Intro

Our analysts Seth Carpenter and Serena Tang discuss why they believe the global economy is set to slow meaningfully in the second half of 2025.

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Serena: Welcome to Thoughts on the Market. I'm Serena Tang, Morgan Stanley's, Chief Global Cross-Asset Strategist.

Seth: And I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.

Serena: Today we'll discuss Morgan Stanley's midyear outlook for the global economy and markets.

It's Wednesday, May 21st at 10am in New York.

Seth, you published a year ahead outlook last November. Since President Trump took office back in January, there's been pretty significant policy and economic uncertainty and quite a few surprises. With this in mind, what is your current outlook for the global economy for the second half of this year and into 2026.

Seth: So, we titled the outlook Skewed to the Downside because we really do think the U.S. economy, the global economy, is set to slow meaningfully from where we were coming into this year. Let's start with the U.S.

As you said, policy changes came in a lot this year since the new administration took over. I would say the two key ones from a macro perspective so far have been trade policy and immigration policy.

Tariffs have gone up, tariffs have gone down, tariffs have been suspended. Right now, what we think is going to ultimately take place is that we will see persistent, notable tariffs on China, lower tariffs on the rest of the world, and then we'll have to see how things evolve. What does that mean? Well, it means for the U.S. higher inflation and lower growth. In addition, immigration reform means that growth is going to slow because the growth rate of the labor force is going to slow.

Now around the rest of the world, the tariff shock matters as well. When the U.S. puts in tariffs on its imports from other countries, that's negative demand for those other countries. So, we're looking for pretty weak growth in the euro area. Now, I will note, lots of people were excited about possible expansionary fiscal policy in Germany, and we think that's still there. We just don't think it's enough to give the euro area robust growth.

In Asia, China's a main driver of the economy. China is a big recipient of these tariffs. We think the deflation cycle that we expected in China keeps going on. This reduction in demand from the U.S. is not going to help, but there'll probably be a little bit at the margin offsetting fiscal policy.

So, what does that mean put together? Lackluster growth in China. Call it 4 percent slow growth for yet another year. Overall, the global economy should step down. Will it be a recession? That's one of the key questions that we hear from clients, but we don't think so. Not quite. Just a meaningful step down

Serena: Interesting. Any particular regions that seem to be bright spots or surprises -- or perhaps have seen the biggest shift in your outlook?

Seth: I guess I'd flag two potential bright spots around the world. The first is India. India has been, for us, a favorite. It will have the highest growth rate of any economy that we have in our coverage area. And because it's such a big economy, that's part of why the global economy can't lose that much steam. India has lots going for it. There are cyclical factors boosting growth in the near term. But there are also longer-term structural policy driven reasons to think that Indian growth will stay solid for the foreseeable future.

I guess I'd also throw in Japan. Now its growth rate isn't going to be anywhere near the kind of growth in number terms that we're going to see from India. But this has to be taken in the context of 25 years of essentially zero growth of nominal GDP. The reflationary cycle that we think started a couple years ago remains intact, even with the tariff shock. And so, we're pretty optimistic still that Japanese reflation will continue.

Serena: And to what extent are U.S. tariffs contributing to global inflationary pressures? I mean, how do you expect the Fed and other central banks to respond?

Seth: The tariffs are imposed by the United States on most of the imports coming into the country, whereas other countries, maybe they have some retaliatory tariffs just against the U.S., but definitely not as broad as the U.S. That means for the U.S. tariffs are going to drive up inflation domestically and drive down growth, whereas for the rest of the world, it's mostly just a negative demand shock. So, they will be disinflationary for the rest of the world and pushing down growth.

What does that mean for central banks? Well, outside of the U.S., central banks are going to see this as slowing aggregate demand, and so it's pretty clear what it is that they want to do. If they were hiking, they can stop hiking. If they were going to hold steady, they can lower rates a little bit. And if they were already lowering interest rates like the European Central Bank, well they can probably keep going with that without having to worry. And that's why we think the ECB is going to lower its policy rate to probably 1.5 percent and maybe even lower, which is below where the market is expecting things.

