Analysts at Morgan Stanley say the advent of advanced artificial intelligence models introduces "structural risks" to equity markets, but they also identify "contradictory elements to these dynamics" that complicate a straightforward disruption story.
Pressure on software stocks has intensified in recent weeks as investors digest the arrival of AI models capable of performing many of the tasks traditionally provided by software companies. That selling has not stayed confined to the software sector; it has moved across industries as market participants weigh the potential for AI to affect firms engaged in data analysis, logistics, real estate and other businesses.
The market reaction has been palpable. The tech-focused Nasdaq Composite has dropped by more than 5% since January 28, while the so-called Magnificent Seven group of mega-cap technology companies has declined by over 8%. Notably, Microsoft and Amazon have fallen 17% and 18%, respectively, amid concern about returns from heavy hyperscaler investment in AI infrastructure and compute.
But Morgan Stanley strategists including Michael Wilson and Andrew Pauker urge a more nuanced reading of how AI may influence corporate prospects and market flows. They highlight what they call "contradictory elements" in the prevailing narrative, particularly "in the sense that they all seem to be in focus at the same time."
"For instance, if AI is going to be highly disruptive and far-reaching in terms of its effectiveness, doesn’t that support the investment case for the infrastructure/compute enablers, especially since the market is broadly rewarding high capex/sales, cost of capital is contained, cost of compute is still elevated, and valuation has not expanded since '23 for the mega cap enablers?"
"Further, if AI adoption is likely to lead to more job loss, isn’t there a phase-in period where natural attrition isn’t replaced, efficiencies are realized and margins expand?"
The analysts also caution that near-term volatility may continue as the business cycle moves into what they describe as a "weak seasonal window" and as liquidity "remains tight." At the same time, they observe that improving breadth in earnings is helping to direct capital toward cyclical sectors.
Against that backdrop, Morgan Stanley expresses portfolio preferences that reflect a balance between quality and defensive positioning. They favor the S&P 600 Small Cap Index over the Russell 2000 on the grounds that the S&P 600 is "higher quality and less geared toward speculative growth areas." They also recommend large-cap healthcare names as "defensive exposure" to guard against potential future volatility.
On an individual-stock basis, the firm identifies what it calls "attractive entry points" in software companies including Microsoft, Palo Alto Networks and Intuit. They also highlight opportunities in business services and real estate stocks such as S&P Global, TransUnion and CBRE Group.
Overall, Morgan Stanley frames the situation as one in which structural risk from AI coexists with offsetting dynamics that could support specific sectors and firms, leaving investors to weigh near-term volatility against possible longer-term benefits for infrastructure, software enablers and efficiency-driven margin improvement.
Notable quotes and positions from Morgan Stanley analysts:
- AI models present "structural risks" to markets but also contain "contradictory elements" that merit careful assessment.
- Prefer S&P 600 Small Cap Index over Russell 2000 for higher quality exposure.
- Large-cap healthcare holdings recommended as defensive exposure.
- "Attractive entry points" identified in Microsoft, Palo Alto Networks, Intuit, S&P Global, TransUnion and CBRE Group.