserve's hawkish policy shift to a slowing economy as stocks retreat.

"The current deceleration in growth is more about the natural ebbing of the cycle than the latest variant of Covid," he and other strategists said in a note. "We have been monitoring PMIs and earnings revisions breadth for signs the slowdown is bottoming, but it has quite a bit further to go, in our view, and equity markets are not yet priced for it."

US equities extended their downturn Monday as investors brace for the Fed to sharply tighten monetary policy to tame inflation that's near 40-year highs.

The Fed this Wednesday will release its first policy decision of the year. It is set to ramp up interest rates soon and draw back further on its emergency, monetary response to the pandemic.

"The Fed is serious about fighting inflation, and it's unlikely that it will be turning dovish any time soon given the seriousness of these economic threats and the political support to take action," Wilson said.

Meanwhile, major US large-cap equity indices are down only 10-15% from their highs, while expensive and unprofitable names – the most speculative parts of the equity market – are lower by 30-50%.

"This is appropriate in our view, not just because the Fed is pivoting, but because these kinds of valuations don't make sense in any investment environment," he said. "In short, the froth is coming out of an equity market that simply got too extended on valuation."

But it does not help that earnings for the fourth quarter have also so far disappointed. And while corporate results are expected to beat estimates by the typical 3-6%, the forecasts could be mixed as companies also publish their full-year guidance, Wilson said.

He added that January's slump "fit nicely" into his "Fire and Ice" narrative he discussed at length in a September 2021 note.

At that time, he laid out two near-term risk paths for the stock market: "Fire," a more optimistic outlook that would occur if the Fed begins to remove monetary accommodation as the US economy overheats; and "Ice," which would occur if upward earnings revisions slow and higher-frequency macro datapoints deteriorate. The latter, he said, would be "destructive" as it would translate to a 20% correction in the S&P 500.

Looking ahead, the equity strategist emphasized the value of playing defense.

"While Defensives and Cyclicals have trounced Secular Growth over the past few months, we think the fatter pitch now is to be long Defensives relative to Cyclicals with the 'Ice' part of our narrative really kicking in."