Morgan Stanley: The current rise in US stocks has solid fundamentals

U.S. stocks have continued to rebound since hitting a bottom in April this year, despite facing trade uncertainties and geopolitical tensions, with the market remaining resilient.

According to news from the Chase Trading Desk, a recent research report by Morgan Stanley analyst Michael J. Wilson and his team points out that the current rally in U.S. stocks is more fundamentally supported than the market generally perceives, with three key driving factors improving: earnings expectation revisions, a shift in Federal Reserve policy expectations, and a reduction in geopolitical and policy risks.

Latest data shows that since mid-April, the breadth of earnings revisions for the S&P 500 index has rebounded from a low of -25% to -5%, indicating that corporate earnings expectations are significantly improving. Historical performance of this indicator suggests that similar turning points typically herald strong future returns.

At the same time, market expectations for Federal Reserve interest rate cuts are also heating up, with Morgan Stanley predicting up to seven rate cuts by the end of next year, potentially providing support for stock valuations in the second half of this year. Additionally, the alleviation of geopolitical and policy risks has further injected confidence into the market.

The report states that these dynamics have collectively driven an improvement in market sentiment, particularly a preference for large-cap quality stocks, which remains bullish in the 6-12 month outlook.

Earnings Improvement: The Core Driving Force of Market Rebound

The report points out that the key indicator of earnings expectation revisions hit bottom on April 17 during Microsoft's earnings report, and has now rebounded from a low of -25% to -5%, with this improvement coming more from positive revisions rather than a reduction in negative revisions.

Historical analysis shows that when earnings revisions exhibit a similar V-shaped recovery, market returns over the next 12 months are often quite strong.

The report emphasizes that large-cap quality stocks, represented by the Magnificent 7, continue to lead in earnings revisions and stock performance, while small-cap stocks, despite participating in the rebound, remain far below historical highs, reflecting their relatively weak pricing power and higher sensitivity to interest rates.

Furthermore, earnings growth is beginning to outpace economic growth, contrasting with trends during 2022-2023. The report attributes this change to a weaker dollar and tax incentive policies in the "Big Beautiful" legislation. Overall, the economic fundamentals still show resilience. The report states that hard data continues to demonstrate strong resilience, the employment market's hiring situation is relatively stable rather than strong, and capital expenditure growth is in the process of bottoming out/re-accelerating.

Federal Reserve Policy Expectations Shift, Rate Cut Expectations May Be Realized Early

Market expectations for the Federal Reserve's monetary policy are shifting, becoming another key factor supporting U.S. stock valuations.

The report emphasizes that the stock market will not wait for a clear signal of a monetary policy shift from the Federal Reserve but will price it in advance. Currently, the market has begun to price in a potential rate cut in the second half of 2025, with Morgan Stanley expecting the Federal Reserve to cut rates seven times by the end of next year. This expectation may become an important positive factor for the stock market in the second half of the year.

Historical data shows that the Federal Reserve's rate cut cycles typically have a positive impact on stock market performance, even if the market prices in this expectation in advance.

The report emphasizes that employment market data will be a key trigger for the Federal Reserve's policy shift. If private sector job growth significantly falls short of expectations, it may prompt the Federal Reserve to begin cutting rates in the coming months.

Geopolitical Risks Ease, Oil Price Decline Reduces Inflation Pressure

The report states that the stock market's performance following recent geopolitical risk events has followed historical patterns, stabilizing in the days after the events.

More importantly, crude oil prices have fallen 14% since June 19, significantly reducing the potential threat of rising oil prices to the business cycle.

Additionally, the previously much-discussed "capital tax" Section 899 is unlikely to be included in the "Big Beautiful" bill, alleviating concerns about risks to U.S. foreign direct investment. Meanwhile, the term premium in the bond market has decreased over the past month, with the 10-year U.S. Treasury yield remaining below 4.5%, reducing interest rate risk.

The Trump administration's strategic shift in the Middle East, particularly regarding investments related to AI development, may bring new growth opportunities for large U.S. companies, further solidifying their high valuation premiums.

Focus on Quality Large-Cap Stocks

Morgan Stanley also specifically emphasizes a preference for quality large-cap stocks, noting that while small-cap stocks have participated in this round of rebound, the Russell 2000 index remains far below its historical highs, while the Nasdaq 100 and S&P 500 indices reached new highs last week.

The report mentions that currently, the equity risk premium is at a 20-year low, while earnings risk is at a 20-year high, which is a contradiction worth noting

However, considering that AI-driven productivity improvements will contribute an additional 30 basis points to the net profit margin of the S&P 500 in 2025-2026, expanding to 50 basis points by 2027, the long-term outlook remains optimistic.

The report adds that the third quarter will better illustrate how tariff costs are distributed, but by the fourth quarter, the impact of tariffs may have peaked. Overall, inflation risks may be less than employment risks, especially in the context of the continuous proliferation of AI technology