A recession might not be the worst thing for the stock market.
In a new note, Mike Wilson, Morgan Stanley’s chief US equity strategist and CIO, said a mild downturn could ultimately set the stage for a bullish run for US stocks, especially if it triggers rate cuts from the Federal Reserve and resets corporate earnings expectations.
It’s a surprising perspective. After all, a recession usually spells trouble for corporate profits, consumer spending, and investor confidence. However, Morgan Stanley believes if a downturn does occur, it won’t be your typical recession.
A mild recession
After trade tensions eased slightly between the US and China, Morgan Stanley said it sees lower recession odds than earlier in the year.
Morgan Stanley’s base case for the S&P 500 in the next 12 months is for the index to hit 6,500, a gain of about 10%, according to the bank’s midyear outlook.
If the economy bounces back from tariff volatility faster than expected, the bank’s bull case for the S&P 500 is 7,200 by this time next year, a gain of 22% from current levels.
But the bank also highlighted an alternative bull case that involves a mild recession before the stock market continues on its upward trajectory.
Morgan Stanley said it believes the most likely way for such a recession to manifest would be a drawdown akin to the April sell-off to occur this summer or fall. While such a scenario doesn’t provide the same level of upside as a bull case without a recession, the bank believes the S&P 500 will have no problem hitting the high 6000s level in the next 12 months.
“Given the rolling recessions we have already experienced and muted growth in much of the private economy over the past few years, we believe the decline in EPS would be more mild than during past recession,” Wilson wrote.
Here’s how a recession and rebound could play out
Companies could continue to struggle with tariff uncertainty and pull the “labor cost lever” — otherwise known as layoffs, something that corporate America has tried to avoid in the past three years — in the next few months. This could be amplified if the Fed focuses on curbing tariff-related inflation and waits too long to cut rates.
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A recession would force the Fed to lower rates to alleviate high unemployment and stimulate the economy, Wilson said. Morgan Stanley economists currently predict a total of seven rate cuts in 2026, which would provide a boost to the stock market.
Expect the market to bottom out and rebound early next year.
“Specifically, EPS growth should trough in modestly negative territory in early 2026 but would be followed by a significant reacceleration in growth led by the more cyclical interest sensitive sectors that have been hurt the most from the crowding out of government spending and higher rates,” Wilson wrote.
Wilson believes a rebound could test stock market highs comparable to the 23x earnings valuations seen in the post-pandemic era.
If a mild recession does occur, investors should expect small caps and lower quality stocks to be the biggest winners, the bank said. That’s because small-cap companies tend to experience relief in low-rate regimes. Investors should keep an eye out in the second half of 2025, as Morgan Stanley believes the rate-cut outlook will become clearer in the coming months.
