Banking titan Morgan Stanley believes market leadership may consolidate around large-caps and AI giants next year as tighter financing and economic crosscurrents create headwinds for smaller firms.
In a new edition of its Wealth Management Insights, Morgan Stanley Wealth Management CIO Lisa Shalett warns that many small-cap stocks remain fundamentally challenged at a moment when capital costs stay elevated and credit stress indicators are flashing.
She also notes that many small firms are burning cash despite a growing economy.
“As we see it, smaller companies will face at least three major obstacles in 2026. First, the data suggest that more than one-third of the Russell 2000 cohort continues to remain unprofitable, even with nominal GDP currently averaging more than 6% and running roughly 50% above the 20-year norm.
Second, small companies’ cost of capital at around 7% remains well above the return on assets, which is less than 2% currently… High-yield credit default swaps have widened over this past month, and we’re watching for signs of credit stress that may not be easily cured by upcoming Fed rate cuts. Finally, the steepening of the yield curve has historically been correlated with large-cap companies outperforming small caps.”
Shalett says improving breadth does not override structural pressures on weaker companies, especially those tied to speculative themes or dependent on cheap funding cycles.
“Despite the allure of momentum, we believe now is not the time to lean into speculation and low quality… Ultimately, the broadening of the US economic boom thesis that includes small, medium-sized, and credit-challenged companies may disappoint in our view.”
She notes that Morgan Stanley recently boosted its allocation to large-cap equities and reiterated a preference for profitability and durable earnings exposure.
“In fact, last week, the Global Investment Committee increased our allocation to US large-cap companies, putting us at a 300 basis point overweight to our benchmark in our key models… Consider taking profits in high-beta, small- and micro-caps, as well as speculative and unprofitable equities, and redeploying that to large-cap, core, and quality stocks, including the Mag 7 and companies in financials, healthcare and energy that stand to benefit from generative AI.”
She also reaffirmed the firm’s longer-term view on the benchmark index, pointing to earnings resilience and productivity potential tied to enterprise AI adoption.
“Our S&P 500 target price for 2026 is 7,200.”
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