Thoughts on the Market: Recent Episodes
Morgan Stanley
Short, thoughtful and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
Even though mortgage rates are up 100 points since the beginning of 2023, home prices are likely to stay flat or increase due to tight housing supply.
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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, co-head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow: And I'm Jay Bacow, the other Co-Head of U.S. Securities Products Research.
Jim Egan: And on this episode of the podcast, we'll be discussing U.S. home prices. It's Wednesday, September 13th at 11 a.m. in New York.
Jay Bacow: Jim, mortgage rates are up over 100 basis points since the beginning of the year, but I hear you were turning more optimistic on home prices. What gives?
Jim Egan: Well, the first thing that I would say is that home price data is pretty lagged and that an increase in mortgage rates is not going to be felt immediately in the data. For instance, let's assume the last week of August ends up being the peak in mortgage rates for this cycle. When would you expect that rate to start showing up in actual purchase mortgages?
Jay Bacow: So, if the peak in mortgage rates is the end of August, we will get data on people applying for the mortgage the following week from the Mortgage Bankers Association. But it takes about seven weeks right now to close a mortgage. If the peak was at the end of August, the mortgages are probably closing towards the end of October, almost at Halloween. But if it closes in October, Jim, when will we actually get that data?
Jim Egan: Right. The home price data is even more lagged than that. The Case-Shiller prints that we forecast and that we've talked about on this podcast, those come out with a two month delay. So those October sales, we're not going to see until December. Again, for instance, the print we just got at the end of August, that was for home prices in June.
Jay Bacow: So in other words, we haven't seen the full impact of this increase in rates yet on the housing market and the data that we can see. But when we do, what's the impact going to be on home prices?
Jim Egan: Well, we think the immediate impact is going to be on a few other aspects of the housing market, and then those aspects are going to potentially impact home prices. The most straightforward level here is affordability, right? That's an equation that includes prices, mortgage rates, as well as incomes, and so we're talking about the mortgage rate component. Now, one thing that you and I have said on this podcast before, Jay, is that affordability in the U.S. housing market, it's still challenged, but at least so far this year it really hasn't been getting any worse. That's not the case anymore. Affordability is still very challenged and now it's started to get worse again. By our calculations, the monthly payment on the median priced home is up 18% over the past year, and that's the first time that deterioration has accelerated since October of 2022. Three month and six month changes in affordability have also resumed deteriorating after those were actually improving earlier this year.
Jay Bacow: So if homes are getting less affordable, presumably home sales should fall?
Jim Egan: We think that would be kind of the probable impact there and it is something that we're seeing. To be clear, affordability is not deteriorating anywhere near as rapidly as it did in 2022, and we don't expect the same sharp declines in home sales. But this really does give us further confidence in our L-shaped forecast, and if anything it could provide a little more pressure on existing home sales. But we're also seeing the impact on the supply side of the equation.
Jay Bacow: But wasn't the supply side already incredibly low? For instance, our truly refinanceable index calculates what percent of the universe has at least 25 basis points of incentive to refinance. It's at less than 1% right now. The average outstanding mortgage rate for the agency market is 3.68%. Are we really expecting the supply to fall further?
Jim Egan: So that wasn't part of our original forecast and we had been seeing existing inventories really start to climb off of recorded lows. For context, our data there goes back about 40 years, but that's taken an abrupt about face in recent months. The 13% year-over-year decrease in inventory that we just saw this past month, that's the sharpest drop since June 2021, with a contraction coming through both new and existing listings. As affordability has resumed its deterioration with this increase in mortgage rates, homebuilder confidence actually fell month over month for the first time this year. Now, tight supply should continue to provide support to home prices, even as affordability has become more challenged.
Jay Bacow: And so what does that support for home prices end up looking like?
Jim Egan: The short answer, we expect a return to year-over-year growth with the next print that we're going to get here at the end of September. Case-Shiller year-over-year has actually fallen for each of the past three months. We think that ends now. We have a forecast of plus 0.7% year-over-year with a print that's just about to come out and that would be a new record high. With home prices then surpassing their levels in June of 2022, at least for that index. Our base case forecast for year end has been 0% growth, with our bull case at plus 5%. The evolution of the inputs since particularly the supply point here continues to be tighter than what was already pretty tepid expectations on our part. That has us expecting HPA to finish the year between these two levels, that base case and that bull case level.
Jay Bacow: All right, Jim, it's always great talking to you.
Jim Egan: Great talking to you, too, Jay.
Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.
Economic growth data from the summer has bolstered belief in a possible soft landing in the U.S., while China has experienced a faster-than-expected deterioration in the macro environment.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about our views on the markets as we head into the fall. It's Tuesday, September 12th at 10 a.m. in New York.
As many of us head back to school, Morgan Stanley Global economics and strategy teams look back on how the economy and the markets have evolved over the summer and look ahead to what changing narratives mean for the economic outlook and asset markets. Our debate centered on two key issues. One, the outperformance of the U.S. economy and the underperformance of China economy. And two, the recent spike in government bond yields at the longer end of the curve.
The U.S. economy has been outperforming our expectations and has led markets over the summer to push out the first expected cut into 2024. The concern is that a still hot economy means that the Fed can keep policy restrictive for longer. Acknowledging the strong incoming data, our economists have revised their 2023 growth expectations significantly higher for the U.S. from 0.4% to 1.7%, even as they maintain that the Fed is done hiking and will be on hold until first quarter of 2024.
On the other hand, in China, the trajectory of economic growth has been different. Over the summer, data have been pointing to a faster than expected deterioration in the macro environment. We have seen successive and incremental property and infrastructure easing measures, but market confidence has not returned and debates around earnings, spillover effects on global growth and the impact on commodities are growing. Noting the macro and policy challenges since the mid-year outlook, our China economists have revised their 2023 growth expectations lower for China from 5.7% to 4.7% for 2023. And our emerging market equity strategists have moved to equal weight on China and revise down their MSCI Emerging Market Index target.
What about our call to be long duration? Ten year Treasury yields have sold off by about 65 basis points since our mid-year outlook on better than expected U.S. growth data, among other factors. Can this continue? Our strategists make modest changes to their rates forecast, but still see a path for low yields, countering the market narrative of growth reacceleration or a higher treasury supply technical. Thus, we reaffirm our conviction to be long duration, despite the rates market moving away from us.
Overall, our conviction on a U.S. soft landing has strengthened. But with monetary policy remaining restrictive, late cycle risks, growth, earnings and defaults remain. We maintain a defensive stance. We prefer bonds over equities and equal-weight stocks, overweight fixed income, underweight commodities, and equal weight cash. Combined with rich valuations, this makes us stay equal-weight equities, with a preference for rest of the world stocks over US stocks. In all, high carry and late cycle environment favor an overweight in fixed income.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Heading into the end of the year, questions remain around Treasury yields and the neutral interest rate.
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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.
Guneet Dhingra: And I'm Guneet Dhingra, Morgan Stanley's Head of U.S. Trade Strategies.
Seth Carpenter: And today on the podcast, we'll be discussing our updated economic and rates outlook for the rest of the year and into 2024. It's Monday, September 11th, at 10 a.m. in New York.
Seth Carpenter: All right, Guneet. We are now about a week into September and we can take stock of what we've learned over the summer. For macroeconomists like me we care about growth, inflation, monetary policy, and I'll say this summer spending indicators came in strong, inflation continued to fall, and we had Jackson Hole, the sort of nerd temple for monetary policy. And I have to say we didn't learn quite as much as I hoped, but we kind of know the Fed has done hiking, or at least very close. But I have to say, in your domain, the Treasury yield is trading roughly 4.25%. On the last day of June, when summer began, it was around 380. Can we just attribute the higher rate to thin liquidity and move on?
Guneet Dhingra: You're right Seth, it's not just thin liquidity, but the conditions of August definitely played a meaningful part in sending yields higher. Typically, as investors look to go away for August, positive carry trades are the easiest trades to have on, and playing for higher yields has been positive carry. Which is why I think in August this year and even the last year, yields tended to go higher. But beyond August, seasonality, which might be the simplest explanation, investors have 4 major narratives out there that R-star, the so-called neutral rate of interest has increased, the end of yield curve control in Japan, more Treasury supply and more recently at the end of the summer, and increased supply of corporate debt.
Guneet Dhingra: So before we go there Seth, you mentioned Jackson Hole at the end of the summer. The idea that some investors have that because the economy has held up so well, despite the Fed's rate hikes, that the underlying neutral rate or R-star must be higher and so will have higher interest rates not just now, but into the future. What is your take on this whole R* debate and what have you learned from Jackson Hole?
Seth Carpenter: Absolutely. So I have to say Jackson Hole was very interesting, but this time there were a lot of very academic minded papers there that were very important to talk about. I can see how they can spur debate, but I'm not sure they provide that much that's actionable in the near term for the Fed or even for markets. And when it comes specifically to R-star, color me a bit skeptical and I say that for a few reasons. One, alternate explanations just abound. We could have got stronger spending because there's more residual impetus from the fiscal policy that's already in the pipeline. And in particular, if we look at where we missed our GDP forecast, a really big part of that was nonresidential structures investment. So that could go a long way to explain it. Second, if R-star really was higher, I think that would mean that the Fed would have to raise the peak rate during this hiking cycle even higher, not just rates off in the future. And so what does that mean? That means that I at least would have expected a parallel shift higher in rates, not just along in selling off. And in fact, you might even see a steeper inversion of the curve as the rate goes higher in the near term, but then has to come down later. So take all of that together, and I guess I'm just really not convinced that there's enough evidence to conclude that R-star is higher.
Guneet Dhingra: Yeah, makes a lot of sense, Seth. And listening to you about the growth and economic picture, I'm even more convinced that this R-star story doesn't quite hold water.
Seth Carpenter: All right, so then there is the yield curve control story. And I will say, at the risk of patting myself on the back, our Japan team had been expecting a tweak to yield curve control in Japan, and we got it. But I know that you're skeptical that that's really the story here. Why do you push back?
Guneet Dhingra: Yeah, I think one of the ways you can actually verify the impact of the yield curve control on the U.S Treasury market, is just break down the price action into different time zones. And what you saw is in the Tokyo time zone, where you would expect a lot of the so-called repatriation flows to play out, we haven't really seen much of a movement in U.S Treasury yields ever since the YCC change announcement. So I would say based on the time zone analysis, it doesn't look like YCC changes are really impacting Treasury yields.
Seth Carpenter: Okay Guneet, I get it. So it wasn't from trading happening in Tokyo, but these sort of markets are global. There could have been traders in London, traders in New York who were reacting to the change in yield curve control and selling their JGBs. And then the traders in Tokyo wake up and go, oh, nothing to do here. What do you make of that story? Why couldn't that be the explanation that it really was yield curve control?
Guneet Dhingra: So if you break it down in the London Time Zone, it actually turns out that Treasury yields have actually gone lower since the YCC announcement in the London Time Zone. To my mind, that speaks to the idea that maybe investors in those time zones are more focused on the weakness in the European economy than any changes to YCC. And speaking of the New York time zone, yes, it is true that the bulk of the sell off in Treasury yields has happened in the New York time zone. But keep in mind, if hedge funds are the only major player selling yields on the back of the YCC, and it's not quite backed up by repatriation flows, it's probably not likely going to be sustainable.
Seth Carpenter: Then let's turn to the last one, increased supply of debt, both Treasury debt and corporate debt. So we know that the U.S deficit is high, Issuance will have to continue for some time. We've heard all of the stories about corporates starting to stir in capital markets and issue more. Shouldn't it be logical that if demand for assets is roughly unchanged but the supply goes up, the price will fall, which should lead to a sell off in rates? What do you make of that story?
Guneet Dhingra: Yeah, the story is pretty logical, but I don't think it still answers the question. If supply was really the main driver, I would expect to see more of a substantial tightening in so-called swap spreads, which is the gap between Treasury yields and the equivalent swap rates. We haven't really seen much of a tightening in swap spreads, which really undercuts the idea that Treasury supply is already on investors minds.
Seth Carpenter: All right. So I think we've gone through a bunch of the narratives, pushd back on a lot of them, maybe debunked them a little bit. I guess the one other question I would have for you is, could it be that markets are waking up to the higher for longer narrative? The Fed's been trying to say that they're going to keep interest rates as high as they need to for as long as they need to in order to bring inflation back to target. Maybe the market's putting more probability on that sort of outcome.
Guneet Dhingra: Just to pretend I'm smarter than the economists, I will use the word bear steepening of the curve here. So in my view, the recent bear steepening of the 2s/10s curve is a combination of two things. Number one, there has been very little change in the market implied Fed funds path through the end of 2024. And number two, the back end has moved higher with some combination of August seasonality and belief around a higher R-star. So I would say it is less about the quote unquote higher for longer expectation, but more about the idea that the Fed fund eventually settles at a higher level in the medium term.
Seth Carpenter: Okay. I guess that's fair. Let's take a step back, though, and take stock of what it is that we've learned. You and I and our colleagues have published work recently, basically saying, here's the mid-year outlook we published in May, here are the data that we got over the course of the summer. What did we get right and what did we get wrong? I econ, I'd say we got right the continued and pretty rapid fall in inflation in the U.S. and the slowing in the labor market, and I'm pretty proud of that. But boy, we got wrong just how strong the U.S. economy would be. And in very stark contrast, we missed just how weak the Chinese economy would be. Boy, we really thought that there'd be a stronger, more vigorous policy response that would get better traction and we'd see a bigger cyclical rebound. What are your key takeaways from what you and your colleagues in strategy have learned over the summer?
Guneet Dhingra: To start with some numbers, we had ten year yields ending at 3.5% by the end of 2023. Currently there are 4.25%. We think we missed two things. First, the market focuses on upside and growth rather than the cooling of inflation. And number two, we missed the investors and how they're behaving, once bitten twice shy, about adding duration until every data point cools down convincingly. Having said that, your forecast is for more cooling and growth and inflation through the year. And so we have only marginally raised our ten year forecast to 3.65% by the end of this year.
Seth Carpenter: I have to say, Guneet, every time I talk to you, I learn something new. So thank you for taking the time to talk.
Guneet Dhingra: Great speaking with you, Seth.
Seth Carpenter: And thanks to the listeners for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Although Europe has been the global leader when it comes to greening its economy, recent challenges may be a cause for concern.
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Rob Pulleyn: Welcome to Thoughts on the Market. I'm Rob Pulleyn, Morgan Stanley's Head of Utilities of Clean Energy Research in Europe.
Jens Eisenschmidt: And I'm Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist.
Rob Pulleyn: On this special episode of this podcast, we'll be discussing the future of Europe's energy transition, including whether its clean energy goals are realistic and the implications for investors and Europe's broader economy. It's the 30th of August, 10 a.m. in London.
Rob Pulleyn: Europe has long been a global leader when it comes to greening its economy. Strong societal and political support has bolstered the region's transition to clean sources of energy, with a European Green Deal and climate target plan aiming to reduce CO2 emissions by at least 55% by 2030 and achieve net zero by 2050. While substantial progress has been made over the previous decades, the region is now facing several challenges. Jens, can you give us the backdrop to Europe's energy transition and some of what's changed recently?
Jens Eisenschmidt: Yes Rob, I mean, you have explained it already. There are big change targets, climate change related targets to the energy transition that Europe has subscribed to. These targets were in place already before the 24th of February in 22, when we saw the Russian invasion in Ukraine that changed the European energy set up profoundly. Now, why is this important? It's important because these targets were done in sort of a plan that relied on a certain energy source that is no longer existing. So let me give you an example. Let's take Germany, which was anyway already quite progressed in its journey onto increasing the share of renewables in electricity production. If you take Germany, they have been turning their back on nuclear power generation, which is another source of emission free power generation, and have embraced as a flex load provider, so as a provider of electricity when renewables are unavailable to natural gas. Now this natural gas supply from Russia is no longer available, as we all know, and of course, that implies that the Germans and other member states of the European Union as well have to change the plan by which they transit to a carbon free economy. And, you know, this is very complicated because it's not only switching one energy source for the other or exchanging one for the other. You also have to look about the infrastructure, you have to see what is essentially giving your energy mix the stability, as I said before, when we don't have sun shining and wind blowing, you need to have a source that's about the question about storage technologies, that's not entirely independent of the energy sources that you have available. And so the last year provided a profound challenge to the way Europe had planned its energy transition, so they have to replan it, and the complexity of that is huge. Essentially, it's something you want to ideally plan at the European level in order to harness all the comparative advantages all the countries have, given example, you have a lot of sun hours in Spain, less so in Germany, so ideally you want to put solar for Europe somewhere south and not so much somewhere north. But that of course means something for the grid, you have to deploy around it. So all that complexity is huge, all the coordination needs are huge and so this is the new situation we are in.
Rob Pulleyn: Yeah, that new situation clearly puts increased pressure on Europe, if electricity prices remain elevated, Europe's large industrial base and you mentioned Germany would continue to shoulder this burden. You know margins, pricing, competitiveness would all suffer and the region's place in the global value chain might be at risk. Now, renewables are increasingly cost competitive, but even when the solar power is still very intermittent and that requires either a stable baseload or at least flexible generation. And as you mentioned, this previously was facilitated partly by Russian gas. Now, with all that in mind Jens, how much investment is needed to fund the transition and is there economic risk associated with this?
Jens Eisenschmidt: So the numbers are huge. We have said that number could be around $5 trillion, other sources estimate this to be slightly higher, but more or less the ballpark is the same. We also know that already $1.4 trillion is earmarked from public funds, so EU budget, meaning that $3.6 are left for the private sector to deploy or for member states to come up from national budgets. So the figure itself boiling down to somewhere between $5 to $600 billion a year until at least 2030 and maybe beyond, these figures are not in itself the problem. The problem is how do you, according to which plan, do you deploy this and what is the sort of economic backdrop in which this investment happens? So ideally, from an economist perspective, this is a productivity increasing undertaking, and if it's done in that way, it won't be necessarily inflationary, it would be mildly growth enhancing. But of course there is a risk that all that investment in particularly being driven by the public sector, crowds out other productive investment. And in that case, it would be less productivity enhancing and more inflationary, which we think is the more realistic case here for Europe. We don't think that this is the end of the world in terms of inflation, but we do estimate a sizable impact of around 20 basis points per year that inflation could turn out to be higher. That all being said, if electricity prices can be reliably and durably lowered, that would have the potential to generate more innovation. Rob, you have your finger on the pulse of new technology, what do you see emerging that may advance the progress of Europe's transition?
Rob Pulleyn: Yeah, thanks Jens. So historically, we've been positively surprised by the pace of levelized cost of energy coming down, particularly in renewables. And we've also been positively surprised by technological developments elsewhere. As we think about the key challenge of this new wind and solar capacity ambitions, the key is intermittency, and therefore industrial scale batteries are going to be key, fuel cells should also be, green gas, which is also needed for industrial abatement, could also be part of that solution. I also think we need to talk about behind the meter, which is really rooftop solar, whether it's solar panels but more crucially one of the parts of the value chain is the inverters. More efficient inverters are one of the most key components for reducing the cost of solar. As we think about electrification of the home in terms of heat pumps, you know, there's another technology which will develop and also passenger vehicles moving to electric, this behind the meter rooftop solar generation will be important combined with batteries and as I said, the inverters are a key part of that. Also will be software, how to manage all of this demand side response, I think is something you're going to hear much more from many of the retail companies we cover and innovating in the space. Now, as we think about the sequence and the steps of decarbonization here, step one, decarbonize the existing power system, step two electrify as much as possible, step three move to green gasses. We will eventually reach an area whereby we cannot decarbonize any further, and that's where carbon capture and storage comes in, for which we're already seeing significant improvement. So, there's many technologies which I think will play a significant role in this. And I suspect despite the current pressures we're seeing at the moment, we will continue to see significant positive surprises over the coming decade and thereafter, notwithstanding that the cost of capital is, of course, higher than it was over the last decade.
Jens Eisenschmidt: So which sectors are likely to benefit the near-term and in the longer term?
Rob Pulleyn: So the obvious answer, and somewhat self-serving, is utilities. To that number you mentioned earlier of $5 billion spent, we also think that the utilities could probably contribute around a European utility in Europe around $1.5 to $2 trillion of this. That still leaves a sizable gap versus what you were talking and perhaps there is upside risk to these investment spends. But within utilities, the obvious route is renewables. Having a tough time, I would say in 2023, trapped within higher costs and capital costs, but also, you know, policy impasse. But if we separate the wood for the trees under the vast majority of scenarios out to 2030 and 2050, the increase in green electricity is going to be substantial and utilities are the natural developers of those assets as they migrate away from coal and some degree gas, into clean energy. But it's not the only area. There's also networks. We need to invest in distribution and transmission, in electricity to actually accommodate these renewables and connect the new areas of upstream electricity generation to the areas of demand, which is primarily the cities and industry. Speaking about industry, there's also a need for green gas, and I actually think other sectors are going to contribute here, most notably oil and gas, which has the technical expertise and of course the industrial plant for industrial gasses. As we look into the supply chains, another area that's been in focus this year, both the OEMs in terms of turbines and solar manufacturers, the cabling, the software, the heat pumps, I think there are many aspects within equity stories which are ancillary to utilities but could create different risk rewards and different opportunities to what you may find in my sector. I think we can both agree that while significant progress has been made, Europe still has a long way to go for the next step of this journey.
Jens Eisenschmidt: I fully agree. I would say that not all hope is lost that current targets will be met, but there are headwinds that cannot be denied.
Rob Pulleyn: Jens, thank you very much for taking the time to talk today.
Jens Eisenschmidt: Thanks, Rob. It was great to speak with you.
Rob Pulleyn: And thank you all for listening. Subscribe to Thoughts on the Market, on Apple Podcasts or wherever you listen, and please leave us a review. We'd love to hear from you.
If China economic woes become a true debt deflation cycle, it could export some of that disinflation to the global economy.
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today, I'll be talking about the global implications of China's economic slowdown. It's Tuesday, August 29th, at 10 a.m. in New York.
China's economic woes continue to be center stage. Our Asia team has outlined the risks of a debt deflation cycle there and how policy is needed to avert the possibility of a lost decade. As always, big economic news from China will get global attention. That said, when we turned bullish on China's economic growth last year, we flagged that the typical positive spillovers from China were likely to be smaller this cycle than in the past.
We expected growth to be heavily skewed towards domestic consumption, especially of services, and thus the pull into China from the rest of the world would be smaller than usual. We also published empirical analysis on the importance of the manufacturing sector to these global spillovers, and the very strong Chinese growth and yet modest global effects that we saw in the first quarter of this year vindicated that view. Now the world has changed and Chinese growth has slumped, with no recovery apparent so far.
The global implications, however, are somewhat asymmetric here. Because we are seeing the weakness now show through to the industrial sector and especially CapEx spending, we cannot assume that the rest of the world will be as insulated as it was in the first quarter. Although we have recently marked down our view for Chinese economic growth, we still think a lost decade can be avoided. Nevertheless, with Chinese inflation turning negative, the prospect of China exporting disinflation is now getting discussed in markets.
Much of the discussion about China exporting this inflation started when China's CPI went into deflation in the past couple of months. Although the connection is intuitive, it is not obvious that domestic consumer price numbers translate into the pricing that, say, U.S. consumers will eventually see. Indeed, even before China's prices turned negative, U.S. goods inflation had already turned to deflation because supply chains had healed and consumer spending patterns were starting to normalize.
For China to export meaningful disinflation, they will likely have to come through one of three channels. Reduced Chinese demand for commodities that leads to a retreat in global commodities prices, currency depreciation or exporters cutting their prices. On the first, oil prices are actually at the same levels roughly that they were in the first quarter after Chinese goods surged. And they're well off the lows for this year. And despite the slump in economic activity, transportation metrics for China remain healthy, so to date, that first channel is far from clear.
The renminbi is much weaker than it was at the beginning of the year. But recent policy announcements from the People's Bank of China imply that they are not eager to see a substantial further depreciation from here, limiting the extent of further disinflation through that channel. So that leaves exporters cutting prices, which could happen, but again, it need not be directly connected to the broader domestic prices within China coming down.
So all of that said, the direction of the effect on the rest of the world is clear. Even if the magnitude is not huge, there is a disinflationary force from China to the rest of the world. For the Fed and ECB, other developed market central bankers, such an impulse may be almost welcome. Central banks have tightened policy intentionally to slow their economies and pulled down inflation. Despite progress to date, we are nowhere near done with this hiking cycle. If we're wrong about China, however, should we start to worry about a global slump? Probably not. The Fed is currently trying to restrain growth in the US with high interest rates. If the drag comes more from China, well then the Fed will make less of the drag come from monetary policy.
Thanks for listening and if you enjoy the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
Proposed regulations for smaller banks show that turmoil in the banking sector may still have an impact on the broader economy.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the links between regulations and the real economy. It's Monday, August 28, at 11 a.m. in New York.
In the euphoria of buoyant equity markets over the last few months, the many challenges facing regional banks have receded into the background. While it certainly has not been our view, a narrative has clearly emerged that the issues in the sector that erupted in March are largely behind us. The ratings downgrades by both Moody's and Standard & Poor's of multiple U.S. banks in the last few weeks provide a reminder that the headwinds of increasing capital requirements, higher cost of funding and rising loan losses continue to challenge the business models of the regional banking sector.
The rating agency actions come on the heels of proposed rules to modify capital requirements for banks with total assets of 100 billion or more. Separately, the Fed has proposed a capital rule on implementing capital surcharge for the eight U.S. global systemically important banks. Further proposed regulations on new long term debt requirements for banks with assets of $100-700 billion are due to be announced tomorrow. It is early in the rulemaking process for all of these proposals. They may change after the comment period and the rules will be phased in over several years once they are finalized. Nevertheless, they outline the framework of the regulatory regime ahead of us.
While we won't go into the detailed discussion of thousands of pages of proposals here, suffice to say that the documents envisage significantly higher capital requirement for much of the U.S. banking sector, and extends several large bank requirements to much smaller banks. One such requirement pertains to the impact on capital of unrealized losses in available for sale securities. Currently, this provision applies only to Category one and Category two banks, that is banks with greater than $700 billion in total assets. But the proposal now expands it to Category three and Category four banks, that is banks with greater than $100 billion in total assets.
A recent paper from the San Francisco Fed shows how the regulatory framework of the banking system affects the real economy. Specifically, the paper demonstrates that banks, which experienced larger market value losses on their securities during the 2022 monetary tightening cycle extended less credit to firms. Given the experience of the last 18 months across fixed income markets, extending the impact of such mark-to-market losses to smaller banks, as is being proposed now, would exasperate the potential challenges to credit formation.
Against this background, we look at the near term prospects for bank lending. In the latest Senior Loan Officer Opinion survey, reflecting 2Q23 lending conditions, lending standards tightened across nearly all categories for the fourth consecutive quarter. Banks expect to tighten lending standards further across all categories through the year end, with the most tightening coming in commercial real estate, followed by credit card and commercial and industrial loans to small firms. The survey also asked banks to describe current lending standards relative to the midpoint of the standards since 2005. Most banks indicated the lending standards are tighter than the historical midpoint for all categories of commercial real estate and commercial and industrial loans to small firms.
The bottom line is that more tightening lies ahead for the broader economy. This survey shows how the evolution of regulatory policy can weigh on credit formation and overall economic growth. Given the disproportionate exposure of the regional banks to commercial real estate debt that needs to be refinanced, commercial real estate is likely to be the arena where pressure has become most evident, another reason why we are skeptical that the turmoil in the regional banking sector is behind us. While the proposed regulatory changes can open doors for non-bank lenders, such as private credit, it is important to note that such lending will likely come at higher cost.
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As the Fed meets this weekend for their annual summit at Jackson Hole, investors are most focused on whether rate hikes will continue and the state of the neutral interest rate.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 25th at 2 p.m. in London.
The eyes of the market will be on Wyoming this weekend, where the Federal Reserve is holding its annual summit at Jackson Hole. While many topics will be discussed, investors are particularly focused on two: is the Fed done raising interest rates? And is the so-called neutral rate of interest higher than initially thought?
The Federal Reserve has been raising interest rates at the fastest pace in 40 years to try to get rates to a level where economic activity starts to slow, easing inflationary pressure. But the level of interest rate that achieves this is genuinely uncertain, even to the experts at the Fed. We believe that they'll feel increasingly comfortable that rates have now hit this level. And in turn, Morgan Stanley's economists do not expect further rate hikes in this cycle. A few things drive our thinking.
First, those inflationary pressures are easing. Two key measures of underlying inflation, core PCE and core CPI, slowed sharply in the most recent reading. Leading indicators for car prices and rental costs, which have been big drivers of high inflation last year, now point in the opposite direction. Bank loan growth is slowing and the torrid pace of U.S. job growth is also moderating, two other signs that interest rates are already restrictive.
