Weekly Warm-up: The Broadening Out Shifts to a Quality Rotation as Early Cycle Phase Ends
The broadening out story is shifting to a quality rotation as we exit the early cycle phase of the rolling recovery. Our factor analysis supports this view led by the sharp reversal in capex/sales. Semis still underperform hyperscalers, but AI adopters likely to outperform both.
- The Market Is Rotating Toward Quality… This is a classic mid-cycle transition as the cycle matures, and the focus returns to free cash flow generation and margin expansion. The S&P 500 is already a high-quality, mega-cap-dominated benchmark: high-quality cohorts represent roughly 42% of the index versus about 28% for low quality. Near-term consolidation/correction remains possible if the war escalates or the Fed unexpectedly hikes this week; but the quality rotation should ultimately support index resilience and broader participation. We continue to think 7000 offers strong technical support should markets remain uneasy about the transition at the Fed and/or conflict escalation. The current setup resembles early-to-mid 2021, when leadership shifted toward quality after a run of more speculative growth and lower quality leadership post-covid. Exhibit 11 is our Quality screen.
- AI Adoption Takes Center Stage... From here, margin expansion is likely to depend less on early-cycle operating leverage and more on AI adoption and other drivers, reinforcing our quality thesis. Earnings revisions are beginning to reflect the opportunity: forward margin expectations are improving most clearly for companies where AI is material to the investment thesis and pricing power is neutral to strong. This group is seeing net margins nearly 400bps in excess of the median stock. Further, our systematic transcript analysis shows that 25% of S&P members cited measurable benefits from AI adoption in calendar 2Q, versus 14% a year ago. We continue to view AI adoption as an important source of earnings growth and operating leverage, with roughly 100 basis points of net margin expansion expected through 2027 related to adoption. Exhibit 12 is our AI adopters screen.
- Focus is on oil and rates in the near term... The bond market is pricing a 38% probability of a Fed rate hike at this week's FOMC meeting, but such an outcome would still represent a hawkish surprise and, potentially, a high-risk maneuver. The case for hiking is that it could help contain the back end of the curve by signaling that this Fed and new Chair is more serious about inflation risks. The counterargument is that markets could extrapolate a surprise hike too aggressively. Our base case remains for the Fed to stay on hold following the recent inflation data. More importantly, the broadening in leadership continues to be driven mainly by earnings strength, where growth has accelerated to 17% for the median stock this quarter. A Fed on hold would be incrementally supportive with that backdrop and even a hike would delay, not derail, our constructive 2026 outlook. This is particularly true with the correlation between equities and bond yields now back to zero and the broadening in stock performance despite stickier back-end yields. Oil is the other wildcard with the conflict re-escalating over the past few weeks. A sustained rise in the price of oil is not priced into the equity markets and another reason to move up the quality ladder in one's portfolio.
A Shift Toward Quality Suggests Early Cycle Is Over
The market is beginning to rotate toward quality, a classic mid-cycle transition as the business cycle matures. From here, margin expansion is likely to depend less on early-cycle operating leverage and more on AI adoption, reinforcing our quality thesis. The S&P 500 is already a high-quality, mega-cap-dominated benchmark: high-quality cohorts represent roughly 42% of the index versus about 28% for low quality. Near-term consolidation and even further downside toward 7000 remains possible if the war continues to escalate and/or the Fed unexpectedly hikes this week, but the quality rotation should ultimately support index resilience and even broad participation, albeit with different leadership. The current setup resembles early-to-mid 2021, when leadership shifted toward quality after an early cycle rebound post-covid. Weak balance sheets, high-beta growth, and low quality earnings factors started to underperform even as the S&P 500 advanced and growth strengthened. Today looks similar: our factor work favors high free-cash-flow yield, low EPS variability, strong balance sheets and high margins. See Exhibit 11 for a screen on this front.
Another similarity is that headline inflation/CPI is on the rise again and lines up with 2021 almost exactly. Back then, the Fed looked through the spike in headline inflation as transitory due to the Covid shock. This time, the rise is mostly energy which the Fed could also look through it as a temporary rise. Last month's decline in CPI was directly the result of energy prices falling sharply since mid-May. However, that reversed over the past week, perhaps forcing the Fed to reconsider at this week's FOMC meeting. The good news is that rates are close to 4% while in 2021, Fed Funds were still on the zero bound and Fed was doing full blown QE versus today's episodic asset purchases mainly at the front end to maintain financial stability in funding markets. Nevertheless, the comparisons to 2021 are notable especially in the context of the quality rotation that is now emerging.
