While market sentiment on U.S. large caps turns cautious, our
Chief CIO and U.S. Equity Strategist Mike Wilson explains why
there's still room to stay constructive.
Read more insights from Morgan Stanley.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief U.S. Equity Strategist. Today
on the podcast, I’ll be discussing why we remain
more constructive than the consensus on large cap U.S.
equities – and which sectors in particular.
It's Monday, June 16th at 9:30am in New York.
So, let’s get after it.
We remain more constructive on U.S. equities than the consensus
mainly because key gauges we follow are pointing to a stronger
earnings backdrop than others expect over the next 12 months.
First, our main earnings model is showing high-single-digit
Earnings Per Share growth over the next year. Second,
earnings revision breadth is inflecting sharply higher from -25
percent in mid-April to -9 percent today. Third, we
have a secondary Earnings Leading model that takes into account
the cost side of the equation; and that one is forecasting
mid-teens Earnings Per Share growth by the first half of
2026. More specifically, it’s pointing to higher
profitability due to cost efficiencies.
Interestingly, this was something we heard frequently last week
at the Morgan Stanley Financials Conference with many companies
highlighting the adoption of Artificial Intelligence to help
streamline operations. Finally, the most underappreciated
tailwind for S&P 500 earnings remains the weaker dollar which
is down 11 percent from the January highs. As a reminder, our
currency strategists expect another 7 percent downside over the
next 12 months.
The combination of a stronger level of earnings revisions breadth
and a robust rate of change on earnings revisions breadth since
growth expectations troughed in mid-April is a powerful tailwind
for many large cap stocks, with the strongest impact in the
Capital Goods and Software industries.
These industries have compelling structural growth drivers. For
Capital Goods, it’s tied to a renewed focus on global
infrastructure spending. The rate of change on capacity
utilization is in positive territory for the first time in
two and a half years and aggregate commercial and industrial
loans are growing again, reaching the highest level since 2020.
The combination of structural tech diffusion and a global
infrastructure focus in many countries is leading to a more
capital intensive backdrop. Bonus depreciation in the U.S. should
be another tailwind here – as it incentivizes a pickup in
equipment investment, benefitting Capital Goods companies
most directly. Meanwhile, Software is in a strong position
to drive free cash flow via GenAI solutions from both a revenue
and cost standpoint.
Another sector we favor is large cap financials which could start
to see meaningful benefits of de-regulation in the second half of
the year. The main risk to our more constructive view remains
long term interest rates. While Wednesday's below consensus
consumer price report was helpful in terms of keeping yields
contained, we find it interesting that rates did not fall on
Friday with the rise in geopolitical tensions. As a result, the
10-year yield remains in close distance of our key 4.5 percent
level, above which rate sensitivity should increase for stocks.
On the positive side, interest rate volatility is well off its
highs in April and closer to multi-year lows.
Our long-standing Consumer Discretionary Goods underweight is
based on tariff-related headwinds, weaker pricing power and
a late cycle backdrop, which typically
means underperformance of this sector. Staying
underweight the group also provides a natural hedge should oil
prices rise further amid rising tensions in the Middle
East. We also continue to underweight small caps which are
hurt the most from higher oil prices and sticky interest
rates. These companies also suffer from a weaker dollar via
higher costs and a limited currency translation benefit on the
revenue side given their mostly domestic
operations.
Finally, the concern that comes up most frequently in our client
discussions is high valuations. Our more sanguine view
here is based on the fact that the rate of change on valuation is
more important than the level. In our mid-year outlook,
we showed that when Earnings Per Share growth is above
the historical median of 7 percent, and the Fed Funds Rate
is down on a year-over-year basis, the S&P 500's market
multiple is up 90 percent of the time, regardless of the starting
point.
In fact, when these conditions are met, the S&P's
forward P/E ratio has risen by 9 percent on average. Therefore,
our forecast for the market multiple to stay near current levels
of 21.5x could be viewed as conservative. Should history repeat
and valuations rise 10 percent, our bull case for the
S&P 500 over the next year becomes very
achievable.
Thanks for tuning in; I hope you found this episode informative
and useful. Let us know what you think by leaving us a
review; and if you find Thoughts on the Market worthwhile, tell a
friend or colleague to try it out!
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