Morgan Stanley IM: Investing Outlook Brightens in Second Half Amid U.S. Policy Developments

KEY TAKEAWAYS

1. Tariff concerns that interrupted market gains earlier this year are receding.
2. The passage of the U.S. tax and spending bill, along with deregulation, may balance tariff impacts, and potential strength in U.S. assets may surprise investors in the second half of 2025.
3. Foreign holders’ selling of U.S. Treasuries may reflect a rebalancing with their holdings at record highs, and the safe haven status of U.S. assets remains intact.
4. Growth and earnings forecasts for the third and fourth quarters came down earlier this year, leaving room for second-half results to beat expectations.

The uncertainty that whipsawed markets earlier this year has given way to greater clarity—and a more positive outlook for the second half. Concerns about the potential impact of high tariffs have eased overall, despite a drop in markets following the Aug. 1 implementation of new U.S. tariffs on imports from countries that had not yet reached trade deals. The completion of the U.S. tax and spending policy legislation may strengthen opportunities for growth.

“As it pertains to tariffs, markets have understood that there’s a pathway to getting some form of agreement,” Jim Caron, Chief Investment Officer of Morgan Stanley Investment Management’s Portfolio Solutions Group, said on a recent webinar for The BEAT, an investing insight series. “There is wiggle room and negotiation around these tariff numbers.”

A range of U.S. policies may give companies a boost, even though tariffs may increase costs for some. Deregulation being pursued by the U.S. administration may lower business costs in certain areas, and in the tax and spending bill, accelerated depreciation may reduce companies’ taxable income. In addition, some government spending policies that may have crowded out private-sector activity are changing, and this shift may accelerate business investment and capital expenditures.

Investors can consider the following key investing themes across assets in the second half of the year:

• Demand for U.S. Treasuries
• Potential for U.S. stocks to surprise to the upside
• Attractive entry points into private market
  

Demand for U.S. Treasuries

Despite discussion in fixed-income markets about the reduction of foreign ownership in U.S. Treasuries, the selling may simply be a rebalancing of exposure—not an indication that foreign holders of U.S. assets no longer view Treasuries or the dollar as safe havens.

Overall, the U.S. Treasury market should not lose sponsorship,” Caron said. “It is merely expected to shift from foreign to domestic buyers.”

Regulatory change could potentially create additional demand for U.S. debt, according to Caron. Shifting regulations related to banks’ supplementary leverage ratios may already be creating increased domestic demand for Treasuries. In addition, a future change in rules that would require banks to hold excess reserves at the Fed could prompt them to shift that money into Treasuries.

“Overall, the U.S. Treasury market should not lose sponsorship. It is merely expected to shift from foreign to domestic buyers.”

Jim Caron
Chief Investment Officer, Portfolio Solutions Group

U.S. investors that may want to consider a strategic rebalancing could sell Treasuries and buy international fixed income assets, including European and Japanese government bonds, and hedge back to U.S. dollars to mitigate risks associated with fluctuations in exchange rates, Caron said. The risk in this strategy would be if Treasury yields were to fall substantially relative to European government debt, though that appears unlikely, given ongoing concerns about the U.S. deficit, resilient economic growth and the Fed’s reluctance to deliver substantial rate cuts.

Potential for U.S. Stocks to Surprise

In the second half of 2025, deregulation and the implementation of tax and spending policy legislation, along with the potential for company earnings that beat expectations, may lead to upside surprises for U.S. stocks, according to Andrew Slimmon, Head of the Applied Equity Advisors Team at Morgan Stanley Investment Management.

Expectations for U.S. growth declined in April, when the Trump administration first announced a potentially stringent tariff regime. Wall Street economists cut growth expectations for the rest of this year, and while third- and fourth-quarter forecasts have recovered somewhat, they remain below where they started the year. Analysts brought earnings expectations down as well, despite first quarter earnings beating expectations. This lowers the bar for growth and earnings in the second half.

“The opportunity here is that if we have another good earnings season, analysts and strategists are going to be forced to raise their numbers for the full year,” Slimmon said.

Though European stock valuations remain below those in the U.S., and secular tailwinds that helped the region in the first half remain in place, they may not represent the opportunitysome investors believe, according to Slimmon. Especially if U.S. earnings exceed current expectations in the second half, and forecasts rise, comparative valuations may not show as wide a difference. Investors might consider reducing European exposure relative to U.S. stocks to neutral.

“The opportunity here is that if we have another good earnings season, analysts and strategists are going to be forced to raise their numbers for the full year”

Andrew Slimmon
Head of the Applied Equity Advisors Team

Opportunity in Private Markets

Private market fund managers are taking longer to return money to investors, which has resulted in a slowdown in capital raising and favorable entry point for new investors, according to Steve Turner, Head of Investment Selection for the Portfolio Solutions Group in Morgan Stanley Investment Management. “Private markets investors have been experiencing constrained distribution activity since 2022, when the shift in the interest rate regime triggered adjustments across capital markets,” Turner said.

There may have been some optimism in late 2024 that policy clarity would support a pickup in transactions and distributions, but that was interrupted by the uncertainty around tariffs. Distributions are still well below average, and net cash flows to investors are still negative.

“There’s a big takeaway here for investors who are not constrained, who have decision-making that is not driven by trapped capital,” Turner said. “This is a significant opportunity to invest in less well-served assets for potentially outsized returns.”

Investors might consider real estate, with widening capitalization rates, lower entry pricing, stabilized supply, asset pricing below replacement cost and motivated sellers creating potential opportunity, according to Turner.

^{Risk Considerations}

^{There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Asset Allocation/Diversification does not protect you against a loss in a particular market; however it allows you to spread that risk across various asset classes In general, equity securities’ values fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities (MBS and ABS) are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the United States. It is possible that these issuers will not have the funds to meet their payment obligations in the future. The issuer or governmental authority that controls the repayment of sovereign debt may not be willing or able to repay the principal and/or pay interest when due in accordance with the terms of such obligations. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Real estate investment trusts are subject to risks similar to those associated with the direct ownership of real estate and they are sensitive to such factors as management skills and changes in tax laws. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on performance. Trading in, and investment exposure to, the commodities markets may involve substantial risks and subject the Portfolio to greater volatility. Non-diversified portfolios often invest in a more limited number of issuers As such, changes in the financial condition or market value of a single issuer may cause greater volatility. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to a Portfolio’s fees and expenses, a Portfolio generally would bear its share of the investment company’s fees and expenses. Alternative investments are intended for qualified investors only. Alternative investments, including hedge funds, provide limited liquidity and include, among other things, the risks inherent in investing in securities and derivatives, using leverage and engaging in short sales. An investment in an alternative investment fund can be speculative and should not constitute a complete investment program. This summary is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy interests in any fund.}