This driver explains why traders shouldn't fight the S&P 500 rally

Morgan Stanley's equity strategy team forecasts a stronger second half of 2025 for the S&P 500, citing an improving rate of change in earnings-per-share revisions and discounted growth slowdown concerns. They anticipate dollar weakness, a bottoming of the AI capex cycle (with Nvidia's gross margins stabilizing), and potential Fed rate cuts in late 2025 as further tailwinds for the market, favoring cyclicals and high-beta growth areas, with capital goods and financial services expected to attract buyers if momentum continues.

Analysis

Morgan Stanley's equity strategy team projects a robust second half for the S&P 500 in 2025, driven by an anticipated V-shaped recovery in earnings-per-share revisions breadth from extreme lows, a pattern historically associated with supportive equity markets and shallow pullbacks. The strategists contend that concerns over a growth slowdown, stemming from trade war hostilities, are now largely priced into the market, and while macro data and earnings may soften over the summer of 2025, a subsequent recovery is expected. This optimistic outlook is further supported by key leading indicators signaling a rebound from tariff-induced uncertainty and a payback in demand following a "pre-tariff pull forward." Identified tailwinds include expected U.S. dollar weakness, with Morgan Stanley forecasting the dollar index to reach 91 by mid-2026, and the bottoming of the AI capital expenditure cycle. Evidence for the latter includes Nvidia's gross margins stabilizing at a perceived surer footing of 60.5%, compared to 78.4% in 2024, following negative sentiment in January 2025 from China's DeepSeek announcement. Furthermore, the team anticipates a potential Federal Reserve pivot towards rate cuts in late 2025, contingent on clearer visibility of tariff effects and the need for liquidity to support Treasury deficit financing. The S&P 500's recent performance, closing above 6,000 and reflecting a 24% gain from its April 7, 2025 low, along with year-to-date gains of 10% for the Industrial Select Sector SPDR ETF (XLI) and 6% for the Financial Select Sector SPDR ETF (XLF), are cited as current market conditions supporting their preference for cyclicals and higher beta growth areas.

Key Decisions for Investors

• Investors should consider the potential for continued S&P 500 strength into the second half of 2025, particularly if the forecasted V-shaped recovery in earnings revision breadth materializes.
• A strategic focus on cyclical and higher-beta growth sectors, such as capital goods and financial services, may be warranted, especially if existing market momentum in these areas persists, aligning with Morgan Stanley's favorable view.
• Key indicators to monitor closely include trends in earnings-per-share revisions, U.S. dollar exchange rates, developments within the AI capital expenditure cycle (notably Nvidia's financial health and margin trends), and any shifts in Federal Reserve monetary policy towards rate reductions or increased liquidity provision.