In this piece, we will take a look at Morgan Stanley’s top cyclical stocks for an economic recovery.
As 2024 approaches its end, the stock market has been through it all. The driving theme of the year has been artificial intelligence as investors and media have ardently poured over AI companies’ every word during all earnings seasons. Alongside AI, the Federal Reserve has been focused on tailoring its interest rate policy to match the labor market’s performance and inflation. Finally, November ends with the result of the 2024 US Presidential Election confirming President-elect Donald Trump’s victory.
These three primary stock market drivers have short and long-term implications for equities. AI companies have to ensure that their margins are robust and that the technologies they have invested billions of dollars into can generate profits. The Fed’s interest rate decisions will determine liquidity for institutional investors, venture capitalists, and the broader corporate sector. Finally, the incoming administration’s policies towards sectors such as energy, banking, and clean energy might shape the macroeconomic environment either to their benefit or encumbrance.
Therefore, it’s worth seeing what the professionals are saying within this dynamically shifting stock market environment. On this front, investment bank Morgan Stanley has plenty of research floating around. Starting from the bank’s head of applied equity team Andrew Slimmon, he believes that the outcome of a Presidential election has rarely impacted the pre-election trend of the flagship S&P stock index. According to Slimmon, if the market has been in an uptrend heading into the election, then it “has been higher 3 and 6 months later 85% of the time, regardless of the election outcome.” He adds that the market has been in an uptrend year as well, and looking at history, November and December are typically the two strongest months for the market.
The MS analyst believes that while this two-month period is the strongest in history, historically, it also “follows the two worst months of the year.” As September and October have not followed this trend, one key historical factor does not match. However, Slimmon is optimistic, going on to outline that “November-December will repeat its historic strong performance once we get through the noise surrounding the election.” Four key reasons are behind this optimism. As per Slimmon, November sees the highest number of corporate buybacks and the most retail funds flow into the market, there will be post-election clarity for firms, and the Fed’s interest rate cuts, no matter how small, are always great for the market. The analyst also cycles back to his opinion that pre-election trends continue to persist post-election, and he shares that communications services, utilities, and financials are some sectors that have performed well before the election.
Jim Caron, MS’ CIO of the Portfolio Solutions Group, shares his take on the remaining unknowns for the stock market now that the election is over. Focusing on the Federal Reserve’s path ahead, he shares that the process of managing interest rates is now “an exercise in risk management” for the central bank. This is because the Fed has to carefully balance between ensuring that interest rates are in neutral territory as implied by the R* or the rate that ensures the economy is in equilibrium. Right now, Caron believes that the rates are in restrictive territory, and the primary risk that the Fed is managing is the condition of the labor market which “would be worsened if policy rates were restrictive when it happened.” This leads Caron to conclude that the Fed might cut rates to range between 4% and 3.7%, and on a more optimistic note, this “may be the case even if the decline in inflation seems to be stalling perhaps temporarily because if they don’t cut rates now, they may not be able to if there are some unfriendly inflation prints ahead.”
What does this careful balance between cutting rates to ensure the labor market remains robust while simultaneously keeping an eye on inflation mean for investors? Well, according to the MS analyst, in the worst-case scenario that the central bank “switches their policy from cutting to hiking,” the 10-year bond yields should range between 3.9% and 4.6%. Not only does this mean that “owning bonds can also be a good hedge against equities,” believes Caron, but he adds that equities ” should still find support and value from a stable and lower bond yield environment.” He concludes by outlining that MS’ portfolio realignment includes moving “to increase equity exposure at duration to hedge and moving into levered credit, December carries with its special significance beyond the normal year-end dynamics, it will set the stage for how Fed policy may move markets.”
Finally, before we head to our list of Morgan Stanley’s top cyclical stock picks, the bank’s key themes for November are also worth noting. On the topic of equities, the bank shares in its November 2024 Beat report that “Financials offer an attractive risk/reward across both our base-case, soft-landing view and a potential risk scenario where inflation concerns return and lift rates higher.” Naturally, any market report without mentioning artificial intelligence would be incomplete, and for MS, utility stocks are among the key AI beneficiaries. It outlines that “utility companies are in the early stages of what will be a multi-year capital expenditure cycle designed to increase their power generation capacity and service new demand.”
Just like Goldman Sachs, MS also believes that there is great potential in the equal-weighted flagship S&P index. Its data shows that when compared to the index’s long-term median 12-month forward consensus EPS of roughly 2%, the EPS of the market cap weighted index is 5.9%. This shows that the cap-weighted index is fully valued, but, for the equal-weight index, the consensus forward estimates are 1.5% which hints at undervaluation. The differential leads MS to conclude that “S&P equal-weighted EPS offer a cleaner comparison and show scope for cyclical EPS upside.”
