Morgan Stanley Sees 7% Rate Cuts Boosting U.S. Stocks

Morgan Stanley has expressed optimism about the future of the U.S. stock market, citing a strong fundamental backdrop that supports the recent rally. The firm believes that improvements in earnings, expectations of rate cuts, and the easing of geopolitical and policy risks are providing solid support for the market. This optimism is particularly focused on large-cap, high-quality stocks.

The U.S. stock market has been on a steady rebound since hitting a low in April, despite uncertainties surrounding trade and geopolitical tensions. Analysts at Morgan Stanley, led by Michael J Wilson, have highlighted three key drivers that are improving the market's fundamentals: earnings revisions, a shift in Federal Reserve policy expectations, and the easing of geopolitical and policy risks.

Since mid-April, the breadth of earnings revisions for the S&P 500 index has improved from a low of -25% to -5%, indicating a significant improvement in corporate earnings expectations. Historically, such turning points have often preceded strong market returns. Additionally, market expectations for a rate cut by the Federal Reserve have been rising, with Morgan Stanley predicting up to seven rate cuts by the end of next year. This could provide significant support for stock valuations in the second half of this year. Furthermore, the easing of geopolitical and policy risks has boosted market confidence.

These dynamics have collectively improved market sentiment, particularly for large-cap, high-quality stocks, which are expected to perform well over the next 6-12 months. The report emphasizes that earnings revisions, driven by positive adjustments rather than a reduction in negative revisions, have been a key driver of the market's recovery. Historically, when earnings revisions show a V-shaped recovery, the market tends to deliver strong returns over the following 12 months.

Large-cap, high-quality stocks, represented by the Mag 7, have continued to lead in both earnings revisions and stock performance. While small-cap stocks have also participated in the rally, they remain well below their historical highs, reflecting their weaker pricing power and higher sensitivity to interest rates. The report attributes the recent outperformance of earnings growth over economic growth to a weaker dollar and tax incentives from the "Inflation Reduction Act."

Overall, the economic fundamentals remain resilient. Hard data continues to show strong resilience, with the job market maintaining stable hiring conditions rather than strong growth. Capital expenditure growth is at a turning point, poised to accelerate. The shift in expectations for Federal Reserve monetary policy is another key factor supporting U.S. stock valuations. The market is already pricing in the possibility of rate cuts in the second half of 2025, with Morgan Stanley predicting up to seven rate cuts by the end of next year. This expectation could be a significant boost for the stock market in the second half of this year.

Historical data shows that rate-cutting cycles by the Federal Reserve typically benefit the stock market, even if the market prices in these expectations ahead of time. The report highlights that job market data will be a critical factor in triggering a policy shift by the Federal Reserve. If private-sector job growth significantly falls short of expectations, it could prompt the Federal Reserve to begin cutting rates in the coming months.

The easing of geopolitical risks has also contributed to market stability. Oil prices have fallen 14% since June 19, significantly reducing the potential threat of rising oil prices to the business cycle. Additionally, concerns about the "capital tax" provision in the "Inflation Reduction Act" have been alleviated, removing a risk to foreign direct investment in the U.S. The bond market's term premium has also declined over the past month, with the 10-year Treasury yield remaining below 4.5%, reducing interest rate risks.

The strategic shift by the Trump administration towards the Middle East, particularly investments related to AI development, could bring new growth opportunities for large U.S. companies, further solidifying their high valuation premiums. Morgan Stanley also emphasizes a preference for large-cap, high-quality stocks, noting that while small-cap stocks have participated in the rally, the Russell 2000 index remains well below its historical highs. In contrast, the Nasdaq 100 and S&P 500 indices reached new highs last week.

The report notes that current stock risk premiums are at a 20-year low, while earnings risk is at a 20-year high, presenting a notable contradiction. However, considering the productivity gains driven by AI, which are expected to add 30 basis points to the net profit margin of the S&P 500 by 2025-2026 and expand to 50 basis points by 2027, the long-term outlook remains optimistic. The third quarter will provide more clarity on how tariff costs are being distributed, but by the fourth quarter, the impact of tariffs is expected to have peaked. Overall, inflation risks may be lower than employment risks, especially as AI technology becomes more widespread.