Morgan Stanley: U.S. stocks may correct by "5-10%" in the third quarter, but any correction is a good buying opportunity

After several months of strong rebound, Wall Street is facing a key question: Does this new bull market need a "timeout"?

According to the Wind Trading Desk, Morgan Stanley released a latest report titled "Does the New Bull Market Need a Pause?" which points out that although U.S. stocks have entered a new bull market, seasonal headwinds and macro uncertainties in the third quarter of 2025 could trigger a brief pullback of 5-10%. However, strategists emphasize that this will not shake the long-term upward trend of the market, and any pullback should be viewed as a strategic buying opportunity.

The bank's chief U.S. equity strategist Michael J. Wilson and his team clearly stated in the report that their bullish stance in recent months is primarily based on the "V-shaped" recovery of the Earnings Revision Breadth (ERB), which began in April 2025. However, recent weak labor market reports, combined with the Federal Reserve's stance of potentially delaying interest rate cuts due to inflation concerns caused by tariffs, constitute the main catalysts for market consolidation in the third quarter.

This combination of "slowing growth" and "hawkish Federal Reserve," especially during the traditionally weak period from August to October, could lead to a market pullback. Morgan Stanley believes the market needs to digest the risk of delayed interest rate cut expectations from the Federal Reserve, as inflation concerns may limit the Fed's ability to take dovish actions in the face of weak growth data.

Nevertheless, Morgan Stanley is increasingly confident about the outlook for the next 12 months and reiterates its "buy on dips" recommendation. They believe that the current pullback risk is temporary, and long-term drivers such as earnings growth, operational leverage improvement, and the proliferation of artificial intelligence (AI) will support the continuation of the bull market.

Why is the Bull Market "Pausing" in the Third Quarter?

According to Morgan Stanley's analysis, U.S. stocks face multiple potential risks as they enter the third quarter, which collectively contribute to the likelihood of a market pullback.

First, the Federal Reserve's policy path is the biggest uncertainty. The report points out that weak labor data typically prompts the Fed to cut rates, but inflation concerns stemming from tariffs may make it more cautious in its actions. Fed Chairman Jerome Powell has indicated that more signs of weakness in the labor market may be needed before resuming rate cuts, as the risk of policy delays is a major bearish factor that the market needs to digest in the short term.

Second, the lagging effects of tariffs are beginning to show. The report argues that the transmission of tariff costs to corporate sales costs (COGS) and final prices takes several quarters, and that time point has now arrived. For consumer goods companies with weaker pricing power, this could mean a hit to profit margins; for industrial companies that can pass on costs, the impact is relatively smaller.

Additionally, several other factors are also worth monitoring. The report mentions that due to the strengthening dollar, the growth rate of global money supply is slowing, which could put pressure on risk assets in the short term. Meanwhile, the unusually rapid Earnings Revision Breadth (ERB) since April may need a "pause for breath," and any slowdown or slight retreat in its growth could exert pressure on the stock market in the coming months Specifically:

• The Fed's "Dilemma": Weak labor data should prompt the Fed to cut interest rates, but concerns about inflation potentially triggered by tariffs may keep the Fed on the sidelines for a longer period. This combination of "slowing growth" and "policy inaction" is unfavorable for the stock market.
• Lagging Impact of Tariffs: The transmission effect of tariffs on corporate costs (COGS) and final prices is beginning to show. For consumer goods companies with weak pricing power, this may mean a hit to profit margins.
• Global Liquidity Tightening: Over the past six months, the weakening dollar has driven an increase of nearly $8 trillion in the global dollar-denominated money supply, which has been a significant fuel for the stock market's rise. If the dollar experiences a temporary rebound due to the Fed's stance not being "dovish" enough, the growth rate of global liquidity will slow, putting pressure on risk assets.
• Pause in the Momentum of Earnings Revision Breadth: The breadth of corporate earnings revisions (ERB) has experienced a historic sharp rebound since the low in April. Maintaining such a steep upward momentum is very challenging, and a consolidation or even slight pullback may occur in the short term.
• Threat of Long-Term Rates: The report emphasizes that the 10-year U.S. Treasury yield is a key threshold. Once it breaks 4.5%, it typically puts pressure on stock valuations, and the correlation between stock returns and bond yields turns negative. This is especially true when rising rates are driven by term premium rather than growth expectations. Recently, the term premium remains high, but the price-to-earnings ratio (P/E) has rebounded to high levels.

