Key Takeaways
- Despite little concrete evidence that tariff rates will come down anytime soon, stocks rallied last week to erase all of their post-“Liberation Day” losses.
- Stocks were boosted by signs of easing U.S.-China tensions and evidence that corporate earnings and the labor market are resilient despite market volatility.
- Morgan Stanley analysts argue a signed trade deal with China and a dovish tilt from the Fed are likely to be two prerequisites for further stock gains.
- Risks to the rally include the possibility tariffs weigh on the labor market, and headwinds from elevated Treasury yields.
Uncertainty on Wall Street is at its highest level in years, but you wouldn’t have known it watching the stock market last week.
The S&P 500 rose for a ninth straight session on Friday, its longest winning streak since 2004, after a strong jobs report and signs of cooling U.S.-China tensions eased Wall Street’s worst tariff fears. Friday’s session also completely erased all of the index’s losses since President Trump’s “Liberation Day” tariffs announcement on April 2 tanked global markets.
That stocks completely rebounded from April’s rout struck some on Wall Street as odd, considering the murky outlook. Though most of Trump’s “reciprocal” tariffs are paused until early July, duties on Chinese goods remain prohibitively high, and the clock is ticking for the White House to negotiate dozens of trade deals. Plus, nearly all U.S. imports are now subject to a global 10% tariff that went into effect on April 9.
Stocks have lost ground to start this week as investors await new developments on tariffs, amid lingering concerns about the impact the levies will have on the economy and corporate profits.
A Softer Trade Stance, Strong Earnings Outlook
The recent rally, Morgan Stanley analysts wrote in a note on Monday, has been driven by “incrementally positive developments in 2 of the 4 items on our checklist for a more durable rally,” namely, optimism about de-escalation with China and an improving earnings outlook.
Stocks jumped after Treasury Secretary Scott Bessent called the U.S.-China trade war “unsustainable,” stoking optimism for a de-escalation. Trump has since said on multiple occasions that he expects duties on Chinese goods to decline, and China has expressed openness to negotiations. Late Tuesday, the Treasury Department announced that Bessent would travel to Switzerland later this week, and will be meeting with a “lead representative on economic matters” from China during the visit.
Meanwhile, first-quarter earnings have held up better than expected. The S&P 500 is on track to report profits grew by more than 10% last quarter, and several market-driving narratives—insatiable AI demand, for example—remain intact.
The Federal Reserve Could Play a Role
Morgan Stanley thinks that two other criteria will need to be met to maintain the rally: 1. The U.S. and China will need to reach a trade deal that reassures investors and businesses that “de-escalation” is more than just lip service; and 2. Fed officials will need to signal they’re willing to cut interest rates to support growth.
“Equity returns can be quite strong in a late cycle backdrop where economic growth is slowing,” which is likely where we are today, according to Morgan Stanley, “but this type of environment tends to happen only when a more dovish reaction function from the Fed starts to get priced.”
Unfortunately for the optimists in the room, Morgan Stanley’s prognosis comes with a big asterisk: “It’s worth noting that our economists don’t see the Fed cutting rates this year (i.e., this is a tough needle to thread).”
The Fed’s policy committee wraps up a two-day meeting Wednesday and is widely expected to leave its benchmark rate unchanged. Investors will be focused on what the Fed says about how tariffs are affecting the outlook for the economy and monetary policy.
Another risk is the possibility that tariffs cause labor market conditions to deteriorate. Small businesses, which employ nearly half of all American workers, can’t adapt to tariffs as easily as their corporate competitors, whose size increases their pricing and financing flexibility. The job market held up in April despite tariff uncertainty, but experts warn it could take months for the full effect of tariffs to become apparent.
Elevated interest rates also threaten to derail the rally. “[Treasury] yields have been surprisingly sticky in the context of slowing growth expectations,” Morgan Stanley analysts note. If the 10-year Treasury yield rose above 4.5%, that would likely push the “equity return/bond yield correlation”—an indicator of stocks’ sensitivity to Treasury yields—“meaningfully negative again, thus pressuring valuations.”
