A Bullish Case for Large Cap U.S. Equities

Summary

Podcast Summary: "A Bullish Case for Large Cap U.S. Equities"

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: A Bullish Case for Large Cap U.S. Equities
• Release Date: June 16, 2025

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Introduction

In the June 16, 2025 episode of "Thoughts on the Market," hosted by Morgan Stanley CIO and Chief U.S. Equity Strategist Mike Wilson, the discussion centers on why Morgan Stanley maintains a more optimistic outlook on large-cap U.S. equities compared to the broader market consensus. Wilson delves into various factors underpinning this bullish stance, highlighting stronger-than-expected earnings projections, sector-specific growth drivers, and favorable macroeconomic conditions.

Earnings Outlook

Wilson begins by underscoring the robust earnings backdrop that differentiates Morgan Stanley's view from the consensus. He states, “We remain more constructive on US equities in the consensus mainly because key gauges we follow are pointing to a stronger earnings backdrop than others expect the next 12 months” (00:30).

Key points include:

• Earnings Growth Projections: Morgan Stanley’s primary earnings model forecasts high single-digit earnings per share (EPS) growth over the coming year. Additionally, a secondary model, which accounts for cost efficiencies, projects mid-teens EPS growth by mid-2026, driven by operational streamlining through artificial intelligence (AI) adoption.

• Earnings Revisions: There has been a significant improvement in earnings revision breadth, shifting from -25% in mid-April to -9% as of the podcast date (01:10). This positive trend indicates increasing confidence in future earnings performance.

• Currency Impact: A notable tailwind for S&P 500 earnings is the weakening U.S. dollar, which has depreciated by 11% from January highs. Morgan Stanley's currency strategists anticipate a further 7% decline over the next year, enhancing earnings, particularly for large-cap companies with substantial international exposure (02:00).

Sector Highlights

Wilson identifies specific sectors poised to benefit from the current economic landscape:

1. Capital Goods:

   • Infrastructure Spending: There is a renewed focus on global infrastructure, driving demand for capital-intensive products. Wilson notes, “The combination of structural tech diffusion and a global infrastructure focus in many countries is leading to a more capital intensive backdrop” (02:30).

   • Capacity Utilization and Loans: Capacity utilization rates have turned positive for the first time in two and a half years, and commercial and industrial loans are climbing, reaching their highest levels since 2020.

   • Incentives for Investment: Bonus depreciation in the U.S. incentivizes equipment investment, directly benefiting capital goods companies.

2. Software:

   • AI-Driven Efficiency: Software companies are well-positioned to enhance free cash flow through generative AI (GenAI) solutions, which offer both revenue growth and cost reductions. Wilson emphasizes, “Software is in a strong position to drive free cash flow via Genai Solutions from both a revenue and cost standpoint” (03:15).

3. Financials:

   • Potential Deregulation: Large-cap financial firms could experience significant benefits from deregulation in the latter half of the year, potentially boosting profitability and growth within the sector.

Risks and Concerns

While the outlook remains positive, Wilson discusses several risks that could impact the bullish case:

1. Long-Term Interest Rates:

   • Interest Rate Sensitivity: A primary risk is the trajectory of long-term interest rates. Despite a favorable consumer price report that helped contain yields, geopolitical tensions have prevented rates from declining further. Wilson remarks, “The 10-year yield remains in close distance of our key 4.5% level above which rate sensitivity should increase for stocks” (04:00).

   • Volatility Trends: On a positive note, interest rate volatility has decreased from its April peaks, now approaching multi-year lows, which could stabilize the investment environment.

2. Underweighted Sectors:

   • Consumer Discretionary Goods: Morgan Stanley maintains an underweight position in consumer discretionary goods due to tariff-related challenges, weaker pricing power, and a late-cycle market backdrop, which historically leads to sector underperformance. Wilson notes, “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” (04:30).

   • Small Caps: The firm also continues to underweight small-cap stocks, which are adversely affected by higher oil prices, persistent interest rates, and the limited benefits from currency translation due to their predominantly domestic operations.

Valuations

A common client concern is the high valuation levels of large-cap U.S. equities. Wilson addresses this by emphasizing the importance of the rate of change in valuations over their absolute levels. He explains, “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” (04:45).

Key insights include:

• Historical Trends: When EPS growth exceeds the historical median of 7% and the Federal Funds Rate decreases year-over-year, the S&P 500’s market multiple has risen 90% of the time, regardless of starting points.
• Forward PE Ratio: Under current conditions, with a forecasted market multiple near 21.5 times, Morgan Stanley views this as conservative. Should valuations increase by 10%, the bullish case for the S&P 500 over the next year becomes highly achievable.

Conclusion

Mike Wilson concludes the episode by reiterating the strong fundamentals supporting large-cap U.S. equities. The combination of favorable earnings growth, sector-specific tailwinds, and manageable risks positions these equities for potential gains. He encourages listeners to consider the structured optimism presented and to engage further by leaving reviews or sharing the podcast with others.

Notable Quotes:

• “We remain more constructive on US equities in the consensus mainly because key gauges we follow are pointing to a stronger earnings backdrop than others expect the next 12 months.” (00:30)
• “Software is in a strong position to drive free cash flow via Genai Solutions from both a revenue and cost standpoint.” (03:15)
• “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.” (04:30)
• “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.” (04:45)

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This comprehensive summary captures the essence of Morgan Stanley’s bullish outlook on large-cap U.S. equities, providing insights into earnings projections, sector performance, risk factors, and valuation considerations. It serves as a valuable overview for those who have not listened to the original podcast episode.

Transcript

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley 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 US 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 US equities in the consensus mainly because key gauges we follow are pointing to a stronger earnings backdrop than others expect 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 minus 25% in mid April to negative 9% 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% from the January highs. As a reminder, our currency strategists expect another 7% downside over the next 12 months. The combination of a stronger level of earnings revisions breath and a robust rate of change on earnings revisions breath 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 US should be another tailwind here as it incentivizes a pickup in equipment investment benefiting 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 deregulation 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% 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% and the Fed funds rate is down on a year over year basis, The S&P 500's market multiple is up 90% of the time regardless of the starting point. In fact, when these conditions are met, The S&P's forward PE ratio has risen by 9% on average. Therefore, our forecast for the market multiple to stay near current levels of 21.5 times could be viewed as conservative. Should history repeat and valuations rise 10%, 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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