← Thoughts on the Market
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Narrator
2024 was a year of transition for economies and global markets. Central banks began easing interest rates, US Elections signaled significant policy change, and generative AI made a quantum leap in adoption and development. Thank you for listening throughout 2024 as we navigated the issues and events that shape financial markets and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world this week. Please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January from all of us at Thoughts on the Market Happy Holidays and a very happy New Year.
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Mike Wilson
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and chief U.S. equity strategist.
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Andrew Pauker
And I'm Andrew Pauker from our U.S. equity strategy team.
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Mike Wilson
Today we'll discuss our 2025 outlook for U.S. equities. It's Tuesday, November 26th at 5:00pm so let's get after it.
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Andrew Pauker
Mike we're forecasting a year end 2025 price target of 6,500 for the S&P 500. That's about 9% upside from current levels. Walk us through the drivers of that price target from an earnings and valuation standpoint.
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Mike Wilson
Yeah, I mean I think, you know, this is really just rolling forward what we did this summer which is, you know, we started to incorporate our economists soft landing views and of course our rate strategist view for 10 year yields which you know, factors into valuation. We really didn't change any of our earnings forecast. That's where we've been very accurate. Where we've been not accurate is on the multiple and I think a lot of clients have also investors have been probably a little bit too conservative on their multiple assumption. And so we went back and looked at, you know, periods when earnings growth is above average, which is what we're expecting. And that's just about 8% if anything north of that. Plus when the Fed is actually cutting rates, which was not the case this past summer, it's just very difficult to see multiples go down. So we actually do have about 5% depreciation in our multiple assumption on a year over year basis. But still it's very high relative to history. But if the base case plays out, but from an economic standpoint and from a rate standpoint, it's unlikely rates are going to come down. So then we basically can get all the appreciation from our earnings forecast for about, you know, 10, 12%, a little bit of a discount for multiple that gets your 9% upside. I just want to make sure listeners understand that the macro outcomes are still very uncertain. And so just like this year, we maybe pivot back and forth throughout the year as becomes what the outcome is actually going to be. For example, growth could be better, growth could be worse, rates could be higher. The Fed may not cut rates. They may have to raise rates again if inflation comes back. So I would just, you know, make sure people understand it's not going to be a straight line no matter what happens. And we're going to try to navigate that with, you know, our style sector picks.
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Andrew Pauker
So there are a number of new policy dynamics that think through post the election that may have a significant impact on markets as we head into 2025. Mike, what are the potential policy changes that you think could be most impactful for equities next year?
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Mike Wilson
Yeah, and I think a lot of this started to get discounted into the markets this fall. I don't think it's a mystery to say that the prediction polls were kind of leaning towards a Republican win starting in really June. And then it kind of went back and forth and then it really picked up steam in September and October. And the things that the market, equity market are most excited about, I would say, is this idea of deregulation. You know, that's something President Elect Trump has talked about. The Republicans seem to be on board with that. That's sort of business friendly, if you will, kind of a repeat of his first term. I would say on the negative side, what markets are maybe wary about, of course, is tariffs. But here there's a lot of uncertainty, too. We just got a tweet yesterday from President elect Trump talking about maybe another 10% on top of the tariffs he was proposing. Originally, some stocks sold off on that. But remember, a lot of stocks rallied yesterday on the news of Scott Bessen being announced as Treasury Secretary because he's maybe not going to be as tough on tariffs. So when I view the next two months as sort of a trial period where we're going to see a lot of announcements going out and then the people in the cabinet positions who are appointed along with the president elect are going to look at how the market reacts and they're going to want to try to think about that in the context of how they're going to propose policy when they actually take office. So a lot of volatility over the next two months as these announcements are kind of floated out there as trial balloons. And then of course, you also have the enforcement of immigration and the impact there on growth and also labor supply and labor costs. And that could be a net negative in the first half of next year. And so look, it's going to be about the sequencing. Those are the two easy ones that you could see, tariffs of some form and of course, immigration enforcement. And those are probably the two biggest potential negatives in the first half of next year.
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Andrew Pauker
Mike, the title of our outlook is stay nimble amid changing market leadership. And I think that reflects our mentality when it comes to remaining focused on capturing the leadership changes under the surface of the market. We rotated from a defensive posture over the summer to a more pro cyclical stance in the fall. Talk about our latest views when it comes to positioning across styles, themes and sectors here.