Historically, the Fed being done raising interest rates has been supportive for markets. But the relationship with high grade bonds is especially notable. Since 1984, there have been five times where the Fed has ended interest rate hiking cycles after multiple increases. Each time the yield on the U.S. aggregate bond index peaked within a month of this last hike. In short, the Fed being done has been good for the U.S. Agg Bond Index.
And we can see the logic to this. If the Fed has stopped raising interest rates, one of two things may very well be true. First, it stopped at the correct level to support growth while also reducing inflation, and that stability with less inflation is liked by the bond market. Or it has stopped because rates are actually too high and set to slow growth and inflation much more sharply. In the second scenario, investors like the safety of bonds.
But behind this question of whether the Fed will pause is another, larger issue. What is the so-called neutral rate of interest that neither slows nor boosts the U.S. economy? During the decade of stagnation that followed the global financial crisis, weak growth led people to believe that this balancing interest rate was extremely low. There are signs this thinking persists, when the Fed surveys its members about where they see the Fed funds rate over the long run, which is a proxy for where this neutral interest rate might be, the median is just 2.5%. In 2012, the Fed thought this same rate was over 4%.
So that will be another focus at Jackson Hole, and beyond. The strength of the U.S. economy in the face of higher rates has been a surprising story. Does that mean that the balancing interest rate is much higher, and will the Fed raise their long run estimates of this rate to reflect this? Or is recent U.S. strength still temporary and not yet fully reflecting the effect of higher interest rates? Expect this debate to continue in the months ahead.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
Inspiring change through informed and inclusive innovation. On Access & Opportunity, host Carla Harris, Senior Client Advisor at Morgan Stanley, explores the lived experiences of the people who face systemic inequities and sits down with founders, investors, developers, activists, and educators who are building a more equitable future today.
As debate season begins among Republican presidential candidates, can investors hope to glean market insights for 2025 and beyond?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the impact of presidential debates on markets. It's Wednesday, August 23rd at 10 a.m. in New York.
Several candidates seeking the Republican Party's nomination for president take the stage in the debate tonight. Coverage of the event in traditional and financial media has escalated in anticipation of the debate. And while it's a good idea for voters looking to understand the candidates better and make an informed choice to tune in to the debate, for those tuning in looking for something that might guide their perception of how the 2024 election might impact financial markets, our guidance is this: lower your expectations.
This debate, the first among many, is likely to tell us a lot less about who the nominee will be than traditional polls. Those polls show former President Trump with solid support that surpasses his main rivals. And while, of course, there's plenty of time for that to change, debates this early in the process haven't historically been reliable indicators of changes in support that may follow. This may be even more true this time around, since President Trump is not attending this debate. And so it will be more difficult to get a read as to which candidates might be better suited than others to make a more persuasive argument to Republican voters than the former president.
Additionally, debates this early in the process generally tell us little about potential policy changes that could result from any one of these candidates ultimately being elected in 2024. Stock and corporate bond investors, in theory, might be very interested in what these candidates have to say about a variety of pending corporate tax code changes starting in 2025. But one shouldn't expect candidates to get into that level of detail on the debate stage. General comments about making sure the tax code doesn't work against the economy are far more likely. Further, the ability of any candidate to execute on their policy vision is going to be a function of the makeup of Congress, which again, this debate is unlikely to give us much information about.
Bottom line, the 2024 election will be consequential to the markets, but tune in to the debate to inform yourself as a voter. As we've said in previous podcasts, it's too early to expect to learn anything that will help you as an investor.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Original Release on August, 1st 2023: While the U.S. economy appears on track to avoid a recession, investors should still consider the implications of an upcoming wave of maturities in corporate credit.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I will be talking about potential risk to the economy. It's Tuesday, August 1st at 10 a.m. in New York.
Another FOMC meeting came and went. To nobody's surprise the Fed hiked the target Fed funds rate by 25 basis points. Beyond the hike, the July FOMC statement had nearly no changes. While data on inflation and jobs are moving in the right direction, the Fed remains far from its 2% inflation goal. That said, Fed Chair Powell stressed that the Fed is closer to its destination, that monetary policies is in restrictive territory and is likely to stay there for some time. Broadly, the outcome of the market was in line with our economists expectation that the federal funds rate has peaked, will remain unchanged for an extended period, and the first 25 basis point cut will be delivered in March 2024.
Powell sounded more confident in a soft landing, citing the gradual adjustment in the labor market and noting that despite 525 basis point policy tightening, the unemployment rate remains at the same level it was pre-COVID. The fact that the Fed has been able to bring inflation down without a meaningful rise in unemployment, he described as quote unquote "blessing". He noted that the Fed staff are no longer forecasting a recession, given the resilience in the economy.
This specter of soft landing, meaning a recession is not imminent, is something our economists have been calling for some time. This has now become more broadly accepted across market participants, albeit somewhat reluctantly. The obvious question, therefore, is what are the risks ahead and what are the paths for such risks to materialize?
One such potential risk emanates from the rising wave of credit maturities from the corporate credit markets. While company balance sheets, by and large, are in a good shape now, given how far interest rates have risen and how quickly they have done so, as that debt begins to mature and needs to be refinanced, it will happen at sharply higher rates. From now through the end of 2024, almost a trillion of corporate debt will mature. Sim ply by holding rates constant, that refinancing will represent a tightening of financial conditions.
Fortunately, a high proportion of the debt comes from investment grade borrowers and does not appear to be particularly challenging. However, below investment grade debt has a tougher path ahead for refinancing. As we continue through 2024 and get into 2025, more and more high yield bonds and leveraged loans will need to be refinanced.
All else equal, the default rates in high yield bonds and leveraged loans currently hovering around 2.5% may double to over 5% in the next 12 months. The forecasts of our economists point to a further slowdown in the economy from here, as the rest of the standard lags of policy are felt. We continue to think that such a slowing could necessitate a re-examination of the lower end of the credit spectrum. The ongoing challenges in the regional banking sector only add to this problem. In our view, in the list of risks to the U.S. economy, the rising wave of maturities in the corporate debt markets is notable.
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Original Release on July, 27th 2023: With higher quality and lower costs, China’s electric vehicles could lead a shift in the global auto industry.
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Adam Jonas: Welcome to Thoughts on the Market. I'm Adam Jonas, Head of Morgan Stanley's Global Autos and Share Mobility Team.
Tim Hsaio: And Tim Hsaio Greater China Auto Analyst.
Adam Jonas: And on this special episode of Thoughts on the Market, we're going to discuss how China Electric vehicles are reshaping the global auto market. It's Thursday, July 27th at 8 a.m. in New York.
Tim Hsaio: And 8 p.m in Hong Kong.
Adam Jonas: For decades, global autos have been dominated by established, developed market brands with little focus on electric vehicles or EVs, particularly for the mass market. As things stand today, affordable EVs are few and far between, and this undersupply presents a major global challenge. At Morgan Stanley Equity Research, we think the auto industry will undergo a major reshuffling in the next decade as affordable EVs from emerging markets capture significant global market share. Tim, you believe China made EVs will be at the center of this upcoming shakeup of the global auto industry, are we at an inflection point and how did we get here?
Tim Hsaio: Thanks, Adam. Yeah, we are definitely at a very critical inflection point at the moment. Firstly, since last year, as you may notice that China has outsized Germany car export and soon surpassed Japan in the first half of this year as the world's largest auto exporter. So now we believe China made EVs infiltrating the West, challenging their global peers, backed by not just cheaper prices but the improving variety and quality. And separately, we believe that affordability remains the key mitigating factors to global EV adoption, as Rastan brands have been slow to advance their EV strategy for their mass market. A lack of affordable models actually challenged global adoption, but we believe that that creates a great opportunity to EV from China where a lot of affordable EVs will soon fill in the vacuum and effectively meet the need for cheaper EV. So we believe that we are definitely at an inflection point.
Adam Jonas: So Tim, it's safe to say that the expansionary strategy of China EVs is not just a fad, but real solid trend here?
Tim Hsaio: Totally agree. We think it's going to be a long lasting trend because you think about what's happened over the past ten years. China has been a major growth engine to curb auto demands, contributing more than 300% of a sales increment. And now we believe China will transport itself into the key supply driver to the world, they initially by exporting cheaper EV and over time shifting course to transplant and foreign production just similar to Japan and Korea autos back to 1970 to 1990. And we believe China EVs are making inroads into more than 40 countries globally. Just a few years ago, the products made by China were poorly designed, but today they surpass rival foreign models on affordability, quality and even detector event user experience. So Adam, essentially, we are trying to forecast the future of EVs in China and the rest of the world, and this topic sits right at the heart of all three big things Morgan Stanley Research is exploring this year, the multipolar world, decarbonization and technology diffusion. So if we take a step back to look at the broader picture of what happens to supply chain, what potential scenarios for an auto industry realignment do you foresee? And which regions other than China stand to benefit or be negatively impacted?
Adam Jonas: So, Tim, look, I think there's certainly room to diversify and rebalance at the margin away from China, which has such a dominant position in electric vehicles today, and it was their strategy to fulfill that. But you also got to make room for them. Okay. And there's precedent here because, you know, we saw with the Japanese auto manufacturers in the 1970s and 1980s, a lot of people doubted them and they became dominant in foreign markets. Then you had the Korean auto companies in the 1990s and 2000s. So, again, China's lead is going to be long lasting, but room for on-shoring and near-shoring, friend shoring. And we would look to regions like ASEAN, Vietnam, Thailand, Indonesia, Malaysia, also the Middle East, such as Morocco, which has an FTA agreement with the U.S. and Saudi, parts of Scandinavia and Central Europe, and of course our trade partners in North America, Mexico and Canada. So, we’ re witnessing an historic re-industrialization of some parts of the world that where we thought we lost some of our heavy industry.
Tim Hsaio: So in a context of a multipolar trends, we are discussing Adam, how do you think a global original equipment manufacturers or OEM or the car makers and the policymakers will react to China's growing importance in the auto industry?
Adam Jonas: So I think the challenge is how do you re-architect supply chains and still have skin in the game and still be relevant in these markets? It's going to take time. We think you're going to see the established auto companies, the so-called legacy car companies, seek partnerships in areas where they would otherwise struggle to bring scale. Look to diversify and de-risk their supply chains by having a dual source both on-shore and near-shore, in addition to their established China exposed supply chains. Some might choose to vertically integrate, and we've seen some striking partners upstream with mining companies and direct investments. Others might find that futile and work with battery firms and other structures without necessarily owning the technology. But we think most importantly, the theme is you're not going to be cutting out the world's second largest GDP, which already has such a dominant position in this important market, so the Western firms are going to work with the Chinese players. And the ones that can do that we think will be successful. And I'd bring our listeners attention to a recent precedent of a large German OEM and a state sponsored Chinese car company that are working together on electric vehicle architecture, which is predominantly the Chinese architecture. We think that's quite telling and you're going to see more of that kind of thing.
Tim Hsaio: So Adam, is there anything the market is missing right now?
Adam Jonas: A few things, Tim, but I think the most obvious one to me is just how good these Chinese EVs are. We think the market's really underestimating that, in terms of quality safety features, design. You know, you're seeing Chinese car companies hiring the best engineers from the German automakers coming, making these beautiful, beautiful vehicles, high quality. Another thing that we think is underestimated are the environmental externalities from battery manufacturing, batteries are an important technology for decarbonization. But the supply chain itself has some very inconvenient ESG externalities, labor to emissions and others. And I would say, final thing that we think the market is missing is there's an assumption that just because the electric vehicle and the supporting battery business, because it's a large and fast growing, that it has to be a high return business. And we are skeptical of that. Precedents from the solar polysilicon and LED TVs and others where when you get capital working and you've got state governments all around the world providing incentives that you get the growth, but you don't necessarily get great returns for shareholders, so it's a bit of a warning to investors to be cautious, be opportunistic, but growth doesn't necessarily mean great returns. Tim, let's return to China for a minute and as I ask you one final question, where will growing China's EV exports go and what is your outlook for the next one or two years as well as the next decade?
Tim Hsaio: Eventually, I think China EVs will definitely want to grow their presence worldwide. But initially, we believe that there are two major markets they want to focus on. First one would be Europe. I think the China's export or the local brands there will want to leverage their BEV portfolio, battery EV, to grow their presence in Europe. And the other key market would be ASEAN country, Southeast Asia. I think the Chinese brands where the China EV can leverage their plug-in hybrid models to grow their presence in ASEAN. The major reason is that we noticed that in Southeast Asia the charging infrastructure is still underdeveloped, so the plug-in hybrid would be the more ideal solution to that market. And for the next 1 to 2 years, we are currently looking for the China the EV export to grow by like 50 to 60% every year. And in that long-terms, as you may notice that currently China made vehicles account for only 3% of cars sold outside China. But in the next decade we are looking for one third of EVs sold in overseas would be China made, so they are going to be the leader of the EV sold globally.
Adam Jonas: Tim, thanks for taking the time to talk.
Tim Hsaio: Great speaking with you Adam.
Adam Jonas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Bond yields have seen a surprising increase as a result of real interest rates, which could mean both good and bad news for other asset types.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, a Senior Fixed Income Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 18th at 2 p.m. in London.
August is a month in financial markets that is often all or nothing. Sometimes it's quiet, a self-reinforcing state where investors desire to recharge and enjoy the nicer weather means fewer deals and lower activity, reinforcing the desire to enjoy the nicer weather.
But there's a flip side. The fact that so many investors' are away in August can also amplify market moves, especially if worries mount, and we see that in the historical data. August has seen the largest average rise in stock market volatility of any month, if we go back to 2010, where it's seen higher volatility in 10 out of the last 14 years. So far, this August is off to another volatile start.
The culprits are plenty. Equity markets have been having a great run based almost entirely on expanding valuations, an unusual occurrence, as Lisa Shalett, the CIO of Morgan Stanley Wealth Management and I discussed on this program last week. Data in China has been weaker than expected and across the U.S., Europe and Japan, bond yields have been rising significantly.
The bond move is especially notable given how it's been happening. Yields aren't rising because of inflation, as last week's U.S. consumer price inflation reading was a little better than expected, and longer run expectations of U.S. inflation are actually lower on the month. The market also has increased its expectation of further rate hikes from the Federal Reserve or the ECB, although it has added another expected hike for the Bank of England.
Rather, the increase in yields this month has been almost entirely due to the so-called real interest rate, that is the yield on bonds over and above expected inflation. In the U.S., ten year real rates are now about 1.9% above expected inflation, which is a similar level to what we saw from 2003 to 2005.
There's both bad and good news here. The bad news is that if investors can get a higher guaranteed return over inflation from government bonds, other assets are going to look less attractive by comparison. We continue to hold a more cautious view on U.S. equity markets as well as commodities.
But there's also some good news. Higher real rates have made TIPS or Treasury inflation-protected securities more attractive and my colleagues in interest rate strategy like them. The recent volatility in bond markets has cheapend mortgage backed securities, where my colleague Jay Bacow, Morgan Stanley's co-head of securitized products research, has recently moved back to a positive view. And higher yields are improving the funding ratio for many pension funds, encouraging them to buy safer, longer term investment grade bonds.
More broadly, higher long term real rates could be a sign that the market is more confident about the long term outlook for the U.S. economy. If we think back to the 1990s, it was a period of higher expected potential growth and higher rates relative to expected inflation. If we think about the sluggish 2010s, it was the opposite with very low rates relative to inflation as the market worried that growth could not achieve escape velocity. It will take years to know if the bond market is really endorsing a stronger long run economic view, but as we hope to emphasize, higher rates aren't necessarily all bad.
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Although China’s economy faces challenges in terms of debt, demographics and deflation, the right policy approach could ward off a debt deflation loop.
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing the journey ahead for China as it faces the triple challenge of debt, demographics and deflation. It's Thursday, August 17, at 9 a.m. in Hong Kong.
Before we get into China, I want to take you back to the oft-told tale from the 1990s when Japan experienced what we now refer to as the ‘Lost Decade.’ During this period, the combination of economic stagnation and price deflation transformed a bustling economy in the 1980s, into an economy that grew at a little more than 1% annually over a decade.
Fast forward to today, where China is confronted with the triple challenge of debt, demographics and deflation, what we are calling the 3Ds. As a result, many investors are now concerned that China will be stuck in a debt deflation loop, just like Japan was in the 1990s.
But is China better placed to manage these headwinds even though the risks of falling into debt deflation loop remain high? We think at the starting point, the answer is yes, but with a few historical lessons that I'll get into in a moment.
For context, China compares better with the Japan of the 1990s in the following four aspects. First, asset prices in China have not run up as much. Second, per capita incomes are still lower in China, implying a higher potential growth runway. Third, unlike Japan, China has not experienced a big currency appreciation shock.
And finally, perhaps the most crucial difference is policy setting. Back in the 90s, the Bank of Japan kept real interest rates higher than real GDP growth between 1991 and 1995. But in contrast to Japan, China's real rates are below real GDP growth currently.
To explain, historically, when economies are seeking to stabilize or reduce debt, the key element is to ensure that there is adequate gap between real interest rates and real GDP growth. In Japan's case, real interest rates were maintained about real GDP growth for the first four years. A similar situation occurred in the US post the 1929 stock market crash. As real rates were kept high, it laid the ground for the beginnings of the Great Depression.
From both of these examples, the historical track shows two policy missteps. First, policymakers' concern about reigniting misallocation leads them to gravitate towards a hawkish bias. Second, policymakers tend to turn hawkish too quickly at the first signs of a recovery. During the Great Depression, easing of policies had led to recovery from 1933 onwards, but a premature tightening of policies in 1936 led to the double dip in 1937/38. Contrast this with the US after 2008, when the Fed was quick to bring rates to zero and embark on successive rounds of quantitative easing while fiscal policy was deployed in tandem.
Sustaining real interest rates 2 percentage points below real GDP growth is key to deleveraging. Why? Because if you think about it, deleveraging will not be possible if the interest rate on your debt is growing faster than the increase in your income.
In this context, while China's real interest rates are below real GDP growth currently, we still see the risk that policymakers will not take up reflationary policies to sustain the rates minus growth gap, which keeps the risk of China falling into debt deflation loop alive.
So what is the potential outcome? China's policymakers will need to act forcefully. If they don't, the economy could fall into debt deflation loop, persistent deflation would take hold, debt to GDP would keep rising, and GDP per capita in USD terms would stagnate, just as it happened in Japan in the 1990s. But, as history has shown us, that doesn't have to be the outcome.
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Although Congress has avoided previous shutdowns with last-minute resolutions, investors shouldn’t get complacent in assuming the same outcome again in the fall.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about what investors need to know about the risk of the U.S. government shutdown. It's Wednesday, August 16th at 10 a.m. in New York.
Congress is in recess until September. When they return, they'll have just a few weeks to pass several funding bills in order to avoid a government shutdown. And while it certainly seems like dramatic deadlines and last minute resolutions are all too common in D.C. these days, investors shouldn't get complacent on this one.
Let's start with why investors should take seriously the risk of a government shutdown, which happens when Congress fails to authorize spending to keep most government functions open. When that happens, there are both direct economic impacts, such as government workers and contractors not getting paid on time and indirect impacts, such as the economic activity of those workers and contractors being crimped given that they're going without pay. In the 2019 shutdown, for example, 800,000 government workers were affected by this disruption. Our economists estimate that for every week the government is shut down, we should expect a 0.05% point reduction in GDP, with that impact compounding and increasing over time. While that's not a huge number, in the context of an already softening economic growth and profit outlook for stocks, it doesn't help.
So if a shutdown presents economic downside, why is that even a possibility? Here's four reasons why. First, Congress faces several challenging negotiations in September, which elevates the complexity of the legislative process ahead of the shutdown deadline. Second, there are disagreements within the Republican Party on what the right level of funding is for the government, meaning one of the two parties has yet to firm up its position to get negotiations going in earnest. Third, there's also disagreement within the Republican Party on aid levels for Ukraine. Finally, there appears to be greater willingness on the part of lawmakers to engage in policy standoffs, as evidenced by the recent debt ceiling negotiation. While history shows that approval ratings for both parties fared poorly following a shutdown, shutdowns happen nonetheless, and quotes from key members of both parties suggest little concern with the political impact of such an event.
So what's an investor to do from here? For the moment, not much. We're not expecting much news on this or market reaction until September. Until then, we'll, of course, keep you updated on anything relevant.
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With the rupee appreciating, manufacturing and services in a consistent rally and demographic trends on an upswing, India may be better poised for a long-term boom than other markets in Asia.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be talking about why India is now our preferred market in Asian equities. It's Tuesday, August 15th at 8am in Singapore.
Before we dive into the details of some important changes in view that we've recently published, let's take a step back and set the scene for today's changes in a broader thematic context.
Firstly, a reminder that we think we began a new bull market in Asia and EM last October. And from the trough in late October, the MSCI Emerging Markets Index is up around 25%. So the changes we're making are about identifying leadership at the market level as we transition towards a midcycle environment. Secondly, we continue to prefer Japan within our coverage, which remains Morgan Stanley's top pick in global equities but is a developed market.
In terms of the changes that we've made on the downgrades side, for Taiwan, it has led the way off the bottom, rising almost 40% since last October. It's a market dominated by technology and export earnings, where the structural trend in return on equity has been positive in recent years as those firms have succeeded globally. Our upgrade last October was a simple cyclical story of distressed valuations at a time of depressed sentiment about underlying demand trends in semiconductors. The situation is very different today. Valuations are back to mid-cycle levels, and while demand remains weak in key areas such as smartphones and conventional cloud, a path to recovery is becoming more evident. Moreover, as has been the case in many prior cycles, a new end use category AI service is generating significant excitement.
Our China downgrade, which is linked to our Australia downgrade via the Australian mining stocks, has a different structural set up. The China market, unlike Taiwan, is overwhelmingly dominated by domestic demand stocks and its domestic demand which has failed to recover convincingly in the post-COVID environment. Indeed, the current investor debate is centered on whether China's demographic transition, high domestic debt to GDP ratio and over-investment in property and infrastructure are starting to generate a balance sheet recession. Core inflation is stuck close to zero, with evidence of high unemployment in the young population and weak wages, with households and private firms no longer willing to lever up. Now, recent statements from the Politburo have begun to acknowledge the need to reverse some of the measures that have pressured the property market. But there is no easy way out of the intertwined property and local government financing debt burdens that have built up in the years when the growth model did not transition fast enough. And at the same time, China faces the new challenge of coping with multi-polar world pressures from the US in particular, which is generating new restrictions on inward technology transfers. All that said, we do not rule out moving back to a more positive stance on China, should policy implementation be more aggressive than hitherto.
For India, the situation is in stark contrast to that in China, as was borne out to me by a recent visit in June to the Morgan Stanley annual Investment Summit in Mumbai. With GDP per capita, only $2,500 versus $13,000 for China and positive demographic trends, India is arguably at the start of a long wave boom at the same time as China may be ending one. Manufacturing and services PMIs have rallied consistently since the end of COVID restrictions, in contrast to the rapid fade seen in China. Also, real estate transaction volumes in construction have broken out to the upside. Moreover, India's ability to leverage multi-polar world dynamics is a significant advantage. Simply put, India's future looks to a significant extent like China's past, and in this context, it's particularly relevant to note long run trends in exchange rates now show the Indian rupee more stable and actually appreciating whilst the renminbi is depreciating.
So considering Indian equities and Chinese equities as a pair in dollar terms, we appear to be at the beginning of a new era of Indian outperformance compared to China. From early 2021, India has broken out dramatically to the upside in performance. And whilst reversion to the mean is often a powerful force in finance, we think this represents a structural break in India's favor.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.
While the Fed fights generationally high inflation, the U.S. economy continues to grow, supported by high levels of spending. This has affected both the bond and equity markets.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, August 14, at 11 a.m. in New York. So let's get after it.
At the trough of the pandemic recession in April 2020, we first introduced our thesis that the health care emergency would usher in a new era of fiscal policy. The result would be higher inflation than monetary policy was able to attain on its own over the prior decade. In the first phase of this new policy regime, we referred to it as helicopter money, as described by Milton Friedman in the early 1970s and then highlighted by Ben Bernanke after the tech bubble as a policy that could always be employed to avoid a deflationary bust. Handing out checks to people is a fairly radical policy, however, the COVID pandemic was the perfect emergency to try it.
The policy shift worked so well to keep the economy afloat during the lockdowns that the government decided to double down on the strategy by doing an additional $3 trillion of direct fiscal spending in the first quarter of 2021. This excessive fiscal policy is why money supply growth increased to a record level at 25% year-over-year in early 2021, and why we finally got the inflation central banks had been trying so hard to achieve post the great financial crisis. After the financial crisis, the velocity of money collapsed, while the Fed's balance sheet ballooned to levels never seen before. The reason we didn't get inflation in that initial episode of quantitative easing is because the money created remained trapped in bank reserves rather than in a real economy where it could drive excess demand in higher prices, a dynamic that's been obviously very different this time.
Fortunately, the Fed is responding to this generationally high inflation with the most aggressive tightening of monetary policy in 40 years. But this is the definition of fiscal dominance, monetary policy is beholden to the whims of fiscal policy. First, it had to be overly supportive and fund the record deficits in 2020 and 21, and then it had to react with historically tighter policy once inflation got out of control. Back in 2020, we turned very bullish on equities on this shift of fiscal dominance and also subsequently indicated it would lead to a period of hotter but shorter economic earning cycles, mainly because the Fed would not have the same flexibility to proactively try to extend economic expansions. We also argued that catching these cycles on both the upside and downside would be critical for equity investors to outperform. From 2020 to 2022, we found ourselves on the right side of that dynamic both up and down, this year, not so much. Part of the reason we found ourselves offsides this year is due to the very large fiscal impulse restarting last year and remaining quite strong in 2023. In fact, we have rarely ever seen such large deficits when the unemployment rate is so low and inflation well above target.
If fiscal policy is showing little constraint in good times, what happens to the deficit when the next recession arrives? The main takeaway for the equity market this year is that fiscal policy has allowed the economy to grow faster than forecasted and has given rise to the consensus view that the risk of recession has faded considerably. Furthermore, with the recent lifting of the debt ceiling until 2025, this aggressive fiscal spending could continue. However, the sustainability of such fiscal policy is the primary reason why Fitch recently downgraded the U.S. Treasury debt. Combined with the substantial increase in the supply of Treasury notes and bonds expected to fund these government expenditures, bond markets have sold off considerably this past month. This should start to call into question the valuations of equities, which were already high even before this recent rise in yields. Furthermore, if fiscal spending must be curtailed due to either higher political or funding costs, the unfinished earnings decline that began last year is more likely to resume as our forecast is still predicting. Equity markets seem to have noticed, with many of the best performing stocks correcting by 10% or more. Even if one is bullish on stocks, such a correction was necessary to reset investor exuberance. The challenge will come this fall if growth fails to materialize as now expected. In that case, a healthy 5 to 10% pullback may turn into the much more significant correction we were expecting to occur in the first half of this year.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
While the Fed navigates a soft landing for the U.S. economy and stock valuations remain high, how can investors navigate the risks and rewards of a surprisingly strong equity market? Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.
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Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Fixed Income Strategist at Morgan Stanley
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Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: And today on the podcast, we'll be discussing what's been happening year to date in markets and what might lie ahead. It's Friday, August 11th at 1 p.m. in London.
Lisa Shalett: And it's 8am here in New York City.
Andrew Sheets: So, Lisa, it's great to have you here. I think it's safe to say that as a strategy group, we at Morgan Stanley have been cautious on this year. But I also think this is a pretty remarkable year. As you look back at your experience with investing, can you kind of help put 2023 in context of just how unusual and maybe surprising this year has been?
Lisa Shalett: You know, I think one of the the key attributes of 2023 is, quite frankly, not only the extraordinarily low odds that history would put on the United States Federal Reserve being able to, quote unquote, thread the needle and deliver what appears to be an economic soft landing where the vast and most rapid increase in rates alongside quantitative tightening has exacted essentially no toll on the unemployment rate in the United States or, quite frankly, average economic vigor. United States GDP in the second quarter of this year looked to accelerate from the first quarter and came in at a real rate of 2.4%, which most folks would probably describe as average to slightly above average in terms of the long run real growth of the US economy over the last decade. So, you know, in many ways this was such a low odds event just from the jump. I think the second thing that has been perplexing is for folks that are deeply steeped in, kind of, traditional analytic frameworks and long run correlative and predictive variables, the degree to which the number of models have failed is, quite frankly, the most profound in my career. So we've seen some real differences between how the S&P 500 has been valued, the multiple expansion that we have seen and things like real rates, real rates have traditionally pushed overall valuation multiples down. And that has not been the case. And, you know, I think markets always do, quote unquote climb the wall of worry. But I think as we, you know, get some distance from this period, I think we're also going to understand the unique backdrop against which this cycle is playing out and, you know, perhaps gaining a little bit more of an understanding around how did the crisis and the economic shocks of COVID change the labor markets perhaps permanently. How did the degree to which stimulus came into the system create a sequencing, if you will, between the manufacturing side of the economy and the services side of the economy that has created what we might call rolling slowdowns or rolling recessions, that when mathematically summed together obscure some of those trends and absorb them and kind of create a flat, flattish, or soft landing as we've experienced.
