Earnings are supporting stocks, but there are two risks to watch, says Morgan Stanley

Morgan Stanley's Michael Wilson highlights robust corporate earnings as a primary support for the stock market, noting median Russell 3000 earnings growth of 11% in Q3 and S&P 500 revenue significantly exceeding expectations, a trend anticipated to continue into 2026. However, Wilson identifies two critical near-term risks: potential market disappointment regarding the Federal Reserve's pace of interest rate reductions, despite equity market resilience to recent Fed commentary, and increasing stress in short-term funding markets, indicated by rising overnight repo usage. He suggests that higher quality market segments are likely to outperform until these macroeconomic and funding market dynamics stabilize.

Analysis

Morgan Stanley's Michael Wilson highlights robust corporate earnings as a key market support, with median Russell 3000 earnings growth accelerating to 11% in Q3, up from 6% in Q2 and 2% in Q1, marking the fastest growth since Q3 2021. This trend, coupled with S&P 500 revenue exceeding expectations by 2.3% (double the historical 1.1% run-rate), is anticipated to continue into 2026, driven by lean cost structures. Despite the S&P 500 trading at an elevated 23 times next twelve-month earnings, significantly above its 10-year average of 18.6x, strong earnings growth provides justification for current valuations.

However, Wilson identifies Federal Reserve policy as a significant near-term risk, noting potential market disappointment regarding the pace of interest rate reductions. While the bond market has adjusted rate-cut projections following recent Fed commentary, the equity market appears to be "shrugging it off," operating under a "good is good / bad is bad" dynamic. Wilson remains cautious, citing signals from both the bond market (reduced pricing of Fed cuts) and the equity market (poor breadth), suggesting it is premature for a rotation into small-cap or cyclical stocks until the Fed clearly signals a more accommodative stance.

A second critical risk stems from increasing stress in funding markets, evidenced by rising overnight repo usage and widening spreads between the secured overnight funding rate (SOFR) and Fed Funds rates. Although the Fed announced an end to its quantitative tightening (QT) program in December, the market may have hoped for a more immediate cessation, with the behavior of short-term funding markets now crucial. This dynamic could impact equity markets, particularly speculative areas, leading Wilson to suggest that higher quality market segments will likely continue to outperform.

Key Decisions for Investors

• Consider re-evaluating portfolio allocations towards higher-quality equities, as they are expected to outperform amidst funding market stress and Fed policy uncertainty.
• Monitor Federal Reserve communications closely for any shifts in interest rate reduction expectations, as a slower pace could impact market sentiment and valuation multiples.
• Exercise caution with small-cap, low-quality, and deep cyclical rotations until there is clearer evidence of the Fed's willingness to implement more aggressive easing.
• Pay close attention to indicators of stress in short-term funding markets, such as overnight repo usage and SOFR-Fed Funds spreads, as these could signal broader market instability.