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Mike Wilson
Yeah, I mean, you know, you have to understand that that pivot was not about the election as much as it was about kind of the economy moving from the risk of a hard landing, which people were worried about this summer, to soft landing again. And then of course, we got the Fed to aggressively begin a new rate cutting cycle with 50 basis points, which was a bit of a surprise given the context of a still decent labor market. So that was the main reason for kind of the cyclical pivot. And then of course, the election outcome sort of turbocharges some of that. So that's why we're sticking with it for now. So to be more specific, what we basically did was we went to quality cyclical rotation. What does that mean? Well, it means, you know, we prefer things like financials, maybe industrials, kind of a close second from a sector standpoint. But this quality feature we think is important for people to consider because interest rates are still pretty high. You know, balance sheets are still a little stretched and you know, price levels are still high. So that means that lower quality businesses and the stocks of those lower quality businesses are probably a higher risk than we want to assume right now. But going into year end first and then 2025, we're going to stick with what we've sort of been recommending on the defensive side. We didn't abandon all of them because of, you know, we don't know how it's going to play out. So we kept utilities as an overweight because it has some offensive properties as well. Most notably levered to kind of this power deficiency within the United States and that, you know, of course with deregulation, a new twist on that could be things like natural gas deployment of natural gas resources, which would help pipelines, LNG facilities potentially, and also new ways to drive electricity production. So with that, Andrew, why don't you maybe dig in a little bit deeper on our financials call and why it's not just, you know, about the election and kind of a rotation, but there's actually fundamental drivers here. Yeah.
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Andrew Pauker
So financials remains our top sector pick following our upgrade in early October. And the drivers of that view are a rebounding capital markets backdrop, strong earnings revisions, and the potential for an acceleration in in buybacks into next year and then post the election expectation for deregulation can also continue to drive performance for the sector in addition to those fundamental catalysts. And then finally, even with the outperformance that we've seen for the group over the last month and a half or so, relative valuation remains undemanding in kind of the 50th percentile of historical levels. So, Mike, I want to wrap up by spending a minute on investor feedback to our outlook. Which aspects of our view have you gotten the most questions on? Where do investors agree and where do they disagree?
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Mike Wilson
Yeah, I mean, it's sort of been ongoing because as we noted, we really pivoted more constructively on kind of a pro cyclical basis a while ago. And the pushback then is the same as it is now. It's just that equities are expensive. And I mean, quite frankly, the reason we pivoted to some of these more cyclical areas is because they're not as expensive. But that doesn't take away from the fact that stocks are pricey. And so people just want to understand this analysis that we did this time around, which kind of just shows why multiples can stay higher. They do appreciate that, you know, things can change. So, you know, we need to be, you know, cognizant of that. I would say there's also debate around small caps. You know, we're neutral on small caps. We upgraded that about the same time after having been underweight for several years, I think, you know, people really want to get behind that. It's been a, it's been a trade that people have gotten wrong repeatedly over the last couple of years trying to buy small caps. This time it seems like there may be some more behind it. We agree. That's why we went to neutral. And I think, you know, there are people who want to figure out, well, why, why don't we go overweight now? And what we're really waiting for is for rates to come down a bit more. It's still sort of a late cycle environment. So, you know, typically you want to wait until, you know, you kind of see the beginnings of a new acceleration in the economy. And that's not what our economists are forecasting. And then the other area is just this debate around government efficiency. And this is where I'm actually most excited because this is not priced at all in my view. There's so much skepticism around the ability or, you know, the likelihood of success in shrinking the government. That's not really what we're, you know, hoping for. We're just hoping for kind of a freezing of government spending. And it's so important to just to think about that way because that's what the fiscal sustainability question is all about, where then rates can stay contained. But then if you take it a step further, you know, our view for the last several years has been that the government has been essentially crowding out the private economy and that really has punished small medium businesses as well as many consumers. And so by shrinking or at least freezing the size of the government and redeploying those efforts into the private economy, we could see a very significant increase in productivity but also see a broadening out in this rally. I mean one of the reasons the market's been equity market's been so narrow is because scale really matters in this crowded out sort of environment. If that changes, that creates an enormous amount of opportunity at the stock level and that broadening out, which is a much healthier bull market potential. What are you hearing from investors, Andrew?
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Andrew Pauker
Yeah, I mean I think the debate now, in addition to the factors that you mentioned, is really around the consumer space. A lot of pessimism is in the price already for consumer discretionary goods on the back of wallet share shift from goods to services, high price levels and sticky interest rates in addition to the tariff risk. So what we did in our note this week is we laid out a couple of drivers that could potentially get us more positive on that cohort and those include a reversion in terms of the wall share shift actually back towards goods. I think that would be a function of lower price levels, lower interest rates. Our rate strategists expect the 10 year yield to fall to 355 by year end 2025. So that would be a constructive backdrop for some of the more interest rate sensitive and housing areas within consumer discretionary. The those are all factors that we're watching closely in order to get more constructive on that space. But that is another area of the market that I have received a good amount of questions on.
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Mike Wilson
That's great. Andrew, thanks a lot. Thanks for taking the time to talk today.
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Andrew Pauker
Thanks Mike.
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Mike Wilson
Anytime and thanks for listening. If you enjoy thoughts on the market Please leave us a review wherever you listen and share the podcast with a friend or colleague today.
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Disclaimer Speaker
The preceding content is informational only and based on information available when creating created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.