Andrew Sheets: How are you thinking about the valuation picture in the market right now? And then I kind of want to get your thoughts about how you think valuations should determine strategy going forward.
Lisa Shalett: So this is a fantastic question because, you know, very often I'm sitting in front of clients who are, you know, very anxious about the next quarter, the next year. And while I think you and I can agree that there certainly are these anomalous periods where valuations do appear to be disconnecting from both interest rates and even earnings trends, they don't tend to be persistent states. And so when we look at current valuations just in the United States, if you said you're looking at a market that is trading at 20x earnings the implication is that the earnings yield or your earnings return from that investment is estimated at roughly 5%. In a world where fixed income instruments and credit instruments are delivering that plus at historic volatilities that are potentially half or even a third of what equities are, you can kind of make the argument that on a sharp ratio basis, stocks don't look great. Now, that's not all stocks. Clearly, all stocks are not selling at 20x forward multiples. But the point is we do have to think about valuation because in the long run, it does matter.
Andrew Sheets: I guess looking ahead, as you think about the more highly valued parts of the market, where do you think that thinking might most likely apply, as in the current valuation, even if it looks expensive, might be more defendable? And where would you be most concerned?
Lisa Shalett: I think we have to, you know, take a step back and think about where some of the richest valuations are sitting. And they're sitting in, you know, some of the megacap consumer tech companies that have really dominated the cycle over the last, you know, 14, 15 years. So we have to think about a couple of things. The first is we have to think about, you know, the law of large numbers and how hard it is, as companies get bigger and bigger, for them to sustain the growth rates that they have. There will never be companies as dominant as, you know, certain banks. There will never be companies that are as dominant as the industrials. There will never be companies that are as dominant as health care. I mean, there's always this view that winners who achieve this kind of incumbent status are incumbent forever. And yet history radically dispels that notion, right? I think the second thing that we need to understand is very often when you get these type of valuations on megacap companies, they become, you know, the increased subject of government and regulatory scrutiny, not only for their market power and their dominance, but quite frankly for things around their pricing power, etc. The last thing that I would say is that, you know, what's unique about some of the megacap consumer tech companies today that I don't hear anyone talking about, is this idea that increasingly they're bumping up against each other. It's one thing when, you know, you are an e-commerce innovator who is rolling up retail against smaller, fragmented operators. It's quite another when it's, you know, three companies own the cloud, seven companies own streaming. And I don't hear anyone really talking about it head on. It's as if these markets grow inexorably and there's, you know, room for everyone to gain share. And I push back on some of those notions.
Andrew Sheets: So, Lisa, I'd like to ask you in closing about what we think investors should do going forward. And to start, within one's equity portfolio, where do you currently see the better risk reward?
Lisa Shalett: So we're looking at where are the areas where earnings have the potential to surprise on the upside, and where perhaps the multiples are a little bit more forgiving. So where are we finding some of that? Number one, we're finding it in energy right now. I think while there's been a lot of high fiving and enthusiasm around the degree to which headline inflation has been tamed, I think that if you, you know, kind of look underneath the surface, dynamics for supply and demand in the energy complex are beginning to stabilize and may in fact be showing some strength, especially if the global economy is stronger in 2024. A second area is in some of the large cap financials. I think that some of the large cap financials are underestimated for not only their diversity, but their ability to actually have some leverage if in fact global growth is somewhat stronger. We also think that there may be opportunities in things like residential REITs. There's been, you know, concern about that area, but we also know that the supply demand dynamics in US housing are in fact quite different this cycle. And last but certainly not least, I think that there are a series of themes around fiscal spending, around infrastructure, around decarbonization, around some of the the reconfiguration of supply chains that involves some of the less glamorous parts of the market, like utilities, like, you know, some of the industrials companies that have some very interesting potential growth attributes to them that that may not be fully priced as well.
Andrew Sheets: Lisa, thanks for taking the time to talk.
Lisa Shalett: Absolutely, Andrew. Always a pleasure.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on Apple Podcasts. It helps more people find the show.
A recent landmark study around weight-loss medicine could spark near-term growth opportunities in pharmaceuticals.
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Mark Purcell: Welcome to Thoughts on the Market. I'm Mark Purcell, Head of Morgan Stanley's European Pharmaceuticals Team.
Terence Flynn: And I'm Terence Flynn, Head of the U.S. Biopharma Team.
Mark Purcell: And on this special episode of Thoughts on the Market, we'll give you an update on the global obesity challenge. It's Thursday, the 10th of August, and it's 1 p.m. in London.
Terence Flynn: And 8 a.m. in New York.
Terence Flynn: Now, a year ago, we came on the show to discuss our views on the global obesity challenge, and the problem has since received significant media attention. We believe that the narrative around obesity has indeed changed, with a more empathetic media tone, exponential social media growth and increased recognition across health care professionals and policymakers. Mark, what exactly happened over the last year?
Mark Purcell: Well, Terence I mean the uptake of obesity medicines in the US has been much stronger than we anticipated. In fact, obesity drug demand has outstripped supply, as you said, driven by social media activity, but also a rapid expansion in reimbursement. When we look back, about 12 million individuals suffering with obesity were covered by insurance and employee opt-ins for the first generation of these appetite suppressing medicines. For newer, higher efficacy GLP-1 medicines, about 40 million lives are covered, and that is more than the estimated number of individuals living with diabetes in the US, which is projected to be about 37 million.
Terence Flynn: Great. Thanks, Mark. Now the greater focus on weight management has spilled over into an increasingly weight centric approach to treating diabetes. What changes are you seeing and how are they impacting the industry?
Mark Purcell: Terence you're absolutely right. Look, for many years, treatment guidelines for diabetes focused on blood sugar control only. Just before the pandemic, there was an increasing focus on controlling cardiovascular risks as w ell, such as preventing heart attacks. In the past 12 months, there's been increased focus on weight management for diabetes, which can help prevent the progression of diabetes and potentially reverse the course of the disease if you catch it early enough. It's estimated about 40% of GLP-1 prescriptions in the US are for patients early in the course of their disease. These dynamics have driven a profound acceleration in the uptake of GLP-1 medicines in diabetes, and we now project GLP-1 sales in diabetes alone to exceed $56 billion in 2030.
Terence Flynn: Mark, I know this SELECT trial has been a focus and this was the first large randomized trial to test whether long term treatment with a weight loss drug can meaningfully improve patients cardiovascular health. Now, this trial appears just to be the tip of the iceberg when it comes to market expansion. Maybe you could walk us through your thoughts on the recent data.
Mark Purcell: Yeah, thanks Terence. I mean, SELECT is a really important obesity landmark study. It addresses the question does weight management save lives? The trial was designed to show a 17% reduction in the risk of heart attacks and strokes and cardiovascular deaths in non-diabetic individuals suffering from obesity who are treated with GLP-1 medicines. And we just got the data top line the other day, and in fact, these medicines are showing a 20% reduction in heart attacks, strokes and cardiovascular death. As you said, I mean, this is just the tip of the iceberg when it comes to new growth opportunities for weight loss medicines, with positive data to be presented at the American Heart Association meeting in November, the SELECT data and also data in heart failure, and then next year we get exciting data in obstructive sleep apnea, in chronic kidney disease and also in peripheral arterial disease. Back to you, Terence. What is your outlook for the size of the obesity market in the US and globally over the next 5 to 10 years?
Terence Flynn: Thanks, Mark. As you mentioned earlier, the uptake of obesity medicines in the US over the last year has been stronger than we anticipated. There have been some supply chain shortages that have capped an acceleration uptake in the US, and delayed the rollout of these medicines outside of the US. But a number of companies are making significant manufacturing investments today which will help improve supply on a global basis, but also create barriers to entry in the future. We're projecting that sales of the new obesity medicines in the US would have exceeded $7 billion this year, if the supply challenges had not been an issue. But if we extrapolate these strong early dynamics in the US, we project the global obesity market could reach over $70 billion in 2030. Our prior estimate was over $50 billion.
Mark Purcell: And Terence, are there any regional differences between Europe and the US and possibly other parts of the world?
Terence Flynn: Now, the majority of the upgrade, Mark, to our forecasts really centered on our US assumption. And this reflects the limited rollout of these drugs in other countries, in part due to supply constraints I mentioned, but also lack of visibility with respect to demand and payer dynamics across different regions. In the future, we do expect this to change, as I mentioned, given improving supply dynamics, improving reimbursement and the rollout of newer oral options that could also help improve global access.
Mark Purcell: So where are we in terms of GLP-1 obesity medicine prices, when it comes to the consumer and when it comes to insurance reimbursement?
Terence Flynn: Yeah, thanks, Mark. I mean, the injectable GLP medicines right now for diabetes are priced at about $900 to $1000 per month here in the US, but net prices are more in the $500 per month range. Now, in obesity, these drugs do cost somewhat more, but over time prices could converge lower. Now, insurance coverage, as you mentioned, Mark, is still a work in progress with over 40 million people now covered. But in our view, the SELECT data, in conjunction with legislation, could really help to expand coverage further. Going back to you, Mark, what's next in the pipeline for these GLP-1 medicines?
Mark Purcell: The key focus is if the industry's pipeline at the moment are combination approaches and new ways to deliver these medicines. We've previously drawn parallels between how the high blood pressure market evolved in the 1980s and how we expect the obesity market to develop in the future, where combining different mechanisms can lead to better and more consistent treatment approaches. In obesity, targeting liver fat and lean body mass, these are things that can improve the quality of weight loss. There are a number of oral treatment approaches in development as well now, which we expect to broaden the appeal of GLP-1 medicines to a new audience, so really, it's an exciting time in the obesity global challenge.
Mark Purcell: Terence, thanks for taking the time to talk.
Terence Flynn: Great speaking with you, Mark.
Mark Purcell: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Forthcoming U.S. restrictions on some tech investments in China may present new opportunities as companies adapt to these constraints.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about developments in the US-China economic relationship. It's Wednesday, August 9th at 10 a.m. in New York.
News this week broke that the U.S. government is close to finalizing rules that would limit U.S. investment into China related to cutting edge tech sectors, such as quantum computing and artificial intelligence. The long awaited move, which we've discussed many times on this podcast, is yet another sign that the rewiring of the global economic system continues, transitioning from one of globalization to that of a multipolar world.
But when news breaks like this, it's helpful to remember that the headlines can sound worse than the reality. Yes, it's likely that the global economy, and therefore markets, would be better off if the U.S. and China could find a way to deepen their economic ties, but the fraying of those ties need not be a substantial negative either. And these new outbound investment restrictions are a great example of that point.
The proposed rule will, reportedly, restrict investment in companies who derive more than half their revenue from the sensitive technologies in question. Effectively, that means the U.S. will mostly be concerned with U.S. investors not funding development of new technology through startups. It could potentially leave the door open for more traditional forms of U.S. investment into China, namely through working with larger companies on market access and supply chain solutions.
So while many companies are still likely to seek diversification away from China for their supply chains, they still have the ability to do this over time, as opposed to an abrupt decoupling that investors would likely see as carrying much greater risk to the global economy and markets.
So, this gives investors a better chance to identify the opportunities that emerge as companies and governments spend money to adopt to these new constraints. Security as an investment theme is something we see potential in, with the defense sector and many industrial subsectors as beneficiaries. Geographically, we see Mexico, India and broader Asia as best positioned to capture investment and jobs from supply chain realignment, given their labor costs and proximity to key end markets.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
The profound demographic changes underway in countries around the world will require innovative, socially focused solutions in sectors including health care, finance and infrastructure.
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Stephen Bryd: Welcome to Thoughts on the Market. I'm Stephen Bryd, Morgan Stanley's Global Head of Sustainability Research.
Mike Camfield: And I'm Mike Camfield, Head of EMEA Sustainability Research.
Stephen Bryd: On this special episode of the podcast, we'll discuss the social factors within the environmental, social and governance framework, or ESG, as a source of compelling opportunities for investors. It's Tuesday, August 8th, at 10 a.m. in New York.
Mike Camfield: And 3 p.m. in London.
Stephen Bryd: At Morgan Stanley Research. We believe that investing in social impact is critical to addressing some of the most pressing challenges facing our world today, such as inequality, poverty, lack of access to health care and education, and the repercussions of climate change. Traditional methods like philanthropy and government aid are a piece of the puzzle, but alone they can't address with the breadth and scale of these issues. So, Mike, looking back over the last couple of decades, investors have sometimes struggled with the social component of ESG investing. Some of the main challenges have been around data availability, the potential for social washing and the capacity to influence systemic change. How are market views on social investing changing right now, and what's driving this shift?
Mike Camfield: It has historically been quite easy for investors to dismiss social, it's too subjective, too hard to measure, overly qualitative, and perhaps not even material in moving share prices. Increasingly, we do find investors recognize the vast and intractable social problems we face, whether that's structural shifts in workforces with countries like Korea, Japan and large parts of Europe projecting working age population decline by double digit percentage in the next 15 to 20 years, significant growth in urbanization or growing middle class populations in countries around the world. Investors also increasingly understand the interconnectivity of stakeholders across society, be that supranational organizations or governments or the corporate world, or even citizens themselves. Concurrently, it's becoming clear that corporate purpose and culture are critical considerations for prospective and current employees, as well as end customers themselves who are prepared to vote with both their wallets and their feet. All that said, we do note the overall impact at EM has garnered in 18% kagger over the last five years to nearly $213 billion with the Global Impact Investing Network pointing out that over 60% of impact investors are targeting some of the UN's socially focused SDGs. Notably goal eight around decent growth, goal five, around gender equality, goal ten around reduced inequalities broadly and goal three good health and well-being. In terms of drivers, we're seeing the realization rapidly dawning amongst investors that the profound changes underway in society and the climate will drive the need for innovative, socially focused solutions in a number of sectors, from health care to finance to infrastructure, as well as significant challenges to resilience and adaptation for industries around the world. With huge shifts in demographics coming whether through urbanization or migration, aging populations in some countries or declining fertility rates, the investing landscape is set to change dramatically across sectors, with change manifesting in anything from shifting consumer preferences to education access and outcomes to greater need for assistive technologies, to substantial food production issues, to financial system access and inclusion, or even simply addressing rapidly increasing demand for basic services and clean energy.
Stephen Bryd: Thanks, Mike. So what are some of the core themes in social investing?
Mike Camfield: Yeah in our recent social skills notes, we did identify five truly global, fast growing and compelling investment themes you can focus on under the broad umbrella of what we would call social investing. Firstly, access to health care, which includes but obviously not limited to pharmaceuticals, vaccines, orthopedics, medical devices, elderly care, sanitation and hygiene, women's health and sexual health. Secondly, nutrition and fitness, which encompasses things like infant nutrition, healthy or healthier food and beverage options, alternative proteins, food safety and food packaging. Thirdly, social infrastructure, which includes mobility, digital and communication systems, connectivity, health care and education facilities, community and affordable housing and access to clean energy. Fourthly, education and reskilling, which includes everything from pre-K, K-12, higher education, corporate and lifelong learning. Our colleague Brenda recently wrote on the potential $8 trillion opportunity in these markets. And finally, right inclusive finance, which encompasses microfinance, financial infrastructure, mobile digital banking, banking for underserved communities, fintech solutions and provision of financial services to SMEs. So Stephen, do you think any industries or regions stand out as leaders or laggards perhaps when it comes to social investing?
Stephen Bryd: You know, Mike, when I think about industries leading, I do think education really stands out. And I think we all recognize that education is really one of the pillars of a productive, well-functioning society, but it does face an array of challenges. A quality education can promote democracy, help communities elevate their social and economic status, and drive innovation in the economy, and yet, over the past few years, multiple issues in education, which were really exacerbated by the COVID 19 pandemic, have hampered equitable progress in society across markets, regions and communities. In our note this past May on education innovators, we really focus on these issues as fields of opportunity for investment in innovation. An example would be improving the quality of the learning experience. The pandemic was an especially disruptive period for K-12 education, leaving a learning deficit that could linger for an entire generation, especially for groups that were already disadvantaged. The pandemic also highlighted the need for more robust lifelong learning opportunities beyond the traditional classroom. We expect to see players that are able to service these needs, best meet market demand. And Mike, in terms of reasons that stand out. A key issue that you highlighted before is data availability. And I would note that really Europe has led the way in terms of best in class disclosure. So Mike, social considerations have historically been viewed as overly qualitative rather than quantitative, but our research has shown a variety of ways in which the S-pillar can closely link to company fundamentals. Could you walk through some of these?
Mike Camfield: Yeah, absolutely, Stephen, I think the starting point for our research was this notion that you can both do good and do well. The values in value based investing can be combined to deliver alpha and positive social impact at the same time. So one of the ways we think to approach this is to assess the corporate culture and its that that forms the first pillar of our forces social investing framework. At its heart, company culture pertains to the shared values, attitudes, practices and standards that shape a work environment and the strategy for business. In our analysis, we want to establish a holistic view of why a company exists, what it's doing to contribute positively towards society, how it's managed, and where its most material social related opportunities and risks lie. In doing that, we've established a data driven, objective process to evaluate culture using eight core components across five performance linked indicators, which are Glassdoor ratings, shareholder voting against management or proprietary, her school employee turnover and board gender diversity. And three engagement focus indicators. The trend in employee diversity, whether the company has a supplier code of conduct in place, and violations of the UN's Global Compact. These data sets are readily available and repeatable, giving a clear view of companies relationship with both its internal and its external stakeholders. Steven, How do you think investors can think about social investing more systematically, can you elaborate a little more on the 4 C's framework?
Stephen Bryd: Yeah happy to Mike, I think you really touched on culture in a very comprehensive way. I really do think it's important that the performance related KPIs that you laid out really do show very clear performance differential between top and bottom quartiles. I want to move on to the second of the C's. This is Cultivate. And here we really focus on three so-called AIM lenses. The first is additionality. This is really the notion of generating positive social outcomes or impacts that otherwise would not have materialized. So finally, Mike, how does A.I play into social investing?
Mike Camfield: Everyone's favorite acronym at the moment, clearly something that we can't ignore. We do believe there's a very real potential for us to be at the start of another economic revolution, driven by rapid technological evolution in AI. The so-called third industrial revolution, otherwise known as the digital revolution, brought with it transformational technologies in cell phones and the Internet, increased interconnectivity, greater industrial productivity and vastly greater accessibility of information. AI looks to play a central role in the fourth Industrial Revolution. Klaus Schwab, founder of the World Economic Forum, popularized that term back in 2015 when he suggested that AI and advanced robotics could herald a substantial shift in industrial capitalism and the so-called knowledge economy. This evolution could fundamentally change employment and geopolitical landscapes. Just as in the early 19th century, when Luddites found machines left weaving skills obsolete. AI could well prove just as disruptive, but technology on a grander scale, across everything from manufacturing to search engines to media content creation. We do see significant AI opportunities in areas like drug development, in education outcomes and access and significant benefits across efficiencies and resource management, whether that's in power grid optimization or in weather prediction, for example. We do suggest a three pronged approach to evaluating AI driven opportunities which focus on areas including reducing harm to the environment, enhancing people's lives through biotech, cybersecurity and life sciences, for example, and enabling technological advancements. Simultaneously, given a relative lack of regulation for the industry at the moment, we do think consistent investor engagement is key to driving responsible A.I practices.
Stephen Bryd: Mike, thanks for taking the time to talk.
Mike Camfield: Great to speak to you, Stephen.
Stephen Bryd: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
The residential housing market continues to face limited inventory, low affordability and high mortgage rates, but the worst may have passed.
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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley U.S. Equity Strategy Team.
Jim Egan: And I'm Jim Egan, Co-Head of U.S. Securities Products Research.
Michelle Weaver: On this special episode of the podcast, we'll discuss the state of the housing market. It's Monday, August 7th at 10 a.m. in New York.
Michelle Weaver: We recently did a deep dive into the global housing market and found that cyclical housing headwinds are significant but approaching a peak globally. And there are a few important things to keep in mind when thinking about this housing cycle. First is that higher interest rates and high home prices have kept affordability low. Second, housing is undersupplied in most economies. And third, there is a big gap between new and existing mortgages. Jim, can you start by talking us through how the structure of U.S. mortgages are different from what's common in other parts of the world?
Jim Egan: Absolutely. So the structure of various mortgage markets has important implications for the pass through of monetary policy changes. And average mortgage terms vary significantly across the globe, from roughly 70% adjustable rate in Australia on one end to nearly all 30 year fixed rate mortgages here in the United States. Though we would say the duration has generally lengthened post the great financial crisis for most economies. Longer duration mortgages lower the sensitivity of housing markets to the policy rate, both in terms of timing and cyclicality. But for the U.S., that 30 year fixed rate, fully amortizing mortgage that's freely repayable at any point in time with no penalty to the borrower, that's a unique feature for our mortgage market. And it's something that's made possible by the fact that roughly 2/3 of that $13 trillion mortgage market is guaranteed by the U.S. government. And that in turn contributes to the sizable and relatively liquid securitization market, which effectively democratizes the risk across a much broader range of investors than just the lenders themselves.
Michelle Weaver: And how have high mortgage rates impacted home sales in the U.S.? If someone's looking to buy a home, are they able to even find listings?
Jim Egan: I think that's an important question, and that's really contributed to our bifurcated housing narrative that we've discussed on this podcast in the past. Mortgage rates go up, affordability deteriorates, but not for current homeowners. They become very locked in at that lower rate and disincentivized to really list their home for sale, and that's why we've seen existing listings fall to 40 year lows. We say 40 year lows because that's just as far back as the data goes, this is the lowest we've seen that. If they're not listing their homes for sale, that means that they're also not buying homes on the follow, and that really brings sales volumes down. That's why in the cycle, existing home sales have fallen twice as fast as they did during the great financial crisis, despite the fact that home prices have remained incredibly protected at near those peaks. Now, let me turn it to you, Michelle. You cover U.S. equities and the housing market has many different links to the equity market. When someone buys a new home, they make a lot of associative purchases, like buying new furniture or making improvements around the house. How have home improvement companies fared?
Michelle Weaver: Sure, so a lot of people made improvements to their houses during COVID to make staying indoors a little bit more comfortable. And post-COVID demand reversion has been a really important driver for the past few years. If you make home improvements one year, you're not going to need to make them again for, you know, several years. And so we think that the reversion of COVID driven overconsumption is largely complete now. Housing prices and housing turnover, these fundamental metrics governing the housing market are likely to resume being the core drivers for the home improvement space from here.
Jim Egan: Now, banks also have a relationship with the housing market through mortgage lending. What've these higher mortgage rates meant for banks?
Michelle Weaver: Interest rates are very high and consequently mortgage rates are also very high. And this has put a damper on demand for new mortgages at banks. There's also a large gap between existing mortgage rates and new mortgage rates, like we were discussing earlier. And in the U.S., homeowners refinanced and masked during COVID when mortgage rates were extremely, extremely low and locked in these rates. Now, less than 1% of American mortgages would be considered in the money to refinance or essentially make sense to refinance. So mortgage originations are expected to continue to stay very low. And this means that banks won't be getting this source of revenue from mortgages.
Jim Egan: Now, that all makes sense on the homeownership side, the mortgage side, but let's think about the reciprocal here a little bit, the rental space. How have high mortgage rates and the lack of supply that we're describing impacted the rental market?
Michelle Weaver: Definitely, high home prices and lack of availability have made it really tough for first time homebuyers. So people that are on the margin between buying their first house or staying in a rental have had to remain renters. And this has increased rents and been a big tailwind for rentership rates that are the owners of these rental properties. Jim, what do you think is going to happen with affordability in the United States, it's been very poor, are you expecting that to improve and what's going to go on with home prices?
Jim Egan: Sure. So affordability remains very challenged, but it's not getting worse. On the margin that's probably going to improve a little bit from here, but remain challenged. Supply remains incredibly tight, but it's not getting tighter. We think that we're in a range bound environment here now, Case-Shiller just turned negative on a year-over-year basis for the first time since 2012. And while we expect that to persist for another couple of months, we expect home prices to basically be unchanged from these levels over the coming year.
Michelle Weaver: Jim, thank you for taking the time to talk.
Jim Egan: Great speaking with you, Michelle.
Michelle Weaver: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
Moves by the Bank of Japan, the downgrade of the U.S. credit rating and new economic data may all have contributed to a spike in bond yields and fall in stock prices.
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Welcome to Thoughts in the Market. I'm Andrew Sheets, Fixed Income Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 4th at 2 p.m. in London.
After a placid July, August has opened with a bout of volatility. In one sense, this isn't unusual. July is historically one of the best months of the year for global equity performance, August and September are two of the worst.
But the way markets have weakened has been more striking. Long term bond yields rose sharply this week, with the U.S. 30 year bond yield rising 27 basis points over the course of the last five days. Long term rates in the UK and Germany also rose sharply. Equity markets fell.
Those facts are clear and indisputable. But why interest rates rose so much, and whether they're responsible for equity weakness? That, ladies and gentlemen of the jury, is a lot less clear.
Indeed, there's more than one driver of last week's events. Maybe it's the Bank of Japan, which late last week raised the effective cap on Japanese government bond yields, which went on to rise sharply over the course of this week. Maybe it's the Fitch rating agency, which on Tuesday downgraded the credit rating of the United States by one notch to AA+. And maybe it's the US economic data, which has been quite strong, something that usually corresponds to higher rates.
There's also the way that yields have risen. While long term U.S. interest rates rose sharply, shorter two year yields barely budged over the last week and in the UK and Germany, those two year yields actually fell. The large move higher in U.S. rates has also occurred while the market's actually lowered its assumption about long run inflation, another unusual occurrence.
In reality, the drivers of these recent events might be all of the above. The initial rise in U.S. yields matched the move higher in Japanese rates, almost one for one. But we do think that move in Japanese rates is now mostly complete. The timing of Fitch's downgrade, which was somewhat unusual, given that there hasn't been any recent legislation to change fiscal policy and the fact that it happened at the start of August, a month that often sees less liquidity, might have given it an outsized impact. And the economic data has been good, suggesting that the U.S. economy for now is handling higher rates, a development that would generally support higher yields and a steeper curve.
And in terms of the global equity reaction, some perspective is probably helpful. While last week saw higher yields and lower prices, since early April, both nominal yields, real yields and global stock prices have all risen together and by quite a bit. Now, it's possible that this relationship between stocks and bonds shifted some this week based on simply how much equity valuations have appreciated, as my colleague Mike Wilson, Morgan Stanley's Chief Equity Strategist, has noted recently. Higher yields make a focus on valuation more important and also make it more essential that good data, the best version of that higher yield story, continues to come through. In bonds, meanwhile, the recent rise in yields is boosting expected returns going forward. On Morgan Stanley's base case forecast, the U.S. ten year Treasury through the middle of 2024 will return over 10%.
Thanks for listening. Subscribe to Thoughts of the Market on Apple Podcasts or wherever you listen, and leave us a review. We'd love to hear from you.
While rate hikes and work from home are depressing office real estate in the U.S., the market is vast globally, and there are clear differences across regions and asset types, ranging from occupancy to design to financing.
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Welcome to Thoughts on the Market. I'm Ron Kamdem, Head of Morgan Stanley's U.S. Real Estate Investment Trust and Commercial Real Estate Research. Today, I'll be talking about our outlook for the future of the global office real estate market. It's Thursday, August 3rd at 10 a.m. in New York.
There is more than 6 billion square feet of office space across the globe with value of more than 4 trillion U.S. dollars. Within this vast market, there are clear differences across the regions, ranging from occupancy to design to financing.
In the U.S., office real estate fundamentals this cycle appear worse than they were during the great financial crisis of 2008 in terms of occupancy, subleasing activity and office utilization. In fact, overall, U.S. office utilization seems to be stalling at 20 to 55% compared to other regional markets in the 60 to 80% range. This trend will likely remain in place as key U.S. tenants are looking to reduce office space by about 10% over the next three years. Work from home and hybrid arrangements are the biggest drivers, particularly with business services and technology focused firms on the West Coast. In addition, sharp rate hikes and regional bank weakness have driven up loan-to-value ratios in the U.S. versus global peers.
