Morgan Stanley Warns of U.S. Recession Risk Amid Tariff Uncertainty

Morgan Stanley has issued a warning that the possibility of a U.S. recession dragging down the global economy is becoming increasingly realistic. While this scenario is not the baseline expectation, the prolonged existence of announced tariffs significantly increases the downside risks to growth and the upside risks to inflation. The economic landscape is fraught with uncertainty, as the U.S. faces potential stagflation—a combination of high inflation and slow economic growth. This situation poses a dilemma for the Federal Reserve, which must decide whether to raise interest rates to combat inflation or lower them to stimulate the economy, potentially fueling a global asset bubble.

The tariff policies implemented by the U.S. have far-reaching implications, affecting not only domestic industries but also global supply chains. Companies reliant on international trade are grappling with increased costs and operational challenges. The prolonged trade tensions have led to a surge in pessimism among market participants, with some analysts predicting that the U.S. economy could enter a recession by 2025. The economic fallout from these policies is not limited to the U.S.; it has ripple effects across the globe, impacting regions that rely heavily on trade with the U.S.

The economic policies of the U.S. have introduced significant uncertainty into the global market. The potential for a U.S. recession, coupled with the risk of stagflation, creates a complex environment for policymakers and investors alike. The Federal Reserve's decisions on interest rates will be crucial in navigating this economic landscape. Raising rates to control inflation could further slow economic growth, while lowering rates to stimulate the economy could exacerbate inflationary pressures. This delicate balance requires careful consideration and strategic planning to mitigate the potential negative impacts on the global economy.

Analysts at Morgan Stanley have emphasized that the significant deterioration in asset prices remains a critical risk to the outlook for U.S. consumer spending. While a U.S. recession leading to a global economic slowdown is not the baseline scenario, it is increasingly becoming a realistic pessimistic outlook. If the announced tariffs persist, the risks of economic downturn and inflation will intensify. The drag from trade and immigration policies is unlikely to be offset by fiscal policy measures and regulatory easing. Additionally, the sharp decline in asset prices poses a substantial risk to consumer spending prospects.

Morgan Stanley currently anticipates that tariff-induced inflation will keep the Federal Reserve on hold, with no rate cuts expected by 2025. Recent strong employment data supports the Federal Reserve's inclination to maintain policy stability. In his remarks, the Federal Reserve Chair indicated a focus on keeping "long-term inflation expectations stable and ensuring that a one-time increase in price levels does not evolve into sustained inflation," suggesting that the Federal Reserve may remain inactive.

Market reactions to the tariff announcements have been intense, raising questions about the economic outlook reflected in current market prices. While the strong negative response in risk markets indicates growing concerns about economic growth, the market has not yet priced in an imminent recession—at least not yet. The future trajectory will heavily depend on the duration of the tariffs. The U.S. government's emphasis on the "reciprocal" nature of the tariffs suggests that negotiations could potentially lower their levels. However, it is currently challenging to gauge the extent of the negotiation space and whether there is a path to de-escalate the escalating trade tensions.

In the current volatile market conditions, two key points are worth noting. First, the "normal" correlation between stocks and bonds has returned—government bonds rise during stock sell-offs. Morgan Stanley views the past few years' positive correlation between bonds and stocks as an anomaly. The return to "normal" correlation enhances the diversification benefits of high-quality fixed-income assets. If the Federal Reserve does not cut rates by 2025, as economists expect, money market yields should remain at current levels (around 4.15%), providing reasonable returns and stability amidst other fluctuations.

Second, the credit market's response has been relatively restrained, whether in terms of credit spread movements or companies' ability to access market financing. Compared to historical relationships with the stock market, the credit market's reaction this time has been more subdued. Morgan Stanley believes that credit is unlikely to serve as an early warning indicator, unlike its role in previous economic and market downturns. Undoubtedly, industries with significant tariff exposure (such as retail credit) have seen noticeable repricing, but beyond these specific industry adjustments, the credit market's de-risking has been relatively orderly.

However, regarding credit spreads, there is still considerable room for further expansion. Morgan Stanley's credit strategists predict that investment-grade and high-yield cash indices could reach spreads of 150 basis points and over 500 basis points, respectively, in a pessimistic scenario, compared to the current levels (as of Thursday's close) of 102 basis points and 385 basis points. This spread widening should be seen as the credit market catching up with other markets in pricing the increased probability of an economic slowdown.