Investing.com -- Morgan Stanley said the return of inflation after COVID-19 has created shorter market cycles and more frequent changes in sector leadership. The firm favors large-cap quality stocks, companies adopting artificial intelligence, and the S&P 500 over international markets.

The investment bank's quality rotation strategy has materialized over the past two months. Stocks with high free cash flow rose 16%, while those with high gross margins gained 9%. Companies with high sales growth stability increased 9%, and firms with low capital expenditure relative to sales climbed 8%.

Market leadership has shifted toward service-oriented, fee-based, and asset-light sectors, which also show strong earnings revisions. Within the financial sector, Morgan Stanley highlights Financial Services and Insurance as notable areas.

The firm noted that the Treasury Department recently expanded its buyback program, coming just two weeks after the Quarterly Refunding Announcement. Morgan Stanley views higher interest rates as primarily driven by strong nominal growth rather than concerns about debt and deficit levels. The firm said Treasury and Federal Reserve actions aim to maintain market functioning rather than restart quantitative easing, though gold and cryptocurrency markets have traded as if more aggressive policy actions might occur.

Brent crude oil has risen 13% over the past two weeks. Morgan Stanley said rising oil prices have historically created headwinds for equities more reliably than falling oil has provided support. A continued closure of the Strait could push oil prices higher, which would pressure input costs and likely drive yields and bond volatility higher. The firm said Energy stocks offer a hedge for equity portfolios in this environment.