Looking at other countries, Australia and Mexico may be having similar problems as far as work from home is concerned, but average loan-to-value ratios are much lower, which lenders typically consider a good sign. Mainland China is unique among our coverage markets for having declining rates. Hong Kong seems to be the most undervalued and closer to bottoming, and we prefer it over Singapore, Japan and Australia. In Latin America, we remain on the sidelines. Despite the increase in net absorption growth, the office real estate market is still showing a slow paced recovery from pandemic levels, especially in Mexico. All in all, global office markets remain 10 to 15% oversupplied.
While higher vacancy is an issue impacting all countries, an important emerging theme across the various region as a bias towards newer and greener buildings. Our channel checks with tenants and landlords suggests that as employees, especially the younger cohorts, choose to work for organizations with strong climate change values, employers will seek to establish offices and more energy efficient buildings. Also, in an effort to encourage office attendance and in-person collaboration, occupiers are gravitating toward younger buildings with more attractive amenities.
Overall, as we look across regions and countries, one common thread is what we call "bifurcation", that is a widening gap between the class-A prime assets and the rest of the commodity B&C space, which is happening at an accelerating pace. We believe it would take 5 to 13 years for the global office market to return to pre-COVID occupancy levels. However, the class A prime assets can recover in half the time as the rest of the market and newer, greener buildings in particular are likely to be most favored.
Bottom line for the U.S looking at fundamentals is that New York and Boston on the East Coast are showing the most resilient trends. Downtown L.A., downtown San Francisco, downtown Seattle and even Chicago are showing the most headwinds, sunbelt markets are somewhere in between but have been lowing.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the market with a friend or colleague today.
The recent downgrade to Fitch's U.S. credit rating should have less of an impact on demand for bonds than the ongoing trajectory of inflation.
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Welcome to the Thoughts on the Market. I'm Michael Zezas, Global head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the impact of the U.S. downgrade to bond markets. It's Wednesday, August 2nd at 11 a.m. in New York.
Yesterday, one of the three main rating agencies, Fitch, downgraded the U.S's credit rating to AA+ from AAA. The U.S. now only has one AAA rating left. Fitch attributed the change to the US's growing debt burden and a, quote, "erosion of governance", unquote, specifically referring to debt ceiling standoffs over the past decade as a cause for concern. The tone of this language may understandably elicit concern from investors, but practically speaking, does it actually matter? In our view, in the short term, probably not.
First off, the downgrade doesn't communicate anything investors didn't already know about the level and trajectory of U.S. debt and deficits. Second, it doesn't tell us anything forward looking about arguably the biggest factor influencing whether or not investors want to own bonds at their current prices, inflation. Third, a ratings downgrade doesn't appear to trigger any structural change in bond demand.
Unpacking that last point a bit more, let's look at the main holders of U.S. Treasuries, the Fed, banks, overseas holders and households. The Fed is under no obligation to adjust Treasury holdings based on credit ratings. It's a similar situation for banks whose incentive to own treasuries is based on risk weightings determined by U.S. regulators, we view as very unlikely to adjust regulations to align with a ratings opinion they likely don't agree with.
Overseas holders typically own treasuries because they have U.S. dollars from doing business with U.S. customers, and we don't see their desire to do business with U.S. companies and consumers changing because of a ratings opinion. As for households, it's possible that some mutual funds and separately managed accounts could want to sell treasuries if they're under a mandate to only own assets rated AAA, but we suspect this type of vulnerability is small and easily absorbable by the market. It's also possible there could be some selling of lower rated bonds, given some portfolios have to maintain an average credit rating, which could be lessened on this downgrade if they own treasuries. But those portfolios could just as easily restore an average credit rating by buying more treasuries versus selling lower rated bonds.
Bottom line, we think investors should look beyond the downgrade and stay focused on the U.S. macro debates that have and continue to matter to markets this year, the trajectory of inflation and whether or not the Fed can control it without a recession resulting.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
While the U.S. economy appears on track to avoid a recession, investors should still consider the implications of an upcoming wave of maturities in corporate credit.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I will be talking about potential risk to the economy. It's Tuesday, August 1st at 10 a.m. in New York.
Another FOMC meeting came and went. To nobody's surprise the Fed hiked the target Fed funds rate by 25 basis points. Beyond the hike, the July FOMC statement had nearly no changes. While data on inflation and jobs are moving in the right direction, the Fed remains far from its 2% inflation goal. That said, Fed Chair Powell stressed that the Fed is closer to its destination, that monetary policies is in restrictive territory and is likely to stay there for some time. Broadly, the outcome of the market was in line with our economists expectation that the federal funds rate has peaked, will remain unchanged for an extended period, and the first 25 basis point cut will be delivered in March 2024.
Powell sounded more confident in a soft landing, citing the gradual adjustment in the labor market and noting that despite 525 basis point policy tightening, the unemployment rate remains at the same level it was pre-COVID. The fact that the Fed has been able to bring inflation down without a meaningful rise in unemployment, he described as quote unquote "blessing". He noted that the Fed staff are no longer forecasting a recession, given the resilience in the economy.
This specter of soft landing, meaning a recession is not imminent, is something our economists have been calling for some time. This has now become more broadly accepted across market participants, albeit somewhat reluctantly. The obvious question, therefore, is what are the risks ahead and what are the paths for such risks to materialize?
One such potential risk emanates from the rising wave of credit maturities from the corporate credit markets. While company balance sheets, by and large, are in a good shape now, given how far interest rates have risen and how quickly they have done so, as that debt begins to mature and needs to be refinanced, it will happen at sharply higher rates. From now through the end of 2024, almost a trillion of corporate debt will mature. Sim ply by holding rates constant, that refinancing will represent a tightening of financial conditions.
Fortunately, a high proportion of the debt comes from investment grade borrowers and does not appear to be particularly challenging. However, below investment grade debt has a tougher path ahead for refinancing. As we continue through 2024 and get into 2025, more and more high yield bonds and leveraged loans will need to be refinanced.
All else equal, the default rates in high yield bonds and leveraged loans currently hovering around 2.5% may double to over 5% in the next 12 months. The forecasts of our economists point to a further slowdown in the economy from here, as the rest of the standard lags of policy are felt. We continue to think that such a slowing could necessitate a re-examination of the lower end of the credit spectrum. The ongoing challenges in the regional banking sector only add to this problem. In our view, in the list of risks to the U.S. economy, the rising wave of maturities in the corporate debt markets is notable.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
With uncertainty around the effects of new central bank policy, investors should be on the lookout for sales growth, cost cutting and sectors that might be turning a corner on performance.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 31st, 11 a.m. in New York. So let's get after it.
This past week was an extremely busy one for global central banks, with the Fed and European Central Bank raising interest rates again by 25 basis points, while leaving the door open to either more hikes or pausing indefinitely. They remain data dependent. However, the biggest change may have come from the Bank of Japan. More specifically, the Bank of Japan decided to get the ball rolling on ending its long standing policy of yield curve control, a policy under which it maintains a cap on interest rates across the curve. This is an important pivot in our view, as it signals the Bank of Japan's willingness to join the fight against inflation. In short, it's incrementally hawkish for global bond markets.
For U.S. equity investors, the main focus has been on the Fed getting closer to the end of its tightening campaign. The key question from investors is whether that means the Fed has orchestrated a soft landing or if a recession is unavoidable. While many investors remain skeptical of the soft landing outcome, equity markets have traded so well this year that these same investors have been swayed into thinking a soft landing is now the highest probability outcome. We believe equity markets are in a classic policy driven late cycle rally. Furthermore, the excitement over a Fed pause has been supported by very strong fiscal impulse and a still supportive global liquidity backdrop, even with central banks tightening. The latest example of a similar late cycle period occurred in 2019. Back then, a robust rally in equities was driven almost exclusively by valuations rather than earnings, like this year. Both then and now, Mega- cap growth stocks were the best performers as equity market internals processed a path to easier monetary policy and lower interest rates. The 2019 analogy suggests more index level upside from here, however, we would note that the Fed was already cutting interest rates for a good portion of 2019, leaving ten year Treasury yields 200 basis points lower than they are today. Nevertheless, equity valuations are 5% higher now than in 2019.
The other scenario is that we are in a new cyclical upturn and growth is about to reaccelerate sharply for both the economy and earnings. While we're open minded to this new view materializing next year, we'd like to see a broader swath of business cycle indicators inflect, higher, breadth improve and short term interest rates come down before adjusting our stance in this regard. In other words, the current progression of these factors does not yet look like prior new cyclical upturns.
Meanwhile, earnings season has been a fade the news so far, with the average stock down about 1% post results. This is worse than the past eight quarters where stocks are flat to up. While hardly a disaster, we think companies will have to start delivering better sales growth to outperform from here. On that score, even the large cap growth stocks have been mostly cost cutting stories to date. Another interesting observation over the past month is that the worst performing sectors are starting to exhibit the best breadth of performance, namely energy, utilities and health care. Industrials is the only leading sector with improving breath. Given the uncertainty there remains about the economic outcome in central bank policy, investors should look to the laggards with good breadth for relative performance catch up. Our top picks are healthcare, utilities and energy.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Chief Cross-Asset Strategist Andrew Sheets explains why it’s increasingly more favorable to be a lender than an asset owner.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, July 28th at 2 p.m. in London.
Markets have been stronger than we expected. Some of the story is straight forward, some of it is not. Indeed across asset classes, the capital structure increasingly looks upside down.
Our investment strategy has been based on the assumption that strong developed market growth was set to slow sharply as post-COVID stimulus waned and policy tightened at the fastest pace in 40 years. Sharp slowing, from an elevated base, has often rewarded more defensive investment positioning.
But our assumption about this growth backdrop has simply been wrong. Growth has been good, with the U.S. printing yet another set of better than expected economic data this week. 20 years from now, an investor looking back on the first half of 2023 might find nothing particularly out of place. The economic data was good and surprisingly so, stocks, especially more cyclical ones, outperform bonds.
Yet that straightforward story has happened alongside something more unusual. Across markets, we can observe a capital structure, that is how much investors are expected to earn as the owner of an asset, a company, an office building and so on, relative to being the lender to the asset. The lender should get a lower return since they're taking less risk, and over the last decade, very low borrowing rates have meant that that very much is the case.
But it's been shifting. To varying degrees, the capital structure now looks almost upside down, with high yields on debt relative to more junior exposure, or the yield on the underlying asset. And we see this in several areas.
In U.S. corporates, higher equity valuations have meant that the forward earnings yield for the Russell 1000, at about 4.8%, is now below the yield on US investment grade corporate debt at about 5.5%, and the difference between these two is only been more extreme in about 2% of observations over the last 20 years.
In real estate, yields on debt have risen much faster than capitalization rates, that is the yield on the underlying real estate asset, and that's happened across both commercial and residential segments.
And across leveraged loans and collateralized loan obligations, or CLO's, the so-called CLO ARB, which is the difference between the yield on the CLO loan collateral and the weighted cost of its liabilities, are unusually low. And we've also seen this in the loan market.
For much of the last decade, the economics of borrowing to buy assets has been attractive. As the examples I've mentioned try to show, these economics are changing. Across scenarios where growth stays solid or especially if it slows, we think being the lender to an asset rather than its owner, is now often the better risk/reward.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen, and leave us a review. We'd love to hear from you.
With higher quality and lower costs, China’s electric vehicles could lead a shift in the global auto industry.
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Adam Jonas: Welcome to Thoughts on the Market. I'm Adam Jonas, Head of Morgan Stanley's Global Autos and Share Mobility Team.
Tim Hsaio: And Tim Hsaio Greater China Auto Analyst.
Adam Jonas: And on this special episode of Thoughts on the Market, we're going to discuss how China Electric vehicles are reshaping the global auto market. It's Thursday, July 27th at 8 a.m. in New York.
Tim Hsaio: And 8 p.m in Hong Kong.
Adam Jonas: For decades, global autos have been dominated by established, developed market brands with little focus on electric vehicles or EVs, particularly for the mass market. As things stand today, affordable EVs are few and far between, and this undersupply presents a major global challenge. At Morgan Stanley Equity Research, we think the auto industry will undergo a major reshuffling in the next decade as affordable EVs from emerging markets capture significant global market share. Tim, you believe China made EVs will be at the center of this upcoming shakeup of the global auto industry, are we at an inflection point and how did we get here?
Tim Hsaio: Thanks, Adam. Yeah, we are definitely at a very critical inflection point at the moment. Firstly, since last year, as you may notice that China has outsized Germany car export and soon surpassed Japan in the first half of this year as the world's largest auto exporter. So now we believe China made EVs infiltrating the West, challenging their global peers, backed by not just cheaper prices but the improving variety and quality. And separately, we believe that affordability remains the key mitigating factors to global EV adoption, as Rastan brands have been slow to advance their EV strategy for their mass market. A lack of affordable models actually challenged global adoption, but we believe that that creates a great opportunity to EV from China where a lot of affordable EVs will soon fill in the vacuum and effectively meet the need for cheaper EV. So we believe that we are definitely at an inflection point.
Adam Jonas: So Tim, it's safe to say that the expansionary strategy of China EVs is not just a fad, but real solid trend here?
Tim Hsaio: Totally agree. We think it's going to be a long lasting trend because you think about what's happened over the past ten years. China has been a major growth engine to curb auto demands, contributing more than 300% of a sales increment. And now we believe China will transport itself into the key supply driver to the world, they initially by exporting cheaper EV and over time shifting course to transplant and foreign production just similar to Japan and Korea autos back to 1970 to 1990. And we believe China EVs are making inroads into more than 40 countries globally. Just a few years ago, the products made by China were poorly designed, but today they surpass rival foreign models on affordability, quality and even detector event user experience. So Adam, essentially, we are trying to forecast the future of EVs in China and the rest of the world, and this topic sits right at the heart of all three big things Morgan Stanley Research is exploring this year, the multipolar world, decarbonization and technology diffusion. So if we take a step back to look at the broader picture of what happens to supply chain, what potential scenarios for an auto industry realignment do you foresee? And which regions other than China stand to benefit or be negatively impacted?
Adam Jonas: So, Tim, look, I think there's certainly room to diversify and rebalance at the margin away from China, which has such a dominant position in electric vehicles today, and it was their strategy to fulfill that. But you also got to make room for them. Okay. And there's precedent here because, you know, we saw with the Japanese auto manufacturers in the 1970s and 1980s, a lot of people doubted them and they became dominant in foreign markets. Then you had the Korean auto companies in the 1990s and 2000s. So, again, China's lead is going to be long lasting, but room for on-shoring and near-shoring, friend shoring. And we would look to regions like ASEAN, Vietnam, Thailand, Indonesia, Malaysia, also the Middle East, such as Morocco, which has an FTA agreement with the U.S. and Saudi, parts of Scandinavia and Central Europe, and of course our trade partners in North America, Mexico and Canada. So, we’ re witnessing an historic re-industrialization of some parts of the world that where we thought we lost some of our heavy industry.
Tim Hsaio: So in a context of a multipolar trends, we are discussing Adam, how do you think a global original equipment manufacturers or OEM or the car makers and the policymakers will react to China's growing importance in the auto industry?
Adam Jonas: So I think the challenge is how do you re-architect supply chains and still have skin in the game and still be relevant in these markets? It's going to take time. We think you're going to see the established auto companies, the so-called legacy car companies, seek partnerships in areas where they would otherwise struggle to bring scale. Look to diversify and de-risk their supply chains by having a dual source both on-shore and near-shore, in addition to their established China exposed supply chains. Some might choose to vertically integrate, and we've seen some striking partners upstream with mining companies and direct investments. Others might find that futile and work with battery firms and other structures without necessarily owning the technology. But we think most importantly, the theme is you're not going to be cutting out the world's second largest GDP, which already has such a dominant position in this important market, so the Western firms are going to work with the Chinese players. And the ones that can do that we think will be successful. And I'd bring our listeners attention to a recent precedent of a large German OEM and a state sponsored Chinese car company that are working together on electric vehicle architecture, which is predominantly the Chinese architecture. We think that's quite telling and you're going to see more of that kind of thing.
Tim Hsaio: So Adam, is there anything the market is missing right now?
Adam Jonas: A few things, Tim, but I think the most obvious one to me is just how good these Chinese EVs are. We think the market's really underestimating that, in terms of quality safety features, design. You know, you're seeing Chinese car companies hiring the best engineers from the German automakers coming, making these beautiful, beautiful vehicles, high quality. Another thing that we think is underestimated are the environmental externalities from battery manufacturing, batteries are an important technology for decarbonization. But the supply chain itself has some very inconvenient ESG externalities, labor to emissions and others. And I would say, final thing that we think the market is missing is there's an assumption that just because the electric vehicle and the supporting battery business, because it's a large and fast growing, that it has to be a high return business. And we are skeptical of that. Precedents from the solar polysilicon and LED TVs and others where when you get capital working and you've got state governments all around the world providing incentives that you get the growth, but you don't necessarily get great returns for shareholders, so it's a bit of a warning to investors to be cautious, be opportunistic, but growth doesn't necessarily mean great returns. Tim, let's return to China for a minute and as I ask you one final question, where will growing China's EV exports go and what is your outlook for the next one or two years as well as the next decade?
Tim Hsaio: Eventually, I think China EVs will definitely want to grow their presence worldwide. But initially, we believe that there are two major markets they want to focus on. First one would be Europe. I think the China's export or the local brands there will want to leverage their BEV portfolio, battery EV, to grow their presence in Europe. And the other key market would be ASEAN country, Southeast Asia. I think the Chinese brands where the China EV can leverage their plug-in hybrid models to grow their presence in ASEAN. The major reason is that we noticed that in Southeast Asia the charging infrastructure is still underdeveloped, so the plug-in hybrid would be the more ideal solution to that market. And for the next 1 to 2 years, we are currently looking for the China the EV export to grow by like 50 to 60% every year. And in that long-terms, as you may notice that currently China made vehicles account for only 3% of cars sold outside China. But in the next decade we are looking for one third of EVs sold in overseas would be China made, so they are going to be the leader of the EV sold globally.
Adam Jonas: Tim, thanks for taking the time to talk.
Tim Hsaio: Great speaking with you Adam.
Adam Jonas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Investors are questioning what new policy changes the 2024 election might bring, how the changes could affect markets and when they should start paying attention.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed-Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about what investors need to know about the 2024 U.S. election. It's Wednesday, July 26th at 11 a.m. in New York.
As the press starts to focus more and more on the 2024 election, so have our clients leading many questions to come our way about who we think will be the next president and what we think they might do that could influence markets. As listeners of this podcast are surely aware, here at Morgan Stanley Research, we obviously care a great deal about elections and their consequences for markets. So then you might be surprised to know that our response so far to 2024 election questions has been, 'Nothing to see here, at least not yet'.
There's two reasons behind this thinking. First, there's no data out there that can tell us much about what the election outcome will be. Polls are, in our view, better predictive tools and they've recently gotten credit for, but polls taken today about presidential candidates over a year away from the election have no track record of predicting anything. The same is true for polls about who the challenging party's nominee will be. And modern U.S. electoral history is full of examples where party nomination frontrunners have either faded or won the nomination, so there's no pattern to rely on there. In short, if you're interested in knowing who will win the election, there's not much to do but watch and wait.
Second, the policy consequences of the election that might matter to markets could evolve greatly over the next 12 months in unpredictable ways. For example, in 2019, the 2020 election seemed set to be all about health care policy, and investors were intensely focused on the potential impact to the pharma sector. But when the pandemic hit, the election's importance to the market became more macro, it was all about the potential for more fiscal stimulus, shifting the election from an equity sector story to one that mattered to the overall stock index and bond yields. In 2007, the 2008 election seemed poised to be all about foreign policy, but then the financial crisis hit and markets again cared about how the outcome would affect potential fiscal stimulus and bank regulation. We could go on, but the point is this, history tells us this election will matter greatly to markets, but it's way too early to reliably know how it will matter.
Now, rest assured, while we're suggesting investors don't have to pay close attention to the US election yet, we are paying attention and putting plenty of time into assessing the various plausible impacts the election could have. In particular around tax policy, tech regulation, defense spending, and refreshing our framework for how fiscal policy in the U.S. reacts to political conditions and party control in Congress. Of course, we'll flag for you when we think it's a productive time to join us in this early preparation, so that when the election and its consequences come more into focus, you'll be front footed.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
Rapidly declining inflation poses a challenge to revenue growth and earnings. So what should investors look out for to identify the winners from here?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, July 25th at 10 a.m. in New York. So let's get after it.
As discussed in last week's podcast, this year's equity market has been all about expanding valuations. The primary drivers of this multiple expansion have been falling inflation and cost cutting rather than accelerating top line growth. Last October, we based our tactically bullish call on the view that inflation was peaking, along with back end interest rates and the US dollar. While the 30% move in equity multiples on the back of this theme has gone much further and persisted longer than we anticipated, we don't feel the urge to turn bullish now. Missing the upside this year was unfortunate, however, compounding with another bad call can lead to permanent loss.
While falling inflation supports the expectations for a Fed pivot on monetary policy, it also poses a risk to nominal revenue growth and earnings. To remind listeners of a key component to our earnings thesis, we believe inflation is now falling even faster than the consensus expects, especially the inflation experienced by companies. With price being the main factor keeping sales growth above zero for many companies this year, it would be a material headwind if that pricing were to roll over. This is precisely what we think is starting to happen for many businesses, especially in the goods portion of the economy.
Last year's earnings disappointment in communication services, consumer discretionary and technology were significant, but largely a function of over-investment and elevated cost structures rather than disappointing sales. In fact, our operational efficiency thesis that worked so well last year was adopted by many of these companies in the fourth quarter, and they've been rewarded for it. From here, though, we think sales estimates will likely have to rise for these stocks to continue to power higher, and this will be the key theme to watch when they report. Last week was not a good start in that regard, as several large cap winners disappointed on earnings and these stocks sold off 10%.
The same thing can be said for the rest of the market, too. If we're right about pricing fading amid falling inflation, then sales will likely disappoint from here. We think it's also worth keeping in mind that the economic data is not always reflective of what companies see in their businesses from a pricing standpoint. Recall in 2020 and 21, the companies were extracting far more than CPI-type pricing as demand surged higher from the fiscal stimulus, just as supply was constrained. This was the inflation driven boom we pointed to at the time, a thesis we are now simply using in reverse.
Bottom line, investors may need to focus more on top line growth acceleration to identify the winners from here. This will be harder to find if our thesis on inflation is correct and cost cutting and better than feared earnings results would no longer get it done, at least in the growth sectors. On the other side of the ledger, we have value stocks where expectations are quite low. Last week, financial stocks outperformed on earnings results that were far from impressive, but not as bad as feared. That trade is likely behind us, but with China now offering some additional fiscal stimulus in the near term, energy and materials stocks may be poised for a catch up move using that same philosophy. In short, growth stocks require top line acceleration at this point to continue their run, while value stocks can do better if things just don't deteriorate further.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
India’s smartphone market could triple in size over the next decade, putting it behind only the U.S. and China.
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Welcome to Thoughts on the Market. I'm Erik Woodring, Morgan Stanley's U.S. Hardware Analyst. Along with my colleagues bringing you a variety of perspectives, today, I'll discuss our outlook for the India smartphone market. It's Monday, July 24th at 10 a.m. in New York.
We're making a bold call for India's smartphone market. We believe it will triple in size over the next decade to $90 billion and account for 15% of global smartphone shipments by 2032, up from just 6% today. That implies that India alone will drive 100% of global smartphone shipment growth over the next decade.
India has the largest worldwide population, but smartphone penetration is significantly lower versus the rest of the world. For the last two decades, investors have been intrigued by the vast growth potential of the India smartphone market. But so far, investor expectations have not played out, as smartphone penetration in India has failed to surpass 40% versus the global average of 60%. And growth in the India smartphone market has been overwhelmingly driven by low end devices, with razor thin margins for original equipment manufacturers or OEMs. In fact, the smartphone TAM or total addressable market is just 25% the size of China, despite a similarly sized population.
But we think the next decade will be different - it will be India's decade. Besides forecasting annual GDP growth of 6.5% for the next decade, our India Strategy and Economics colleagues believe that over the next decade, domestic consumption in India will more than double - driven by a number of important factors, including widespread economic reforms.
These efforts are expected to bring meaningful demographic change, with income per capita expected to double, and the number of high income households expected to quintuple over the next decade. Alongside nearly 100% electrification of the country and a government led effort to prioritize digital transformation, we expect strong demand for technology goods to emerge over the next decade. We see these factors as setting the stage for robust smartphone growth in India.
A recent AlphaWise smartphone survey of Indian consumers confirmed these trends, with three in four survey respondents acknowledging they are likely to purchase a new smartphone in the next 12 months, in line with other leading emerging markets. In fact, some respondents acknowledged they are more likely to own a smartphone over other household items such as a PC, car or refrigerator.
Furthermore, Indian consumers are willing to pay up to 20% more for their next smartphone to gain access to premium technologies such as 5G compatibility, longer battery life, better camera quality and more storage capacity. While it's still early days, we believe these survey results illustrate the growing importance of the smartphone in India and the rising potential for the Indian smartphone market.
When we take a step back, the two most important factors underpinning our $90 billion India smartphone TAM are growing smartphone penetration and positive mix shift, meaning customers are shifting their purchases to higher end devices. We estimate that in a decade, Indian smartphone penetration will reach 60%, the global average today. Furthermore, we estimate that over the next decade, 80% of India's smartphone market growth will come from smartphones priced in excess of $250, which have only accounted for about 10% of smartphone growth in India over the last five years.
Combined, we believe these factors will drive a 11% annual smartphone market growth in India over the next decade, allowing India to become the third largest smartphone market in the world at $90 billion, trailing just China and the United States.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With positive GDP growth and increasing revenues, Japan equities are becoming a preferred market globally.
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Chetan Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist.
Daniel Blake: And I'm Daniel Blake, Asia and Emerging Markets Equity Strategist.
Chetan Ahya: Over the last two days in this special three part series on Japan, we discussed a constructive outlook for Japan's economy and the various structural reforms it's undergoing. Today in this final episode focused on Japan, we'll talk about the key investment implications of these macro trends. It's Friday, July 21st at 9 a.m. in Hong Kong and Singapore.
Chetan Ahya: Dan, you've been highlighting Japanese equities as our most preferred asset within the region and globally. Your bullish view is based on three powerful drivers of outperformance coming together, namely macro, micro and multipolar world. Starting with the macro, our economists expect an uplift in nominal GDP growth trend, how does this benefit Japanese equities?
Daniel Blake: So we see this being another era for the Japanese market, having first exited deflation in 2013 with the initial Abenomics program, but now moving into positive nominal GDP growth from 2023 onwards. It's hugely important for companies who have been hemmed in with an inability to lift prices and hence they have been unable or unwilling to lift base wages or dividend levels. So this new pricing flexibility in top line growth supports the equity market in five key ways. First, we're going to see faster revenue growth. Second, we think this will mean wider operating profit margins given fixed cost leverage will now be working in favor of the bottom line. Third, financial sector earnings have been repressed by ongoing Bank of Japan policy, but a gradual process of normalization should help release the earnings power of Japanese financials. Fourth, domestic portfolios are highly risk averse and focused on cash and deposits. We think there will be some ongoing shift towards higher return assets, including equities. And finally, we think valuations for the equity market can continue to trend higher on convergence with global norms.
Chetan Ahya: And on micro front, we've been discussing about the improvement in corporate governance for almost a decade now. What's changed this year?
Daniel Blake: Yes, the environment has been changing for the better part of a decade, really since the introduction of the corporate governance and stewardship codes back in 2015 and 16. We are seeing progressive improvement with record levels of investor activism and engagement, and we're seeing signs that management teams are taking up the challenge of improving profitability with record buybacks and record levels of dividend payout ratios. That said, the progress has been patchy at times and coming into this year, 50% of equity market constituents were still trading below book value. So what's changed this year is in this backdrop of improving corporate governance we've had new calls from the Tokyo Stock Exchange for companies trading below book value to explore ways to meet their cost of capital and lift valuations. We think that additional support that will come through as companies look to engage with investors and unlock value will help to boost Japan's sustainable return on equity to 11 to 12%, that compares with Japan's 15 year average of just 4% before the Abenomics program took hold. And it would bring it up more consistent with global averages.
Chetan Ahya: Dan, one of the big themes Morgan Stanley research is exploring deeply this year is the transition from a globalized or multipolar world. How does this emergence of multipolar world impact Japan and its equity markets in particular?
