Thoughts on the Market: Rolling Recovery and the Equity Landscape

Mike Wilson: Welcome to Thoughts on the Market. I’m Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist.

Today we’re going to discuss client questions and feedback regarding our views, specifically the transition from a rolling recession to a rolling recovery and a new bull market. We’ll also address the tension between market expectations for rate cuts and the Fed’s potential actions, and why accelerating inflation could be positive for equities.

Andrew Pauker: Mike,a key debate with clients centers on whether the labor cycle and earnings recession are behind us or ahead. Can you elaborate on your take and why you believe the rolling recession ended with what you’ve termed “liberation Day,” signaling a transition to an early cycle backdrop?

Mike Wilson: We’ve maintained the view that, starting in 2022, the pullback from COVID-era demand – a demand that was pulled forward – initiated a rolling recession.This began in the technology sector and consumer goods, where demand was most pronounced during lockdowns.

We later saw recessions in housing, manufacturing, commodities, and transportation, resulting in anemic growth.Sectors that remained strong included AI CapEx, consumer services, and government spending. We anticipated, as early as last year, that a government recession would finalize this process. Developments related to debt ceilings – what we call “Doge” – acted as the catalyst. We highlighted this in January, though the full extent of job losses from those efforts wasn’t clear until recently. The data revealed a significant spike, effectively concluding the rolling recession. Even AI CapEx began decelerating in the summer of 2024,and we’re now observing weakness in consumer services.

We believe the rolling recession has now impacted the entire economy. Supporting this is the labor data, confirming significant job reductions, and revisions reinforcing this trend. Private sector data also supports our view. Notably, we’re seeing a V-shaped recovery in earnings revision breadth, a phenomenon we’ve discussed extensively. This kind of recovery is rare, especially following “Liberation Day,” which drove earnings revisions lower and negatively impacted company outlooks.

Furthermore, layoffs haven’t continued at the same pace, the dollar has weakened, and the AI CapEx cycle bottomed out in April – all contributing to a more positive earnings environment. This V-shaped recovery in earnings revision breadth is a rare occurrence, and the private economy is finally emerging from a three-year earnings recession.

Why Some Inflation Could Be Good for Equities

The bond market’s comfort level with the Federal Reserve’s 2 percent inflation target is a key factor to watch.While there’s a risk the Fed might need to except higher inflation to address the national debt, recent bond market behavior suggests this isn’t an immediate concern. As long as yields remain below 4.50 percent – currently near 4 percent – the situation appears manageable.

The uncertainty surrounding the fiscal situation that plagued the bond market in the fourth quarter of last year has diminished. The passage of the recent spending bill provides clarity on the deficit impact, offering the bond market a more stable outlook. This contrasts sharply with the uncertainty leading up to and following the election, where potential policy shifts under a new management created significant volatility.

Andrew pauker: One of the points that our colleague in rate strategy Matt Hornbach has highlighted is that the difference between now and the fourth quarter of last year when we saw that dynamic play out was that, you know, the bond market was very focused on the uncertainty around the fiscal situation. You know, we were going into an election, there was a fair amount of uncertainty around what Trump would do from a fiscal standpoint.

And now, that is a known known, you know. We have the One Big Beautiful Bill signed into law. We know what the deficit impact is, so there is more clarity for the bond market on that front. So that is one key difference now versus last fall and why we may not see the same kind of reaction in the rates market.

The concept of allowing inflation to “run hot” – as outlined in a recent note – suggests that a moderate increase in inflation could actually benefit equities. The deceleration of inflation over the past couple of years has contributed to deteriorating earnings, particularly for small-cap indices. A more tolerant Fed in 2026, allowing for some inflation, could possibly reverse this trend.

Mike, you brought up, kind of, run it hot, which was the title of our note from a couple of weeks ago. I just wanted to get your take on why some inflation coming back is actually a positive for equities and why actually the deceleration that we’ve seen in inflation over the last couple years is one reason why earnings for small cap indices, as an example, have deteriorated so much. And so, for in this environment where the Fed is perhaps a bit more tolerant of inflation in 2026, why t