The S&P 500 could drop 6% next year and investors will find better returns in European and Japanese stocks, Morgan Stanley says

• The S&P 500 is up 25% in 2021 but it's likely to decline from record highs to 4,400 in 2022, said Morgan Stanley on Monday.
• Earnings growth of 45% has helped pull the benchmark above 4,700, but the expansion is set to slow next year and in 2023.

The S&P 500 is on course to deliver double-digit returns in 2021 but the benchmark is likely to pull back next year as earnings growth moderates, said Morgan Stanley analysts, who recommended investors turn to European and Japanese equities.

The S&P 500 has spiked 25% during 2021, driving to record highs past 4,700 in building on its 2020 increase of 16% as it recovered from a pandemic-driven bear market. Before the coronavirus crisis hit, the index soared by about 29% in 2019.

However, it looks set to lose steam next year, with Morgan Stanley expecting it to fall back to 4,400. That level represents a decline of 6% from where the S&P 500 was sitting Monday.

"With financial conditions tightening and earnings growth slowing, the 12-month risk/reward for the broad indices looks unattractive at current prices," said equities analysts led by Mike Wilson in a note published Monday.

Key to the S&P 500's leap this year has been Corporate America's earnings, which have been "the most bullish thing about 2021" in expanding by about 45%, or 7% above Morgan Stanley's original estimate.

But that red-hot pace will likely settle down in 2022, with a 10% rise in S&P 500 earnings to $227 per share, followed by an 8% profit increase in 2023 to $245 per share.

"While our economists remain bullish on GDP growth for next year, we are haircutting earnings growth for higher costs and taxes (in 2023) as our policy team still expects passage of the Build Back Better spending bill before year-end. Those adjustments shave approximately 4% off [per-share earnings] in 2023, all else equal."

Morgan Stanley said 2022 is shaping up to a stockpicker's year, recommending investors focus less on sectors and styles. "We go into year-end favoring earnings stability and undemanding valuation given our view for a tougher operating environment and higher long end rates," it said.

That view puts the bank overweight healthcare, real estate, and financials stocks and more constructive within sectors on consumer/business services and "reasonably priced" software," said Wilson. The bank is underweight the consumer discretionary and tech hardware sectors.

Meanwhile, Morgan Stanley strategists in Europe said they are overweight European and Japanese equities and noted potential downside for the S&P 500.

"[We] think that 2022 is really about 'mid-to-late cycle' challenges: better growth squaring off against high valuations, tightening policy, rambunctious investor activity, and inflation being higher than most investors are used to," wrote European analysts led by Andrew Sheets. "Navigating these will be about finding an alignment of risk premiums and fundamentals," which they see existing in Europe and Japanese equities, among other assets.