Daniel Blake: Thanks, Chetan. And as we're thinking about a multipolar world transition, we think there are two scenarios for global supply chains and interdependencies. One is a de-risking process, which is our base case, where supply chains are strengthened, diversified, and we see ongoing policy support for investment into emerging industries. The second scenario, which we hope to avoid, is one of decoupling. But if we focus on the de-risking scenario, we think Japanese companies will benefit from that trend for two reasons. One, we have a high allocation in the Japanese market of companies skewed towards industrial automation, semiconductor manufacturing equipment, precision instruments, specialty chemicals, all of the inputs for supply chain diversification that are crucially in demand in this de-risking process. And the second reason is investor portfolios are also being diversified, and Japan's deep capital markets have been in a good position to absorb this shift.
Chetan Ahya: So taking it together, where does this leave your view on Japan equities and what are the risks to your call?
Daniel Blake: So overall, we see Japanese equities as our most preferred market globally with another 7% upside to our base case for the TOPIX index. As a result of the three drivers we'll discuss today, we're above consensus on earnings forecasts, seeing 10% growth in 2023 and 2024. Investors are still underweight on Japanese equities and we expect ongoing inflows over the coming quarters. The most acute risk to the call is if we end up in a global recession or if in Japan, core inflation overshoots 2% sustainably, forcing a tightening cycle in Japanese yen appreciation. We think the underlying environment will manage to mitigate these risks more than they have in the past, but that remains a cyclical risk for the Japanese equity outlook.
Chetan Ahya: Dan, thank you for taking the time to talk.
Daniel Blake: Great speaking with Chetan.
Chetan Ahya: And thanks for listening to our special three part series on Japan. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.
As Japan anticipates shifts in structural policy and GDP growth, these are the industries within the market that are poised to benefit. Chief Asia Economist Chetan Ahya, Chief Japan Economist Takeshi Yamaguchi, and Japan Senior Advisor Robert Feldman discuss.
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Chetan Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist.
Takeshi Yamaguchi: I'm Takeshi Yamaguchi, Chief Japan Economist.
Robert Feldman: And I'm Robert Feldman, Japan Senior Advisor.
Chetan Ahya: Yesterday I discussed broad economic contours of Morgan Stanley's constructive view on Japan. Today, in the second installment of our special three part episode on Japan, we will dig deeper into the implications of the shift in Japan's nominal GDP path, the outlook for BOJ policy, as well as the outlook for structural reforms. It's Thursday, July 20th at 9 a.m. in Hong Kong.
Robert Feldman: And 10 a.m. in Tokyo.
Chetan Ahya: Yamaguchi-San, let's start here. The change in inflation dynamics that I covered on yesterday's episode could mean a momentous shift in Japan's nominal GDP path. Maybe you could start here with you walking us through some of the key implications of this shift.
Takeshi Yamaguchi: Yes, Japan's nominal GDP has been in a flat range for many years, since 1990's after the collapse of the asset bubble. But now it's finally getting out of the range, and we expect this trend of positive nominal GDP growth to continue over the medium term. I think there are mainly three implications from economists' viewpoints. First, we expect compensation of employees, that's the amount taken by workers, and corporate earnings to grow at the same time. Before it was like a zero sum game with almost no nominal GDP growth, but now we expect a bigger economic pie which should benefit both workers and companies. Japan's wage trend is already improving after strong spring wage negotiations this year. Second, we think that the revival of positive nominal GDP growth will improve Japan's fiscal sustainability. We are already seeing a big increase in tax revenue with strong nominal GDP growth. Meanwhile, we expect the average interest costs or interest burden to increase only gradually due to monetary policy and also because average maturity of Japanese government bonds exceeds nine years. And finally, we think the outlook of higher nominal GDP growth strength should have some positive impact on asset prices, including equity prices. This is not the only reason behind the recent equity market moves, but the likely shift in the nominal GDP growth trend is playing some role here in our view.
Chetan Ahya: Another question I want to ask is around the Bank of Japan's yield curve control program. You're expecting the BOJ to adjust its policy around yield curve control program at the upcoming policy in end July, which would be the second shift in monetary policy stance last December. Do you see further shifts in monetary policy and would it disrupt the virtuous cycle we are forecasting?
Takeshi Yamaguchi: At that July monetary policy meeting we don't expect the BOJ to get rid of YCC, the yield curve control framework, but we expect the BOJ to change the conduct of YCC by allowing more fluctuations of ten year JGB yields, potentially to plus/minus 1%, around 0%. And that said, we think the BOJ governor Ueda directly emphasized that the 2% inflation target is still not achieved in a sustainable manner. So we expect the BOJ to maintain the current short term policy rate of -0.1% after the YCC adjustment. In the third quarter next year we expect the BOJ to exit negative interest rate policy after observing another round of solid spring wage negotiations. But even so, Japan's real interest rates would remain extremely low for some time. So we think the virtuous cycle we've been highlighting will likely remain intact.
Chetan Ahya: Thank you, Yamaguchi-San. Robbie, let me turn it over to you. Japan has been feeling increasing pressure from demographics and other factors at home and geopolitics abroad. And so in response it's developing a new grand strategy and undergoing a number of structural reforms. You believe these reforms could lead to higher growth, walk us through why you feel so positive.
Robert Feldman: Thanks, Chetan. Structural reforms are being triggered by both market forces and policy. The market forces are technology change, labor shortage, geopolitical pressures, higher interest rates, pricing power from the end of deflation and supply chain derisking. The policy forces are corporate governance changes, immigration law changes, startup policies, monetary policy and climate and sustainability policy. There are lots of market forces and lots of policy forces behind these changes.
Chetan Ahya: In what industries do you expect to see the biggest changes?
Robert Feldman: There are five industries where I think there will be major changes. And other industries, of course, will have them as well, but these five industries could even be subject to disruption. These are energy, agriculture, AI and I.T., health care and education. Let me say a couple words about each. In energy Japan has been a little bit behind some other countries in introducing renewables, but it's catching up. A particularly promising is offshore wind, and especially offshore floating wind. There still has to be some cost reductions, but there's a lot of interest and Japan has huge resources in this area. In agriculture Japan is 60% dependent on foreign countries for total calorie intake. Moreover, about 10% of the agricultural land in the country is lying unused. That's because of land law issues, etc. and vested interests, but there's huge opportunity there. AI and IT, this is where probably progress has been the fastest because of the labor shortage. Japan views AI and IT as a savior because this labor shortage is just so intense. Health care, Japan is an old country and it's getting older, health care costs are going up and so it's imperative that living standards be maintained in the health care area through lower costs and better effectiveness. Japan has a good healthcare system, but it's under a lot of monetary pressure and that's why the technology changes are so important. And finally, education. If technology is going to spread, we need workers who are educated in the new technology. And that's where reskilling and recurrent education, lifelong education will become so, so important. This will be primarily a private sector initiative because government is focused on standard, primary, secondary education. So there's a lot of opportunity in the education business. There are 72 listed companies in education in Japan.
Chetan Ahya: And how much progress has been made so far on these structural reforms? And what does the timeline look from here?
Robert Feldman: Progress has been fastest in AI and IT, because the labor shortage is so intense. AI is viewed as a savior here in Japan rather than with the trepidation in some other countries, due to this labor shortage. We've also seen good progress in energy in a number of fields hydrogen, solar, carbon capture, wind and ammonia. Health care has seen much progress within hospitals where IT platforms are quite advanced at administrative functions. Agriculture has been slower, but there are amazing advances in vertical farming. On the timeline these changes are happening now and likely to see significant momentum in the next 2 to 3 years. There is no time to waste and I'm expecting very rapid progress, particularly in AI/IT, energy and health care.
Chetan Ahya: Yamaguchi-San, Robbie, thank you both for taking the time to talk.
Takeshi Yamaguchi: Great speaking with you, Chetan.
Robert Feldman: Thanks for having us.
Chetan Ahya: And thanks for listening. Tomorrow, I will return for part three of the special segments on Japan. My guest will be Daniel Blake, our Asia equity strategist. We will discuss the market implications of our constructive Japan macro outlook and what investors should pay attention to. If you Enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
The first of our three-part series on the Japanese economy dives into the three key factors that have triggered a recent surge in interest from investors.
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist. Along with my colleagues bringing you a variety of perspectives, I'm kicking off a special three part episode on our outlook for Japan. Today I'll be discussing our view on the Japanese economy. It's Wednesday, July 19th at 9am in Hong Kong.
As you may have seen, Japan's economy and financial markets have attracted outsized investor interest this year. We at Morgan Stanley Research have had a constructive view on the macro and markets outlook for some time, based on three pillars: A decisive shift away from deflation, structural macro reforms coupled with the improved corporate governance on the macro front and return on equity for the corporate sector.
Let's start with the macro outlook. From my vantage point, the single most important factor that defines the Japan narrative is inflation. Between 1993 and 2012, the Japan economy was trapped in deflation, with headline inflation hovering around 0%. The pursuit of Abenomics from 2013 onwards brought about a transition from deflation to low-flation and inflation managed to move a tad bit higher to an average of 0.5% from 2013 to 2019. In this cycle, we are seeing yet another shift in which Japan is decisively exiting deflation. Indeed, we see Japan transitioning into moderate inflation territory, where inflation averages 1 to 1.5% over the medium term.
How is this inflation outcome achieved? Since the early 1990's, Japan has experienced monetary easing and fiscal easing, but the two have never really come together in a coordinated fashion, and in fact at times have neutralized each other. This started to change in 2013, when fiscal easing was combined with quantitative and qualitative monetary easing, which we think was critical to initial exit from deflation.
In this cycle, we finally saw wage growth rising to a multi-year high, which in our view is the final key ingredient that will sustain inflation in the range of 1 to 1 and a half percent. Moreover, we don't expect a premature withdrawal of accommodative macro policies. Against this backdrop, we believe inflation expectation will be re-anchored to a higher level than before.
Why is the liftoff of inflation so important? Well, moderate inflation is what makes the economic machine work. If consumers expect deflation or low-flation, they will be incentivized to put off their spending plans. For the corporate sector, the resulting high level of real interest rates will not catalyze new investment. This whole situation changes when moderate inflation takes hold and inflation expectations shift. Animal spirits come back to life, and that is at the heart of why we are bullish on Japan.
In the next episode, we are going to continue this conversation with our two leading minds on Japan, our Chief Japan Economist Takashi Yamaguchi, and Japan Senior Advisor Robert Feldman. The three of us will dive into the implications of the shift in Japan's nominal GDP path, the outlook for BOJ's policy, as well as the outlook for structural reforms. And to wrap up the series, I'll speak with our Equity Strategist Daniel Blake about our market outlook and what investors should focus on.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.
With the moratorium on federal student loans ending soon, discretionary spending is likely to go down and delinquency is likely to rise as consumers face the end of a three-year reprieve.
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Welcome to Thoughts on the Market. I'm Sarah Wolfe from the U.S. Economics Team. Along with my colleagues, bringing you a variety of perspectives, today I'll be talking about the implications from the upcoming student loan restart. It's Tuesday, July 18th at 10 a.m. in New York.
The more than three year long moratorium on federal student loans is ending soon, expected to resume on October 1st, impacting nearly 27 million borrowers who have federal student loans in forbearance, totaling a trillion dollars or $41,000 per borrower on average.
We believe this will translate into a hit to disposable income and a moderate pullback in discretionary spending in the fourth quarter of this year and partially into the first quarter of 2024. Altogether, we estimate it could shave about ten basis points off of total year real PCE growth or seven basis points off GDP growth. But we think that this is likely an upper estimate for a few reasons. First of all, there's a 12 month grace period that will allow households to take the next year to start making payments without falling delinquent—so not everybody is going to start making payments in October—consumers can tap into their savings and there could be debt reprioritization.
There's going to be varying impact across different demographics. We find that those aged 25 to 34 are most likely to hold student debt, But borrowers age 35 and older hold the largest debt balance in dollar terms and as a share of disposable income. We also find, based on geography, that southern states, including Mississippi, Alabama, Georgia and South Carolina, have the highest average student loan balance as a share of per capita disposable income while states in the Northeast, like Massachusetts, Connecticut, New Jersey and New Hampshire have the lowest. It's worth mentioning that this is more of a result of disposable income being lower in southern states than debt balances being higher.
So how will this impact credit? My colleagues from the Morgan Stanley U.S. consumer finance team expect the combination of student loan payments starting in October with the absence of loan forgiveness to lead to potential delinquencies as consumers divert cash flow, servicing other forms of debt like credit card and autos, towards their student loans. This could accelerate delinquency rates which are now above 2019 levels and increasing at the fastest clip in 15 years.
One thing we're keeping an eye on are the new Biden administration initiatives that could provide some relief for low and middle income consumers. For example, as I mentioned, a 12-month ramp up grace period for borrowers means they won't be penalized or moved into delinquency if they fail to pay over the next year, though interest does still accrue. Also, a new save income driven repayment option should fully go into effect as of July 2024, lowering payments owed by undergraduate borrowers if they adopt this new income driven repayment plan.
Overall, we believe the student loan repayment restart will be a hit to spending and borrowing that will spill over into U.S. hard lines, so these are appliances and sports equipment, broad lines, which are companies that deal in high volume at the cheaper end of a product line, and food retail industries, though at varying degrees. Retailers with customer demographics skewed towards younger and lower income consumers that sell into more discretionary categories appear to be the most at risk.
Furthermore, our soft lines retail—that is clothing—and brands team think companies with outsized exposure to luxury and men's apparel, denim and swim could see the biggest slump in demand from student loan repayment, whereas those with sports apparel and footwear exposure may be the most insulated.
That said, the bottom line is that no retailer is free from exposure to all three key student loan holder demographics, which skew younger, less affluent and more urban.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While falling inflation is good news for many, equity investors may see volatility in earnings growth as pricing power fades.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 17th at 11 a.m. in New York. So let's get after it.
Last week was all about the downward surprise to the June inflation data. More specifically, both the consumer and producer price indices came in well below expectations and suggests the Fed is on its way to winning its hard fought battle to beat inflation back down to 2%. Both stocks and bonds celebrated the news as a likelihood for a soft landing and the economy increased. Our view is not so sanguine on stocks as the steeper fall in inflation supports our view for a much weaker than expected earnings growth.
Three years ago, at the trough of the pandemic recession, we were a lonely voice on the idea that inflation would surge higher due to excessive fiscal and monetary support. Furthermore, we suggested it would lead to a surge in earnings growth as companies discovered an ability to raise prices at will while the government subsidized labor costs. As we move to 2021, this over-earning broadens out as consumers spent their excess savings on everything from sporting goods to travel and leisure activities. By last summer, this boom in spending was so strong the Fed was forced to raise interest rates at a pace not seen in 40 years. With a lag in monetary policy close to 12 months, it should be no surprise that we are now seeing the headwinds on growth and inflation today.
Because markets are forward looking, they understand this dynamic perhaps better than the average investor. In fact, it is the primary reason we decided to get tactically bullish on U.S. stocks last October. At that time, we suggested long term interest rates in the U.S. dollar would top in anticipation of the Fed's aggressive policy having its desired effect on inflation and growth. That began to play out in the fourth quarter as price earnings multiples expanded from 15.3x in October to 18x in early December. We decided to take the money and run at that point, thinking the market had already fully discounted the peak in inflation interest rates in the US dollar. Over the next six months, 18x did provide a ceiling on valuations. However, over the last six weeks, valuations have risen another 10% as the inflation data confirmed what we already knew. Meanwhile, artificial intelligence has given investors something to get excited about, but at unattractive valuations in our view.
As noted earlier, we think inflation is now likely to surprise in the downside. A move to disinflation is positive for stocks because valuations typically rise under those circumstances. However, that has already happened. Now we expect disinflation to shift to deflation in many parts of the economy, in other words,prices began to fall. Most are not forecasting such a decline because it seems hard to fathom after what they witnessed in the real economy. However, it's just the mirror image of what happened in 2020 and 21 when supply was short of demand. At that time, inflation surprised companies and investors to the upside and led to much better earnings growth than forecasted. Now pricing power is fading due to demand falling short of supply, and this is likely to surprise many companies and investors to the downside. More importantly, it's not expected by the consensus anymore or is it in stock valuations at this point.
We are already seeing pricing come down in many areas like consumer goods and commodities. Housing and cars are also seeing price degradation, especially in electric vehicles where supplies now overwhelming demand. In the latest consumer price index released last week, we even saw deflation in both airlines and hotel prices, two areas where demand is still robust. The bottom line, while falling inflation last week was great news for the Fed and its war on higher prices, equity investors should be careful what they wish for, as this is a slippery slope for earnings growth and hence stock valuations which are now quite extended.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
With inflation slowly moving lower, government bonds are looking increasingly more attractive and may be primed for a comeback later this year.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today, I'll be talking about the case for government bonds. It's Friday, July 14th at 11 a.m. in New York.
With the U.S. labor market remaining resilient, the prospects for bond markets would depend critically on the outlook for inflation. Our economists expect core inflation to continue to move lower, slowly but surely, shifting consumption patterns in which spending on services slows while goods consumption continues to contract, will weigh on core inflation.
Recent data have been supportive of this expectation. The June employment report we got last Friday, showed a slowing in the services sector earnings growth. Overall, average hourly earnings moved sideways and still are higher than the historical averages. But the average hourly earnings for the services sector decelerated again in June. Though two months do not establish a firm trend, the deceleration in service's average hourly earnings since April is good news for the inflation outlook. The Consumer Price Index and the producer price index data that we got this week also reflect this ongoing deceleration in inflation. On a year-over-year basis, headline inflation came down to 3% while core inflation came in at 4.8%, down from 5.3% in May. Core Producer Price Index also came in below consensus and is now running at 2.6% year-over-year, down from 2.8%.
This moderation in economic activity and inflation goes beyond what many Fed officials would consider their model expectations. Such a deceleration, even if associated with a soft landing, could see them adjusting their current hawkish stances.
Of course, in the best environment for government bonds, central banks are actively easing monetary policy, an environment our economists see taking shape at the end of the first quarter of next year. As such, expected returns for government bonds this year, while admirable, may be closer to average calendar year return than the returns typically delivered during the recessionary periods. At the same time, we think government bonds could perform even better than average, considering the risks that markets are not pricing in.
The possibility that central bank hikes to date may weigh on economic activity into year end, and that inflation is likely to fall meaningfully into year end with sticky components becoming less sticky, increases the attractiveness of government bonds in our view. Hence, while they have been battered and bruised, government bonds look primed for a comeback in 2023.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
As airlines scramble to decrease their carbon footprint by 80% before 2050, can sustainable aviation fuel lead the charge?
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Welcome to Thoughts on the Market. I'm Ravi Shanker, Morgan Stanley's freight transportation and airlines analyst. Along with my colleagues bringing you a variety of perspectives, today I'll discuss the path to decarbonization in aviation. It's Thursday, July 13th at 2 p.m. in New York.
The global aviation industry emits roughly 1 billion tons of CO2 per year - comparable to the emissions of Japan, the world's third largest economy, and aviation emissions are estimated to double or even triple between 2019 and 2050 in a business-as-usual scenario.
In order to reach net-zero emissions by 2050 and align with the goals of the Paris Agreement, the global aviation industry needs to reduce its CO2 absolute footprint by 13% by 2030, and 80% by 2050. We think the industry has three solutions for doing so. One, change its fleet mix towards more fuel efficient aircraft. Two, scale other modes of propulsion such as electric/hybrid engines and hydrogen. And three, change their jet fuel mix towards more sustainable aviation fuel.
Based on currently available technologies, we see the third option, sustainable aviation fuel or SAF, as the most realistic pathway for the airlines industry to meet its 2030 decarbonization goals. SAF is a biofuel used to power aircraft that has similar properties to conventional jet fuel, and can be dropped into today's aircraft and infrastructure. SAF is derived from non-fossil sources called feedstock, such as corn grain, oilseeds, algae, oils, fats and greases, forestry residues, and municipal solid waste streams. There are currently various certified SAF production procedures, all of which make fuel that performs at levels operationally equivalent to jet A1 fuel.
Replacing conventional jet fuel with SAF can mitigate CO2 materially. The challenge, however, is that SAF accounts for less than 1% of the fuel used in global aviation, and for the aviation industry to meet its decarbonization targets SAF supply needs to scale materially. The key constraints around wide adoption of SAF are cost, feedstock availability, impacts to nature and biodiversity, and, finally, the capital required to produce SAF at scale.
That said, support for SAF has improved materially over the last two years. In 2021, President Biden's climate agenda outlined a goal of producing 3 billion gallons of SAF per year by 2030, roughly 10x the current global SAF production. And in 2022, the Inflation Reduction Act extended and bolstered incentives for SAF. Since then, new capacity has been announced and multiple airlines have committed to using more SAF through long term offtake agreements. Meanwhile, more than ten global airlines target to replace at least 10% of their jet fuel demand with SAF by 2030. In addition, several U.S. state jurisdictions are adopting clean fuel standards or are exploring similar programs. The EU, UK and Japan have also put in place various incentives and targets since 2021. While these developments are highly encouraging, more widespread support and long term certainty are needed to scale SAF production to the levels required to meet the 2030 targets.
Is this achievable? We will continue to monitor developments and bring you updates as we make progress along the path to decarbonizing aviation.
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With a potential government shutdown looming in the fall, investors may want to keep an eye on the U.S. Treasury market to insulate themselves from risk.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the potential market impacts of a government shutdown. It's Wednesday, July 12th at 10 a.m. in New York.
Press reports warning of a potential government shutdown this fall have understandably led to some questions from clients this week. They're asking what, if any, market impact should they expect if the U.S. fails to appropriate spending for the next fiscal year starting October 1st. The concern, of course, is that markets may react negatively perceiving economic risk if the government without funding ceases certain operations. But some historical perspective is helpful here and leads us to categorize this as a risk worth monitoring but not panicking about.
First, while government shutdowns create a very real strain for parts of the economy, like government employees and contractors doing business with the government, our economists have pointed out that in the past, the aggregate impacts to the overall economy have tended to be modest and fleeting. A key reason why is that the norm has been that after shutdowns, the government typically appropriates back pay and resumes prior expected payments to vendors. So spending is simply deferred and made up in the future rather than completely foregone.
Not surprisingly, then, market impacts have tended to be inconsistent and fleeting. True, there have been episodes when stocks sold off heading into and during shutdowns and then rally back when shutdowns ended, but it's difficult to desegregate the shutdown as a market driver from other prevailing economic conditions and market valuations. Said more simply, if equity and or credit markets were pricing higher economic optimism, a shutdown could be a temporary headwind for markets. But such a dynamic is far from something that we would base strategic investment guidance on.
Despite all this, if you're still looking for a market that might be more insulated from the risk of a shutdown, then given current conditions, we'd look toward the U.S. Treasury market. While it might seem counterintuitive to own government bonds in a government shutdown, remember it was the debt ceiling issue that carried default risk, not a shutdown. In the shutdown, the U.S. Treasury has money and authority to pay bondholders, just not authority to pay certain other government operations. Further, we already think Treasuries are poised to have a strong second half of 2023 as yields could start to decline on softening economic data and an expectation that the Fed would soon be done hiking rates. And while a government shutdown wouldn't necessarily add to that trend, it certainly adds some degree of risk to the economy, reinforcing the case for owning bonds.
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The market for artificial intelligence technologies could reach $275 billion by 2027, but not all companies will be able to generate revenue. Here’s what investors should watch.
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Welcome to Thoughts on the Market. I'm Shawn Kim, Head of Morgan Stanley's Asia Technology Research Team. Along with my colleagues bringing you a variety of perspectives, today I'll discuss why A.I matters for investors and our outlook for the next 5 to 10 years in the evolution of A.I. It's Tuesday, July 11th, at 9 a.m. in New York.
In the span of just six months, open A.I has moved from being a niche IT research and development, to a key driver of what is set to become a $3 trillion IT spend by 2029. Despite this rapid progress, we're still in the early stages of A.I technologies. We believe today's machine learning stage of A.I adoption precedes a much larger future market when we reach the inference phase, which is where A.I would be able to make predictions based on novel data. And that, in turn, would eventually expand to an even bigger potential market in endpoint or edge A.I inference.
The A.I technology total addressable market or the TAM, which includes semiconductors, hardware and networking, is at $90 billion today and we estimate it will grow to 275 billion by 2027. That's more than half the size of the semiconductor market today.
This remarketable growth is actually led by semiconductors, where we see the A.I semiconductor market TAM tripling over the next three years from 43 billion to 125 billion, and signifying our growing the overall A.I market. Companies that we consider A.I leaders are generally showing high growth and returns, consensus shows a three year average EPS growth of 24%, which is more than twice the earnings growth of global stocks on average.
Our investment framework addresses three key criteria. One, which parts of the tech supply chain are the biggest beneficiaries of A.I, in terms of revenue exposure and how that exposure is growing relative to their traditional businesses. Two, the quality of those earnings and whether they are based on volume or pricing. And three, whether stock valuations reflect that upside potential.
We believe we are far from bubble metrics, although the market will inevitably compare A.I. to the dot.com boom. However, today's leading A.I companies are well-established with good cash flow characteristics, for the most part, unlike many companies that became casualties of dot.com collapse.
As we embark on what we view as a new, decade-long paradigm shift, we expect outperformance to come in waves and think we are currently very early in the enabling technology stage. And like so many technologies, A.I is also a double edged sword. There are companies that are in the right place at the right time now, but also have what it takes to fully commercialize the A.I opportunity over the long term. The flip side is companies that are less relevant to A.I products or services but will infuse optimism in their forward guidance via mentions of A.I.
While we expect A.I will be a growth driver for most, it will not generate revenue growth for everyone. Other potential risks include the fact that the chip cycle is not just depending on the A.I, but also on the wider global economic cycle. And furthermore, we believe any big visions of A.I's transforming the world as we know it must rest on a solid foundation of physics, ethics and the law, a big topic we will continue to follow closely and bring you updates.
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As earnings season kicks off, market valuations continue to trend high based on major growth expectations. However, investors may want to keep an eye on liquidity.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 10th at 11 a.m. in New York. So let's get after it.
With year to date U.S. equity returns driven nearly 100% by higher valuations, the market either doesn't care about earnings or it expects a major reacceleration in growth both later this year and next. One might argue that the higher valuations are anticipating the end of the Fed's rate hiking campaign, even though the bond market doesn't seem to agree with that conclusion, given the recent rise in yields. In short, the price earnings ratio for the S&P 500 is up approximately 15%, and with interest rates up this year, the equity risk premium has collapsed by 100 basis points to its lowest level since the tech bubble era.
With second quarter earnings season beginning this week, 'better than feared' likely isn't going to cut it anymore. While earnings results so far this year remain right on track for the sharp earnings recession we forecast, we don't expect second quarter earnings to disappoint expectations in aggregate, given second quarter estimates have now been revised lower by 7.5% since the beginning of the year. Instead, we would point out that the consensus bottom-up second quarter EPS forecast for the S&P 500 is -7% year over year, hardly exciting. Furthermore, the consensus pushed out the trough earnings per share growth quarter from the first quarter to the second quarter over the last three months. We expect this trend to continue through the balance of the year, which would also be in line with our forecast. In other words, no big second half recovery as the consensus and valuations now expect. More specifically, third quarter is when our forecast starts to meaningfully diverge from the consensus. This means the key driver for stocks during this earnings season will come via company guidance for the out quarter rather than the second quarter results. We suspect some companies will begin to walk down the estimates, while others will continue to tell a more optimistic story. In short, this earnings season should matter more than the prior two, and should provide significant alpha opportunities for investors in terms of both longs and shorts.
In our view, the year to date multiple expansion has occurred for a couple of reasons beyond earnings growth optimism. One, excess liquidity provided by global central banks amid a weaker U.S. dollar and the FDIC bail out of depositors. And two, excitement around artificial intelligence’s potential impact on productivity and earnings growth. On the liquidity front we think that support is starting to fade. One way of measuring liquidity is global money supply in U.S. dollars. One of the reasons we turned tactically bullish last October was due to our view that the U.S. dollar was topping. This, along with the China reopening and the Bank of Japan's monetary policy actions, added close to $7 trillion to global money supply over the following six months. We've pointed out previously that the rate of change on global money supply is correlated to the rate of change on global equities, as well as the S&P 500. Over the past few months, global money supply in U.S. dollars has begun to shrink again, just as the Treasury begins to issue over a trillion dollars of supply to restock its coffers post a debt ceiling resolution last month.
As an early indicator that market liquidity is fading, nominal ten-year yields broke out last week above the psychologically important 4% level, and real rates are making new cycle highs. Interest rate volatility also picked up as uncertainty about the Fed's next moves increased. Neither higher interest rate levels nor volatility are generally conducive to higher equity valuations.
Bottom line, with earnings season upon us, we aren't expecting any fireworks from the earnings reports directly. However, with expectations for growth now much higher than six months ago, we suspect it will be a 'sell the news' event for many stocks, no matter what the companies post, as the market begins to look ahead to what is likely going to disappoint lofty expectations.
