Core Viewpoint - Morgan Stanley strategists believe that the market may be significantly underestimating the prospects for earnings growth in the U.S. stock market, driven by positive operating leverage, declining wage costs, and pent-up demand, indicating that fears of an economic recession may have passed [1][3]. Group 1: Economic Transition and Earnings Growth - The rolling recession has ended, and earnings revisions are showing signs of recovery, with a historical acceleration in the breadth of earnings revisions reaching +35% on a three-month change basis, typically seen only in the early cycle following a recession [4]. - The return of positive operating leverage is driving a sharp increase in Morgan Stanley's non-PMI earnings model, with median earnings growth for Russell 3000 constituents turning positive at +6% after a prolonged period of stagnation [4][6]. - The ratio of cyclical stocks to defensive stocks has increased by approximately 50% from the April low, breaking a downward trend that began in April 2024, signaling a better growth backdrop ahead [4]. Group 2: Key Indicators of Early Cycle - Key indicators confirming the transition to an early cycle include a slowdown in wage growth, pent-up demand, and the Federal Reserve's interest rate cuts, which are essential for establishing a positive operating leverage environment [6]. - The decline in wage growth is crucial as it constitutes a major part of corporate cost structures, leading to a more streamlined cost structure that supports positive operating leverage [6]. - The unique nature of this cycle, influenced by post-pandemic economic conditions and returning inflation, has not seen a nonlinear rise in unemployment rates despite the slowdown in wage growth [6]. Group 3: Federal Reserve's Role and Inflation Tolerance - Morgan Stanley anticipates that the Federal Reserve will exhibit a higher tolerance for inflation by 2026, which is critical as inflation is closely linked to income growth [7]. - The recent weakness in income growth is partly attributed to declining inflation and pricing power, suggesting that if the U.S. economy shifts to recovery next year alongside Fed rate cuts, corporate income and earnings growth could exceed market expectations [7][8]. - The relationship between the Producer Price Index (PPI) and S&P 500 sales growth indicates that if inflation rises again while the Fed maintains a loose stance, corporate earnings will receive a significant boost [8].