Meanwhile, last week’s hyperscaler price action following GOOGL’s earnings and capex increase reflects the market’s renewed focus on capital discipline within a higher-quality leadership regime. While investors remain focused on the pace of capex, hyperscalers retain an important opex lever through leaner operations and AI-driven efficiencies. Our proprietary AI mapping also identifies hyperscalers as among the largest beneficiaries of adoption. They also combine strong core businesses—as reflected in GOOGL’s cloud results—with the potential to lead in the agentic application layer. As we noted last week, after roughly 30% relative outperformance in three weeks, the risk/reward of our Hyperscalers-versus-Semis relative recommendation had become less compelling.
However, with Semis a classic early cycle group, and having reached a peak rate of change on earnings revisions, we think hyperscalers are still likely to outperform semis from here; it just might happen with both going lower together in this next leg. Our silver stock analog remains intact even with the short-lived bounce in semis early last week. Eventually, both should find their footing as the correction in the broader market that began in May concludes. Oil and rates will have a lot to do with that timing and as we noted last week, we think 7000 on the S&P 500 will provide strong technical support should markets remain uneasy during this transition period at the Fed and re-escalating conflict in Iran.
At the same time, the outlook for AI adopters is becoming increasingly compelling, with the benefits of implementation helping to offset concerns around potential disruption. This is especially important because several industries often viewed as vulnerable— including Transports, Software & Services, and Professional Services—also rank among the more attractive adopter groups in our thematic research team's AI mapping work and our industry-level work. Earnings revisions are beginning to reflect the opportunity across the market: forward margin expectations are improving most clearly for companies where AI is material to the investment thesis and pricing power is neutral to strong ( Exhibit 6 and Exhibit 7 ). Exhibit 12 highlights a long screen of companies that meet these criteria and also carry a Morgan Stanley Overweight rating. We continue to view AI adoption as an important source of earnings growth and operating leverage, with roughly 100 basis points of net margin expansion expected through 2027 related to adoption.
Work from our thematic research colleagues shows that adoption is moving decisively from experimentation to measurable enterprise value. In 2Q26, 40% of identified AI adopters cited at least one quantifiable benefit, up from 21% a year earlier and 37% in the prior quarter; across the broader S&P 500, roughly 25% cited measurable benefits, versus 14% a year ago. Those gains are concentrated in revenue generation, cost savings, capital efficiency and productivity, with the strongest momentum in Technology, Communication Services and Financials. Companies also reported an average 9.6% net productivity increase over the past year, led by software development, customer service, finance and operations. The labor impact is therefore less about wholesale replacement than role redesign, higher revenue per employee and durable operating leverage—suggesting the adoption cycle remains early. See here and here for more.
As already noted, this week brings an important FOMC meeting. The bond market is pricing a 38% probability of a hike, but such an outcome would still represent a meaningfully hawkish surprise, and potentially a high-risk maneuver. The case for hiking is that it could help the Fed/Treasury contain the back end of the curve by signaling that the Fed is serious about inflation risks and different than what the Fed did in 2021. The counterargument is that markets could extrapolate a surprise hike too aggressively, as in 1994—particularly given Chair Warsh’s reduced emphasis on forward guidance. Our view remains that the Fed will stay on hold following the recent inflation data, especially with the findings from Warsh’s task forces not due until the fall and midterms presenting a political headwind to hikes. More importantly, the broadening in leadership has been driven by earnings strength at the median stock level, where growth has accelerated to 17% this quarter. Therefore, a Fed on hold would be incrementally supportive, but even a hike would only delay, not derail, our constructive 2026 outlook, particularly with the correlation between equities and bond yields currently near zero and the broadening happening even with back-end yields higher ( Exhibit 9 and Exhibit 10 ). Net net, if the Fed remains on hold this week, stocks will like that in the short term, but it's unlikely to extinguish the uncertainty around the path of rates and reaction function of the new Fed over the next several months, particularly with the re-escalation of the conflict with Iran.
