The stock market hasn’t priced in a recession just yet. If it does, the S&P 500 could fall another 23%, Morgan Stanley says

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With the S&P 500 down more than 20% this year, both retail and institutional investors are debating whether the worst is over for stocks.

The answer? Don’t bet the house on it—or at least that’s what Morgan Stanley says.

The investment bank’s strategists, led by chief investment officer Michael J. Wilson, said in a Tuesday research note that the S&P 500 has yet to price in a full-blown economic recession.

Wilson and his team stuck to their 3,400 end-of-year price target for the index, which represents a 10% drop from current levels, but also argued stocks could fall further in a recessionary scenario in which corporate earnings take a hit.

“We don’t think 3,400 discounts a full-blown economic recession (i.e., an unemployment cycle). In our view, such an outcome would imply a much lower trough for the S&P 500 of ~2,900,” the strategists wrote.

If they’re correct, it would mean the blue-chip index still has another 23% to fall in a worst-case scenario.

Fire, ice, and a buying opportunity?

For months now, Morgan Stanley has been detailing its “fire” and “ice” markets narrative. The idea is that stocks and the economy are being hit by inflation, or “fire,” on one side and slowing economic growth, or “ice,” on the other. That makes it difficult for the Federal Reserve to raise interest rates without sparking a recession.

Last week, Fed officials voted to hike rates for the third time this year, this time by 75 basis points, with Chair Jerome Powell saying another 75 or 50 point hike is likely in July. The Fed has pledged to continue raising rates until there is “clear and convincing” evidence that inflation is coming down.

Wilson and his team argued on Tuesday that roughly 60% of the drawdown in stocks may already be over based on historical analysis after the hikes, but earnings multiples are likely to continue falling.

Today’s 15.3x price/earnings multiple for the S&P 500 could fall to 14x if a recession comes, they said.

While that still isn’t the base case for Morgan Stanley, the investment bank’s economists see a 35% chance of recession by the first half of 2023.

Wilson and his team of strategists wrote on Tuesday that they “would probably err a bit higher” than their economics team if asked to give the odds of a U.S. recession, given their “more negative view on the consumer and corporate profitability.”

An all-time high 67% of consumers polled by Morgan Stanley last week listed inflation as their No.1 economic concern, and 70% said they would be adjusting their spending as a result. This, along with the recent all-time-low reading of U.S. consumer sentiment, as measured by the University of Michigan, has the strategists worried about the health of the U.S. consumer moving forward.

In a Tuesday morning interview with CNBC, Wilson said that he sees the odds of a U.S. recession being more like “50-50” as a result of U.S. consumers’ spending woes and a slew of ongoing macroeconomic concerns from the war in Ukraine to lockdowns in China.

The odds of a serious economic downturn have “increased materially since the start of the year,” he said. However, the CIO also noted that bear markets for stocks typically end when recessions become official, so investors shouldn’t get too spooked by persistent downtrodden economic predictions.

The start of the new bull market may very well begin when the U.S. economy officially enters a recession.

“The market is going to have a really difficult time looking forward until it knows that the risk of recession is extinguished. And we won’t know the answer to that for at least three or four months, is my guess,” Wilson said. “As soon as the recession is obvious, that’ll probably really be the time you want to step in.”

This story was originally featured on Fortune.com

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