Morgan Stanley outlines the best-case scenario for stocks in the 4th quarter

The Federal Reserve nailed the rate-cut scenario that Morgan Stanley called its best-case result leading into the decision. Now it’s up to the labor market whether the firm can get its ideal fourth-quarter setup.

Heading into last week’s announcement, Morgan Stanley was looking for a 50-basis-point cut that didn’t also stoke worries about unnecessary growth. That ended up playing out, and stocks ripped higher to records the next day.

Now, in new research, Morgan Stanley’s chief US equity strategist Mike Wilson is outlining what has to take place for a similar strong fourth quarter.

“A drop in the unemployment rate and strong payroll data (without downward revisions) is likely the most risk-on signal for equities in 4Q,” he wrote. “Such a development can counter seasonal weakness in earnings revisions and election-related volatility — 2 important dynamics the market faces over the next month and a half.”

Job market deterioration was a major factor in the Fed’s decision to cut by half a point. In reducing rates this much, the central bank seeks to stave off any potential labor-led slowdown and ensure support for the economy.

Incoming payrolls data will gauge its success. With September’s figures set for release on October 4th, Morgan Stanley outlined three main outcomes to expect:

The best scenario is if unemployment drops below 4.1% and non-farm payrolls reach above 150,000. In this case, the market could see a sustained rotation into cyclical equities as investors take on more risk appetite.

Depending on future rate cuts, other benefactors include small caps, industrials, consumer discretionary and housing stocks.

The worst-case scenario occurs if unemployment rises above 4.3% and non-farm payrolls fall below 100,000. This would be a risk-off outcome, giving defensive equities the upper hand.

Alternatively, the jobs report could stay at current levels. This mixed outcome offers no obvious risk level, though large-cap quality stocks could generally outperform.

Bank of America similarly highlighted that labor reports are now the biggest market movers ahead of the election. Stock options are pricing in over 1% moves on the S&P 500 for October 4th, in whichever direction.

To be sure, job conditions are not the only thing Morgan Stanley is watching. Also of interest are earning revisions, manufacturing data, and the Conference Board Leading Economic Indicators and Employment Trends index.

“Bottom line, the Fed’s larger than expected rate cut can buy more time for high quality stocks to remain expensive and even help lower quality stocks to find some support; however, the labor and other growth data now likely needs to improve in order to justify these conditions through year end,” Wilson wrote.