Morgan Stanley Says The US Midterm Elections Could Spark A Rally In Stocks: Here's How To Trade It

Hawkish comments from the U.S. Federal Reserve weighed on markets last week. With midterm elections and more inflation data on the horizon, markets will be tested once again, but one analyst firm told investors to stay bullish on equities. 

What To Know: Morgan Stanley's Michael Wilson was staying bullish this week as he anticipated the midterm elections acting as a catalyst for stocks.

"In the end, we think it survives again with the midterms providing the catalyst for lower bond yields and higher equity prices," Wilson wrote Monday in a note to clients. 

With polls pointed to Republicans winning at least one chamber of Congress, Wilson expects the midterms to throw a wrench in the Democrat's aggressive fiscal spending plans. The Republicans have talked about freezing debt spending via the debt ceiling as they did in 2011, he noted.

"This would be a sharp reversal from the past few years when budget deficits reached levels not seen since World War II. In our view, a clean sweep by the Republicans on Tuesday could greatly raise the odds of such an outcome," Wilson said. 

He anticipated a clean sweep for Republicans would spark a market rally, but he warned the results may not be clear until later in the week.

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How To Trade It: Given the delay in counting mail-in ballots, Wilson anticipated elevated volatility in the markets and recommended tight stop losses be put in place.

"Because this is purely a tactical trading view and not in line with our core fundamental view which remains bearish, we will remain disciplined on how much leash to give it," Wilson said. 

Last week, the SPDR S&P 500 ETF Trus (ARCA: SPY) traded down to the $370 level before moving higher. Morgan Stanley believed that level could be tested again this week, but it was willing to stay in bullish trades all the way down to the $365 level. 

"Anxiety around the CPI release scheduled for Thursday morning is another reason to think both rate and equity vol will remain high," Wilson said.

The analyst firm noted the 10-Year Treasury yield was a better trading signal this week. If it made new highs above 4.35%, Morgan Stanley said it would advise clients to exit bullish trades. Still, the firm sees a potential trading opportunity ahead.

"In short, the bear market rally is likely to hang around for longer than most expect if it can survive this week's test," Wilson said.

SPY Price Action: The SPY was up 0.22% at $377.19 at the time of publication, according to Benzinga Pro.

Photo: Angelique Johnson from Pixabay.