Morgan Stanley expects that AI financing pressure, the midterm elections and tightening liquidity could push the S&P 500 into a further pullback, with a low possibly reaching 7,100 points, while it still maintains its year-end target of 8,000 points.
Morgan Stanley warned that the U.S. stock market may not yet have completed this round of correction. Three factors - pressure on artificial intelligence financing, the midterm elections and persistently tightening financial conditions - could drive the S&P 500 lower in the coming weeks, but the firm still expects the market to move higher again before the end of the year.
Mike Wilson, Morgan Stanley's chief U.S. equity strategist, said in his latest client note that the S&P 500 could fall to around 7,100 points in the short term, equivalent to a decline of about 8% from recent levels, marking the largest correction since the market turmoil triggered by the Iran war this year. Despite a more cautious short-term view, Morgan Stanley still maintains its base-case forecast of 8,000 points for the S&P 500 by year-end. If the index recovers from around 7,100 points to that target, the rebound would be about 12%.
Internal market correction has lasted for months, while AI financing pressure still needs to be digested
Wilson believes the U.S. stock correction that began in June has entered its final phase. Although the main stock indexes had still been hovering near record highs, a large number of individual stocks have already suffered sharp declines. Morgan Stanley's calculations show that since early June, about 60% of Russell 3000 constituents have fallen more than 20% from their stage highs, more than one-third have dropped 30%, and about one-eighth have fallen more than 50%.
The correction within the technology sector has been especially pronounced. The firm's data show that about 96% of semiconductor stocks have fallen more than 20% from their highs, and 87% have dropped more than 30%. Wilson believes the gap between index performance and individual stock moves may ultimately be corrected through a further pullback in the S&P 500. His tactical downside target is around 7,100 to 7,200 points, slightly below the index's 200-day moving average.
Morgan Stanley sees the outlook for artificial intelligence investment and financing as the first risk that needs to be digested in the short term. Recently, investors have become doubtful about the return prospects for AI capital expenditure, while credit spreads on data center-related bonds have widened, raising financing costs for some companies. As technology companies continue to issue bonds and shares to raise funds, the capital market also needs to absorb a large supply of new securities. Rising financing costs and increased debt issuance have left the AI investment chain facing a more complicated funding environment.
The credit condition of some companies has also drawn attention. The debt of AI cloud computing company CoreWeave entered distressed debt territory this month, intensifying market concerns about related financing risks. Wilson expects AI financing problems may come to a head within the next three to four weeks, with the semiconductor industry at the center of the related pressure. Morgan Stanley judges that the semiconductor sector may find interim support around mid-November, but before that it could still fall another 10% to 15%. The firm believes the timing of the end of the sector's correction may roughly coincide with the easing of financing concerns.
U.S. midterm elections approach, market focuses on post-election uncertainty
The second potential clearing event is the U.S. midterm elections on Nov. 3. Morgan Stanley noted that, based on historical data, the months before midterm elections are often a period of relatively weak performance for U.S. stocks. Previous Goldman Sachs data showed that in midterm election years since 1974, the median return for the S&P 500 from Aug. 1 to voting day was zero. By contrast, historical performance after elections tends to be more positive. Morgan Stanley's analysis of market data from 1950 to 2022 shows that three months after U.S. midterm elections, the S&P 500 rose about 8% on average; over the following six months, the average cumulative gain was about 15%.
The firm believes the election itself may become a point in time that removes political uncertainty from the market. Regardless of the specific outcome, the end of the election may reduce some policy risks that investors previously found difficult to assess. However, policy changes after the election remain an important variable. Wilson mentioned in the report that the Trump administration had previously signaled it could expand military action against Iran after the election. Related uncertainty has become one of the market risks receiving attention in recent conversations with clients. Morgan Stanley said the timing and actual impact of such sudden events are difficult to predict accurately, so it has not treated a specific military escalation as a definite scenario.
Fed liquidity policy may determine when the correction ends
The third risk comes from persistently tightening U.S. financial conditions, and Wilson views liquidity changes as an important factor that could trigger the market's final round of declines. The Federal Reserve raised the target range for the federal funds rate by 25 basis points in September to 3.75% to 4.00%, after which U.S. Treasury yields rose markedly. High energy prices and a slower pace of central bank balance sheet expansion have also increased pressure on risk assets.
Wilson pointed out that even if the Fed does not continue raising policy rates, rising bond yields alone will tighten financial conditions by raising financing costs. This market-driven tightening may help the Fed restrain economic growth and inflation, but it could also create pressure that financial markets find difficult to bear, prompting the central bank to reassess its policy stance. Morgan Stanley believes the market needs to closely watch whether the Fed signals increased liquidity. If financing pressure continues to expand, a monetary policy adjustment could become an important catalyst for ending the stock market correction.
However, there are not yet obvious signs of stress in money markets that would force the central bank to intervene immediately. Market participants widely expect the Fed to keep rates unchanged at the monetary policy meeting ending on Wednesday, according to a Wednesday report. The CME FedWatch Tool shows the market is pricing about a 90% probability of no change in rates. In such a policy environment, Wilson believes the market's earlier correction has already digested some risks, but the main indexes may still need to fall further to align with weaker market breadth.
Morgan Stanley currently continues to favor companies with higher earnings quality and sound financial conditions, and believes a market environment more suitable for increasing risk exposure may emerge in the coming weeks. The firm maintains its year-end S&P 500 target of 8,000 points and sets its 12-month base-case target at 8,300 points. Its judgment still depends on a gradual easing of financing pressure, an improvement in financial conditions and continued corporate earnings growth.
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