Morgan Stanley expects tech rally will stall – here’s how investors should prepare

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The tech sector has been a bright spot in the markets this year, but now analysts at Morgan Stanley are dialing back their expectations.

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The S&P 500 tech sector has appreciated by about 11% year-to-date, but now Morgan Stanley is recommending investors lower their broad exposure to the sector in the near term, or at the very least, hedge sector exposure into earnings season as part of the bank’s overall call for investors to become more “defensive” with their holdings.

Morgan Stanley analysts say they have held the view all year that a more defensive rotation was forthcoming at some point – and they say that point is now.

They downgraded the technology sector to underweight, commenting in a U.S. Equity Strategy note that, “We think a lot of the positive fundamentals have been reflected in the price.”

“Tech will not forever be immune from the changing attitudes toward risk assets we are seeing across markets and think the sector may have benefitted from a false sense of security the past few months,” the bank said in its note.

The analysts acknowledged that strong earnings growth has been driving the performance of the sector, but that it’s become crowded with investors.

The analysts caution that earnings growth may already be priced in with consensus projections for 25% year-over-year growth in earnings in the second quarter of 2018. While these numbers may be achievable, they don’t see much room to meaningfully surprise to the upside.

Trade and tariff risks could also hurt the sector, noting that, “Perhaps no sector in the global economy has benefitted as much from low trade barriers as tech.”

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With trade barriers on the rise there is rising risk of operational hurdles and rising costs that may pressure the tech supply chain. Tech broadly has the highest revenue exposure to China. Morgan Stanley analysts expect management teams will be forced to address trade issues when reporting results, creating a risk to guidance and projected earnings growth.

As part of their recommended defensive rotation, the analysts also downgraded small caps to equal weight and upgraded the consumer staples and telecom services sectors to equal weight from underweight.