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!
