Limited "upside potential" for US stocks? The key lies in whether the Federal Reserve will cut interest rates "beyond expectations"

Renowned Wall Street bear Morgan Stanley's chief US stock strategist Mike Wilson has warned that unless the Federal Reserve cuts interest rates more than the market expects, stock market investors will be very disappointed.

Wilson accurately predicted on July 9th that the S&P 500 was "highly likely" to face a 10% pullback. From late July to early August, the US stock market as a whole declined, even experiencing a "Black Monday" on August 5th. In Wilson's view, concerns about a "hard landing" for the US economy are the key reasons for this downturn. As US economic data continues to be released, the market is gradually starting to price in a "soft landing" for the economy, with several stock indices rebounding to historical highs.

However, Wilson pointed out that the trends in the bond market, the Japanese yen, and the commodity market continue to show concerns about the US economy. In terms of the stock market, both cyclical and defensive stocks have seen little to no rebound.

Wilson warned that unless the Federal Reserve cuts interest rates more than expected, the economy strengthens, or additional policy stimulus is introduced, stock market returns in the next 6-12 months will be extremely limited, and investors should continue to choose quality stocks.

Interest rate cut exceeding expectations, September non-farm payrolls data is crucial

In Wilson's view, the non-farm payrolls data to be released on September 6th will be crucial in assessing the extent of the Federal Reserve's interest rate cut. If the employment data is stronger than expected and the unemployment rate decreases, the market may have more confidence that the risks to economic growth have subsided, stock market valuations may remain high, and may drive the recovery of lagging asset markets. Conversely, if the report is weak and the unemployment rate further rises, it may reignite concerns about economic growth and put pressure on stock market valuations.

Morgan Stanley economists expect non-farm payrolls to reach 185,000, higher than market expectations, with an expected unemployment rate of 4.2%. Currently, the market generally expects an addition of 165,000 jobs, significantly higher than the previous month's 114,000, and expects the unemployment rate to decrease slightly from 4.3% to 4.2%.

The non-farm payrolls data to be released by the US Department of Labor will be the final heavyweight employment data before the September Federal Reserve decision, which will affect the key judgment of a 25-point or 50-point rate cut in September.

The CME Group's FedWatch Tool shows a 69% probability of a 25-basis-point rate cut in September and a 31% probability of a 50-basis-point rate cut. In addition, bond traders previously expected a total of about 100 basis points of rate cuts this year, indicating that the Federal Reserve may announce rate cuts at upcoming policy meetings, including a significant 50-basis-point cut.

Wilson pointed out that the market has already priced in a "soft landing" for the US economy, with the S&P 500 index's price-to-earnings ratio reaching 21 times. **In the case of a "soft landing," there is limited upside for the stock market in the next 6-12 monthsIn the case of a "hard landing", with the S&P 500 index valuation far above average, there is significant downside risk for stock indices. Currently, stock market investors will heavily rely on the upcoming labor report.

Without sufficient evidence of economic improvement, high-quality defensive stocks are a better choice

Wilson stated that the Bloomberg Economic Surprise Index has not reversed its downward trend since April, and the performance of cyclical stocks and defensive stocks is still on a downward trend. They believe that this supports the view that it makes sense to lean towards high-quality defensive stocks in a portfolio until there is more evidence of economic growth improvement.

Regarding the hot AI stocks of the past year, Wilson mentioned that although they have experienced significant pullbacks, it does not mean that this theme has ended. It just means that investors have opportunities to look for new themes. Wilson does not agree with investors shifting towards small-cap stocks or other cheap cyclical stocks. These areas usually perform poorly unless U.S. labor data significantly exceeds expectations and the Fed decides to cut interest rates by 200 basis points as priced in by the market.

It is worth noting that the bond market has to some extent already priced in rate cuts by the Fed, with long-term interest rates falling by over 100 basis points in the past 10 months