Bull Market Recovery Driven by Policy Sequencing and Dovish Fed
TL;DR
- A new bull market began in April, signaled by the end of a rolling recession and bear market, presenting an underappreciated opportunity for significant earnings upside as the recovery broadens.
- The Trump administration's policy sequencing, intentionally growth-negative initially, is now positioned as growth-positive for 2026, aligning with a "run it hot" thesis despite market skepticism.
- The Federal Reserve is expected to deliver more dovish policy than anticipated due to labor market weakness and the administration's growth objectives, despite near-term risks from data delays.
- A new business cycle is underway, but the typical broadening of stock performance is delayed by the Fed's later-than-normal easing policy, holding back a full rotation to early cycle winners.
- The S&P 500 target of 7800 by year-end assumes 17% earnings growth, supported by anticipated volume and pricing improvements, with certain sectors like Financials, Industrials, and Healthcare favored.
- Strategic sector preferences include overweighting Consumer Discretionary (Goods over Services) and favoring Software over Semiconductors, alongside a shift to favoring small caps over large caps for the first time since March 2021.
Deep Dive
Morgan Stanley's 2026 outlook posits a growth-positive year driven by a deliberate policy sequencing strategy and the early stages of a new bull market that began in April. This perspective, which remains out of consensus, anticipates that initial growth-negative policies will transition into a "run it hot" environment conducive to broader economic recovery and corporate earnings growth, despite near-term risks from delayed Federal Reserve action. The opportunity lies in an underappreciated bull market that has just begun, with significant upside potential as the recovery broadens and operating leverage returns.
The core of this constructive view rests on the administration's strategy of "kitchen sinking" the economy at the outset to clear the decks for subsequent growth initiatives, a tactic informed by the economy's reduced slack compared to previous cycles. This policy cadence, while executed faster than anticipated, is seen as growth-positive for 2026. Furthermore, April marked the end of a three-year rolling recession, signaling the emergence of a new bull market and recovery. This recovery, however, has been hampered by the Federal Reserve's delayed rate cuts, a consequence of COVID-cycle distortions and more recently, government shutdowns impacting labor data releases. This delay has suppressed the typical broadening of stock performance towards early-cycle winners. The confluence of labor market weakness and the administration's desire to "run it hot" suggests the Fed will ultimately adopt a more dovish stance than currently priced in by markets, creating a near-term risk but reinforcing the long-term bullish outlook. The market's underappreciation of this nascent bull market, evidenced by the S&P 500's 20% decline and average stock's 30% drop into April, suggests significant upside for earnings due to anticipated volume and pricing improvements.
The implications for investment strategy are clear: substantial earnings growth is expected, making many stocks less expensive than they appear. Morgan Stanley's 12-month target for the S&P 500 is 7800, projecting 17% earnings growth with modest valuation contraction. Key sector preferences include Financials, Industrials, and Healthcare, with an upgrade to Consumer Discretionary, favoring goods over services. Relative trade recommendations include Software over Semiconductors and Small Caps over Large Caps, reflecting an anticipation of early-cycle broadening and a more accommodative Fed. The overarching takeaway is that the current market narrative remains underappreciated, presenting a favorable environment for those who recognize the early stages of this recovery and its associated earnings upside.
Action Items
- Audit policy sequencing: Analyze 3-5 past policy shifts for growth-negative to growth-positive transition timing and impact.
- Measure market disconnect: For 3-5 sectors, calculate correlation between unemployment rates and stock performance.
- Track consumer services recession: Monitor 3-5 key service sector indicators for signs of ongoing recessionary trends.
- Evaluate Fed policy timing: Assess 2-3 potential Fed actions against labor market data releases for dovish policy expectations.
- Analyze earnings upside: For 5-10 companies, project operating leverage return based on volume and pricing trends.
Key Quotes
"We based our differentiated view on the notion that policy sequencing in the new Trump administration would intentionally be growth-negative to start. We likened the strategy to a new CEO choosing to kitchen sink the results in an effort to clear the decks for a new growth-positive strategy. We thought that transition would come around mid-year."
