The stock rally is facing a bearish cocktail as falling inflation eats into profits and liquidity comes out of the market, Morgan Stanley says

• The rally in stocks will be challenged by a bearish cocktail, Morgan Stanley warned.
• That's because slowing inflation could hurt corporate profits, taking stock prices lower.

The current rally in stocks is facing a cocktail of bearish forces, according to Morgan Stanley.

"Investor sentiment and positioning has turned 180 degrees at an inopportune time, in our view," strategists said in a note on Tuesday, pointing to the growing optimism for stocks as the S&P 500 extends its strong performance this year. The benchmark index is now up 20% from its low in October 2022, and officially entered a new bull market in early June.

But that uptrend could soon face challenges, the bank said, particularly as inflation continues to ease. Lower inflation is desired by consumers, but it's a potential headwind for corporations, since falling prices can eat into revenue growth and hurt corporate earnings.

Morgan Stanley strategists have sounded the alarm for months of a coming a corporate earnings recession, which could potentially take profits down another 16%. Those losses could collide with other pressures that could weigh on stocks, particularly as politicians mull hefty government spending cuts and Fed continues to reduce the size of its balance sheet, which will further tighten financial conditions.

Government spending cuts could notch $1.5 trillion over the next decade, according to estimates from the Congressional Budget Office, a move that's expected to weigh GDP down 2% over the next year.

Meanwhile, $1.2 trillion in Treasurys will be issued over the next six months and weigh on liquidity, which could be a major headwind for stocks.

"This should begin to hit asset prices by the end of this month and carry into the fall. In addition to this domestic dynamic, we think global M2 (in USD) growth is also likely to flatten out and possibly fall again, adding one more element to the cocktail that could surprise newly minted bulls," strategists added.

Wall Street experts have been divided on the current rally in stocks, with some commentators warning of a sharp pullback as the US still faces an elevated risk of recession. The economy has a 71% chance of tipping into a downturn by May 2024, according to the New York Fed's recession probability indicator.