The S&P 500 correction is nearing its final stage even as the Iran war continues, according to strategists at Morgan Stanley, who warn that Federal Reserve interest-rate hikes still pose a threat to stocks.

There is growing evidence that the equities slide “is getting closer to its ending stages,” the team led by Michael Wilson said, citing the example of previous “growth scares” that were not accompanied by a recession or rate hike.

The strategists note that over half of Russell 3000 stocks are down more than 20% from their 52-week highs. The S&P 500 forward price to earnings ratio has also dropped over 15%, suggesting that market pricing increasingly reflects risks posed by the Middle East war.

“We think the equity market is less complacent on growth risks than consensus believes,” the strategists said in a note Monday.

The S&P 500 has dropped 8.4% since Jan. 27. Stocks have been hit by fears over artificial intelligence and the war, which has effectively closed the Strait of Hormuz and severed a crucial route for global energy supplies. Brent crude reached $116.89 a barrel on Monday as additional US troops arrived in the Middle East and Iran-backed Houthi militants in Yemen entered the conflict.

The Morgan Stanley team said that markets have so far priced in higher energy costs. The increase in oil prices, compared to the prior year, is roughly half that of previous periods when an oil shock ended the business cycle, they argued. Positive earnings growth will also help protect against recession.

“The market is saying the cumulative probability of the paths to resuming tanker flow in the Strait are much higher than the recession probability, and we agree,” the team wrote.

Still, interest-rate hikes are a near-term risk for US stocks, according to the strategists. The sensitivity of equities to rates is close to the highest level of the past several years, they said. The 10-year Treasury yield is also closing in on 4.5%, a level which historically pressures stock valuations.

“Whether the move in yields today is being driven by inflation considerations, a more hawkish Fed or by deficit considerations from the war or both, we think it’s an important risk variable to consider,” the strategists said.

Written by: Rose Henderson @Bloomberg

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