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Though the debate around the global strength of the dollar in currency markets continues, the dollar’s current high yield in a world of weak global growth could help it appreciate
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Welcome to Thoughts on the Market. I'm James Lord, Morgan Stanley's Head of Foreign Exchange and Emerging Market Strategy. Along with my colleagues bringing you a variety of perspectives, today, I'll be discussing the status of the U.S dollar within global foreign exchange or FX reserves. It's Friday, July 7th, 3 p.m. in London.
The debate about the dollar's status as the world's dominant currency usually resurfaces during every business cycle, and as our world increasingly transitions from globalized toward a multipolar model, this debate appears more relevant.
Indeed, some economic actors are already de-risking their currency reserves away from the dollar, promoting the use of local currencies as an alternative in international trade and trying to reduce the dollar's global role through other means.
Yet, this debate is usually a distraction from determining where the dollar is headed. In contrast to the popular narrative, we believe the dollar can appreciate, even if its use as a reserve currency or invoicing currency in international trade declines.
Let's first address the dollar's status as the world's dominant central bank reserve currency. The purpose of FX reserves is to bolster the external stability of an economy and enable central banks to act as lenders of last resort to those in demand of foreign currency. It's intuitive to think that reserve choices might therefore be correlated with the value of currencies themselves, yet relying on that intuition would not have served you well in recent history.
Case in point, while the dollar remains the world's dominant reserve currency, its share has dropped by around 20% over the last 20 years, most rapidly over the last ten. Nevertheless, over the last decade, the dollar has been one of the world's strongest currencies, with the Fed's real broad dollar index reaching a near 20 year high in October 2022.
The dollar's declining share of global FX reserves has not been relevant in figuring out where the dollar is heading, in part because FX reserve managers are less influential in currency markets today, but more importantly, because other investors have favored U.S. assets.
To be clear, this does not mean that watching trends in FX reserves is not important. A sudden, sharp decline in the market share of a reserve currency could well be driven by a sudden loss of confidence in the macroeconomic stability of an economy, diminishing its attraction as an investment destination. If so, the currency of that economy would likely decline.
This concern has not driven the decline of the dollar's share of global FX reserves in recent years, as evidenced by its continued strength. Moreover, U.S. assets retain unique appeal for global capital, as the recent boom in U.S. tech stocks and rising optimism about the productivity enhancing implications of A.I show.
Meanwhile, the dollar provides one of the highest yields of the world's major currencies, thanks to the Fed's hiking cycle. In a world of weak global growth, this yield will also likely help the dollar to appreciate.
For clues about the future direction of exchange rates, we would be watching for signs that investment opportunities in different economies are improving. For now, the dollar offers attractive yields and remains a safe harbor during the current period of slow global economic growth.
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Artificial intelligence could help biopharmaceutical companies reduce costs as well as improve their chances of developing successful new drugs.
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Welcome to Thoughts on the Market. I'm Terence Flynn, Morgan Stanley's Head of U.S. BioPharma Research. Along with my colleagues bringing you a variety of perspectives, today, I'll focus on how artificial intelligence and machine learning can reshape the health care sector. It's Thursday, July 6th at 10 a.m. in New York.
As we've discussed on this podcast, Tech Diffusion is one of the big three themes we at Morgan Stanley Research are following this year. The other two being the Multipolar World and Decarbonization. As a quick reminder, by tech diffusion, we mean the process by which any transformative technology is adopted widely by consumers and industries.
When it comes to the healthcare sector, it's still early but we believe artificial intelligence and machine learning adoption is poised to accelerate significantly. The biopharma industry specifically is moving to unlock the potential of A.I across multiple areas, including drug discovery, clinical development, manufacturing and physician patient engagement.
We see two broad areas where A.I enabled investments in drug development could drive significant value in the biopharma space. One is direct cost savings, so think of improved R&D margins, for example. And two is increased probability of success of pipeline programs. Here we estimate that even small improvements in the probability of success could drive significant value.
Now, let me put some numbers around this. Over the past ten years, the FDA has granted 430 new drug approvals or about 43 per year. We estimate that every two and a half percentage point improvement in early stage development success rates could lead to an additional 30 new drug approvals over the course of ten years, or nearly a 10% boost. Assuming that each incremental approved drug generates over 600 million in peak sales, we estimate that 60 additional therapies approved over a ten year period would translate into an additional 70 billion in drug development and PV for the biopharma industry.
However, biopharma is not the only health care subsector that's poised to benefit from A.I.. Looking at health care services and technology, A.I represents an opportunity to drive meaningful change in efficiency in how care is delivered. A.I tools have predictive capabilities that could be used for early diagnosis and detection of disease, which could lead to improved clinical outcomes and patient experience and reduce the cost of care over time. Many health systems have already begun to migrate data from on premises to the cloud, an important step for capturing the full benefits of A.I.
We will continue to monitor further developments in health care, both near-term and long term, and will provide you with our latest analysis and insights.
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With the U.S. possibly imposing tighter trade policies towards China, investors may want to look into diversifying their investments.
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Welcome to the thoughts on the market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the U.S., China relationship and its impact on markets. It's Wednesday, July 5th at noon in New York.
In recent weeks, the Biden administration has focused on the U.S. relationship with China. Treasury Secretary Yellen is headed to Beijing this week for meetings with senior officials in China, following on Secretary of State Blinken's recent visit. Whenever these diplomatic efforts pick up, investors tend to ask if it's a sign that there could be a softening or even a reversal in policy choices by the U.S. in recent years to create more rules and barriers to trade in certain higher tech industries. The interest is because these moves drove concern among many investors that multinational companies would have a harder time doing business in China in the future. But in our view, these policies are not going to reverse, but rather will likely become tighter.
Consider that the stated goal of these meetings was to open regular communication channels on economic and security issues. It's obviously important for countries to have regular communication to avoid misunderstandings spiraling into conflict. But this appears to be where the ambition for these meetings ends. There's no more talk of reaching comprehensive free trade agreements, for example.
Given that context, it makes sense that we're continuing to see news reports that the Biden administration is preparing fresh non-tariff barriers which would impact China. This includes further tightening export controls on semiconductors in an attempt by the U.S. to protect its technical advantage in an industry that's critical to both its economic and national security. It also includes long awaited outbound investment restrictions, which could crimp foreign direct investment into China.
To be clear though, none of this is the same as a hard decoupling of the U.S. and China economies, nor would it have the related shock effect on global markets. The effects here are likely to be incremental adjustments by companies over time to deal with these policies. This is why, for example, we've seen many multinationals announce their diversifying they’re supply chains by investing in new geographies like Mexico and Turkey. But for the most part, they're not pulling existing resources out of China.
Given all of that, investors may want to react to this nuanced situation by incrementally shifting international equity allocations to countries whose stock markets have solid valuations and may also benefit from companies' new supply chain investments. Japan in particular stands out to our colleagues in equity strategy, and Mexico and India also appear to be solid options longer term.
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Original Release on June, 15th 2023: With more Asian economies on pace to join the recovery path set by China, confidence in economic outperformance versus the rest of the world is rising.
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist at Morgan Stanley. Along with my colleagues bringing your variety of perspectives, today I'll be discussing our mid-year outlook for Asia's economy. It's Thursday, June 15 at 9 a.m. in Hong Kong.
Asia's recovery is for real. We believe its growth outperformance has just started. We expect a full fledged recovery to build up over the next two quarters across two dimensions. First, we think more economies in the region will join the recovery path. Second, the recovery will broaden from services consumption to goods consumption and in the next six months to capital investments, or CapEx. We see Asia's growth accelerating to 5.1% by fourth quarter of this year. There are three main reasons why we expect this growth outperformance for Asia.
First, Asia did not experience the interest rate shock that the U.S. and Europe did. Asian central banks did not have to take rates through restrictive territory because inflation in Asia has not been as intense. Plus, Asia's inflation has already declined and we expect 80% of region’s inflation will get back into central bank's comfort zone in the next 2 to 3 months.
The second reason is China. While China's consumption recovery is largely on track, we have seen downside in the last two months, in investment spending and the manufacturing sector. We believe policy easing is imminent as policymakers are keen on preventing a deterioration in labor market conditions and on minimizing social stability risks. Easing should help stabilize investment spending and broaden out the recovery in back half of 2023.
Beyond China, India, Indonesia and Japan will also contribute significantly to region's growth recovery.
India is benefiting from cyclical and structural factors. Cyclically beating healthy corporate and banking system balance sheets mean India can have an independent business cycle driven by domestic demand, and we are seeing that appetite for expansion translating into stronger CapEx and loan growth.
As for Japan, it is in a sweet spot, having decisively left the deflation environment behind, but not facing runaway inflation. Accommodative real interest rates are helping catalyze private CapEx growth, which has already risen to a seven year high. And, in another momentous shift, Japan's nominal GDP growth is now rising at a healthy pace after a long period of flatlining.
Finally, we believe Indonesia will be able to sustain a 5% pace of growth. Indonesia runs the most prudent macro policy mix amongst emerging markets. In particular, the fiscal deficit has been maintained below 3%, since the adoption of the fiscal rule and has only exceeded that in 2020 during the worst of the pandemic. This has resulted in a consistent improvement in macro stability indicators and led to a structural decline in the cost of capital supporting private domestic demand.
The risks to our next 12 month Asia outlook are hard landing in the U.S., which Morgan Stanley's U.S. economists think it's unlikely and a deeper slowdown in China. But we believe China's recovery will only broaden out in the second half of 2023. And given this, we feel confident about our outlook for Asia's outperformance in 2023 vis-à-vis rest of the world.
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Original Release on June, 6th 2023: Consumers in the U.S. are largely returning to pre-COVID spending levels, but new behaviors related to travel, credit availability and inflation have emerged.
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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley U.S. Equity Strategy Team.
Sarah Wolfe: And I'm Sarah Wolfe from the U.S. Economics Team.
Michelle Weaver: On this special episode of the podcast, we're taking a look at the state of the U.S. consumer as we approach the midyear mark. It's Tuesday, June 6th at 10 a.m. in New York.
Michelle Weaver: In order to talk about where the consumer is right now, let's take it back two and a half years. It's January 2021, and households are slowly emerging from their COVID hibernations, but we're still months away from the broad distribution of the vaccine. Consumers are allocating 5% more of their wallet share to goods than before COVID, driving record consumption of electronics, home furnishings, sporting goods and recreational vehicles. All the things you needed to make staying at home a little bit better. Our U.S. economists at Morgan Stanley made a high conviction call in early 2021 that vaccine distribution would flip the script and drive a surge in services spending and a payback in goods spending. Sara, to what extent has this reversion played out and where do you think the U.S. consumer is now?
Sarah Wolfe: The reversion is definitely played out, but there's been some big surprises. Basically, the spending pie has just been greater overall than expected, and that's thanks to unprecedented fiscal stimulus, excess savings and significant supply shortages. So we've not only seen a shift away from goods and toward services, but a much larger spending pie overall. The result has been a 13% surge in goods inflation over nearly three years, an acceleration in services inflation, and a return to pre-COVID spending habits that's much greater in real spending terms than in nominal terms. So if we look in the details, where has the payback been the largest? We've seen the biggest payback in home furnishing, home equipment, jewelry, watches, recreational vehicles, but we've seen the most robust recovery in discretionary services like dining out, going to a hotel, public transportation and recreational services.
Michelle Weaver: Sara, has the recent turmoil in the banking sector affected the U.S. consumer and do you think there's a credit crunch going on right now?
Sarah Wolfe: Bank funding costs have risen meaningfully and are expected to rise further, leading to tighter lending standards, slower loan growth and wider loan spreads. But let me be clear, this is not a credit crunch, nor do we expect it to be. We think about the pass through from tighter lending standards to the consumer to ways directly and indirectly. The direct channel is tighter lending standards for loans on consumer products, including credit cards and autos, and indirectly through tighter lending standards for businesses, which has knock-on effects for job growth. We've already seen the direct channel of consumer spending in the past year, as interest rates on new consumer loan products hit 20 to 30-year highs, raising overall debt service costs and forcing consumers to reduce purchases of interest sensitive goods. Dwindling supply of credit as banks tighten lending standards is also dampening consumption.
Michelle Weaver: Great. And given that credit is getting a little bit tougher to come by, can you tell us what's happening with savings and what's happening with the labor market and labor income?
Sarah Wolfe: This is very timely. Just a few days ago, we got a very strong jobs report for May. I think that this really supports our call for a soft landing, and even though consumers are increasingly worried about the economic outlook, about financial prospects, it's clear that we still have momentum in the economy and that the Fed can achieve its 2% inflation target without driving the unemployment rate significantly higher. We are seeing under the details that consumer spending is slowing, there's a pullback in discretionary happening, there's a bit of trade down behavior. But with the labor market remaining robust, it's going to keep spending afloat and prevent this hard landing scenario. Michelle, let me turn it to you now, let's drill down into some specifics. What are the latest spending trends around spending plans you're seeing in your consumer survey?
Michelle Weaver: Sure. So consumers expect to pull back on spending for most categories that we asked them about over the next six months. And the only categories where they expect to spend more are necessities like groceries and household products. We also added two new questions to this round of the survey to figure out which discretionary categories are most at risk of a pullback in spending. We asked consumers to order categories based on spending priority and identify categories where they would pull back on spending if forced to reduce household expenses. We found that travel and live entertainment were most at risk of a pull back, and this isn't just a case of income groups having different attitudes towards spending, we saw similar prioritization across income cohorts.
Sarah Wolfe: So you mentioned travel, travel's been in a boom state in the post-COVID world. But you're saying now that households are reporting that they would pull back if they needed to. Are we seeing that already? What do we expect for summer travel? What do we expect for the remainder of the year?
Michelle Weaver: So the data I was just referencing was if you had to reduce your household expenses, how would you do it? And travel was identified there. So that's not a plan that's currently in place. But summer travel may be a bit softer this year versus last year. In our survey, we asked consumers if they're planning to travel more, the same amount or less than last summer, and we found that a greater proportion of consumers are planning to travel less this year. Budgets are also smaller for summer travel this year, with more than a third of consumers expecting to spend less. We're seeing a mixed picture from the company side. Airlines are seeing very strong results still, and Memorial Day weekend proved to be very strong.. But the data around hotels has started to weaken and the revenue per available room that hotels have been able to generate has been pretty choppy and forward bookings that hotels are seeing have actually been flat to down for the summer. Demand for resorts and economy hotels has fallen but demand for urban market hotels still remained very strong. Sarah, how does this deceleration, both services and goods growth play into your team's long standing argument for a soft landing for the economy?
Sarah Wolfe: It's really the key to inflation coming down and avoiding a hard landing. With less pent up demand left for services spending and a strong labor market recovery, supply demand imbalances in the services sector are slowly resolving themselves. We estimate that there's a point three percentage point pass through from services wages to core core services inflation throughout any given year. Core core services, is services excluding housing inflation. So with compensation for services providing industries already decelerating for the past five quarters, we do expect the largest impact of core services inflation to occur in the back half of this year. So that's going to see a more meaningful step down in inflationary pressures later this year. This combined with a rising savings rate, so a shrinking spending pie, means that there's just going to be less demand for goods and services together this year. Altogether, it will enable the Fed to make progress towards its 2% inflation target without driving the economy into a recession.
Michelle Weaver: Sarah, thank you for taking the time to talk.
Sarah Wolfe: It was great speaking with you, Michelle.
Michelle Weaver: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
A surprising increase in the sale of new homes doesn’t mean that overall demand for housing is on the rise. Find out what to expect for the rest of the year.
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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow: And I'm Jay Bacow, the other Co-Head of U.S. Securitized Products Research.
Jim Egan: And on this episode of the podcast, we'll be discussing the U.S. housing market. It's Thursday, June 29th at 11am in New York.
Jay Bacow: All right, Jim. We put out our mid-year outlook about a month ago, and since we put out that outlook, we've had a breadth of housing data and it feels like you can pick any portion of that housing data, sales, starts, home prices and it's telling a different story. Which one are we supposed to read?
Jim Egan: I think that's a really important point. The U.S. housing market right now is not a monolith, and there are different fundamental drivers going on with each of these characteristics, each of these statistics that are pushing them in different directions. Let's start with new home sales. I think that was the most positive, we could say the strongest print from the past month. The consensus expectation, just to put this in context, was a month over month decrease of 1.2%, instead, we got an increase of 12.2%. To put it succinctly, new home sales are basically the only game in town. Existing listings remain incredibly low. We've talked about affordability deterioration on this podcast. We've talked about the lock in effect, the fact that the effective mortgage rate for existing homeowners right now is over three points below the prevailing mortgage rate. That just means there's no inventory. If you want to buy a home right now, there's a much greater likelihood that it's a new home sale than at any point in the past 10 to 15 years. And new home sales were the only housing statistic in our mid-year forecast where we projected a year over year increase in 2023 versus 2022 because of these dynamics.
Jay Bacow: All right. So that's the new home sales story. Does that mean that we're just, broadly speaking, supposed to expect more housing activity?
Jim Egan: This is the single most frequent question that we've been getting the past two weeks because of this data that's come in. And what we want to be careful to do here is not conflate this growth in new home sales with a swelling in demand for housing. As we stated in the outlook, we expect the recovery in housing activity to be more L-shaped. This behavior is apparent in more higher frequency data points, purchase applications for instance. 2023 remains far weaker than 2022. Average weekly volumes are down 35% year-to-date versus last year, and they're really not showing much sign of inflecting higher. In fact, if we look at just May and June versus 2019 prior to the pandemic, purchase applications are down almost 40%. Now, comps will get easier in the second half of the year. Year-over-year decreases will come down, but total activity is not inflecting higher. This is also showing through existing home sales, which are not showing the same improvement as new home sales. Existing home sales are down 24% year to date versus 2022. Also pending home sales, which missed a little bit to the downside just this morning.
Jay Bacow: Okay. So when I think about the process of housing activity at the end, you've got a home sale, existing home sale, a new home sale. At the beginning, you've got either people applying to buy a home or starting to build a home. And the housing start data, that was pretty strong relative expectations as well, right?
Jim Egan: It was. And the dynamics that we're discussing here, fewer existing home sales and climbing new home sales, that's leading to new home sales making up a larger share of that total number. And subsequently, homebuilder confidence is growing as a result. We think you can view this large number as perhaps a manifestation of that confidence, but we also want to stress that you need to think about that starch number in terms of single unit starts versus multi-unit starts. And yes, single unit starts were stronger than we anticipated, but they were still down year-over-year and through the first five months of this year, they're down 23%. Again, as with most housing activity data, the year over year comps are going to get easier in the back half of this year. That year over year percent will fall. We think they'll only finish the year down about 12%. But that's still a starch number that looks more L-shaped than a strong recovery. On the other hand, five plus unit starts in May were higher than in any single month since 1986. Multi-unit starts are still really driving the bus here.
Jay Bacow: Okay. So with that homebuilder confidence, what are homeowners supposed to be thinking? They just saw the first negative year-on-year print in home prices since 2012. Are we in a repeat of previous things or are things going to get better?
Jim Egan: Look, we just actually, in the mid-year outlook process, upgraded our year end home price forecast from -4% in December of 2023 to flat in December of 2023 versus December of 2022. That being said, while making that upgrade, we maintained that home prices were going to turn negative this month for the first time since 2012. We believe it's going to be short lived, largely because of the dynamics that we've already been discussing on this podcast. Current homeowners are not incentivized to list their home for sale. Existing listings continue to be incredibly low. The past few months, they've actually resumed falling year-over-year. When you look at affordability it’s still challenged, but it's not getting worse. When you look at overall inventories, they're still close to multi-decade lows, but we're not setting new historic lows each month. All of that leads to even more support for home prices on a go forward basis. We're still confident in our 0% for the end of the year. We might spend a couple more months here in negative territory before we kind of rebound back towards that flat by the end of 2023.
Jay Bacow: All right. So new home sales, surprised to the upside, but we shouldn't conflate that with swelling demand for housing. Home prices just trended negative, but we think that was expected and they're going to end the year flat versus 2022. Jim, always great talking to you.
Jim Egan: Great talking to you, too, Jay.
Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.
How will corporate credit markets fare as the Fed keeps rates higher for longer? Look for wider spreads, further decompression and muted excess returns.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed-Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the outlook for corporate credit markets. It's Wednesday, June 28th at 11 a.m. in New York.
Our economists are calling for one more 25 basis point rate hike in the upcoming Fed meeting in July and pause thereafter until the end of first quarter of next year. They're also calling for continued growth slowdown because of the policy tightening that we have seen over the last 15 months or so. A restrictive pause, which means rates staying higher for longer, and muted growth will weigh more on the performance of the corporate credit markets, especially as refinancing needs pick up. So our call is for wider spreads, further decompression and muted excess returns for corporate grade markets. Within credit we favor higher quality, which means investment grade credit over leveraged credit, both in bonds and in loans.
Let's dig into some details. Industrial grade credit looks attractive from a duration lens, and we expect 7% plus total returns over the next 12 months. From a spread perspective, our base case target, a 150 basis point, calls for modest widening. Although risks are skewed to the downside in the recession bear case scenario to 200 basis points. We think the banking space looks cheap versus the market, especially money center banks. We favor single A's or triple B's and shortening of portfolio duration. Our preference is to own the front end of the curve within the investment graded space.
Higher for longer puts more pressure on lower quality borrowers. While the macro outlook is not acutely challenging for credit, it progressively erodes debt affordability. For larger and higher quality borrowers, we expect the net impact to be gradual decline in interest coverage ratios and a voluntary focus on right sizing balance sheets. For smaller and lower quality companies, this adjustment could well be disruptive as 2025 maturity walls come into view.
So even in leverage credit, we would look to stay up in quality. The layering of leverage and rate sensitivity in loans informs our preference for bonds in general relative to loans. We expect loan only structures to underperform mixed capital structures. We also expect sponsor commitment will be put to test. That said, higher quality names within the loan market are a way to benefit from the shape of the rates curve and generate better near-term carry.
In all, we forecast wider spreads and higher default rates in the lower quality segments of the credit markets. Relative to the modest widening in the investment grade space within high yield and leveraged loans, we expect more significant widening in the range of 120 basis points of widening. This will result in marginally negative excess returns for these segments and will screen even worse when adjusted for volatility and downside risk.
We forecast default rates pushing above long-run averages with loan defaults outpacing bond defaults, especially after accounting for distressed exchanges.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With A.I. rapidly reaching the mass market, investors are pondering the risks and upsides to A.I. diffusion. History may provide some answers.
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Welcome to Thoughts on the Market. I'm Ed Stanley, Morgan Stanley's Head of Thematic Research in Europe. And along with my colleagues, bringing you a variety of perspectives, today I'll be discussing ten key lessons from the last hundred years of tech diffusion. It's Tuesday, the 27th of June at 3 p.m. in London.
Tech diffusion is one of the three big themes we at Morgan Stanley Research are following in 2023. The other two being the multipolar world and decarbonization. And when we say ‘tech diffusion,’ which has become a term of art, we mean the process by which any transformational technology is adopted widely by consumers and industries. Think of the light bulb, the first power plant, the internet, and now, A.I..
Our recent analysis of the last hundred years of tech diffusion helps to shed light on ten critical questions around how, when and where stocks will be impacted from the development of A.I..
One of the most important issues to consider is how fast A.I. diffusion is happening and whether regulation can restrain this. Since its pivotal moment when it was released in November, the leading generative A.I. tools are on pace to do in one year what the internet took seven years to achieve in spilling over to the mass market, and electricity took around 20 years to do the same thing.
The next critical question to consider is whether we tend to see upside or downside happen first for industries being impacted. In examining 80 structural positive and negative adoption curves over the last 50 years, we find that downside disruption often occurs sooner and twice as quickly as upside disruption.
So how does the downside play out for stocks perceived to be by investors more at risk from these types of technology disruption? The market typically de-rates and waits. So valuations fall somewhere between 50 to 60% in the years 1 to 3 post-a-disruptive-event with consensus sales and profit downgrades taking anywhere around 5 to 7 years to materialize. This process is shorter for business to consumer, B2B and longer for business to business contracts, B2B.
And what about the ways that upside plays out? For perceived winners, upgrades need to arrive within 6 to 12 months post the initial re-rating. However, we find that missing the first year of upside tends to have little impact on long term compound returns for investors.
Investors also wonder to what degree A.I. might be a bubble. And this is a fair question considering the market excitement and froth in A.I. at the moment, but we're watching Internet search trends to answer this question. And if you look at image generation tools for A.I., we're already about 50% lower than peak search volumes. So it's a trend we're going to have to continue to watch pretty closely.
Given all this, at what point do we expect killer apps to emerge that are built on top of these technologies? Well, our analysis of the last 50 examples of these killer apps emerging suggests that they tend to take a year and a half to emerge. This is why it's often very challenging to find domain specific winners in the public markets because they are still likely to be in venture backed scale up stage at the moment.
But when the killer apps do emerge, the next question becomes how much value will accrue to the incumbents versus the disruptors. And on this point, history suggests that diffusion of technologies that are transformational like this have tended to lead to changes in stock market
leadership over the last hundred years, with ultimately 2.3% of all companies generating all $75 trillion of net shareholder returns since 1990.
In this context, are pure play or diversified stocks the best ways to play these themes? Over the long run, we believe that pure play stocks exposed to themes such as A.I., can be expected to be valued at approximately 25% premium to non pure play stocks on average.
And the final two questions we get from investors take a more macro tilt. First, how much and when can we expect to see productivity gains? We are already seeing these productivity gains. The question is, what range? And we've seen anywhere between 20 to 55% for software developers, we've seen 14% for call center workers, and healthcare is also a large focus of academic research in terms of A.I. productivity and efficiency gains.
Finally, there is the question of deflation. When and how much can we expect from this kind of technology? This remains the most challenging question to answer. Technology of all kinds has proven consistently deflationary, and we think this is no different. But we do suggest that investors familiarize themselves with the emerging debates on virtual assistance, which could accelerate these deflationary spillover effects.
We'll continue to track all these developments around the ten key lessons and questions from history, and we'll provide you timely updates accordingly.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While many countries are gearing up to combat climate change, financing these large projects may pose a challenge.
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Simon Waever: Welcome to Thoughts on the Market. I'm Simon Waever, Morgan Stanley's Global Head of EM Sovereign Credit Strategy.
Carolyn Campbell: And I'm Carolyn Campbell, Head of Morgan Stanley's ESG Fixed-Income Research.
Simon Waever: On this special episode of the podcast, we'll discuss the credit impact of climate finance in emerging markets.
Carolyn Campbell: It's Monday, June 26, at 10 a.m. in New York.
Simon Waever: We believe that the ramp up in climate mitigation and adaptation financing from developed markets can be a key credit positive for emerging market countries, if executed correctly. The amounts of financing required in low and middle income countries to adapt to and mitigate the effects of climate change is likely to be over 1 trillion per year by 2030. Carolyn, let's start with that 1 trillion figure and the scale of the challenge. How are low and middle income countries positioned for climate change?
Carolyn Campbell: So when we think about climate change, there's two sides of the coin. There's climate change mitigation, which is everything that will slow or prevent the temperature from rising more than a degree and a half above pre-industrial levels, which is the goal of the Paris Agreement. And on the other side, we've got adaptation, which is financing projects that will build resiliency to physical risks, for example, or to help transform the economy away from dependency on industries that are likely to be harmed by climate change. So on the mitigation side, we've seen energy consumption in emerging markets steadily rise over the past couple of decades as their economies continue to develop and their populations grow often at faster rates than we see in developed countries. Now, while we've seen absolute levels of renewable energy usage tick up in these countries, on a proportional basis we're not seeing a material change, and that's because of this absolute rise in energy usage overall. So that leaves a lot of scope for the expansion of low carbon technologies such as wind and solar and so on, and that's obviously very expensive. On the adaptation side, a lot of the emerging markets are located in areas that will bear the brunt of climate change, whether that's through worsening storms or increased droughts, rising sea levels and so on, and they don't have the same infrastructure or economic diversity to deal with these climate impacts. So it's an immense amount of capital required for both types of projects, as you said, likely to be greater than a trillion dollars per year by 2030. And so far, developed markets have actually come up short on their promise to deliver $100 billion annually in climate finance. So all this being said, I think it begs the question how will they pay for it without incurring an unsustainable debt load?
