Morgan Stanley: Morgan Stanley updates market cycle framework: mature expansion still favors equities, while the stress phase poses a greater test

Why does the cycle indicator point to mature expansion?

Morgan Stanley’s U.S. market cycle indicator has improved continuously since bottoming in October 2024 and is now near a four-year high. In May 2025, the indicator moved from the defensive transition phase into mature expansion, driven by a rebound in consumer loan growth and the housing under construction indicator.
Mature expansion means the composite indicator is above trend and most components are improving. Currently, 7 of the 10 components have strengthened over the past six months, with the breadth of improvement near its best level since the post-pandemic reopening; the employment-to-population ratio, real personal income and mergers and acquisitions activity components weakened over the same period.
The framework combines macroeconomic, credit and corporate risk appetite data to assess the medium-term cycle and relative asset performance.

This is the bank’s first framework update since 2019. Changes in the post-pandemic interest rate and inflation environment reduced the ability of some old indicators to distinguish between strong and weak U.S. equity environments; the new version replaces 5 of the 10 measures, adding data such as durable goods inflation, housing under construction and nonfinancial leverage.
Each component now uses a rolling 10-year history to calculate standardized scores, replacing comparisons with the full historical record to reduce distortions caused by structural change. The 10 measures are then aggregated with equal weights and combined with the breadth of improvement over the past six months to classify the cycle.

Historically, equities have had their clearest advantage over high-yield bonds in this phase: U.S. equities outperform U.S. high-yield bonds by approximately 3.1 percentage points more than usual, while the additional advantage in Europe is 4.6 percentage points. Developed-market equities typically outperform emerging markets, and large-cap stocks also tend to outperform small caps.
Morgan Stanley therefore maintains its view favoring equities over fixed income in global asset allocation and prefers U.S. equities. The bank also believes AI investment could lift equity returns in this cycle above historical patterns: its equity strategists forecast total AI investment of 1.6 trillion U.S. dollars in 2027, with roughly two-thirds translating into revenue for S&P 500 companies.
The bank expects earnings at AI enablers and application companies to grow 25% in 2027, contributing 78% of overall S&P 500 earnings growth; this additional support depends on investment and its transmission into revenue and earnings.

Historically, the indicator has shifted from mature expansion to a defensive phase 11 times, with the Federal Reserve raising rates on a net basis in the preceding 12 months in 8 of those instances. Rate increases typically tighten financial conditions and slow credit growth, while corporate capital markets activity also tends to slow.
Risk-asset momentum usually weakens in the defensive phase, but equities and credit assets have historically still delivered positive total returns. The S&P 500 has averaged a forward 12-month return of about 11% in this phase; however, excess returns on U.S. and European high-yield bonds have been 3 and 5.2 percentage points below their long-term averages, respectively.
Morgan Stanley believes AI capital spending could provide additional support and could also mean that the historical relationship between rate increases and the indicator’s shift to a defensive phase does not recur this cycle.

The market stress phase corresponds to data below trend and continuing to deteriorate. This phase has occurred only 5 times in the model’s history, and most defensive phases have been followed by a return to mature expansion, but risk assets have historically suffered significant declines when the cycle moves into market stress.
Because economic data typically bottom after markets do, a rebound late in the stress phase raises the phase’s average return. Morgan Stanley therefore focuses on the period around the turning point: historically, the S&P 500 fell an average of 38% from its peak during the associated drawdown around entry into this phase, while U.S. high-yield bond excess returns fell 25%.