Tariffs "pushed up inflation in the third quarter and lowered growth in the fourth quarter," the market is too complacent, Morgan Stanley recommends "long U.S. Treasuries, short U.S. dollars"
Morgan Stanley warns that the market is underestimating the impact of tariffs on the U.S. economy, advising investors to buy U.S. Treasuries and sell dollars to hedge against excessive optimism. It is expected that inflation will rise to 4.0% in the third quarter of 2025, and GDP growth will drop to 0.2% in the fourth quarter. The impact of tariffs will lead to economic turmoil, and while current CEO confidence and the transmission of tariffs to consumer prices do not pose a threat yet, future risks should be monitored
Morgan Stanley warns that the market has underestimated the potential impact of tariffs on the U.S. economy, with sentiment being overly complacent. It advises investors to buy U.S. Treasuries and sell dollars to hedge against excessive market optimism.
On July 29, according to Wind Trading Platform news, Morgan Stanley stated in its latest research report that its economists' baseline forecast shows that tariffs will push the U.S. economy into an inflation "slowdown zone" in the third quarter of 2025, followed by a growth "pitfall" in the fourth quarter. However, the risk market seems indifferent to both scenarios.
Morgan Stanley suggests that investors hedge against market complacency by buying U.S. Treasuries and selling dollars, noting that while rising inflation is already fully anticipated, a slowdown in growth could catch the Federal Reserve and investors off guard, leading to lower U.S. Treasury yields and a weaker dollar.
Morgan Stanley indicated that current CEO confidence and the transmission of tariffs to consumer prices do not pose a threat to the U.S. economy, but investors should be wary of "tariff fatigue," as the economy is expected to experience turbulence in the next six months.
Tariff Impact Pathway: From Inflation Slowdown Zone to Growth Pitfall
Morgan Stanley economists' baseline forecast outlines a clear timeline for tariff impacts: tariffs will elevate inflation in the third quarter of 2025 (inflation slowdown zone), and then immediately drag down economic growth in the fourth quarter (growth pitfall).
Specifically:
The core PCE inflation rate is expected to jump from 2.3% in the second quarter of 2025 to 4.0% in the third quarter, before falling back to 2.9% in the fourth quarter.
Real GDP growth is projected to plummet from 2.1% in the second quarter to 1.2% in the third quarter, and further drop to a mere 0.2% in the fourth quarter.
Notably, Morgan Stanley economists' forecast for the growth slowdown in 2025 is more pessimistic than the median forecast of Federal Reserve FOMC participants, although both forecasts are similar regarding inflation and labor market trajectories.
Morgan Stanley also stated in the report that data shows importers paid new tariffs in April, May, and June at levels not seen in decades. Monthly customs revenue in July appears set to reach new highs.
Data indicates that customs revenue from early July to the annualized $340 billion accounts for 1.10% of nominal GDP, while the average level over decades has only been 0.25%.
Morgan Stanley expects these customs revenues to have a significant impact on the U.S. Treasury's financing needs, helping to delay the increase in coupon bond issuance until 2027
The market is overly complacent, suggesting "long US Treasuries, short USD"
Although importers have paid some tariffs, they may not have passed on all costs to consumers. Before this happens, consumers may continue to behave as if nothing is wrong—recent retail sales data supports this view.
Morgan Stanley believes that CEO confidence represents the most important transmission channel. CEO confidence often changes in sync with economic growth, and the two enjoy a symbiotic relationship.
Data shows that after the announcement of "reciprocal tariffs" in April, CEO confidence briefly approached the net pessimistic zone, and the stock market also briefly entered the "stall zone."
The research report points out that, currently, neither CEO confidence nor the transmission of tariffs to consumer prices poses a threat to the US economy. In this context, the confidence of investors reflected in the performance of US stocks seems reasonable.
However, Morgan Stanley still advises investors to combat tariff fatigue. According to economists' baseline views, the economy will experience turbulence in the next six months, which will drive US Treasury yields lower, as the slowdown in inflation has been fully anticipated, but a deterioration in growth may catch the Federal Reserve and investors off guard.
Morgan Stanley expects the USD to weaken alongside the decline in US Treasury yields and emphasizes that if a slowdown in growth also catches CEOs and stock investors off guard, the stock market may once again enter the "stall zone."
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