Why the Market Rally May Be Misleading

May 20, 2025

While the stock market has rallied back to January’s levels, other asset classes are sending more cautionary signals.

Author
Lisa Shalett

Key Takeaways

  • While stocks and credit spreads have round-tripped to January levels, other asset classes are flashing warning signals.
  • Rising real rates and widening term premiums in Treasuries suggest bond investors are focused on U.S. debt sustainability.
  • Gold’s outperformance and the dollar’s decline indicate potential shifts in global reserves and risk premiums.
  • We are not out of the woods yet. Investors should position for potential U.S. equity returns between 5% and 10% and focus on diversification.

After a stunning market reversal spurred by the 90-day reciprocal tariff pause and talks of a trade truce with China, stock indices and credit spreads are now about back to where they were at the beginning of the year. On paper, it’s almost as if all of the tariff-related and confidence-shattering events of the past few months never happened.

 

While equity and credit investors are cheering the recovery, Morgan Stanley’s Global Investment Committee notes that investors in other key asset classes aren’t as ready to forget. Alongside the investor euphoria suggested by the rise in stocks, dynamics in Treasuries, the U.S. dollar and gold signal a more complex macroeconomic backdrop that equity and credit investors may be shrugging off. 

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Wealth Management

Mind the Gaps

While equities have staged a stunning reversal, other asset classes such as Treasuries, the US dollar and gold are signaling that perhaps the coast is not fully clear.

U.S. Treasuries: Reflecting Debt Concerns

Diminishing worries about recession and inflation have pushed 2-year yields higher. However, they remain below January’s levels, indicating fundamentally tougher economic growth ahead. Meanwhile, the benchmark 10-year yield continues to hover around the 4.5% threshold that has proven to be a headwind for stock multiples. Notably, the main drivers of the long-duration rate have been gains in the real rate and term premium components of the Treasury yield.

Taken together, the steepening yield curve, higher real rates, and expanding premiums suggest that bondholders are no longer just thinking about growth, inflation and Fed policy, but also about U.S. debt sustainability. With U.S. debt at about $36 trillion and an average financing cost of 3.6%, interest payments alone now account for $1.3 trillion, about 18% of total annual spending.

 

Overall, the outlook for long-term debt sustainability remains fraught, especially as we enter the final innings of debate on the budget, debt ceiling and tax bills, where almost all proposals contemplate at least $2 trillion in new debt. Higher debt and interest costs could lead to higher rates for longer and lower equity multiples.

U.S. Dollar: Likely Victim of Global Rebalancing

While the U.S. dollar has moved with real yields over the past 80 years, starting in 2019, it grew strongly correlated with the “U.S. exceptionalism” theme and the appreciation of U.S. tech stocks. But since peaking in January, the dollar is now down roughly 8% against virtually every major currency, even with a resurgent stock market and higher real rates.

 

This shift may be due to a rebalancing of global capital flows and central bank reserves. If the dollar is entering a new secular regime of relative weakness, as we anticipate, it too could signal lower equity multiples.

Gold: Disconnected From ‘Safe Haven’ Role

Ordinarily, gold underperforms during secular equity bull markets. However, the precious metal has outpaced U.S. equities since 2022, as it did from 1972 to 1981, a tough sideways market for stock investors.

 

With gold disconnected from the role of a “safe haven,” its strength suggests a global preference for central bank reserve diversification and risk management. This is yet another reminder that risk premiums in other asset classes may not be providing much shelter from any potential storms.

Considerations for Investors

Investors wishing for a return of the “Goldilocks” scenario of 2023 and 2024 may be disappointed. Uncertainty remains, and investors should consider positioning for a backdrop of an average of 5%-10% U.S. equity returns amid increased structural volatility, higher real rates, and a weak U.S. dollar.

 

Rather than count on valuation expansion to drive gains, consider adding diversifying positions in international equities, commodities, energy infrastructure and hedge funds. It also makes sense to stay overweight on short-to-neutral-duration investment-grade bonds and municipal bonds.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 19, 2025, “Mind the Gaps.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report. 

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