Mike Wilson explains that the administration's initial policy approach was designed to be intentionally growth-negative. Wilson uses the analogy of a new CEO "kitchen sinking" results to clear the way for future growth. This strategy was anticipated to transition around the middle of the year.
"The US economy had much less slack when President Trump took office the second time compared to the first time he came into office, and this was the main reason we thought it was likely to be sequenced differently."
Mike Wilson highlights a key difference between the two Trump administrations. Wilson points out that the US economy had less available capacity or "slack" when Trump began his second term. This reduced slack was a primary factor in Wilson's expectation that economic policy would be implemented differently this time.
"In short, we believe a new bull market and rolling recovery began in April, which means it's still early days and not obvious, especially for many lagging parts of the economy and market. That is the opportunity."
Mike Wilson asserts that a new bull market and a broad economic recovery commenced in April. Wilson emphasizes that this phase is still in its early stages and not yet apparent across all economic sectors or market segments. Wilson identifies this lack of broad recognition as a significant opportunity.
"The missing ingredient for the typical broadening in stock performance that happens in a new business cycle is rate cuts. Normally, the Fed would have cut rates more in this type of weakening labor market. But due to the imbalances and distortions of the COVID cycle, we think the Fed is later than normal in easing policy, and that has held back the full rotation toward early cycle winners."
Mike Wilson identifies the absence of interest rate cuts as a factor limiting broader stock market gains. Wilson notes that typically, the Federal Reserve would lower rates more aggressively during a weakening labor market. However, Wilson believes that due to unique economic conditions stemming from the COVID cycle, the Fed is delaying policy easing, which is hindering a full market rotation.
"In our view, this type of labor market weakness coupled with the administration's desire to run it hot means that ultimately the Fed is likely to deliver more dovish policy than the market currently expects. It's really just a question of timing."
Mike Wilson predicts that the Federal Reserve will implement a more accommodative monetary policy than currently anticipated. Wilson bases this on observed labor market weakness combined with the administration's aim to stimulate the economy. Wilson suggests that the timing of these dovish policy actions is the primary uncertainty.
"For the S&P 500, our 12-month target is now 7800, which assumes 17% earnings growth next year and a very modest contraction in valuation from today’s levels."
Mike Wilson sets a 12-month price target for the S&P 500 at 7800. Wilson explains that this target is predicated on an expectation of 17% earnings growth for the index in the upcoming year. Wilson also anticipates only a slight decrease in market valuations from current levels.
Resources
External Resources
Books
- "2026 U.S. Outlook: The Bull Market’s Underappreciated Narrative" by Mike Wilson - Mentioned as the subject of the podcast episode, detailing an out-of-consensus view on economic growth and market performance.
Articles & Papers
- "insights" (Morgan Stanley) - Referenced as a place to read more from Morgan Stanley.
People
- Mike Wilson - CIO and Chief U.S. Equity Strategist at Morgan Stanley, author of the 2026 U.S. Outlook.
Organizations & Institutions
- Morgan Stanley - Publisher of the "Thoughts on the Market" podcast and the 2026 U.S. Outlook report.
Podcasts & Audio
- Thoughts on the Market - Podcast featuring Mike Wilson discussing the 2026 U.S. economic outlook.
Other Resources
- AI CapEx growth - Mentioned as a factor in the rate of change trough of expectations.
- COVID cycle - Referenced as a period with imbalances and distortions affecting Fed policy.
- DOGE - Mentioned as a factor in a recession in government.
- run it hot thesis - The policy approach favored by the administration for economic growth.
- rolling recession - A period of economic downturn that began three years prior and ended in April.
- S&P 500 - Referenced for its performance metrics, including a 20% decline into April and a 12-month target of 7800.
- S&P stock - Mentioned in relation to its performance, with an average decline of over 30% into April.