The Fed could guide small-cap stocks toward a 'sweet spot' as it gets ready to slash interest rates, longtime Morgan Stanley bear says

• The Federal Reserve signaled last week that it's ready to start weighing the prospect of lower interest rates.
• That's great news for small-cap stocks, according to Morgan Stanley's Mike Wilson.

Small-cap stocks could be best positioned to benefit from the Federal Reserve's potential interest-rate pivot, according to longtime Morgan Stanley bear Mike Wilson.

The bank's CIO and chief US equity strategist said Monday that the central bank choosing to call time on its inflation fight and prop up economic growth would help lower-quality companies' share prices to surge in 2024.

"If inflation stabilizes at a higher level, small caps/cyclicals/lower-quality stocks could be beneficiaries," Wilson wrote in a research note seen by Business Insider.

"Of course, this is a fine line with inflation statistics still running above target," he added, referring to the monthly rate still being above the central bank's desired 2%. "Should these numbers start to rise again, the Fed could reverse course."

"Right now though, we could be entering a sweet spot that supports this rotation if nominal growth accelerates."

Chair Jerome Powell seemed to signal on Wednesday that the Fed could cut interest rates as early as March, sparking a bout of market euphoria.

"The question of when will it become appropriate to begin dialing back the amount of policy restraint in place – that begins to come into view, and is clearly a topic of discussion out in the world and also a discussion for us at our meeting today," he said, which investors have seized upon as a sign that the central bank will start easing monetary policy from March onwards.

Powell's comments sparked a surge for small-cap stocks, which tend to benefit the most from lower borrowing costs. The Russell 2000 index has jumped 6% since Wednesday afternoon, while the large-cap benchmark S&P 500 is up 2% over the same period.

Monday's research note aside, Wilson has tended to stay bearish on stocks in 2023 despite a surprise rally that's powered both Big Tech behemoths and the Dow Jones Industrial Average to new all-time highs.

Just last week, he predicted that the fourth quarter of this year will bring about a large-cap earnings slowdown, which he said would back up his forecast that the S&P 500 will finish the year trading at 4,500 points, implying a 5% drop from its current level.