Morgan Stanley told clients that strong fundamentals continue to support small-cap stocks, even as expectations for Federal Reserve rate cuts this year fall.
Equity strategist Michael Wilson said investors should “stick with small caps despite the falling cumulative probability of Fed rate cuts.” He noted that earnings strength is now the main driver of performance.
Small-cap earnings growth is at its highest level since 2022, rising 8% year-on-year after a -8% decline last year. Morgan Stanley also highlighted that earnings revisions for small caps have accelerated relative to large caps, helping the group break out of a multi-year downtrend.
The bank noted that small-cap returns are now largely uncorrelated with real interest rates, meaning yields matter less than earnings.
Morgan Stanley’s sector preferences for small caps remain the same, including discretionary goods, regional and mid-cap banks, shorter-cycle industrials, and SMID-cap biotech.
Looking at earnings season, Wilson expects an above-average EPS beat rate of 5% or more for the S&P in Q4. He emphasized that strong revenue and profit beats will be needed to drive meaningful stock price moves.
The firm also addressed speculation about the next Federal Reserve chair. Despite Kevin Warsh being seen as a more hawkish choice, small caps and rate-sensitive cyclicals have generally outperformed, reinforcing the view that strong fundamentals are the key factor behind recent gains.