Simon Waever: Yep, that is the question. And I would say the good news so far is that more and more sources are being made available with some being more targeted than others. The first main source is loans. So these generally come from either bilateral agreements, so from other sovereigns, or from multilateral institutions such as the World Bank. An example of a new facility being made available just in the past year is the resilience and sustainability trust from the IMF, which has now already made disbursements to six countries with more on the way. And the advantage of this facility, compared to others from the IMF, is that it comes at a lower cost and a longer maturity. The second main source is the capital markets. The instruments people will be most familiar with here are the labeled bonds, such as green, sustainable or even sustainability linked bonds that see their coupons change depending on various targets being met. But today, there's also an increasing use of the debt for nature swaps such as used in Belize and Ecuador recently and the introduction of climate resilient debt clauses. What this means is that if an adverse event happens like a hurricane, etc., there can be an automatic pause or delay in payments, which in theory should help both the country and creditors because you avoid going into any distress situation on the bonds. But another interesting avenue that's opened up in the last decade or so has been to raise financing by turning carbon into a commodity, whether as a voluntary carbon offset or through direct carbon pricing. Carolyn, how would those be used?
Carolyn Campbell: Yeah. So on the voluntary carbon side, a credit represents one tonne of carbon reduced, removed or avoided, and a lot of emerging markets are able to sell these credits, not necessarily at the sovereign level directly, but in some cases, yes, to developed markets, either to the sovereigns or to corporates who are willing to buy those emissions to offset against their own. And so those projects can be anything related to forest preservation or other natural capital projects or linked to renewable energy deployment and so on, and that can help raise the financing to get those projects off the ground. On the other side, there's direct carbon pricing, which is compulsory and includes things like Europe's emissions trading scheme or commonly thought of as cap and trade programs. There's also carbon taxes which raise revenue from businesses that emit and tax every tonne of carbon emitted. And direct carbon pricing is really important because the revenues raised from these schemes don't actually have to be applied to green projects so they can further other local development priorities. Lots of interesting avenues, but not every avenue will be suitable for every country, there's a wide range of emerging markets out there. But let's assume for a moment that all the financing will actually be deployed at a sufficient scale over the near and medium term. What does that mean for the credit quality of these recipient nations?
Simon Waever: Yes. So as we've actually covered before on this podcast, developing countries are facing significant financing challenges. And by that I mean they've been used to getting a lot of cheap financing over the last ten years, that's no longer available. So if the result is that more financing is being made available, that is credit positive, especially if it then also comes at lower financing costs and with longer maturities. I would of course say that the magnitude of the impact is going to differ by country, and overall, I would highlight the lower rates of countries as benefiting the most. And just to give two examples of countries that have benefited recently, one is Kenya. They've been under pressure in the markets because they have a 2 billion maturity next year that people were questioning where they were going to get the funds to repay it. Now, through the help of the IMF and their new Resilience Sustainability Trust facility, they've seen larger disbursements and the markets have traded much better. The other example is Ecuador that was able to complete a debt for nature swap that in the end resulted in lower debt burden, fewer bonds outstanding, and at the same time helping conserve the Marine area in Ecuador. But actually, all this is a lot about just a near-term impact. The longer term impacts will eventually turn out to be even more important, I would think. Carolyn, could you give some examples of this?
Carolyn Campbell: So on the one side, we've got climate resiliency improvements that can materialize in ways like reduced costs in the face of acute weather events or economic resiliency to slow onset adverse climate events, we mentioned droughts earlier. Another very important avenue is fundamental improvements via the renewable energy transition. So deployment of renewable energy might increase overall levels of electrification in the country, which can boost productivity and so on. If we think about South Africa as an example, South Africa has struggled with lower productivity because of its dependency on aging coal power plants. So there's a real case to be made about the benefits of renewable energy deployment there in terms of economic productivity. So all this sounds great, but there are some real execution risks for this quantity of financing and getting these projects off the ground. Simon can you tell us what that might mean for these countries?
Simon Waever: Right. That's a key topic, and it may be that there's actually insufficient climate financing, and that would at best mean that you have other suboptimal financing sources used. But at worst, that we see scaled back, delayed or even canceled climate projects. And actually the risk of this happening isn't low, so it's something we do need to watch. And then another risk is that the debt dispersed but used in the wrong places or used inefficiently, because then you end up with the countries with higher leverage that doesn't actually see the benefits.
Simon Waever: But with that, Thanks, Carolyn. Thanks for taking the time to talk.
Carolyn Campbell: Great speaking with you, Simon.
Simon Waever: And thanks to everyone for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
This year, foreign exchange has been even harder than usual to predict. Even so, the outlook for the U.S. Dollar may prove to be a handy asset moving forward.
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Welcome to Thoughts on the Market. I'm Dave Adams, Head of G10 Foreign Exchange Strategy at Morgan Stanley. And today I'll be talking about our outlook for the U.S. dollar and why it may prove an important driver of investor returns this year. It's Friday, June 23rd at 3 p.m. in London.
Foreign exchange has long been known as a hard asset class to predict, and this year has proven to be even harder than usual. Consensus trades left and right have missed the mark, and both disagreement and uncertainty are the highest we've seen in years.
So where do we go from here? We think the U.S. dollar is going to keep rallying, rising about 5% or so by the end of the year. Central bankers are likely to keep their feet on the brakes in order to tackle inflation. And in doing so, growth is likely to remain anemic, with risks skewed to the downside.
Against this backdrop, we think two key themes are going to emerge: demand for carry and demand for defense. Carry is attractive in a slow growth world and is likely to explain a lot more of investor returns if prices don't move very much. And defensiveness is an alluring quality in financial assets when optimism is low, uncertainty is high and risks abound.
It's pretty rare to find a financial asset that offers both of these qualities. Typically, insurance costs you money. But the good news is that the US dollar does. The dollar tends to be negatively correlated versus the equity market, meaning that when equities go down, the dollar goes up, and that relationship has only strengthened in recent years.
Meanwhile, U.S. rates are elevated versus the rest of the world thanks to Fed rate hikes. Dollar rates are roughly 2% higher than those in Europe and even 5% higher compared to those in Japan.
Foreign exchange is a relative game, and if investors are buying the dollar, they're probably selling something. We think in this high uncertainty environment currencies which are most sensitive to growth and risk assets would likely weaken the most. In the G10 space, the Australian dollar and the Swedish krona both look vulnerable here, while in emerging markets that's probably the South African rand and the Chinese renminbi.
There are plenty of potential risks on the horizon to keep investors worried; banking sector volatility, geopolitical risks, sticky inflation, just to name a few. As the investment outlook remains cloudy and hazy, the U.S. dollar is a handy asset to keep in the portfolio as a positive carry insurance hedge.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.
As the U.S. Economy still angles for a soft landing, the recent Federal Open Markets Committee meeting may have left more questions than answers.
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Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the outcome of the June Federal Open Market Committee meeting and our outlook for the U.S. economy. It's Thursday, June 22nd at 10 a.m. in New York.
Hawks and doves entered the battlefield at the June FOMC meeting, wrangling over the extent to which further rate hikes might be needed and how forcefully to convey that. As expected, the FOMC held rates steady at 5.1% and maintained a tightening bias in the statement. But it's also important to note that the statement included an ever so slight change in language that made further rate hikes seem less certain. So in all, this suggests the Fed could raise rates later this year, although when thinking about the very next meeting we think the bar to hike in July is much higher than market pricing implies.
And the new summary of economic projections, which is made up of Federal Open Market Committee participants projections for things like GDP growth, the unemployment rate, inflation and the appropriate policy path, FOMC participants revised up the policy path for this year by a full 50 basis points. So that would imply two more 25 basis point rate hikes. They also lifted their growth projections for this year, they revised down the unemployment rate and they revised upward their core PCE inflation forecast. So all in all, that's a summary of economic projections that skewed very hawkish.
Now, we find the upward revision to core PCE most perplexing as incoming data on inflation had been in line with the Fed's forecasts, and especially as key measures of core services inflation have consecutively softened. Now in relation to our forecasts, we think this sets up core inflation to fall faster than the Fed currently projects, which should offset the takeaways from a higher peak rate in the DOT plot. The core inflation projection for this year and the level of the Fed funds rate could get revised downward by the time the FOMC meets in September.
In our latest outlook, we continue to see a soft landing for the U.S. economy this year, with inflation and wages slowly easing, as well as job gains. Now consistent with this expectation, we continue to look for the Fed to hold the peak rate at 5.1% for an extended period before making the first .25% cut in March 2024. Like the Fed, we have to be humble here and we do see the effects of banking stresses on the economy as highly uncertain, and we'll hone our expectations for the economy and monetary policy as the incoming data unfold.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While high oil prices at the end of last year drove down demand and freed up supply, this year many expect the market to tighten again. So why hasn’t it tightened yet?
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Welcome to Thoughts on the Market. I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the outlook for the global oil market for the rest of 2023. It is Wednesday, June 21st at 3 p.m. in London.
Last year saw severe tightness in most commodity markets. Demand still benefited from the post-COVID recovery, and supply was disrupted by the war in Ukraine. In many markets, prices had to rise to a level where demand destruction occurred. In the oil markets, that led Brent crude oil to rise to $130 a barrel, gasoline to $180 and diesel $190 a barrel.
Those prices clearly did the trick. In response, the global economy slowed down and oil demand softened towards year end, resulting in a slight oversupply at market earlier this year.
In recent months, however, the main narrative in the oil market has been a one of re-tightening into the second half. The market was clearly in surplus in the first quarter, but was widely expected to tighten again by the second half due to a combination of China reopening, continued recovery in aviation and downside risk to supply from Russia. Those factors should see the market balance in the second quarter and reenter a meaningful deficit in the third and fourth quarter, driving prices higher.
In fact, that was also our expectation at the start orrf the year. However, if this was indeed to play out, we should see it by now. Given we are currently in June, the most actively traded Brent contract is the one for August delivery. North Sea oil delivered in August will typically arrive at a refinery around about September, with end products made from that crude oil such as gasoline, diesel and jet typically delivered to end customers by October. Therefore, the oil market is already trading the anticipated supply-demand balance deep into the second half. Yet the expected tightness has not yet emerged.
This is not due to China's reopening, which has boosted oil demand broadly as expected. Already in March, Chinese refinery runs and its crude oil imports reached all time highs again. The recovery in aviation, and with that jet fuel consumption, is also broadly playing out as expected.
Instead, most reasons for the weaker than expected oil market balance lie on the supply side. For starters, Russian exports have been remarkably resilient. The EU sanctions on the imports of Russian oil were widely expected to result in lower oil production from the country, but this has not materialized. On top, oil production from other non-OPEC countries have surprised to the upside. Notwithstanding low investment levels over the last few years, oil production has grown in a wide variety of countries, including the United States, but also Brazil, Canada, Argentina, Guyana, Colombia, Mexico, Oman and even China.
As a result, oil production from non-OPEC countries has started to grow faster than global oil demand once again. When that is the case, the balance in the oil market can only be maintained if OPEC cuts production. And that is indeed what the producers group has been doing. OPEC already announced a production cut back in October of last year, and then again in April of this year, and again earlier this month. However, in doing so, OPEC loses market share to non-OPEC producers and it builds up spare capacity, both factors that typically end up weighing on oil markets.
We still foresee a small deficit in the oil market in the third and the fourth quarter, but this is mostly a function of seasonality in demand and OPEC cuts. Those factors are not inherently bullish.
If second half tightening does not play out, then market participants may need to consider what lies just beyond that. Our balances for early 2024 do not look so tight. Next year, demand will no longer be supported by another year of China reopening and aviation growth. There will still be supply growth in several non-OPEC countries, and seasonality, which is currently a tailwind, will turn into a headwind.
There is still likely a period ahead when global GDP growth re-accelerates and the impact of little investment in new production capacity should start to bite. However, the cyclical and the structural outlook do not always align. Over the next six months, we see oil prices broadly stable at about $75 to $80 a barrel for Brent. What market participants find right in front of them is neutral rather than constructive.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While the U.S is moving towards a soft landing and Japan is seeing nominal growth, the European economy continues to face restrictive policy.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy. Along with my colleagues, bringing you a variety of perspectives, today, I'll talk about our mid-year outlook for macro markets. It's Tuesday, June 20th at 10 a.m. in New York.
As we look ahead at macro markets for the next 12 months, central banks are front and center again. Our economists see them finding peak rates mid-year, while growth slows and inflation remains sticky. They also see the U.S. moving towards a soft landing, while the Euro area economy continues to face more restrictive policy. The U.K. continues to muddle through, while Japan delivers a year of nominal growth.
Two global risk scenarios that our economists consider, a hard landing in the U.S. and then faster disinflation also in the U.S., should keep macro markets on the defensive. We think sovereign bond yields will end the year lower than in the first half, while the U.S. dollar will end the year stronger. We think macro markets already reflect the base case outlook for a soft landing and gradual adjustments in monetary policy. The view from our economists, which is mostly in the market price, aligns neatly with this consensus.
So what will move markets into year end? Price action should, of course, evolve as surprises to this consensus view unfold. As usual, uncertainties around the outlook for monetary policy are murky, raising risks that the outcome will surprise currently held consensus views.
One uncertainty involves the stance of monetary policy and the impact of the previous tightening that's been put in place. Have central banks tightened enough already to bring inflation back to target, in a suitable time frame? How long and variable are the lags of monetary policy today?
We think rates market volatility, currently at its local lows, under appreciates the multitude of risks that lie ahead. For example, the lack of negative headlines around regional banks in the US have made investors complacent about bank stresses being behind us. However, key data points on bank balance sheets show that things have worsened on the margin since March.
As for government bonds, we expect them to end the year with a rally for which investors have been waiting for, and we wouldn't be surprised if the positive returns accrued in line with historical seasonality. For example, strength in July and August, followed by a lull and then further strength in November and December.
If you look at the US dollar, there's been a debate around the extent of the dollar's dominance in the global economy. As things stand, foreign investors continue to have a voracious appetite for US dollar denominated assets thanks to their strong returns and the U.S. economy's deep and liquid capital markets. So we forecast continued U.S. dollar strength into year end as tepid growth and asymmetric downside economic risk amplify investor demand for carry and defensive assets.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
With investors anticipating earnings surprises for US stocks, the outlook for municipal bonds is looking brighter.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley.
Mark Schmidt: And I'm Mark Schmidt, Head of Municipal Strategy.
Michael Zezas: And today, we'll be talking about the core of many investors' fixed income portfolios, municipal bonds. It's Friday, June 16th at 9am in New York.
Michael Zezas: As our equity strategists continue to highlight the risk of earnings surprises for U.S. stocks, the outlook for the bond market looks considerably better. A soft landing, so call it, slow growth and slowing inflation, would mean favorable total return prospects across fixed income. In fact, even as the Fed's been raising short term rates, longer term bond yields have been falling as investors anticipate both inflation and growth to decline. So, Mark, for the benefit of listeners, tell us why this is a sweet spot for munis.
Mark Schmidt: Thanks, Michael. Municipal bonds, high credit quality and tax exempt income are an opportunity for investors in high tax brackets right now. Credit quality for municipals can seem confusing, but we like to think of it in a pretty simple way. What's the outlook for tax collections? Income tax collections were mixed in April, but sales and property taxes continue to grow. Also, most state and local governments still have plenty of cash on reserve in case the economy performs worse than our economists expect. That cash comes from all the aid that the federal government provided, several hundred billion dollars, in fact, to municipal issuers in response to COVID. That's created a balance sheet buffer that can still support issuers today, even as growth slows. Now, even though credit quality remains pretty good, the good news is we don't think you need to take a lot of risks to enjoy the benefits of tax free income in your portfolio.
Michael Zezas: And Mark, investors ask a lot about what the right maturity of bond is for their portfolio. What do you think investors should favor right now? Shorter or longer maturity bonds?
Mark Schmidt: Longer maturity bonds generally offer higher returns, but of course, with higher risk as well. Right now, we actually see superior risk adjusted returns in a 1 to 5 year or 1 to 10 year latter. We'd look for investment grade credits in those shorter maturities for investors seeking higher income with higher risk. We'd recommend a barbell approach, one that blends short 1 to 5 year maturities with select maturities between 15 and 20 years. On the long end of the curve, we prefer very high quality AA bonds. With credit spreads and risk free rates at multi-year highs, we just don't think you need to reach for yield in this environment, especially as the economy slows. But Michael, one question that always comes up with regards to municipal bonds is the risk of the tax exemption changing, given how important tax free income is for municipal investors. Congress does change the tax code from time to time, do you expect major legislation out of Washington anytime soon?
Michael Zezas: In short, no. Major tax reforms tend to happen once in a generation, and they tend to need one party to control both the White House and both chambers of Congress. And even then, a big tax code change needs to be their priority. So, the earliest this could possibly happen again would be after the 2024 election, so call it 2025. And then again, even then, it's not clear that even if one party were to take control of Congress and the White House, that this would be a priority for them. So in short, it's not something I'd be particularly concerned about. But Mark, turning it back to you. Munis helped to build all kinds of infrastructures in states and cities, colleges, hospitals, airports and toll roads. They all issue municipal bonds. What sectors do you like right now?
Mark Schmidt: We think the outlook for most transportation issuers remains pretty good. Summer vacations are right around the corner, and we all definitely want to pack our bags and hit the road. All those travelers going through airports and on toll roads is good news for credit quality. Now, as for one sector where credit quality is more mixed, health care providers are still recovering from all the disruptions related to COVID. You all know the story, of course, as more patients required more specialized care, the demand for nurses and frontline health care workers skyrocketed, leading to higher costs across the board. Those costs are now stabilizing, but we continue to think it will take some time for credit quality to fully recover. When it comes to some of these choices about sectors and credit quality, though, remember that volatility is relative. Compared to other asset classes, fundamentals for investment grade municipal bonds don't change very quickly or very often. They're the classic late cycle haven, as you've mentioned, Michael, in years before.
Michael Zezas: Well, Mark, this has been really insightful. Thanks for taking the time to talk.
Mark Schmidt: Great speaking with you today, Michael.
Michael Zezas: And thanks for listening. If you enjoy thoughts on the Market, please be sure to rate and review us on the Apple Podcasts app. It helps more people find the show.
With more Asian economies on pace to join the recovery path set by China, confidence in economic outperformance versus the rest of the world is rising.
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist at Morgan Stanley. Along with my colleagues bringing your variety of perspectives, today I'll be discussing our mid-year outlook for Asia's economy. It's Thursday, June 15 at 9 a.m. in Hong Kong.
Asia's recovery is for real. We believe its growth outperformance has just started. We expect a full fledged recovery to build up over the next two quarters across two dimensions. First, we think more economies in the region will join the recovery path. Second, the recovery will broaden from services consumption to goods consumption and in the next six months to capital investments, or CapEx. We see Asia's growth accelerating to 5.1% by fourth quarter of this year. There are three main reasons why we expect this growth outperformance for Asia.
First, Asia did not experience the interest rate shock that the U.S. and Europe did. Asian central banks did not have to take rates through restrictive territory because inflation in Asia has not been as intense. Plus, Asia's inflation has already declined and we expect 80% of region’s inflation will get back into central bank's comfort zone in the next 2 to 3 months.
The second reason is China. While China's consumption recovery is largely on track, we have seen downside in the last two months, in investment spending and the manufacturing sector. We believe policy easing is imminent as policymakers are keen on preventing a deterioration in labor market conditions and on minimizing social stability risks. Easing should help stabilize investment spending and broaden out the recovery in back half of 2023.
Beyond China, India, Indonesia and Japan will also contribute significantly to region's growth recovery.
India is benefiting from cyclical and structural factors. Cyclically beating healthy corporate and banking system balance sheets mean India can have an independent business cycle driven by domestic demand, and we are seeing that appetite for expansion translating into stronger CapEx and loan growth.
As for Japan, it is in a sweet spot, having decisively left the deflation environment behind, but not facing runaway inflation. Accommodative real interest rates are helping catalyze private CapEx growth, which has already risen to a seven year high. And, in another momentous shift, Japan's nominal GDP growth is now rising at a healthy pace after a long period of flatlining.
Finally, we believe Indonesia will be able to sustain a 5% pace of growth. Indonesia runs the most prudent macro policy mix amongst emerging markets. In particular, the fiscal deficit has been maintained below 3%, since the adoption of the fiscal rule and has only exceeded that in 2020 during the worst of the pandemic. This has resulted in a consistent improvement in macro stability indicators and led to a structural decline in the cost of capital supporting private domestic demand.
The risks to our next 12 month Asia outlook are hard landing in the U.S., which Morgan Stanley's U.S. economists think it's unlikely and a deeper slowdown in China. But we believe China's recovery will only broaden out in the second half of 2023. And given this, we feel confident about our outlook for Asia's outperformance in 2023 vis-à-vis rest of the world.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While investors are feeling optimistic with the strong performance in markets despite some predicted challenges, it may be too soon to tell if these possible hurdles have been completely avoided.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Wednesday, June 14th at 2 p.m. in London.
It's hard to ignore a sense of relief and increased optimism that's starting to percolate among investors. After a hard 2022, there was widespread trepidation entering this year that slower growth, quantitative tightening and further rate hikes would continue to pressure markets. Yet year-to-date, performance has been pretty good. Is that evidence that these problems aren't really problems anymore?
Markets have been strong. But in terms of that strength showing that markets have passed the test of slower growth or policy tightening, I think it's more accurate to say that it's too soon to tell.
Let's start with the idea that markets have already weathered a period of weaker growth. While leading economic indicators of the economy are soft, so far, actual activity has held up pretty well. The U.S. economy grew 1.3% in the first quarter and has added 1.6 million new jobs year-to-date. It's the coming quarters, specifically the next 3 to 6 months, where our economists see the weakest stretch of economic activity.
Next, how about market resilience suggesting that rate hikes don't matter, or at least don't matter very much? Here we think the question is to what extent rate increases hit with a lag. The optimistic case is that markets are forward looking, and thus have already discounted the full impact of very large recent rate increases by both the Fed and the European Central Bank.
But there's also a school of thought that higher rates don't fully hit the economy for 12 months, or more. 12 months ago, the federal funds rate was still just 1%. Maybe the full effects of policy tightening haven't yet hit.
Another part of the theme of tighter policy is the reduction of central bank balance sheets or quantitative tightening. Again, it's tempting to view recent market strength as evidence that this dynamic doesn't matter as much as expected, and that may be true. But I think the jury's still out. Year-to-date, the aggregate bond holdings of the world's central banks have actually risen, not fallen, thanks to continued easing from the Bank of Japan and support for the US banking sector from the Federal Reserve. That should now change going forward, with these balance sheets shrinking, giving us a better measure of the true impact.
Third is the effect of tighter lending conditions. The optimistic case is that following quite a bit of banking sector volatility in March, recent market resiliency shows that this is just another test that the current market has passed. But lending, like monetary policy, could act with a lag. Morgan Stanley's banking analysts see tighter lending from the U.S. banking sector playing out over an extended period of time, rather than quickly, and all at once.
Markets have been resilient year-to-date, a welcome respite from a poor 2022. We don't think, however, that this resilience is yet proof that markets have successfully answered the question of what the impact of lower growth, tighter policy or tighter bank credit will be. Rather, these questions are still sitting there, waiting to be answered over the next several months.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave a review. We'd love to hear from you.
With the European economy losing momentum amidst a rally in growth stocks globally, the time of European equity outperformance may be in the past for now.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for European equities in the second half of this year. It's Tuesday, June 13th at 2 p.m. in London.
After a record burst of outperformance between October and March, European equities have started to underperform their international peers over the last couple of months, and we think this is likely to continue over the summer for two reasons.
Firstly, the European economy seems to be losing some momentum, with many of the region's leading economic indicators turning back down over the last month or so. Now, while the magnitude of their reversal is small so far in absolute terms, the European Economic Surprise Index, which tracks how the data comes in relative to expectations, has fallen much more sharply and is now close to a ten year low. We think this is an important development, as this index is often a good lead indicator for future earnings and hence is now pointing to downside risks ahead for corporate profitability in Europe.
The second factor starting to drag on Europe's relative performance, is the strong rally in growth stocks that we are seeing globally. While Europe has its own fair share of such companies, its tech weight overall remains considerably below that of most other regions. For example, tech is at about 7% of the European equity market versus 13% for Asia and over 30% for the U.S.. Quite simply, the size of this differential makes it difficult for Europe to keep pace with other regions when growth stocks are outperforming more broadly, such as now.
While these two factors are likely to weigh on Europe's relative performance in the near term, we also see downside risks to broader global equity indices over the summer, given the potential for slowing growth and deteriorating liquidity dynamics in both the US and Europe. Taken together, we think these headwinds could see European equities fall by up to 10% over the next few months. Given this backdrop, we have further increased our preference for defensives over cyclicals, by upgrading pharmaceuticals to overweight, to sit alongside telecoms and utilities in our most preferred list. In contrast, we remain underweight cyclical sectors such as autos, capital goods, chemicals and energy. From a style perspective, we think it is too soon to take profits in the growth sectors and hence remain positive on the likes of luxury goods, medtech, semis and software.
The biggest change to our view recently has become more downbeat on the outlook for European financials, which we think fits a, "right place but wrong time narrative". Specifically, while the sector looks attractive from a bottom up perspective in terms of low valuations, strong balance sheets and healthy earnings trends, we think the top down macro environment has become more challenging as we near the end of the current rate hiking cycle and with the prospect of slower economic growth and lower bond yields ahead.
Notwithstanding our near-term caution, however, we are more positive on European stocks over the longer term, given the backdrop of what we think will ultimately be relatively resilient earnings and low equity valuations. For example, Europe's price to earnings ratio is now down to just 12.5 times versus the U.S. at close to 18 times. Looking out further on a 12 month view, our models suggest 8% price upside from here, which would rise closer to 12% if we include dividends and buybacks. So, when we put all of the above together, we think the outlook for European stocks is perhaps best described as one of short term pain, but for longer term gain.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With AI gaining momentum among investors and the Fed potentially pausing on rate hikes, signs are now pointing towards the end of the bear market rally.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, June 12th at 11 a.m. in New York. So let's get after it.
At the beginning of the year, we noted that our view is much more in line with the consensus and we discussed that it might take some time for that to change. Suffice it to say, it has taken longer than we expected. At the end of January, sentiment and positioning had improved enough to put stocks in a vulnerable state, and sure enough, we had a 10% correction in the S&P 500 over the following six weeks, with the average stock down about 13%. Since then, the average stock has lagged the overall index by about 10%. We think this is mostly due to increased liquidity from the depositor bailouts, at the same time artificial intelligence began to gain momentum with investors. The combination of perceived safety and of newfound open ended growth story was too much for investors to resist. Hence, we have one of the most concentrated markets in history.
For most of the past two months, sentiment has remained somewhat pessimistic, which is part of the reason why the average stock hasn't done very well. But sentiment has turned outright bullish in the past week. Furthermore, it's not just sentiment, as both retail and institutional flows have returned to the equity markets with technology and artificial intelligence the dominant themes.
This past week there were several other warning signs that this bear market rally may have finally exhausted itself after eight months. First, several sell side strategists and market commentators have publicly stated the bear market is now over at this point.
Second, we don't find much value in the 20% threshold for declaring new bull markets. Instead, our conclusion is driven more by the fundamentals, valuations and expectations relative to our outlook. In short, our earnings view is much more pessimistic than the current consensus expectation, which is now assuming a second half reacceleration story. We can also find several instances of bear market rallies that exceeded the 20% threshold, only to eventually give way to new lows. One example is particularly relevant, given our 1940s and fifties boom bust framework that we discussed in last week's podcast. After the boom in 1946, following the end of the war, the S&P 500 corrected by 28%, followed by a 24% choppy bear market rally that lasted almost eighteen months before succumbing to new lows a year later. Thus far, it appears similar to the current bear market, which corrected 27 and a half percent last year and is now rallied 24% from its intraday lows, but is still 10% below the highs.
Third, when we called for a bear market rally last October, it was predicated on two key assumptions. First, market concern around the Fed and terminal rate had likely peaked, and second, the US dollar was also peaking. Both of these developments occurred as long term interest rates and the U.S. dollar topped last October. Falling rates and the US dollar have combined to drive both valuations and earnings expectations higher. On the latter point, the U.S. dollar index is now flat on a year-over-year basis, which compares to up 21% at its peak last fall. The question is how much did a weaker dollar help the top line for multinational companies and the S&P 500 overall? Furthermore, will this dollar weakness continue or will it flatten out and or even reverse into a headwind? It's hard to know for sure, but our house view is for a stronger dollar, and it's important to acknowledge the S&P 500 has become very negatively correlated to the dollar over the last decade.
Finally, we think the Fed's potential pause on rate hikes this week could serve as the perfect bookend to this bear market rally that began with a peak in the Fed's terminal rate last fall. In many ways, it's often easier to travel than arrive at the destination.
