The Rally Is Back, But Risks Are Rising

The speed of the equity rebound is impressive, but the bigger question for investors is what’s powering it—and what could derail it.

A sharp rebound has lifted equity markets to new highs, driven by heavy spending on AI infrastructure and rising earnings expectations. However, household balance sheets are increasingly fragile, long-term rates are rising, and equity gains have been concentrated in a small group of stocks, posing risks for investors. Stronger performance outside the U.S., including Japan and parts of emerging markets, is reshaping where opportunities may sit. After a difficult first quarter, U.S. equity markets have delivered an extraordinary start to the second quarter. In just seven weeks, stocks have not only recovered lost ground – they have pushed to new highs for the year, with the S&P 500 Index up more than 8% year to date. That kind of move can make the market feel unstoppable. However, Morgan Stanley’s Global Investment Committee believes it is important for investors to consider the drivers of the market’s momentum, as well as the potential challenges ahead. Here are five things investors should keep in view heading into summer. 1 Stocks are up, but households are under strain The Global Investment Committee is tilting portfolios toward stocks, seeing potential for roughly 11% to 12% upside over the next nine to 12 months. Our one-year target for the S&P 500 is 8,300. Still, the economy underneath this rally does not appear evenly strong. The rally is driven heavily by a spending boom on artificial intelligence (AI) infrastructure that has helped semiconductor stocks enjoy historically rare market gains. U.S. consumers, meanwhile, are not keeping pace. When adjusted for inflation, household purchasing power has weakened, and signs of stress are becoming harder to ignore: Rising credit-card delinquencies, more personal bankruptcies, and incomes lagging inflation all point to an increasingly fragile consumer. The Global Investment Committee is tilting portfolios toward stocks, seeing potential for roughly 11% to 12% upside over the next nine to 12 months. Our one-year target for the S&P 500 is 8,300. Still, the economy underneath this rally does not appear evenly strong. The rally is driven heavily by a spending boom on artificial intelligence (AI) infrastructure that has helped semiconductor stocks enjoy historically rare market gains. U.S. consumers, meanwhile, are not keeping pace. When adjusted for inflation, household purchasing power has weakened, and signs of stress are becoming harder to ignore: Rising credit-card delinquencies, more personal bankruptcies, and incomes lagging inflation all point to an increasingly fragile consumer. 2 Profits are strong, but markets are narrow Positive corporate earnings data has sustained the market recently: First-quarter results delivered meaningful upside surprises, and analysts have raised expectations for earnings growth over the next several years. However, even as earnings forecasts improve broadly, equity price gains have stayed concentrated, with only a small group of large stocks and sectors, especially those tied to the AI buildout, driving most of the market’s recent advance. That suggests that either more stocks could begin catching up or – more on this below – that earnings optimism is overstated. Positive corporate earnings data has sustained the market recently: First-quarter results delivered meaningful upside surprises, and analysts have raised expectations for earnings growth over the next several years. However, even as earnings forecasts improve broadly, equity price gains have stayed concentrated, with only a small group of large stocks and sectors, especially those tied to the AI buildout, driving most of the market’s recent advance. That suggests that either more stocks could begin catching up or – more on this below – that earnings optimism is overstated. 3 Pricing is driving profitability As investors get excited about stronger earnings, it’s worth asking whether companies are generating these profits from higher productivity or pricing power. Productivity-driven gain

Insights to help you go further. Disclosures: Index Definitions For index, indicator and survey definitions referenced in this report please visit the following: https://www.morganstanley.com/wealth-investmentsolutions/wmir-definitions Risk Considerations Important note regarding economic sanctions. This report references jurisdiction(s) or person(s) that are the subject of economic sanctions. Any references in this report to jurisdictions, persons (individuals or entities), debt or equity instruments, or projects that may be covered by such sanctions are strictly incidental to general coverage of the relevant economic sector as germane to its overall financial outlook, and should not be read as recommending or advising as to any investment activities in relation to such jurisdictions, persons, instruments, or projects. Readers are solely responsible for ensuring that their investment activities are carried out in compliance with applicable laws. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies. Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Also, municipal bonds acquired in the secondary market at a discount may be subject to the