Is the U.S. recession dragging down the world? Morgan Stanley: This seems increasingly realistic

Morgan Stanley warns that while a global recession is not the baseline expectation, it has become an increasingly realistic pessimistic scenario.

Analysts state that the significant deterioration of asset prices remains an important risk to the outlook for U.S. consumer spending. Although a U.S. recession triggering a global economic downturn is not the baseline scenario, it is becoming an increasingly realistic pessimistic scenario. If the announced tariffs persist in the long term, the downside risks to growth will significantly increase, while the upside risks to inflation will also intensify.

U.S. Recession Risk Soars, Inflation Expectations Adjusted

According to Xinhua News Agency, on April 2nd, U.S. Eastern Time, after the U.S. stock market closed, President Trump signed two executive orders regarding so-called "reciprocal tariffs" at the White House, announcing a 10% "minimum baseline tariff" on trade partners and imposing higher tariffs on certain trade partners.

Vishwanath Tirupattur, head of global quantitative research at Morgan Stanley, analyzes that global trade tensions may enter a period of sustained high levels. The new tariff policy has raised the effective tariff rate in the U.S. to its highest level in a century. European policymakers may go beyond these countermeasures and focus on service trade—where the EU has a significant deficit with the U.S.

Morgan Stanley's U.S. economists emphasize that if the announced tariffs persist in the long term, the downside risks to growth will significantly increase, while the upside risks to inflation will also intensify. The drag from trade and immigration policies is unlikely to be offset by fiscal policy measures and deregulation. Furthermore, the significant deterioration of asset prices remains an important risk to the outlook for consumer spending. Although a U.S. recession triggering a global economic downturn is not the baseline scenario, it is becoming an increasingly realistic pessimistic scenario.

Morgan Stanley currently expects that inflation caused by tariffs will keep the Federal Reserve on hold, and there may not be any rate cuts in 2025. In terms of data, last Friday's strong employment figures supported the Fed's tendency to maintain policy stability. Powell emphasized in his speech last Friday that the Fed will focus on keeping "long-term inflation expectations stable and ensuring that a one-time increase in price levels does not evolve into a persistent inflation problem," indicating that the Fed may remain inactive.

Market Reaction: Panic Not Yet, But Risks Significantly Rise

The market's strong reaction to the tariff announcement raises the question: what economic outlook is currently reflected in market prices?

In Morgan Stanley's view, while the strong negative reaction in risk markets reflects growing concerns about economic growth, the market has not yet priced in an impending recession—at least not at this moment.

The future direction will heavily depend on the persistence of the tariffs. The U.S. government continues to emphasize the "reciprocal" nature of the tariffs, which means that levels may be reduced through negotiations. However, it is currently difficult to interpret how much negotiating space exists and whether there is a way to alleviate the escalating trade tensions.Tirupattur stated that there are two points worth noting amid the current severe market volatility:

First, the "normal" correlation between stocks and bonds has returned—government bonds rise during stock sell-offs.

Morgan Stanley believes that the positive correlation between bonds and stocks moving in tandem over the past few years is an anomaly. The current return to "normal" correlation enhances the diversification benefits of high-quality fixed income assets. If the Federal Reserve does not cut interest rates in 2025, as economists expect, money market yields should remain at current levels (around 4.15%), providing reasonable returns and stability amid fluctuations elsewhere.

Second, the response of the credit market has been relatively restrained, both in terms of credit spread changes and companies' ability to access market financing. Compared to the historical relationship in the stock market, the credit market's response this time has been more moderate.

Morgan Stanley believes that credit is unlikely to serve as a warning indicator, which is different from its role in previous economic and market downturns. There is no doubt that industries with significant tariff exposure (such as retail credit) have already seen notable repricing, but aside from these specific sector changes, the de-risking in the credit market has been relatively orderly.

However, regarding credit spreads, there is still considerable room for further widening in the future. Morgan Stanley credit strategists expect 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 widening of spreads should be viewed as the credit market catching up with other markets in pricing the rising probability of an economic slowdown