Morgan Stanley sees improving fundamentals driving small-cap outperformance

Investing.com -- Morgan Stanley told clients in a recent note that improving fundamentals continue to support small-cap equity outperformance, even as the market pares back expectations for Federal Reserve rate cuts this year.

Equity strategist Michael Wilson said investors should “stick with small caps despite the falling cumulative probability of Fed rate cuts,” arguing that earnings strength is now the dominant driver.

According to Wilson, small-cap earnings growth is at its strongest level since 2022, with the strategist noting it has risen 8% year-on-year, up from -8% a year ago.

The firm added that “relative earnings revisions breadth versus large caps accelerated further last week as the group broke out of a multi-year relative performance downtrend.”

The bank emphasized that the correlation between small-cap returns and real rates is now “around 0,” meaning yields are “less of an important determinant right now; it’s more about earnings.”

Morgan Stanley’s existing sector preferences apply to small caps, highlighting Discretionary Goods, regional and mid-cap banks, shorter-cycle industrials and SMID-cap biotech.

On earnings season, Wilson expects “an above-average (5%+) EPS beat rate for the S&P in 4Q,” though they stressed that both revenue and profit beats will be needed to generate meaningful share price reactions.

He also addressed recent speculation around the next Federal Reserve chair. Despite expectations that Kevin Warsh would be a more hawkish choice, Morgan Stanley noted that “small caps and more rate sensitive cyclicals have generally outperformed” as his odds increased, reinforcing the firm’s view that strengthening fundamentals are driving performance.

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