Intro

Morgan Stanley’s CIO and Chief U.S. Equity Strategist Mike Wilson joins Andrew Pauker of the U.S. Equity Strategy team to break down the key issues for equity markets ahead of 2025, including the impact of potential deregulation and tariffs.

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Mike Wilson: Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist.

Andrew Pauker: And I'm Andrew Pauker from our US Equity Strategy Team.

Mike Wilson: Today we'll discuss our 2025 outlook for US equities.

It's Tuesday, November 26th at 5pm.

So let's get after it.

Andrew Pauker: Mike, we're forecasting a year-end 2025 price target of 6,500 for the S&P 500. That's about 9 percent upside from current levels. Walk us through the drivers of that price target from an earnings and valuation standpoint.

Mike Wilson: Yeah, I mean, I think, you know, this is really just rolling forward what we did this summer, which is 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. What 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 percent; 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 percent 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 earnings rates are going to come down. So, then we basically can get all of the appreciation from our earnings forecast for about, you know, 10-12 percent; a little bit of a discount from multiples, that gets you your 9 percent upside.

I just want to, you know, make sure listeners understand that the macro-outcomes are still very uncertain. And so just like this year, you know, we maybe pivot back and forth throughout the year … as [it] becomes [clear], you know, 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.

Andrew Pauker: There are a number of new policy dynamics to 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?

Mike Wilson: Yeah, and I think a lot of this started to get discounted into the markets this fall, you know, the prediction polls were kinda leaning towards a Republican win, starting really in June – and it kind of went back and forth and then it really picked up steam in September and October. And the thing that the markets, 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 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 obviously got a tweet last night from President-elect Trump, and it was, you know, 10 percent additional tariffs on certain things. And there’s just a lot of confusion. Some stocks sold off on that. But remember a lot of stocks rallied yesterday on the news of Scott Bessent being announced as Treasury Secretary because he's maybe not going to be as tough on tariffs.

So, what I view the next two months as is 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, you know, 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 can 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.

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.

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, you know, aggressively begin a new rate cutting cycle with 50 basis points, which was a bit of a surprise given, you know, the context of a still decent labor markets.

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? 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 in 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 lever to kind of this, power deficiency within the United States. And that, of course with deregulation, a new twist on that could be things like natural gas, deployment of, you know, 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 column, and why it's not just, you know, about the election and kind of a rotation, but there's actually fundamental drivers here.

Andrew Pauker: Yeah, 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 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 on demand – and 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?

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, which is 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, you know, 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 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 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 it 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 is because scale really matters in this crowded out, sort of environment.

If that changes, that creates opportunity at the stock level and that broadening out, which is a much healthier bull market potential.

So, what are you hearing from investors, Andrew?

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 – kind 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 wallet 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.

Those are all factors that 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.

Mike Wilson: That's great, Andrew. Thanks a lot. Thanks for taking the time to talk today.

Andrew Pauker: Thanks, Mike. Anytime.

Mike Wilson: 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.