Morgan Stanley (MS) equity strategists are raising their S&P 500 (^GSPC) forecast for next year, predicting earnings growth as the key force pushing equity prices higher.

“We extend our S&P 500 price target horizon to December 2021, and raise our base case estimate to 3,900 from 3,350,” wrote equity strategist Michael J. Wilson.

His team sees “a return to pre-Covid-19 levels of GDP by 2021 and returns to well above prior peak through 2022.”

On the earnings front, the strategist predicts a “strong rebound in GDP feeding robust top line growth while 2020's cost cuts allow for rebounding margins and powerful incremental flow-through that drives operating leverage and margins higher than expected by the consensus.”

“Since August, we believe the market has been in the process of digesting/consolidating the extraordinary initial gains in this new bull market,” wrote Wilson.

‘Show me the Money!’ scenario for US equities

“After a year of big swings in valuations, 2021 will be about who can deliver on earnings. As such, we favor reasonably priced stocks/sectors that will benefit the most from a strong US economy and under appreciated operating leverage,” wrote Wilson.

His team expects the average stock to do even better than the index over the course of the next year, leaning cyclically in the firm’s recommendations.

“Our sector OWs remain Financials, where we see positive upside skew on rising rates and better credit; Materials and Industrials on a demand rebound, earnings leverage, and inflation protection; and Health Care given its GARP characteristics and re-rating potential with fading political overhangs,” wrote Wilson.

He also has a preference for small caps, which tend to lead in recoveries, over large caps largely on the group's ability to deliver greater earnings surprises.

“This is already playing out but we think the trade has more upside potential,” said Wilson. The Russell 2000 (^RUT) on Monday was up more than 2%, hitting new highs.

Last week’s Pfizer (PFE) positive vaccine news was the catalyst for investors who began rotating out of stay at home COVID-19 trades, and into re-opening and recovery names. Some of that same action was present on Monday when Moderna (MRNA) announced a 94.5% efficacy rate for its COVID-19 vaccine candidate.

“Near term, we continue to see a range of 3150-3550 for the S&P 500 as the market deals with the second wave of virus, remaining election uncertainties and the specter of higher rates,” he added. ‘

The note warns of the risk of greater lockdowns because of rising cases.

“That could lead to a rotation back toward the work-from-home beneficiaries and away from the reopening stocks that rallied so much on last week's vaccine news,” wrote Wilson.

Uncertainty over the Senate runoffs in Georgia on January 5 is also a concern.

“While consensus expects the Republicans to win at least one seat to hold the Senate, we can't be sure and won't know for 7 more weeks. Much like the election itself, it's the uncertainty of the outcome rather than the outcome itself that can wreak havoc on volatility and the leadership,” added the strategist.

Ines covers the U.S. stock market. Follow her on Twitter at @ines_ferre

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