Morgan Stanley: The U.S. economy and markets are not synchronized, and this gap will continue to widen.

Recently, Morgan Stanley released a research report titled "Weekly World View: Economy and Market," focusing on the differences between the economic outlook and the views of the US stock market by strategists. The report mentioned that the US economy is expected to slow down in the second half of the year, but the target point for the S&P 500 index after one year is 6500 points. Morgan Stanley expects the US dollar to continue to decline by 10%, and these drastic fluctuations imply that the gap between the economy and the market will widen. In the report, Morgan Stanley stated that not everyone is interested in economics like we are, but investors focus on the economy because it helps drive the market. However, it is crucial to remember that the economy is not the market, and the stock market is not the economy. This fact is especially true now, and current policies may magnify this difference. For example, policies not only affect different companies differently but also have a significant impact on the Gross Domestic Product (GDP). Similarly, the fluctuation of the US dollar will have a greater impact on some companies, but overall, the overseas profits make up a much larger percentage of the S&P 500 index than the 12% export share in the GDP. Currently, we predict that the US and global economy will slow down significantly, while the stock market remains resilient, and our colleagues remain positive. Let's delve deeper. We believe that inflation will rise in the coming months as the impact of tariffs gradually translates into consumer prices. Historically, the impact of tariffs on the personal consumption expenditure price index has a lag of about 3-4 months, but the current adjustment of supply chains and inventory cycles may complicate the situation. In this context, we expect the US economy to slow down in the second half of the year with the implementation of tariffs and immigration restrictions. The latest non-farm employment report shows a cooling labor market but not a collapse, as the rise in the unemployment rate is due to an increase in labor force participation. Immigration restrictions are slowing down the growth of the labor supply, which is consistent with the latest non-farm employment data. These factors should prompt the Federal Reserve to maintain the current interest rates for longer than the market expects. These unfavorable factors lie ahead, so should some work be done to reconcile short-term economic risks with the long-term target of the S&P 500 index? Chart 1: The economic slowdown caused by tariffs and immigration restrictions will become evident in the second half of this year, but we expect the Federal Reserve to keep interest rates unchanged throughout the year. Morgan Stanley's stock strategy team targets the S&P 500 index at 6500 points in one year, based on earnings per share close to $300 (about a 10% increase) and a P/E ratio of 21.5. To address this apparent conflict, our stock strategists expect increased volatility by the end of the summer. Another key point is that earnings growth is essentially nominal, while the economic slowdown we mentioned is more significant in terms of real GDP. There is still a gap between our 4% nominal GDP growth forecast and earnings forecast, but as shown in Chart 2, although there is a correlation between earnings and nominal GDP growth, the deviation may continue. Chart 2: There may and indeed are persistent deviations between the economy and the market. Other drivers of differences between earnings growth and nominal GDP growth are related to the trends of the US dollar, regulatory policies, and fiscal policies. The stock market has a much larger exposure to other regions globally than the overall economy. So far, the US dollar has dropped by nearly 10%, and our internal view suggests it may fall by about another 10%. These pronounced fluctuations mean that the gap between the economy and the market will widen. Regarding fiscal policy, economic literature clearly states that total demand, not tax treatment, is the primary driver of investment spending, but recent tax provisions are likely to disproportionately affect the earnings of certain industries. We believe that deregulation is significant for corporate profits but less impactful on revenue. The recent reduction in supplementary leverage ratios is a good example we expect this to not boost the GDP but provide strong support for bank earnings. Finally, as inflation peaks and starts to decline, and the labor market is very weak, we expect the Federal Reserve to start cutting interest rates. Our strategy colleagues believe this fact will support the P/E ratios, which standard macroeconomics find challenging to evaluate. Looking ahead, as markets usually do, the productivity boost from artificial intelligence is coming, and the market can fully price in these earnings before they are reflected in the GDP data. The market is not the economy, and the economy is not the market.