Stock Screens
Earnings Season Chartbook
- Price reactions have been challenged in 2Q with the median absolute T+1 at -0.9% and relative at -0.8%. Estimates into the quarter rose +2% instead of the seasonal -5% and this higher bar may be creating headwinds to price performance. Albeit, it is still early in earnings season.
- EPS surprise at +28% in aggregate and +7% for the median stock, well above historical averages of 4.4%. A large proportion of this can be attributed to unrealized gains at GOOG from an equities securities portfolio.
- Sales surprise at +3%, well above historical averages of 1.3%.
- Median Russell 3000 stock has EPS+17% y/y and sales +8% y/y.
- 2Q EPS expected at 32% Y/Y and sales at 10% Y/Y.
- S&P 500 earnings revisions breadth (ERB) saw a seasonal pause into earnings season but remains strong in historical context at+14%. We see green shoots on ERB after early reports.
- Calendar 2026 earnings have revised higher to 27% y/y. Earnings growth contribution is roughly equal between top-line growth and margin expansion.
- Mag 7 earnings are expected to grow 49% in 2026 vs. 16% for the S&P 493. After the upward revisions for Mag 7 on 2026 EPS, Mag 7 2027 EPS growth has fallen to 9% versus 17% for the S&P493.
Key Charts
Scorecards
Price Reaction
- 2Q saw -0.9% median T+1 price reactions on an absolute basis and -0.8% relative to the broad index.
- Energy and Materials have seen the strongest T+1 price reactions so far, but on a small sample size.
- Comm. Services, Industrials and Tech have seen the most negative T+1 price reactions so far.
Surprise
- 2Q EPS surprise at 27.7%, strongly ahead of the historical average of 4.4%.
- 2Q Sales surprise at 3.3%, above the historical average of 1.3%.
Company Guidance & Revisions
- S&P 500 earnings revisions breadth (FY2 estimates) is strong in absolute terms at +14% but softened due to seasonal weakness. Early reporting is showing a positive spike in short-term ERB as earnings continue.
- Financials and Defensives (Utilities, Real Estate, Healthcare) have seen relative ERB strength in the past two weeks as index ERB softened.
- Materials, Industrials, and Staples have seen the most negative ERB change over the past two weeks.
Sales
- Consensus expects 10% sales growth in 2Q.
- Consensus expects 10% 2026 Sales growth and 8% 2027 EPS growth
EPS
- Consensus expects 32% EPS growth in 2Q.
- Consensus expects 27% 2026 EPS growth and 15% 2027 EPS growth.
Margins
- Realized (LTM) EBIT margins are at 19.3% today and are expected to be 20.4% for FY2026 and 22.0% for FY2027.
- Realized (LTM) net margins are at 14.6% today and are projected at 15.8% for FY2026 and 16.6% for FY2027.
- 2Q consensus margins are at 16.6% for the S&P 500.
2Q Systematic Earnings (Full MS Coverage)
Summary:
- Previews: KPI previews are +26% vs +24% net positive last quarter and NTM EPS previews are +20% vs +19% last quarter on projected NTM impacts. Previews are currently net positive across all sectors with the exception of Materials and Utilities.
2Q Preview Tracking
Our Morgan Stanley Analysts submit a systematic earnings preview where they forecast two items: 1) KPI and 2) NTM EPS impact. Below we summarize the sector and industry summaries of these previews. The population is the Morgan Stanley US coverage, which is broader than the S&P 500 and roughly similar to the Russell 1000.
Methodology: Each analyst identifies the key performance indicator (KPI) for each individual stock and it may differ from NTM EPS. For example, the KPI for a Financial Services or Semiconductor company may be net assets or GPU demand and this may differ from NTM EPS (although, it is often similar). Each analyst chooses one of five forecasts for both KPI and EPS: very negative, negative, in-line, positive, or very positive. We roll up these previews into a net score by taking (positive-negative)/total reactions.
Key Performance Indicator (KPI) Previews
EPS Previews
Screen 1: Favored Stocks with Positive Surprise Expected
We screen for OW-rated stocks that are expected to beat on key KPI, or to see N12M consensus EPS revised higher post results.
Screen 2: Less Favored Stocks with Negative Surprise Expected
We screen for stocks that are rated Equal Weight or Underweight by our analyst and are expected to miss on their key KPI. Note that the KPI may be different than N12M EPS.