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The most accurate forecaster for 2018 among prominent sell-side research teams sees an attractive entry point for equity investors in 2019, but unfortunately, it won’t happen before a lot of market pain.

In January, 2018, the consensus view of strategists and economists was that a “synchronized global economic expansion” would push equity markets significantly higher during the year. Morgan Stanley U.S. equity strategist Michael Wilson and Britain-based global equity strategist Andrew Sheets, however, successfully predicted the market would face “difficult hand-off” as central banks normalized interest-rate policy. As a result, Morgan Stanley forecast a series of “rolling bear markets.” And that’s precisely what materialized in volatility-related ETFs, commodities, dividend stocks, technology stocks and credit markets through the year.

Now, Mr. Wilson sees a 50-per-cent chance of a U.S. earnings recession – two consecutive quarters of year-over-year losses – and a sharp slowdown in the U.S. economy for the year ahead.

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Morgan Stanley is paying particular attention to its proprietary Business Conditions Index. This benchmark compiles the work of the company’s U.S. equity analysts to gauge financing costs, new business and product orders, input prices and capital spending expectations for corporate America.

The chart below (reproduced from the Morgan Stanley report) highlights the roots of Mr. Wilson’s bearish outlook – a sharp deterioration in the business conditions index that has negative ramifications for U.S. manufacturing activity.

The two lines on the chart have historically moved roughly in tandem. Since September, however, the business conditions index has dropped rapidly, potentially signalling a slowdown in the overall economy.

For stock investors, the big opportunity in 2019 will occur after the ISM Manufacturing index declines – something likely to happen in the first quarter.

Mr. Wilson believes that defensive market sectors such as consumer staples, utilities and real estate will continue to outperform as the year begins. But, the relative performance of defensive and cyclical (economically sensitive) equities indicates that markets have already priced in a major slowdown. This paves the way for a significant rally for cyclical stocks as the economic data bottoms out.

As for what investors should buy when the opportunity arises, Mr. Wilson favours bank and financial stocks. He notes that U.S. large-cap bank valuations have declined by 34 per cent in the past 12 months and are now close to levels seen during recessions. He adds “we do not see a threat on the horizon large enough to justify multiples that low.”

I’m paying more attention to Morgan Stanley forecasts for 2019 in large part because of their strategists’ success last year. It indicates that they are successfully identifying the market factors that will have the most effect on asset prices. At the same time, predicted hot streaks don’t last forever and investors should not take undue market risks from a single analyst opinion.

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BUSINESS CONDITIONS SIGNAL SLOWDOWN

Morgan Stanley Business

Conditions Index (left scale)

ISM Manufacturing PMI (right scale)

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THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW

BUSINESS CONDITIONS SIGNAL SLOWDOWN

Morgan Stanley Business Conditions Index (left scale)

ISM Manufacturing PMI (right scale)

90

65

80

60

70

60

55

50

40

50

30

20

45

10

0

40

2014

2016

2018

2017

2015

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW

BUSINESS CONDITIONS SIGNAL SLOWDOWN

Morgan Stanley Business Conditions Index (left scale)

ISM Manufacturing PMI (right scale)

90

65

80

60

70

60

55

50

40

50

30

20

45

10

0

40

2014

2016

2018

2017

2015

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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