- Stimulus or not, a V-shaped economic recovery is full steam ahead, says Morgan Stanley's Mike Wilson.
- In a recent note, the chief investment officer and chief US equity strategist laid out five trades investors can make to capitalize on the early-cycle activity.
- Visit Business Insider's homepage for more stories.
As the global economy began to awaken from its slumber this summer amid eased government lockdowns, many on Wall Street started to recommend investors look increasingly toward cyclical stocks, which benefit from early-cycle activity.
But as fiscal support in the US from the first economic stimulus package began to evaporate in August, faith in the health of the economic recovery began to wane. Without more stimulus, the economy would sputter. That shift into cyclicals? Forget about it.
"Our economists will admit that this forecast hinges on additional fiscal action, especially 'CARES 2.0' in the US," said Morgan Stanley strategist Andrew Sheets in a September note. "With it, growth could surprise to the upside. Without it, our numbers could face a material downgrade."
"For markets, we need to balance a story of continued recovery with prices that clearly reflect more optimism, as well as the fact that our forecasts are unusually dependent on a single event (CARES 2.0)," Sheets added.
Now, that narrative seems to have changed.
In his weekly note, Mike Wilson — Morgan Stanley's chief investment officer and chief US equity strategist — said the bank's economists now believe the economic recovery is strong enough for the time being without stimulus, and that they expect 5.5% year-over-year real gross domestic product growth throughout 2021.
"Our economists believe there is enough momentum in the recovery to keep the US economy on pace to return to pre-Covid (4Q19) levels of real GDP by the middle of next year," Wilson said. "Bottom line, a near term fiscal deal would be nice insurance but not necessary for economic recovery to continue."
The chart below shows this dynamic in action. It reflectcs the degree to which manufacturing activity has rebounded, along with a similar increase in cyclical stock returns, relative to their defensive counterparts.
Even if a deal isn't reached before the November election, the increasing likelihood of a Democratic sweep means a robust stimulus package is probably on its way within months, Wilson said.
With that established, he laid out five trades — which he said "should all prove to be money makers over the next 3-6 months no matter what the outcome of the election and a second wave of the virus" — that investors should begin making as the economic recovery marches on.
5 trades to make to benefit from the economic recovery
Though Wilson conceded that the month ahead may be rocky with the election coming into view, he first recommended investors look toward cyclical stocks and away from defensive stocks and growth stocks with high price multiples.
"A rebounding economic environment tends to foster outperformance of cyclically geared equities. We believe this cycle is no different," Wilson said. "Cyclicals are off of their relative lows, but remain well below trend based on this relationship, implying there is still more upside for cyclical stocks relative to defensive ones even in the absence of a fiscal deal in the near term."
Those looking for exposure to cyclical stocks might consider cyclical-focused exchange-traded funds like the Consumer Discretionary Select Sector SPDR Fund (XLY) or the Vanguard Industrials Index Fund (VINAX).
Second, he suggested investors favor small-cap stocks compared to large-caps.
"Our call for a stronger rebound in small caps earnings is playing out," Wilson said. "They have seen numbers revised up 16.6% vs 1.8% for large caps. They saw sharper cuts to their numbers in the wake of the pandemic and it makes sense to us that they will see a more powerful recovery."
The iShares Core S&P Small-Cap ETF (IJR) offers exposure to small-cap stocks.
Wilson also recommended allocating portfolios to be equal weight the S&P 500 instead of weighted by market cap, as expensive growth stocks like the FAANMGs make up a disproportionate percentage of the index's market cap.
Fourth, Wilson suggested looking to back-to-work stocks instead of work-from-home winners as economic activity and work life resumes some form of normal.
Finally, he recommended stocks with operating leverage in earnings into next year.
"We believe many analysts are still underestimating the magnitude of operating leverage next year as the economy reopens and cost saves from this year's actions to flow to the bottom line," Wilson said.
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