Morgan Stanley: stock market may be in for shock

Bond investors are bearish, while equity investors are bullish. Morgan Stanley says “equity investors will be the ones that are disappointed.”Morgan Stanley's Lisa Shalett says near record highs in stocks are masking potentially negative fundamentals. The “overshoot” in first-quarter GDP “augurs for a more meaningful deceleration,” she said.Bond investors — via a wonky measure called the yield curve — have been flashing a warning sign about a slowdown in US economic growth. Yet investors in equities are sending stocks to record highs.Morgan Stanley says that equity bulls may be in for a shock. “The bond market is clearly telling you one thing, and that is that the economy is slowing,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, told Business Insider in an interview. “Equity investors will be the ones that are disappointed.”Shalett on April 15 put out a report to clients outlining the fork in the stock and bond markets, saying at the time: “Equities now discount an economic soft landing, but the bond market expects deteriorating growth and possibly a recession. This disconnect is likely not sustainable.”In an interview this week, she elaborated, saying recent GDP figures of 3.2% for the first quarter may have been what Shalett calls an “overshoot,” and “augurs for a more meaningful deceleration.”Credit investors seem to be taking all of this in. Much of the US Treasury yield curve is currently inverted, meaning short-term bond investors are atypically more wary than long-term ones. That inversion has previously indicated that a recession could be on the horizon.But equity investors don't seem to be getting the message. An earnings outlierShalett pointed to US earnings. While they “have so far certainly surprised on the upside” — Bloomberg data show that more than three quarters of companies that have reported so far have beaten their earnings expectations — such strong results could be an outlier. Lack of details on forward guidance, margin pressure, and a drop in capital expenditure are worrying signs that equity investors are discounting, Shalett says, saying she expects a 4% decline overall in full-year results. Shalett listed potential landmines threatening the US economy in general and corporate earnings specifically, including: negative manufacturing data, trade headwinds from a weakening Europe, a strong US dollar, rising labor costs, higher oil and industrial metals prices, increased capital costs, and above-average inventories.