Source: Morgan Stanley “2025 US Equities Outlook: Stay Nimble Amid Changing Market Leadership”
Since the COVID - 19 pandemic, growth and inflation data have become more volatile and unpredictable. Recently, market internals have shifted from pricing a reflationary outcome in the spring, to a growth risk scenario in the summer, and to a backdrop of reaccelerating growth today. We have endeavored to capture these rotations. We emphasized a defensive bias over the summer and shifted our preference to quality cyclicals in early October. Going forward, investors need to be nimble in response to changes in market leadership, especially considering the uncertainty introduced by the election outcome. Therefore, we maintain a relatively wide range of bull - and - bear price targets, with a base case of 6,500, a bull case of 7,400, and a bear case of 4,600.
Raising the Base Case Target Price to 6,500
In the base case, we forecast a 21.5x P/E multiple on 12 - month forward (2026) EPS of US $303, corresponding to a forward 12 - month price target of 6,500. A healthy mix of mid - single - digit revenue growth and margin expansion is expected to drive EPS growth of 13% and 12% in 2025 and 2026, respectively. As the Fed cuts rates and business cycle indicators improve, earnings growth is expected to continue broadening. A potential increase in corporate animal spirits post - election could lead to a more balanced earnings profile across the market. Given above - average earnings growth and accommodative monetary policy, the market multiple is likely to remain elevated relative to history, although significant compression is less likely. However, valuation may be volatile due to factors such as policy, interest rates, and geopolitics. The median stock multiple of the S&P 500 is less extended at 19.0x and should stay supported if the earnings recovery broadens out as expected.
Investment Recommendations
1. Remain Bullish on Quality Cyclicals: Fed rate cuts and stabilizing macro indicators support the outperformance of this cohort. The outcome of the US election is expected to lead to a lighter regulatory environment and a rebound in animal spirits, which will further benefit this group, with financials being particularly favored.
2. Underweight Selected Sectors: Given potential tariff risks and limited pricing power, we continue to underweight consumer discretionary goods stocks. Additionally, as the market leadership shifts away from defensives, we also underweight consumer staples.
3. Tech Sector Differentiation: Within the technology sector, relative earnings revisions suggest that software stocks have the potential to catch up and outperform semiconductor stocks.
4. Stance on Small and Large Caps: Due to the negative correlation of small caps with interest rates and weaker relative earnings revisions, we maintain a neutral stance on small versus large caps for now.
Market Outlook Under Different Scenarios
Bullish Scenarios
1. Successful Policy - Driven Fiscal Consolidation: If government spending cuts proceed as expected, although it may initially weigh on economic growth, in the long run, it could reduce the crowding - out effect on businesses and foster the growth of the private economy. Interest rates may decline, and the P/E ratio could remain high. Earnings growth is expected to accelerate in 2026, with a broader market participation. Funds may flow from large - cap stocks to other sectors that benefit from this shift, driving the index higher.
2. Rebound in Animal Spirits Fuels Organic Growth: The significant increase in interest rates in 2022 had a broad - reaching impact on growth. Multiple factors have helped the economy avoid a hard landing. Looking ahead, a rebound in animal spirits is expected to drive up the ISM index, accelerate industrial production and consumption growth, and improve the labor market. Fed rate cuts will further boost confidence, spurring corporate investment and hiring. Earnings growth is projected to be robust in 2026, accompanied by valuation expansion. Notably, software stocks are expected to benefit from the development of AI, contributing to the overall index valuation increase.
Bearish Scenarios
1. Risk of Economic Hard Landing/Recession: Although economists predict a soft landing, several risk factors remain. Reduced fiscal support, high interest rates, a slowing labor market, and changes in tariff and immigration policies could potentially trigger a recession. The New York Fed's recession model, based on the yield curve, indicates an elevated risk of recession. While fiscal dominance may have postponed the recession, the waning of stimulus effects and cooling consumer demand increase the likelihood of a downturn. Although the labor market appears stable currently, there are potential risks, such as changes in immigration policies that could affect labor supply and a possible reduction in government hiring that might lead to higher unemployment. The market may not have fully priced in these risks.
2. High Interest Rates Pressure Valuation: If the rebound in animal spirits accelerates economic activity, inflation could rise unexpectedly. This might force the Fed to halt or reverse its rate - cutting cycle, or concerns about fiscal sustainability could drive up the term premium, putting downward pressure on stock valuations. Although the compression may not be as severe as in 2022, the market could still experience a 15 - 20% decline.
Sector - Specific Investment Strategies
Financials
We upgraded financials in early October due to reduced risks entering the earnings season, accelerating capital markets activity, attractive relative valuation, and favorable positioning. Post - election, expectations of deregulation are expected to further boost their performance. Our large - cap bank analysts predict a significant pickup in capital markets activity. Earnings revisions have been positive, and relative valuation remains appealing. The Senior Loan Officer Survey also indicates an improvement in C&I loan growth in 2025.
Industrials
We are overweight industrials as part of our pro - cyclical investment strategy. US reshoring is a positive factor for the sector, with companies like ETN and ROK expected to benefit. Trump's policies, such as tariffs, could drive investment in certain industries. In the freight sector, while the election was not seen as a major catalyst for restocking by most respondents, some companies are considering increasing inventory ahead of potential tariffs. We have identified several industrial stocks that could gain from the election outcome.
M&A Targets
We anticipate a cyclical and structural rebound in M&A activity. Global M&A announcements have been increasing, and we expect a significant pickup in 2025, driven by factors such as high stock market levels, economic soft landing, lower interest rates, and growing corporate confidence. Our bottom - up analyst survey also supports this expectation. We have used a quantitative model, ALERT, to screen for stocks likely to receive tender offers. These stocks span various sectors and offer potential investment opportunities.
Software (in the Tech Sector)
Within the technology sector, we have a preference for software stocks, especially on an equal - weighted basis. Although software stocks underperformed in 2024, we believe revisions are bottoming out. Our TMT team's CIO Spending Survey shows that software is the top spending category for 2025, and a rebound in business confidence post - election should further boost the spending environment. Fundamentally, software stocks are trading at historically low valuations and are expected to rebound in earnings in 2025. In the long term, the development of AI is expected to benefit software stocks, and their relative earnings revisions suggest catching - up potential.
High - Quality Small and Mid - Caps (with Resistance to Interest Rate Risks)
After taking profits in large caps in early October, we turned neutral on small vs. large caps. While small caps offer stock - picking opportunities, they currently exhibit a negative correlation with interest rates and weaker relative earnings revisions compared to 2016. We have screened for small - cap stocks that are cyclical, of high quality, and less sensitive to interest rates. These stocks could benefit from potential market broadening, but investors should closely monitor macro data and earnings revisions to gauge the timing of a broader rally in small - cap indices.