Stock market outlook: 3 things could derail S&P 500 rally, Morgan Stanley says

Three things might be standing in the way of a summer rally in stocks, Morgan Stanley warns.

Andrew Sheets, the global head of fixed income research at Morgan Stanley, said the bank is eyeing obstacles that could derail stocks this summer, a season that’s historically been the strongest for the stock market.

July, in particular, is known as one of the best months of the year for equities, with the S&P 500 gaining every July since 2014, Sheets said on the bank’s “Thoughts on the Market” podcast.

Markets, though, have already gotten a few signals that equities are turning more volatile. After a strong second quarter, the Nasdaq 100 has seen big swings in recent weeks, and is about flat from where it began the second half. A rotation trade has roiled the sector as investors take profits in high-flying areas like chips and memory stocks.

Here are three obstacles facing stocks that Morgan Stanley is watching for:

1. The Iran war kicks off again

The market is flirting with this risk this week after President Donald Trump declared the ceasefire with Iran is over. The US launched fresh strikes on Iran on Wednesday, which the military said was in retaliation for Iran striking commercial ships passing through the Strait of Hormuz.

Morgan Stanley’s base-case for equities this year — which has the bull market in stocks continuing — relies partly on the assumption that maritime traffic flows will eventually normalize through the Strait, with oil supply returning to pre-war levels and Brent crude falling back to at least $75 a barrel within 12 months.

“The US has already drawn down its Strategic Petroleum Reserve to its lowest-ever levels, potentially reducing some ability to absorb shocks if the conflict re-escalates,” Sheets said.

The concern in markets is that higher oil prices could push up the prices of other goods, cranking up inflationary pressures throughout the economy.

2. The Fed hikes rates

Markets are seeing a higher chance that the Fed could raise interest rates this year to tackle inflation. But the idea that the Fed will hold on interest rates steady through the end of the year is a key pillar upholding the bull market, Sheets said.

“The risk is that this assumption is just wrong, perhaps soon. There is certainly an argument that, if the Fed is worried about inflation, it shouldn’t wait to act,” he added.

Markets are pricing in an 82% chance the Fed will hike rates at least once by the end of the year, according to the CME FedWatch tool.

3. The AI capex outlook weakens

AI investment has played a critical role in boosting stocks — but that effect could start to unwind if investors were to see evidence that Big Tech firms are starting to rein in AI spending.

Capex estimates have been continually revised higher each quarter, which has “helped boost confidence” that the AI trade is still strong.

The bank said that its base case is for AI investment to rise from around $800 billion in 2026 to around $1.2 trillion in 2027.

“But the risk would be that second-quarter earnings now show more hesitation to spend, maybe because the share prices of some of these big spenders have been recent underperformers. And given how much the current growth and earnings story is linked to AI, and how popular AI exposure is with investors, that would create a risk,” Sheets added of the impact on equities.

Investors have already started punishing some of the biggest spenders in the AI trade, a sign that anxiety is swirling over how much money is being poured into AI and whether it will all be worth it from an ROI perspective.

The Magnificent Seven stocks, which make up some of the largest AI spenders, dropped 13% from their May peak through their trough in June as some investors took profits. The Roundhill Magnificent Seven ETF is now trading relatively flat for the year.