Expect corporate earnings growth to peak in the first half 2018, as economic growth decelerates, according to equity strategists at Morgan Stanley (MS). They do not envision a recession starting in 2018, but growing anticipation of a recession in 2019 probably will result in "narrower breadth and bigger drawdowns" among stocks, along with more volatility, as 2018 progresses.

They also indicate that "credit markets may be topping now, which tends to be a good 6-12 month leading indicator for stocks." (For more, see also: Vanguard Sees 70% Chance of Correction, Erasing 2017 Returns.)

In 2017, "risk-adjusted returns [were] almost absurdly good," and thus are likely to change in 2018, per Morgan Stanley's November 27 report, "2018 US Equity Outlook: Attention! Road Ahead Narrows." Their new base case for the S&P 500 Index (SPX) is to reach 2,750 by year-end, only 4.4% above Thursday's open. In fact, Morgan Stanley indicates that this target, which would represent the high for the year, may be attained in the first half of 2018. (For more, see also: Global 4% GDP Growth Can Fuel Stocks in 2018: Goldman.)

Sector Recommendations

Morgan Stanley remains overweight in what it calls "pro-cyclical late-cycle sectors," including energy, technology, industrials and financials. They are underweight in what they call "defensive bond proxies," specifically, consumer staples, telecommunications, REITs​ and consumer discretionary.

Additionally, they prefer small cap and mid cap stocks to large caps. As far as growth versus value is concerned, they do not expect either category of stocks to outperform the other, so they suggest that investors hold a mix of both types.

Classic Late Cycle

That's how Morgan Stanley describes the current U.S. economic environment. Unemployment is at 4.1%, or 0.4% less than what the Federal Reserve considers to be non-inflationary. As a result, labor costs, especially for skilled labor, are moving upwards.

Various indicators of consumer and business confidence are near record highs. Nonetheless, Morgan Stanley believes that while the U.S. economy is still expanding, "we are late in the game." However, they add that "late cycle is not bearish for equities," and "some of the best returns tend to come at the end."

They recommend energy, technology and industrials on the basis that these sectors historically perform well in the late stages of an economic cycle. They note that all three have performed well recently, with an uptick in capital spending and higher oil prices, both of which are common late cycle phenomena, they say.

Morgan Stanley's overweight position in financials is a bet on the big banks which, they say, "are more geared to the front end of the yield curve rising than the yield curve steepening." As for regional banks, the report indicates that a flat yield curve, which Morgan Stanley projects for 2018, means that they are unlikely to do well next year.

Late Cycle Underperformer

​Consumer discretionary, the report says, is "a classic late cycle underperformer," and has been in this mode for nearly two years. While tax cuts may prompt an increase in discretionary consumer spending, Morgan Stanley believes that this actually could hasten the end of the cycle, and lead to even greater underperformance by consumer discretionary.

Regarding consumer staples, telecom and REITs, Morgan Stanley has been underweight in all three throughout 2017, finding that these "defensive bond proxies" tend to lag when the global economy is accelerating. However, when an economic cycle top is evident, they may upgrade one or more of these sectors, and recommend rotation into them.

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