On the topics of financial stocks and the benefits stemming from artificial intelligence on utilities, MS shares that financial stocks “offer an attractive risk/reward profile.” This optimism is driven by the sector’s exposure to interest rates. In its data, the bank outlines that when compared to materials, industrial, and energy stocks, as well as the spread between 10-year and 2-year bonds, financial stocks offer as much as a 15-point performance gain over a base of 100 points. It adds that financial stocks also lead cyclical stocks when Citi’s US Economy Surprise Index starts to edge higher. As for utilities, the bank shares that positive “forecasts for the data center buildout have helped catalyze outperformance for utilities relative to other defensive sectors.”
For some financial stocks, you can check out 10 Best Local Bank Stocks To Invest In Now and 10 Best Diversified Bank Stocks to Buy Now.
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Our Methodology
To make our list of Morgan Stanley’s top cyclical stocks, we ranked the bank’s recent list of favored cyclical stocks by the number of hedge funds that had bought their shares in Q3 2024.
Why are we interested in stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
9. Yum! Brands, Inc. (NYSE:YUM)
Number of Hedge Fund Holders In Q3 2024: 34
Yum! Brands, Inc. (NYSE:YUM) is one of the biggest restaurant chain operators in the world. As of H1 2024, 79% of the firm’s revenue came from its KFC and Taco Bell brands. Additionally, during the same time period, 56% of the revenue came from the US. Consequently, Yum! Brands, Inc. (NYSE:YUM)’s performance is dependent on consumer spending in the US and operational efficiencies at these two key brand restaurants. Since it’s a restaurant chain, the firm is dependent on its ability to balance high volumes with low costs to keep its margins robust. Yum! Brands, Inc. (NYSE:YUM) also benefits from owning iconic franchises that garner strong consumer loyalty due to their unique taste and global brand recognition. The firm’s reliance on the US for most of its revenue can prove to be an advantage in today’s slowing global economic output where the American economy has proven to be an exception.
Yum! Brands, Inc. (NYSE:YUM)’s management commented on its two key franchises during the Q3 2024 earnings call. Here is what they said:
“Despite the complex consumer environment around the globe, our team managed to grow profits 3% year-over-year with the quarter bringing to light the real strengths of our twin growth engines, Taco Bell U.S., which meaningfully outperformed the industry on comp sales and KFC International, which meaningfully outperformed on unit growth. Although the U.S. QSR industry experienced negative traffic trends in Q3, Taco Bell U.S. posted an impressive 4% increase in same-store sales and led the industry in Q3 on value perception among all QSR users. Taco Bell delivered another quarter of significant market share gains driven by the execution of the brand’s magic formula involving brand buzz, value, category entry points and digital engagement.
Taco Bell’s competitive advantages in innovation, value leadership at compelling price points and strong consumer connection are clear reasons why the brand remains a category of one when it comes to winning with consumers in any economic environment. Our other twin growth engine, KFC International, delivered 9% year-over-year unit growth, an incredible result that led all major competitors and that reflects the underlying power of the brand and the confidence of our franchise partners in the future of our business. KFC International’s development was diverse, spanning 64 countries. Furthermore, gross unit openings year-to-date are up nearly 150 units over last year. Building on this momentum, KFC is enhancing its core capabilities to ensure growth over the long term by establishing 7 centers of excellence focused on restaurant design, customer insights, market planning, food innovation and more.”
8. The Gap, Inc. (NYSE:GAP)
Number of Hedge Fund Holders In Q3 2024: 39
The Gap, Inc. (NYSE:GAP) is an American retailer whose stock has been focused on its turnaround efforts in 2024. The shares jumped by 49% in March after the firm’s Q4 2023 earnings results beat analyst estimates. The respite was short-lived as The Gap, Inc. (NYSE:GAP)’s shares then fell by mid-April only to regain momentum and jump by 43% in May. This jump came after yet another earnings beat after first-quarter revenue and EPS of $3.39 billion and $0.41 beat analyst estimates. The trend of The Gap, Inc. (NYSE:GAP)’s stock being dependent on earnings reports is because of the firm’s ongoing strategy to foster a strong brand identity among consumers and cut down costs by reducing its portfolio. The firm’s shares jumped by 20.6% in November following its third-quarter revenue of $3.8 billion meeting analyst estimates and EPS of $0.72 smashing estimates of $0.58 out of the park. To further sweeten the deal, The Gap, Inc. (NYSE:GAP) also raised its full-year guidance to $14.9 billion.
During the Q3 earnings call, The Gap, Inc. (NYSE:GAP)’s management commented on the current phase of its strategy which revolves around operational efficiencies.
“We’ve made great strides on product and marketing and are focused on continuous improvement as we expand our aperture to include enhancements to both the in-store and online experiences for our customers. While each of our brands is in a different stage of the reinvigoration journey, I’m encouraged to see them gaining traction as we continue to execute our playbook and drive toward becoming a high-performing house of iconic American brands that shape culture. Moving on to our third strategic priority. We are deep in the work of strengthening our operating platform. During the quarter, the resilience of our supply chain was notable as we navigated the port strike, natural disasters, and the various associated challenges. Our scale, agility, and strong partnerships have allowed us to secure long-term freight contracts and make advancements in the diversification of our sourcing footprint over the last few years.”