Now for the Fed, things are much more tricky. The Fed cares about inflation, the Fed cares about U.S. growth, and both of those variables are going in the opposite direction of what they want over the rest of this forecast. Right now, inflation's too high for the Fed, and history shows that inflation goes up first with tariffs before the growth rate hits. So, the Fed's probably going to wait until the hard data show a bigger slowdown in the economy, a worsening. And the labor market. That is a bigger concern for them than the already too high inflation that is set to rise further over the rest of the year.

Serena: And in your view, how does trade policy uncertainty influence business investment, particularly in export-oriented industries or in economies tightly linked to U.S. demand?

Seth: Yeah. I think it has to be negative and therein lies one of the biggest challenges is just how negative. And I can't say for sure. But what we do know is that an uncertainty tends to be very negative for business investment spending decisions. If you're trying to make a decision, should I build a new factory?

This is something that's going to have a long life to it, and you're going to get benefits hopefully for several years. How big are those benefits relative to the cost? Well, right now it's not at all clear, and so there's an option value to waiting.

And we think that uncertainty is depressing investment decisions right now. I think it has to affect export-oriented industries. There's a lot of questions about what sort of retaliatory tariffs, other countries might impose.

But it also affects domestic driven businesses because, well, they're going to have to see what their demand is. And some of the ones that are just focused on the U.S. economy are selling imported goods. So, it affects businesses across the board. 

Serena: Right. And how do U.S. tariff hikes spill over into emerging markets, and how might these countries buffer against these shocks?

Seth: Yeah, I think there's a range of outcomes and the range is as wide as there are different countries. If you stay close to home. Take Mexico. Mexico is a big trading partner with the U.S. and early on in this whole tariff discussion, they were actually the targets of lots of tariff threats. That could have hurt them directly because there'd be less demand for their exports to the United States.

Now we've got some resolution. We have the trade agreement with Canada and Mexico, and most of Mexico's exports to the U.S. are exempt under those conditions. However, the indirect effect is important as well. Mexico is very attached to the U.S. economy, and so as the U.S. economy slows because of these tariffs, the Mexican economy will slow as well.

But there's also an indirect effect through currency markets, and I think this is a channel that's more broadly applicable across EM. If the Fed is going to be on hold, like we think holding interest rates higher for longer than the market might currently think, that means that EM central banks who might want to lower their policy rate to support their economy are going to be caught in a bit of a bind.

They can't afford to take the risks that their currency will misbehave if they ease too much too far ahead of the Fed. And so, I think there is a little bit of a constraint for EM central banks, thinking about how much can I attend to domestic matters and how much do I have to pay attention to external matters?

Serena: Now, I know forecasting economic growth is difficult in even the best of times, and this has been a period of exceptional volatility. How are you and your economic colleagues factoring all of this uncertainty?

Seth: It's a great question and luminary minds like Neils Bohr, the Nobel Laureate in physics, and Yogi Berra, everyone's favorite prophet, have both said, ‘Forecasting is hard, especially about the future.’ And this time, as you note, is even more so. So, what can we do? We try to come up with as many different scenarios as we can. We ask ourselves not just what's the most likely outcome, because there's uncertainty. The policy changes could come fast and furious. We also try to ask ourselves, if tariffs were to go back up from where they are now, how would that outcome turn out. If tariffs were to go away entirely, how would that turn out?

You have to start thinking more and more, I think, in terms of scenarios.

Serena:  And does this, in your view, change how much or how little investors should focus on the macro economy?

Seth: Well, I think it means that investors have to focus every bit as much on the macro economy as they have in the past. I think it's undeniable that if we're right – and the U.S. economy slows down materially, and the global economy slows down with it – longer-term interest rates are probably going to come down along the lines of what our colleagues in interest rate strategy think. That makes a lot of sense to me. I think the trickier part though is knowing where the macro economy is going.

We've got our forecast, but we are ready to make a revision if the facts change. And I think that's the trickier part for investors. The macro economy still matters but having a lot of conviction about where it's going, and as a result, what it means for asset prices? Well, that's the trickier part.

Serena, you've been asking me lots of questions and they've been great questions, but I'm going to turn the table. I'm going to start asking questions right back to you.

But we probably have to save that for another episode. So, let's pause it there.

Serena: That sounds great Seth.

Seth: And to the people listening, I want to say thanks for listening. And if you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or a colleague today.