Citigroup Inc. and Morgan Stanley strategists are split over whether earnings can provide the much-needed fuel for U.S. equities in the second half of the year.

Battered U.S. stocks are likely to rally in the remainder of 2022 as corporate earnings remain resilient to surging inflation and slowing economic growth, according to Citi.

"Current risk-off positioning and second-half earnings resilience set up for a mean reversion trade higher into year end," Citi strategists led by Scott T. Chronert wrote in a note on Friday. They expect the S&P 500 to finish this year at 4,200, about 7.7% higher from the latest close and a 12% drop for the full year.

This view stands in sharp contrast to that of Morgan Stanley's Michael J. Wilson, one of Wall Street's most vocal bears, who says that U.S. earnings face another "massive headwind" from a surging dollar and expects the recent rally in stocks to fizzle out. Wilson says the S&P 500 bear market will continue, and sees fair value at 3,400-3,500 in case of a soft landing and 3,000 in a recession, 23% downside from the Friday close.

Citi strategists see the U.S. economy remaining resilient in the second half, and say the recession risk is more likely in early to mid-2023. They point out that there's a strong correlation between the Federal Reserve's rate trajectory and earnings growth, and in the past it's been common for earnings to rise as the Fed tightens its policy and to contract as the Fed switches to easing in response to economic weakness.

"The inflation surge beginning about this time a year ago has mostly been an incremental positive for earnings growth," strategists wrote. "We don't expect a new structural paradigm at this point, but do think that current earnings tailwinds can continue in the immediate term."

U.S. stocks have slumped this year as a toxic mix of surging prices and hawkish Federal Reserve fueled fears of an economic recession. The S&P 500 has attempted to rebound after falling into a bear market, but gains have been capped by fears that the second-quarter earnings season, which kicks off this week, will show sharp cuts to company guidance amid a deteriorating consumer outlook.

"Any combination of slowing economic activity, decelerating inflation reads, or a pause in expected Fed path would trigger a stronger finish to the year," Citi strategists said.

Sagarika Jaisinghani reports for Bloomberg News.

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