Ahead of their earnings releases, Bernstein recommended pair trade in the institutional brokerage space on Tuesday: buying Goldman Sachs Group Inc (NYSE:GS) and selling Morgan Stanley (NYSE:MS).

The Analyst

Bernstein analyst Christian Bolu initiated coverage of Goldman with an Outperform rating and $300 price target. Morgan Stanley shares were initiated with an Underperform and $51 price target.

The Thesis

The factors that drove outperformance among institutional brokers during the 2003-2006 cycle — such as rising rates, benign credit conditions and deregulation — are once again in play, Bolu said in the initiation note.

More importantly, the analyst said he does not forecast the risks related to complex product innovation that contributed to the 2008 crisis. Instead, Bolu said that since 2006, capital levels have tripled and liquidity has doubled.

After a decade of deleveraging, investment management teams are refocusing on growth, the analyst said. To illustrate his point, the analyst noted that 2017 was the first year since 2006 where every global investment bank grew their balance sheets.

Bernstein prefers institutional brokers to retail, as the "near-perfect" operating conditions that benefited retail brokerage are yielding to the "new normal" of higher volatility and increased deposit competition.

The firm said it believes these risks are not adequately factored into earnings forecasts or valuations.

Outsized Earnings Growth Forecast For Goldman

The revenue recession that has impacted Goldman shares is at an inflection point, Bolu said. Fast-growing "strategic growth" businesses such as investment banking, investment management and lending have overtaken trading as the dominant driver of revenue, the analyst said.

"Execution of growth initiatives and a modest recovery in trading could drive outsized earnings growth and 12-13-percent-plus ROE through 2020."

Below-Consensus Expectations For Morgan

The Morgan Stanley bull case of lending-driven ROE expansion and increasing capital return is at a negative inflection point, Bolu said. The analyst said he expects a significant slowdown in lending growth over the next few years in light of deposit outflows and rapidly rising deposit costs. 

In a stance that's at odds with consensus expectations, the analyst said he expects rising interest rates to hurt growth at Morgan Stanley.

"With regard to capital, expect 2018 CCAR cycle to represent the first down year for buybacks since 2013 and underperform Street expectations." 

In the long run, Morgan Stanley's leverage limits the likelihood of above-peer capital return, according to Bernstein. 

The frim's 2018-2020 forecasts for Morgan Stanley are 5-8 percent below consensus.

The Price Action

Goldman shares have gained about 13 percent over the past year compared to Morgan Stanley's 29 percent-plus gains.

In early trading Tuesday, Goldman shares were rallying 2.7 percent and Morgan Stanley was up 1.9 percent. 

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