The stock market correction is 'incomplete' and earnings guidance points to a sharp slowdown for corporate profit growth in 2022, Morgan Stanley says

The "duration and depth of this incomplete correction will be determined by how much growth disappoints," said the investment bank.

• The S&P 500 index is in a slump this year and its correction is "incomplete," says Morgan Stanley. 
• The investment bank said stocks are vulnerable to disappointing data on economic growth. 
• Wall Street analysts, meanwhile, are cutting down expectations for year-over-year profit expansion. 

This year's selloff in stocks has a way to go before it's finished as the market looks vulnerable to slowing economic growth, said Morgan Stanley on Monday in a note that also highlighted lower earnings expectations among Wall Street analysts. 

The S&P 500 has slumped by more than 8% in 2022 and dipped into correction territory last month before rebounding a bit. A correction is a loss of more than 10% from a recent high, and the index in early January hit an all-time at 4,818.12. 

Investors have hammered stocks as the Federal Reserve prepares to raise interest rates multiple times this year to combat inflation that's reached a 40-year high, at 7.5% in January. But the market has been enveloped in an "obsession" with the Fed and inflation, Morgan Stanley said.

"While these still matter, the duration and depth of this incomplete correction will be determined by how much growth disappoints, in our view," said equity strategists led by Michael Wilson.

Morgan Stanley said it's been more concerned about economic growth than other investment houses, and last week's consumer sentiment reading from the University of Michigan highlights why growth is on its radar.

The widely watched consumer sentiment gauge for February fell from 79 to 76.2, the lowest reading since August. Much of the drag came from a slide in economic expectations and from households earning less than $75,000 a year reporting setbacks in financial conditions. 

"Whether it's the payback in demand, or sharp decline in real personal disposable income, we think the rate of consumption is likely to disappoint expectations in the first half of 2022," said Wilson. "Furthermore, this weaker consumption is arriving just as supply chains are finally loosening up, something that is likely to be aided by the end of Omicron and the labor shortages it has created in the transportation and logistics industries." 

Meanwhile, the risk of Russia invading Ukraine materially increases the odds of a "polar vortex" for the the stock market and economy, Morgan Stanley also said Monday. 

If economic growth does reaccelerate, then markets can find some footing, the investment bank said. However, that will also allow the Fed and other central banks to be aggressive in pulling back on monetary stimulus until inflation drifts back considerably toward inflation goals of 2% to 3%. 

The outlook for 2022 corporate profits is dimming, meanwhile. Based on how Wall Street analysts overall are revising numbers higher or lower, the year-over-year spread in earnings revisions breadth "is now quite negative" at 6.3% compared with 27.6% a year ago, said Morgan Stanley.

"This spread tends to lead year over year forward earnings and is indicating that a sharp contraction will hit in Spring," it said.

It noted that the rate of change on forward sales has flattened out since mid-July 2021. "Companies are able to maintain pricing power and grow margins when demand/forward sales is at its strongest. That dynamic reverses once sales growth starts to decline," and that "paints a grim picture" for operating margins. 

The sharpest downward revisions have been in the transportation, communication services and industrials sectors while energy, auto and tech hardware companies are leading upside changes, the bank said.