Key manufacturing data point to the direction of stocks in 2022 — and the S&P 500 will struggle to eke out a gain, Morgan Stanley says

• The S&P 500 could have trouble notching a gain this year if manufacturing activity data are weak, Morgan Stanley said Monday.
• There's a tight correlation between the New York Fed's manufacturing survey and the broad equity index.
• The S&P 500 has declined about 6% so far this year, but has recovered from its lows.

A gain for the S&P 500 index in 2022 looks challenging with the outlook for US manufacturing activity appearing weak, Morgan Stanley said in a report Monday.

Manufacturing orders are likely to set the direction for stocks, said analysts, who cited a close relationship between new order activity in monthly manufacturing surveys and the broad equity index's year-over-year change, especially during the past 20 years.

The note comes as the Institute for Supply Management's Purchasing Managers Index (PMI) for January is due Tuesday, and economists polled by Econoday expect the headline reading to fall to 57.5 from 58.7 in December.

Also, due Tuesday is IHS Markit's final January reading on US manufacturing activity. Its gauge in early January hit a 15-month low of 55, with the economy hurt by supply chain delays and staff shortages as the Omicron coronavirus variant spread.

And earlier this month, the New York Federal Reserve's Empire State Manufacturing Survey said business activity in early January "abruptly leveled off," with a plunge of 33 points to minus 7. The new orders index slumped 32 points to minus 5, but firms were generally optimistic about the six-month outlook.

The tight correlation between the S&P 500 and manufacturing data is most commonly seen with the monthly PMI, but the Empire survey that's usually released two weeks earlier also exhibits the same relationship with stocks, Morgan Stanley Wealth Management said in a weekly update from its global investment committee.

"With both series still pointing downward, year-over-year gains in the S&P 500 may prove challenging," wrote Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management.

The S&P 500 has lost nearly 6% this year through mid-Monday but has recovered from last week's dive into correction territory, which marks a decline of 10% or more from a recent high. Stocks have been slammed with rate hikes from the Fed on deck as consumer price inflation stands at a nearly 40% high of 7%.

Markets are grappling with alternative scenarios on how the Fed's hawkish monetary policy will play out, said Shalett.

"One is that Fed tightening is too much too late, and it will slow growth and inflation just as cyclical forces are correcting extremes, thus raising the risk of a recession. Alternatively, the Fed is too measured, which will allow inflation expectations to climb while consumption is crushed by high prices, thus risking stagflation," she wrote.

"Either way, investors need to consider whether inventories are ample and supply chains secure; if high inflation is destroying demand; if the hoped-for shift toward spending on services is impaired or delayed; and how the confluence of the fiscal cliff and tighter monetary policy could affect the economy."