4 Market Events That Could Spur the Next Leg of the Rally

After one of the best first halves for U.S. stocks in the past 50 years, the S&P 500 has continued to set new highs in July, powered by expectations that the current economic slowdown will be temporary, as global central banks (including the U.S. Federal Reserve) move to stimulate growth, and trade tensions ease. Bullish investors seem to be preparing for an earnings rebound in the second half of the year.

By now, those potential positives are fully priced into stocks, so the market needs fresh upside news to drive further gains. My view for the past few months has been, and continues to be, cautious, as has Morgan Stanley’s overall. Here are four of the most credible potential catalysts for more upside to the U.S. stock market rally, as well as some reasons to be wary of that exuberant narrative:

• The Fed could cut rates by a half a percentage point on July 31: Futures markets now reflect a 67% likelihood that the Fed will cut rates by that much—rate cuts usually come in quarter-percentage-point increments—at the conclusion of its next meeting at the end of this month. The fact that a 50 basis point cut isn’t fully baked in leaves some room for upside if the Fed were to cut by that much—especially if at the same time global central banks also provided more stimulus (cutting rates is one way central banks stimulate the domestic economy because lower rates encourage companies and individuals to borrow money and spend more). The 50 basis point cut may not happen, however, as some economic reports, such as retail sales, employment gains and regional manufacturing surveys, have turned up in the past week, potentially making the need for a major rate cut less apparent.

• U.S. consumer spending could strengthen: Some bullish investors believe U.S. consumers will increase spending in the coming months, boosting growth. Indeed, some key readings of consumer-spending strength have improved lately, such as retail sales and employment. Consumer sentiment remains high. I’d caution that these can be lagging economic indicators.

• The U.S dollar could weaken substantially: When the dollar weakens against other major currencies, that makes U.S. exports cheaper (and more appealing to foreign buyers), while making imports more expensive. Those dynamics should be positive for U.S. corporate earnings. However, given that U.S. stocks and the strong dollar have been locked in a virtuously supportive dynamic for years, I think a weaker dollar now could benefit non-U.S. stocks more than U.S. stocks.

• More individual investors could jump into stocks. Many retail investors have remained on the sidelines during the rally. If they buy in now, chasing performance, those inflows could fuel further market gains. We haven’t seen that kind of market exuberance yet. However, it’s worth pointing out that retail investors generally have had less influence on market direction in recent years. A bigger factor has been corporate stock buybacks, which may be curtailed by profit slumps. 

Investors should weigh the likelihood of such catalysts, given that the positives—a rate cut, good news on trade and an economic soft landing—are in our view already priced into markets.

I see a decent likelihood that the four factors I’ve outlined will be positive over the next year. If they come to pass, however, the S&P 500 may not be the biggest beneficiary. Given that, I suggest investors use active stock selection to choose among the small-to-midcap, value-style, cyclical and non-U.S. equities that I believe would be the main beneficiaries of stronger economic growth ahead.

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