Morgan Stanley: Oil prices push rates higher, but AI earnings still support an overweight in equities

Why remain overweight equities as high oil prices push up interest rates?

Morgan Stanley maintains an overweight in global equities and an underweight in core fixed income, with cash and commodities both at neutral weights. Relative to its allocation benchmark, equities are overweight by 5 percentage points and core fixed income is underweight by 3 percentage points.
Brent crude remained above 100 dollars a barrel in October. Energy prices and inflationary pressures have pushed central banks toward a more hawkish stance, while bond yields are increasingly moving with oil prices. But the bank believes growth in major economies remains resilient and corporate earnings can support risk assets.
The bank's US market cycle model indicates a ‘mature expansion’ phase: model indicators are above trend and generally improving. Historically, equities have typically outperformed government bonds in this phase, and their margin of outperformance over high-yield credit has been the largest of any phase of the cycle.

High interest rates and rate volatility have put pressure on some equity valuation multiples, but Morgan Stanley believes earnings growth remains the main driver of returns. The bank expects AI capital spending by major cloud providers and emerging cloud service providers to continue growing over the next two years, particularly benefiting US corporate earnings.
The bank expects AI-related builders and adopters to contribute approximately 78% of the earnings growth of the S&P 500 in 2027; earnings at these companies are expected to grow 25%, compared with just 4% for the rest of the index.
US equities are the bank's preferred market, with a focus on high-quality earnings and AI adopters; European and Japanese equities remain at neutral weights. Emerging markets overall are relatively less favored because of weaker macroeconomic and corporate narratives, geopolitical risks and concentration risks, although the bank favors selected markets such as South Korea.
As of 29 October 2026, the S&P 500 stood at 7,720 points. The bank's base-case target for the second quarter of 2027 is 8,300 points, while its bear-case target for the same period is 5,900 points, indicating substantial downside alongside its upside view.

Morgan Stanley attributes the recent widening of technology-related credit spreads mainly to pressure from bond supply, rather than widespread stress across the entire AI financing system. High-quality major cloud providers are expected to account for more than 75% of AI capital spending in 2027–2028 and are relatively insensitive to rising rates; staggered, more regular bond issuance also helps the market absorb supply.
Pressure varies among borrowers: spreads on lower-rated companies, data center construction bonds and emerging cloud service providers may remain volatile. Changes in investment returns and financing structures are key factors affecting these issuers' performance through 2027.
Rising rates also hurt weaker borrowers: some B- and CCC-rated companies have more concentrated debt maturities, higher leverage and weaker interest coverage. The bank has therefore recently favored the quality advantage of investment-grade credit over high-yield bonds; its base case for the second quarter of 2027 still expects US high-yield spreads to narrow to 275 basis points.

The bank expects the Federal Reserve to raise rates by 25 basis points each in December 2026 and March 2027, fewer hikes than markets have priced in; it also expects developed-market government bond yields to be below market forward pricing by the end of 2027.
Despite modest expected returns and continued rate volatility, the bank remains slightly overweight government bonds because of their defensive role. The US 10-year Treasury yield was 4.94% as of 29 October 2026; the bank expects it to be 4.85% in the second quarter of 2027.
European fiscal pressure is another constraint. The bank expects euro area growth of about 1% and a fiscal deficit of 3.5% of GDP in 2027. If euro area sovereign yields rise too quickly, the European Central Bank may pause balance sheet reduction, while use of the Transmission Protection Instrument would require wider spreads and broader funding stress.

Morgan Stanley maintains a neutral allocation to commodities overall: the energy outlook remains uncertain, and although it favors gold, its upside is smaller than before. The bank expects Brent crude at 105 dollars a barrel in the fourth quarter of 2026 and 95 dollars in the second quarter of 2027; as Gulf exports recover, overall crude supply remains impaired and freight rates remain high.
Gold remains the bank's preferred commodity, with its second-quarter 2027 target raised from 4,900 to 5,000 dollars an ounce. Physical demand provides support, and prices have further upside if the macroeconomic environment eases or oil prices fall.
Gold's defensive role is also changing: the bank observes that since 2020, gold has failed to diversify equity risk but has helped cushion the largest bond sell-offs; that role is valued more when fiscal and inflation concerns rise.