Is a Pullback a Good Buying Opportunity?

Despite short-term fluctuations, Morgan Stanley maintains a bullish outlook on the U.S. stock market for the next 12 months, with its confidence primarily stemming from the strong recovery in corporate earnings.

The report emphasizes that since mid-April 2025, the breadth of earnings revisions for the S&P 500 has shown a clear "V-shaped" recovery. This is a key technical indicator, as it typically moves in sync with the stock market and leads lagging earnings data. Strategists believe this phenomenon indicates that the bear market that began in 2024 bottomed out in April, marking the start of a new bull market.

Morgan Stanley believes that the market effectively digested expectations of a "mild recession" at the April low. The report proposes a framework of "rolling recessions," indicating that most private sectors and corporate earnings in the U.S. have experienced a non-synchronous recession over the past few years, with many companies cutting costs during this period. Now, with the AI investment cycle bottoming out, the weakening dollar, and cash flow improvements from tax cuts, companies are entering a phase of positive operating leverage and profit expansion

• Corporate Earnings Revision Breadth V-shaped Recovery: Since May, Morgan Stanley's bullish outlook has been primarily due to the observation that the Earnings Revision Breadth (ERB) has achieved a "V-shaped" reversal from a low of -25% in April, and has currently rebounded to +10%. This indicator typically leads actual earnings data during earnings season, signaling a fundamental improvement in corporate earnings prospects.

• Positive Operating Leverage: The report suggests that the U.S. economy has undergone a "rolling recession" over the past three years, during which many companies have cut costs. As demand recovers, these companies will demonstrate positive operating leverage, driving margin expansion.

• AI and New Policy Dividends: The adoption of AI, newly introduced pro-growth tax policies (such as the cash tax savings from the OBBBA Act mentioned in the report), and deregulation measures will collectively drive corporate capital expenditures, M&A activities, and earnings growth, with effects expected to be more pronounced in 2026-2027.

• The Federal Reserve Will Eventually Cut Rates: The report posits that, despite uncertainties regarding timing, the weakness in the labor market and the eventual easing of inflationary pressures will create conditions for the Federal Reserve to initiate a "strong rate-cutting cycle." The market anticipates that rate cut expectations may begin to be priced in as early as the fourth quarter of this year.

The Federal Reserve Will Eventually Shift, the Bond Market Has Signaled

Regarding the Federal Reserve's policies, Morgan Stanley believes that while it may maintain a wait-and-see approach in the short term, the initiation of a rate-cutting cycle is highly probable.

The report analyzes that labor market data is one of the most lagging indicators in the Federal Reserve's decision-making, often leading to a "half-step behind" approach in both rate cuts and hikes. However, the market has already acted in advance. The report cites data indicating that the bond market currently estimates an 88% probability of a Federal Reserve rate cut in September, and the 2-year U.S. Treasury yield is approximately 80 basis points lower than the federal funds rate. Historically, this widening spread is often a precursor to rate cuts.

Morgan Stanley's internal view is that the Federal Reserve may not cut rates this year, but the extent of rate cuts next year will exceed expectations. The report suggests that as long as a deep recession does not occur, this path will be "very favorable" for the stock market. Once inflation concerns dissipate, weak labor data will prompt the Federal Reserve to take more aggressive rate-cutting measures, providing strong liquidity support for the stock market.

Focus on the Market and AI

Based on the judgment of "short-term pullback, long-term bullish," Morgan Stanley believes that "buying on dips" is key.

The report points out that the market low in April 2025 will be a solid bottom, and even if the economy is "officially" declared to be in recession in the fall and winter, the market will hold its ground. Therefore, any 5-10% pullback triggered by short-term factors should be viewed as a good opportunity to increase holdings of quality assets In terms of sector and style selection, the report recommends favoring large-cap stocks over small-cap stocks, and industrial stocks over consumer discretionary stocks. This is partly due to the greater impact of tariffs on profit margins in the consumer goods sector, and partly because large-cap and industrial stocks are better positioned to benefit from economic recovery and capital expenditure cycles.

Additionally, the report emphasizes the importance of artificial intelligence (AI) as a long-term investment theme. Morgan Stanley's research team has categorized the impact of AI on different companies and suggests focusing on those "AI adopters" and "enablers" for whom AI is core to their business and who possess strong pricing power. AI-driven productivity improvements will be a key driver of corporate profit growth in the coming years.

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