Morgan Stanley CIO details AI-era stock picks and defensive plays


Morgan Stanley’s investment chief and head U.S. equity strategist Mike Wilson has been one of Wall Street’s biggest bears over the past two years. And despite missing the mark with many of his more pessimistic forecasts in 2023, he remains concerned about the stock market’s potential for returns moving forward.

By this time next year, Wilson believes the S&P 500 won’t have moved much at all, rising just 2% to 4,500. The slowing effect of years of inflation and rising interest rates will ultimately depress the economy and corporate earnings in 2024, the Wall Street veteran warns, and that will lead to some pain for stocks.

It’s an outlook that means investors in broad market indexes might not make much of a profit next year, but Wilson laid out a few ways they can juice their returns in a Monday note to clients. He highlighted traditional defensive stocks in the consumer staples and healthcare sectors that should perform well if a recession hits, as well as “late cycle cyclical” plays in the energy and transportation sectors. And surprisingly, Wilson also detailed some “select growth opportunities,” particularly in AI, that could offer long-term potential despite his near-term bearishness.

“The leading macro data suggests that we’re in a late cycle market environment,” he explained, referring to the period before a recession. But it’s also a “stock-picking environment.”

Near-term earnings headwinds—and a stock pickers’ market

Before jumping into Wilson’s sector and stock picks for 2024, it’s important to detail the reasoning behind his mostly bearish outlook. First, Wilson noted that the economy and stock market were more resilient in 2023 than he anticipated. In January, the CIO predicted corporate profit margins would deteriorate and the economy would struggle under the weight of rising interest rates and inflation, leading the S&P 500 to end 2023 at 3,900. But that’s a far cry from Monday’s level above 4,400.

“The path of earnings growth for the S&P 500 has proven to be lower directionally this year, but we were too bearish in terms of expected magnitude of the decline,” he admitted Monday. 

However, Wilson attributed the surprising strength in the market to the outperformance of big tech stocks that did an “outstanding job on cost discipline and taking share in an economy supported by aggressive fiscal spending.”

Big Tech’s rise has helped the S&P 500 recover from a dismal 2022 even amid a broad earnings recession for most public companies, which are still struggling with inflation and rising borrowing costs. But Wilson warned that this is typical “late cycle behavior.”

“The question for investors at this stage is whether the leaders can drag the laggards up to their level of performance or if the laggards will eventually overwhelm the leaders’ ability to keep delivering in this challenging macro environment,” he wrote.

Wilson hinted that his view is the market’s laggards overwhelming their Big Tech leaders is a more likely scenario, noting that fourth-quarter earnings estimates for both Big Tech and the overall market are declining—“an early indication of continued downside for 2024 consensus estimates.” He fears that consumer spending will also begin to slow as fiscal stimulus from the pandemic era fades and the impact of the Federal Reserve’s interest rate hikes over the past 20 months weigh on “both corporate and consumer sentiment.”

The good news is that near-term uncertainty should give way to an “earnings recovery” in 2024 as the Fed cuts rates, but it won’t be enough to give investors the returns they’ve become accustomed to in recent decades. Wilson’s 2% expected annual return is far from the nearly 7% average the S&P 500 has managed since 2000.

Of course, not everyone is so bearish. The veteran strategist Ed Yardeni, founder of Yardeni Research, believes the S&P 500 will soar over 22% to 5,400 by year-end 2024. And UBS sees the index rising to 4,600, slightly ahead of Morgan Stanley’s outlook.

Still, with increased odds of a weak year in the stock market, Wilson said that 2024 could be the year of the stock picker. Investing in broad indexes is likely to be ineffective, but after the decline in many equities in 2023, there is a “richer opportunity set under the surface of the market” in individual stocks with compelling valuations. “We think it’s prudent to deploy a stock picking approach,” he wrote.

Defensive names, late-cycle cyclical plays, and AI-era picks 

When it comes to stock picks, with a recession potentially on the way, Wilson believes investors should look to classic defensive stocks. These are companies that offer critical services that aren’t as affected by economic cycles, including consumer staples and healthcare. Even in the worst of times, Americans will still need to buy toothpaste and visit the doctor. And evidence shows that they’ll keep smoking—or even smoke more—too. Here’s Morgan Stanley’s full list of traditional defensive stocks for 2024.

In the period before a recession hits, so-called “late cycle cyclical” stocks also tend to outperform their peers. With that in mind, Wilson highlighted airlines, oil and gas giants, and aerospace and defense leaders that could outperform in 2024. 

However, he also offered a caveat: the list of late cycle cyclicals will begin to underperform traditional defensive plays in 2024 if a recession does hit, as Morgan Stanley expects, so investors should keep that in mind.

Finally, Wilson threw in a curve ball for investors. While growth stocks don’t usually perform well during periods of rising interest rates or recessions, the AI trend is too big to ignore. Wilson noted that the technology is likely to boost corporate margins and worker productivity. “Our analysts see AI-based innovation creating new digital consumer use cases, driving incremental enterprise top-line and efficiency opportunities, and fostering tech diffusion across the economy,” he explained. 

On top of that, if a recession does hit in 2024, it will likely lead the Fed to cut interest rates. And growth stocks tend to outperform during periods when interest rates are falling, even if it is a new era of higher rates overall.

The “pivot to more accommodative monetary policy should be constructive for equities,” Wilson wrote, adding that “relief on interest rates as we progress through next year should also aid corporate and household sentiment which has remained subdued.”

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