The bottom line, sentiment and positioning are now 180 degrees from where they were on January 1st. This means stocks are no longer set up for the disappointment we think is coming in the form of much weaker than expected earnings this year. This reset can happen either slowly as companies miss expectations one by one, or quickly from another exogenous shock that is just too much for the market to absorb. In that latter case, the equity risk premium is likely to spike, price earnings multiples are likely to fall sharply and we may make a new bear market price low before estimates fall in earnest. We suspect the weaker liquidity backdrop from greater Treasury issuance discussed last week could serve as that exogenous shock.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps for people to find the show.
While the forecast for global bonds remains strong for the latter half of 2023, other asset classes could see bifurcated results across regions.
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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.
Andrew Sheets: And I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist.
Seth Carpenter: And on part two of the special two-part episodes of the podcast, we're going to focus on Morgan Stanley's year ahead strategy Outlook. It's Friday, June 9th at 10 a.m. in New York.
Andrew Sheets: And 3 p.m. in London.
Seth Carpenter: All right, Andrew, in the first part of this two part special, you were grilling me on the economic outlook. You were taking me to task on all of our views, pointing out the different ways in which our clients, investors around the world were pushing back at different parts of our story. And now, it's payback time. Let me ask you, basically, what are we thinking as a research house in terms of where the best trades are likely to be for markets? We're looking for a soft landing in the U.S., but that doesn't mean a good outcome. So very weak economic activity and policy rates that are still restrictive. So what is that type of backdrop going to mean for one of the most closely watched assets in the world, the U.S. dollar?
Andrew Sheets: Sure. So we do think that this backdrop, despite the fact that on the surface it looks decent, you have the U.S. and Europe avoiding recession. You have stronger growth in Asia, but you have a lot of uncertainties that are front loaded, and you still have slowing growth, you still have tight monetary policy. And we think this is going to still lead to a somewhat more difficult backdrop for markets over the next three months. And so I think in that context, the U.S. dollar looks quite attractive. The US dollar pays investors to hold it, it's a so-called positive carry currency against most major currencies and it's a diversifying currency, so as an asset it helps protect your portfolio. And I also think kind of within this context, if any economy is going to be able to handle higher interest rates, well, it might be the U.S. where a large share of consumer debt is fixed in a long term mortgage, which is very different from what we see in Australia or the UK or Sweden. So, we think that the dollar will do better, we think the dollar will do better in large part because of this attractiveness in a portfolio context that it offers investors a positive yield, while at the same time offering portfolio protection.
Seth Carpenter: All right. So, if you're feeling reasonably upbeat about the dollar, presumably that spills over to dollar denominated assets. At the end of last year, the strategy team published a piece that was called ‘The Year of Yield.’ Are you still feeling that good about bonds in the United States in particular? Is it really fixed income securities that are your strongest call?
Andrew Sheets: So, we still feel good about bonds, but I would say that the start of the year has been a pretty mixed picture. I think kind of relative to what we were expecting at the start of the year, the Fed and the ECB have raised rates more. Growth has been somewhat stronger, inflation has been somewhat higher. I would say none of those things are good for the bond market and yields instead of falling have kind of trended sideways. So they've done okay, but they've not done as well as we on the strategy side initially thought. But, you know, looking ahead, we think that the case for high quality fixed income is still quite good. We still think we see slowing in the second half of the year, which we think will be supportive for bonds. We think, certainly based in large part on the forecasts from you and the economics team, that the Fed and the ECB are largely done with their rate hikes, which we think will be supportive for bonds, and we think that inflation will moderate over the course of the year, which could also be supportive. So, we still think that when we look across global assets, while we see positive returns from most bond and equity markets, we think it's high grade bonds that generally offer the best risk adjusted return on our forecasts.
Seth Carpenter: Okay, So risk adjusted return on bonds seem attractive to you. The natural follow up question to that is what about equities? Equities have actually performed reasonably well this year. On our first part of this podcast, I said that we are looking for a soft landing. What's the call on equities in the United States? Is this going to be a great second half of the year for equities?
Andrew Sheets: So we think the equity picture is quite bifurcated. In some ways, I think it ties quite nicely to the bifurcated global economic picture that you and the economics team are talking about. Where growth in Asia is accelerating, this year, it's accelerating in the second half of the year, while growth in the U.S. and Europe is slowing. And it's that bifurcation that we think is mirrored in the equity market where we see quite good returns for Japanese, in emerging market equities, we see double digit total returns over the next 12 months. But we see a U.S. equity market that's broadly flat in 12 months time to where it is today. Now, what's driving that is we do think that the slowing growth we have this year and tighter monetary policy that will hit profitability. We think it's already been hitting profitability, we think it will continue to. And more tactically, we think that a lot of the big questions for the market are somewhat unresolved, but will be tested very soon. It's the next two quarters, which is the weakest stretch of U.S. GDP growth. It's the next two or three quarters that we think is the bulk of the risks to U.S. earnings. It's this year, it's not next year. And we think the next two quarters is where monetary policy relative to inflation tightens more in our forecast horizon rather than tightening more in the future. So, when we think about the resilience of stocks, especially U.S. stocks year-to-date, it's been very impressive, it's been stronger than we expected. But also, I think year- to-date, growth has been pretty solid. The Federal Reserve's balance sheet has declined to less than initially expected. You haven't necessarily, I think, gone through some of the tests that investors, ourselves, thought might present more headwinds to the equity market, and those tests are going to present themselves, we think, rather soon.
Seth Carpenter: Okay. So you highlighted a dichotomy there, especially for the second half of the year. That lines up, I would say, with some of our economic outlook, other parts of the world maybe doing a little bit better. I started off very narrowly with just the dollar. Are there other currencies in other parts of the world where based on, either what's going on with their central banks or what we think is going to be going on with their economic performance. Other currencies that you think would be really good for investors to take a look at.
Andrew Sheets: So if I think about where we're forecasting currency strength, we do have the dollar appreciating against most currencies. So I'd say that's a dominant story. We do have the Japanese Yen doing modestly better, and that's largely a function of valuations that look to us very low versus history adjusted for inflation. And we do think that you could have a somewhat uncommon occurrence where Japanese equities and the currency both do well. We think that's the case because the currency is so inexpensive relative to other currencies and because Japanese corporates are already expecting their currency to strengthen some that, that wouldn't necessarily be an additional hit to profitability. The Brazilian Real is another currency that we're predicting to be stronger relative to regional peers. We think both the Indian Rupee and the Indonesian Rupiah can also do well as those economies are relatively strong in a regional context, and in a global context, looking out over the next 12 months.
Seth Carpenter: All right. That's super helpful. I guess the last question will come back to you with, again, trying to take this global perspective on things, is commodities. Commodities are traded around the world. They are often a reflection of economic performance in different regions. We've got two big economies that we think will be growing fairly slowly, but we've got China and the rest of Asia that we think will be doing well. What is the outlook for commodities, and maybe especially oil, as we look forward the next six months, the next year?
Andrew Sheets: Yeah so, we're underweight commodities. And here I want to talk about the market from a so-called factor perspective. When we think about markets, I think it can be helpful to think about them in terms of fundamentals, carry and momentum, as different things that can drive the market and especially for commodities where those things all matter. So, you know, what do we mean by fundamentals? Well, we think as growth slows, that's a negative for commodity demand relative to supply, and so a forecast where slowing growth is still ahead of us and it's really front loaded in our forecast is somewhat of a headwind to commodities. If I think about carry, that's another way of saying what does it pay you to hold the commodity or what does it cost to hold the commodity? And given how high short term U.S. interest rates are, it's quite expensive to hold copper or gold rather than hold a Treasury bill which pays you interest. The commodity does not. So, we think that works against commodities some. And then there's also momentum you tend to see in commodities more so than other asset classes that they tend to trend. They tend to stay in the same direction that they're traveling, rather than reverse, and commodity prices have been heading down. And if we look at the data, we think that tends to be more of a negative thing than a positive thing. So broadly, we think commodities produce lower risk adjusted returns than other assets. We do see oil prices modestly higher by the middle of 2024. We see Brent at about 78. So that's a little bit higher from current levels. But I think it's an asset class where after some very good returns in the recent past, is one where the risk reward looks less favorable relative to some other things.
Seth Carpenter: All right, I'm going to call it there. Andrew, I really want to thank you for taking the time to talk, and let me throw a bunch of questions at you.
Andrew Sheets: Seth, great speaking with you.
Seth Carpenter: And thanks to everyone else for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or a colleague today.
As we look toward the second half of 2023, the U.S. and Europe are likely to see very slow growth but avoid a recession, while Asia may be poised to become an engine of economic growth.
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Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Morgan Stanley's Chief Global Cross-Asset Strategist.
Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.
Andrew Sheets: And on this special two part episode of the podcast, we'll be discussing Morgan Stanley's global mid-year outlook. Today we'll focus on economics, and tomorrow we'll turn our attention to strategy. It's Thursday, June 8th at 3 p.m. in London.
Seth Carpenter: And it's 10 a.m. in New York.
Andrew Sheets: Seth, it's great to sit down with you. We've been talking over the last several weeks as Morgan Stanley's gone through this outlook process. And this is a big joint collaborative forecasting process across Morgan Stanley research, where the economists and the strategists get together and think about what the next 12 to 18 months might look like. And, you know, we're sitting down at this really fascinating time for markets. The U.S. labor market is at some of its strongest levels since the late 1960s. Core inflation is at levels that we really haven't seen since the 1980s. The Federal Reserve and the European Central Bank have been raising rates at a pace that hasn't really been seen in 30 or 40 years. So, as you step back from all of these quite unusual occurrences, Seth, how do you frame where the global economy is at the moment and where is it headed?
Seth Carpenter: I'd say there's one major dichotomy that I'll first start with in the global economy. On the one hand, Asia as a region really poised to have the strongest economic growth. And in very sharp contrast, when I think about the rest of the world, the United States and the Euro area, we see those as being actually quite weak. Second, China, you can't get out of a discussion of the global economy without talking about China. And there, the first quarter saw massive growth in China as all of the restrictions from COVID were removed, and as the government shifted the rest of its policies towards being supportive of growth. Now, there's been a little bit of a stumble in the second quarter, but we think that's temporary. And so you'll see a cyclical boost to Asia, coming out of China. Layer on top of this our structurally bullish views on economies like India and Indonesia, where there's a medium term, really positive note, you have all of these coming together, and it sets the stage for Asia really to be an engine of economic growth. The sharp contrast, the United States, the euro area. The inflation that you referenced has led central banks to raise interest rates for one reason and one reason alone. They want to slow those economies down, so the inflationary impulses start to fade away.
Andrew Sheets: So Seth that's great context, and I'd like to drill down a little bit more detail on two economies in particular, the United States and China. For the United States, this idea of a soft landing, I think investors will point to the fact that given how strong the labor market is, given how high inflation is, given how inverted the yield curve is, given how much banks are tightening lending conditions, all those factors make it less likely historically that a recession is avoided. So, why do you think a soft landing is the most likely option here? Why do you think that that's our central scenario?
Seth Carpenter: Yeah, I completely agree with you, Andrew. The discussion, the debate, the push back, the soft landing part of our thesis is definitely central to all of that discussion. Maybe I'll just start a little bit with the definition because I think the phrase soft landing can mean different things to different people. What I don't mean is that we just have great economic growth and inflation comes down on its own. Quite to the contrary, we are looking for economic growth in the United States to slow so much that it basically comes to a standstill. This year and next year are both likely to be years where economic growth is substantially below the long run productive capacity of the economy. Why? Because the Fed is raising interest rates, making the cost of borrowing, making the cost of extending credit higher, so that there is less spending in the economy so that those inflationary impulses go away. So that's what we're thinking is going to happen, is that we'll have really, really weak growth. But your question also gets into is if you're going to have that much slowing in the economy, why not a recession? And here, it's always fraught to say this time is different. But I think you highlighted what is really different about this cycle. It's the first time the Fed is pulling inflation down, instead of trying to limit its rise, in 40 years. But in addition to that, we're coming out of COVID. And I don't think anyone would argue that COVID is a normal part of an economic business cycle in the United States.
Andrew Sheets: So we've just covered some of the reasons why we are more optimistic than those who expect a recession in the U.S. over the next 12 months. There are investors who say we're too pessimistic, and yet the economy in the first half of this year, the U.S. economy has been surprisingly solid and chugged along. So, what do you think is behind that? And why is it wrong to say that the last six months kind of disprove the idea that you need material slowing ahead?
Seth Carpenter: Let's examine the facts. Housing activity actually did fall pretty substantially. If we compare where non-farm payrolls are and if you do any sort of averaging. Over months. Where we are now is actually much less hiring than what we saw six months ago, nine months ago, a year ago, the payrolls report for the month of May notwithstanding. We are seeing some slowing down there. And remember, I just said one of the reasons why we think we're going to get a soft landing is that the economy is still shorthanded. Some of the strength that we're seeing in hiring is making up for the fact that businesses were so cautious to hire in the past. I think the last thing to keep in mind is if we are wrong, if this slowing isn't in train, then the Federal Reserve is just going to have to raise interest rates even more because inflation, although it's coming down, there is a residual amount of inflation that really does need to be, in the Fed's mind, at least squeezed out of the economy by having subpar growth.
Andrew Sheets: I'd like to turn now to the world's second largest economy, China, where there's also a great level of skepticism towards the economy generally, but also our view that the economy will recover in the second half of the year. If you look at commodity prices, Chinese equity prices, China's currency, there's been a lot of weakness across the board. So, what do you think has been going on? Why do you think the data has softened more recently and why is that not the right thing to extrapolate going forward for China growth?
Seth Carpenter: Absolutely. All the asset prices that you point to, all of the market trades that people were looking to for a strong China recovery. Boy, they were a little bit disappointing. But the reason I think they were disappointing in general is because it was a different kind of expansion, so much domestic spending, so much on services. People were very much accustomed to looking at a Chinese surge coming from investment spending, infrastructure spending, housing spending, and most of the spending was elsewhere. So I think that's the first part of the puzzle. The second part of the puzzle, though, is Q2 legitimately has had a notable slowdown. Does that mean the whole China reopening story is derailed? I don't think so, and I don't think so for a few reasons. One, we are still seeing the spending on consumer services. So that's important. Second, we think what the government is planning on doing is topping up growth to make sure that the unemployment rate, especially among young people, continues to come down. And so it'll set us up for a strong second half of the year.
Andrew Sheets: I'd like to ask you next about inflation. You know, I think something that's so fascinating about this year is if you were sitting there in early January, there was a real temptation, I think, by the market to think, 2023 was supposed to be the year where inflation is coming down. Yet inflation has been kind of surprisingly high this year. So if you think about our inflation forecasts, which do have inflation moderating throughout this year and into next year, what do you think is the more dominant part of that story that investors should be mindful of? Is it that inflation's falling? Is it that core inflation is still uncomfortably high? Is it a bit of both?
Seth Carpenter: How about if I say absolutely all of the above? The inflation forecasting since COVID has been one of the most challenging parts of this job, I have to admit. So what is going on? Headline measures of inflation. So including food and energy prices that people like to strip out because it can be volatile, those are unquestionably off their peak and have come down a lot, not surprisingly, because oil prices, natural gas prices had spiked so much and those have backed off. But even looking at the core measures, as you say, we are seeing that core inflation has peaked in the U.S. and the euro area, sort of the major developed market economies where, you know, markets are focused and we are seeing things come down. And in particular, if you look in the United States, inflation on consumer goods, if you average over the past six months or so, has been about zero or negative. So went from very high inflation down to zero and for a few of those months, outright negative inflation. So I think it's impossible to say that we haven't seen a shift in terms of inflation.
Andrew Sheets: And for monetary policy, what do you think that means? If we think about the big central banks, the Fed, the European Central Bank, the Bank of Japan, what do you think this inflation backdrop means for monetary policy, looking forward?
Seth Carpenter: So for the Federal Reserve in the U.S. and the European Central Bank in the euro area, very, very similar. Different a little bit in terms of the specific numbers, the specific timing. But the strategy is the same, which is to raise policy rates to the point where they feel confident that they’re exerting restraint on the economy and allow inflation to come down over the course of another year or two years. In the United States, for example, you know, our baseline view is that the Fed did its last rate hike at the May meeting. The market is debating with itself as to whether or not the Fed is done. But, you know, the idea is make sure rates are in a way restrictive and then stay there for as long as needed to ensure that you get that downward trajectory in inflation and then only very gradually start to lower the policy rate as inflation comes down and looks like it's very clearly going back to target. In the euro area, same answer. Qualitatively, we're not convinced they're quite done raising rates. We think they probably have two more policy meetings where they raise their policy rate 25 basis points at each meeting. But then staying at that peak rate for an extended period of time and then gradually letting the policy rate come back down as the economy slows. Now, you mentioned Japan. And Japan, in our view, is really a bit different. When we think about the underlying, the trend inflation. We think that is about to peak now and come back down and in fact get below their 2% inflation target.
Andrew Sheets: Very interesting. Seth, thanks for taking the time to talk.
Seth Carpenter: Andrew, it is always a pleasure for me to get to talk to you.
Andrew Sheets: And thanks for listening. Be sure to tune in for part two of this episode where Seth and I will discuss Morgan Stanley's mid-year strategy Outlook. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
On the heels of Congress’s raising the debt ceiling, markets are wondering: What’s next from D.C.? Here are three things we’re watching.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about what we're watching in Washington, D.C.. It's Wednesday, June 7th at 3 p.m. in New York.
Now that the debt ceiling has been raised and the risk of a U.S. default is behind us for quite some time, it begs the question, what could come next out of Washington, D.C. that markets need to care about? While there's nothing definitively impactful on the horizon from our perspective, here's three things we're watching.
First, we continue to expect that, any day, the White House could announce new restrictions on outbound investments towards China. If this were to occur, its scope would matter greatly. Limited restrictions might not matter, but wide ranging restrictions could seriously interrupt foreign direct investment into China at a time when investors are asking questions about the sustainability of China's economic recovery in light of some recent weak data.
Second, we have to keep an eye on the emerging discussion around AI regulation. To be clear, there don't yet appear to be any well-formed views by either party on how regulation should develop. So Congress is likely far from action. But the shape of any eventual action will likely determine which use cases for AI will be permitted. So paying attention to these emerging debates will be important.
Finally, candidates for president in the 2024 U.S. election have started to emerge. This has stoked questions about potential looming changes in policies that matter to markets. This includes tax policy, where key corporate and personal tax changes are set to expire starting in 2025, making the outcome of the election potentially impactful to corporate margins and therefore equity and credit markets. This certainly bears watching and we'll be investing substantial time in researching this topic in the coming months. But we caution that it's far too early to draw any conclusions about the likelihood of election outcomes and resulting policy paths. So in our view, it's still just a bit too early to impact markets.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague. Or leave us a review on Apple Podcasts. It helps more people find the show.
Consumers in the U.S. are largely returning to pre-COVID spending levels, but new behaviors related to travel, credit availability and inflation have emerged.
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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley U.S. Equity Strategy Team.
Sarah Wolfe: And I'm Sarah Wolfe from the U.S. Economics Team.
Michelle Weaver: On this special episode of the podcast, we're taking a look at the state of the U.S. consumer as we approach the midyear mark. It's Tuesday, June 6th at 10 a.m. in New York.
Michelle Weaver: In order to talk about where the consumer is right now, let's take it back two and a half years. It's January 2021, and households are slowly emerging from their COVID hibernations, but we're still months away from the broad distribution of the vaccine. Consumers are allocating 5% more of their wallet share to goods than before COVID, driving record consumption of electronics, home furnishings, sporting goods and recreational vehicles. All the things you needed to make staying at home a little bit better. Our U.S. economists at Morgan Stanley made a high conviction call in early 2021 that vaccine distribution would flip the script and drive a surge in services spending and a payback in goods spending. Sara, to what extent has this reversion played out and where do you think the U.S. consumer is now?
Sarah Wolfe: The reversion is definitely played out, but there's been some big surprises. Basically, the spending pie has just been greater overall than expected, and that's thanks to unprecedented fiscal stimulus, excess savings and significant supply shortages. So we've not only seen a shift away from goods and toward services, but a much larger spending pie overall. The result has been a 13% surge in goods inflation over nearly three years, an acceleration in services inflation, and a return to pre-COVID spending habits that's much greater in real spending terms than in nominal terms. So if we look in the details, where has the payback been the largest? We've seen the biggest payback in home furnishing, home equipment, jewelry, watches, recreational vehicles, but we've seen the most robust recovery in discretionary services like dining out, going to a hotel, public transportation and recreational services.
Michelle Weaver: Sara, has the recent turmoil in the banking sector affected the U.S. consumer and do you think there's a credit crunch going on right now?
Sarah Wolfe: Bank funding costs have risen meaningfully and are expected to rise further, leading to tighter lending standards, slower loan growth and wider loan spreads. But let me be clear, this is not a credit crunch, nor do we expect it to be. We think about the pass through from tighter lending standards to the consumer to ways directly and indirectly. The direct channel is tighter lending standards for loans on consumer products, including credit cards and autos, and indirectly through tighter lending standards for businesses, which has knock-on effects for job growth. We've already seen the direct channel of consumer spending in the past year, as interest rates on new consumer loan products hit 20 to 30-year highs, raising overall debt service costs and forcing consumers to reduce purchases of interest sensitive goods. Dwindling supply of credit as banks tighten lending standards is also dampening consumption.
Michelle Weaver: Great. And given that credit is getting a little bit tougher to come by, can you tell us what's happening with savings and what's happening with the labor market and labor income?
Sarah Wolfe: This is very timely. Just a few days ago, we got a very strong jobs report for May. I think that this really supports our call for a soft landing, and even though consumers are increasingly worried about the economic outlook, about financial prospects, it's clear that we still have momentum in the economy and that the Fed can achieve its 2% inflation target without driving the unemployment rate significantly higher. We are seeing under the details that consumer spending is slowing, there's a pullback in discretionary happening, there's a bit of trade down behavior. But with the labor market remaining robust, it's going to keep spending afloat and prevent this hard landing scenario. Michelle, let me turn it to you now, let's drill down into some specifics. What are the latest spending trends around spending plans you're seeing in your consumer survey?
Michelle Weaver: Sure. So consumers expect to pull back on spending for most categories that we asked them about over the next six months. And the only categories where they expect to spend more are necessities like groceries and household products. We also added two new questions to this round of the survey to figure out which discretionary categories are most at risk of a pullback in spending. We asked consumers to order categories based on spending priority and identify categories where they would pull back on spending if forced to reduce household expenses. We found that travel and live entertainment were most at risk of a pull back, and this isn't just a case of income groups having different attitudes towards spending, we saw similar prioritization across income cohorts.
Sarah Wolfe: So you mentioned travel, travel's been in a boom state in the post-COVID world. But you're saying now that households are reporting that they would pull back if they needed to. Are we seeing that already? What do we expect for summer travel? What do we expect for the remainder of the year?
Michelle Weaver: So the data I was just referencing was if you had to reduce your household expenses, how would you do it? And travel was identified there. So that's not a plan that's currently in place. But summer travel may be a bit softer this year versus last year. In our survey, we asked consumers if they're planning to travel more, the same amount or less than last summer, and we found that a greater proportion of consumers are planning to travel less this year. Budgets are also smaller for summer travel this year, with more than a third of consumers expecting to spend less. We're seeing a mixed picture from the company side. Airlines are seeing very strong results still, and Memorial Day weekend proved to be very strong.. But the data around hotels has started to weaken and the revenue per available room that hotels have been able to generate has been pretty choppy and forward bookings that hotels are seeing have actually been flat to down for the summer. Demand for resorts and economy hotels has fallen but demand for urban market hotels still remained very strong. Sarah, how does this deceleration, both services and goods growth play into your team's long standing argument for a soft landing for the economy?
Sarah Wolfe: It's really the key to inflation coming down and avoiding a hard landing. With less pent up demand left for services spending and a strong labor market recovery, supply demand imbalances in the services sector are slowly resolving themselves. We estimate that there's a point three percentage point pass through from services wages to core core services inflation throughout any given year. Core core services, is services excluding housing inflation. So with compensation for services providing industries already decelerating for the past five quarters, we do expect the largest impact of core services inflation to occur in the back half of this year. So that's going to see a more meaningful step down in inflationary pressures later this year. This combined with a rising savings rate, so a shrinking spending pie, means that there's just going to be less demand for goods and services together this year. Altogether, it will enable the Fed to make progress towards its 2% inflation target without driving the economy into a recession.
Michelle Weaver: Sarah, thank you for taking the time to talk.
Sarah Wolfe: It was great speaking with you, Michelle.
Michelle Weaver: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Original Release on May 11th, 2023: While personal computer sales were on the decline before the pandemic, signs are pointing to an upcoming boost.
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Welcome to Thoughts on the Market. I'm Erik Woodring. Morgan Stanley's U.S. IT Hardware Analyst. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss why we're getting bullish on the personal computer space. It's Thursday, May 11th, at 10 a.m. in New York.
PC purchases soared during COVID, but PCs have since gone through a once in a three decades type of down cycle following the pandemic boom. Starting in the second half of 2021, record pandemic driven demand reversed, and this impacted both consumer and commercial PC shipments. Consequently, the PC total addressable market has contracted sharply, marking two consecutive double digit year-over-year declines for the first time since at least 1995.
But after a challenging 18 months or so, we believe it's time to be more bullish on PCs. The light at the end of the tunnel seems to be getting brighter as it looks like the PC market bottomed in the first quarter of 2023.
Before I get into our outlook, it's important to note that PCs have historically been a low growth or no growth category. In fact, if you go back to 2014, there was only one year before the pandemic when PCs actually grew year-over-year, and that was 2019, at just 3%. Despite PCs' low growth track record and the recent demand reversal, our analysis suggests the PC addressable market can be structurally higher post-COVID. So at face value, we're making a bit of a contrarian bullish call.
This more structural call is based on two key points. First, we estimate that the PC installed base, or the number of pieces that are active today, is about 15% larger than pre-COVID, even excluding low end consumer devices that were added during the early days of the pandemic that are less likely to be upgraded going forward.
Second, if you assume that users replace their PCs every four years, which is the five year pre-COVID average, that about 65% of the current PC installed base or roughly 760 million units is going to be due for a refresh in 2024 and 2025. This should coincide with the Windows 10 End of Life Catalyst expected in October 25 and the 1 to 3 year anniversary of generative A.I. entering the mainstream, both which have the potential to unlock replacement demand for more powerful machines. Combining these factors, we estimate that PC shipments can grow at a 4% compound annual growth rate over the next three years. Again, in the three years prior to COVID, that growth rate was about 1%. So we think that PCs can grow faster than pre-COVID and that the annual run rate of PC shipments will be larger than pre-COVID.
Importantly though, what drives our bullish outlook is not the consumer, as consumers have a fairly irregular upgrade pattern, especially post-pandemic. We think the replacements and upgrades in 2024 and 2025, will come from the commercial market with 70% of our 2024 PC shipment growth coming from commercial entities. Commercial entities are much more regular when it comes to upgrades and they need greater memory capacity and compute power to handle their ever expanding workloads, especially as we think about the potential for A.I. workloads at the edge.
To sum up, we're making a somewhat contrarian call on the PC market rebound today, arguing that one key was the bottom and that PC companies should outperform in the next 12 months following this bottom. But then beyond 2023, we are making a largely commercial PC call, not necessarily a consumer PC call, and believe that PCs have brighter days ahead, relative to the three years prior to the pandemic.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While 2022 saw the fastest pace of policy tightening on record, has the Fed’s hiking cycle properly set the U.S. economy up for a soft landing in 2023?
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Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss our 2023 outlook for the U.S. economy. It's Friday, December 2nd, at 10 a.m. in New York.
Let's start with the Fed and the role higher interest rates play in the overall growth outlook. The Fed has delivered the fastest pace of policy tightening on record and now feels comfortable to begin slowing the pace of interest rate increases. We expect it to step down the pace to 50 basis points at its meeting later this month and then deliver a final hike in January to a peak rate of between 4.5 and 4.75%. But in order to keep inflation on a downward trajectory, the Fed will likely keep rates at that peak level for most of next year. This shift to a more cautious stance from the Fed we think will help the U.S. economy narrowly miss recession in 2023. And we think only in the back half of 2024 will the pace of growth pick back up as the Fed gradually reduces the policy rate back toward neutral, which is around 2.5%. Altogether, we forecast 2023 GDP growth of just 0.3% before rebounding modestly to 1.4% in 2024.
One bright spot in the outlook is that inflation seems to have reached a turning point. Mounting evidence points to a slowing in housing prices and rents, though they continue to drive above target inflation. Core goods inflation should turn to disinflation as supply chains normalize and demand shifts to services and away from goods. Used vehicle prices are a big contributor to lower overall inflation in our forecast, as our motor vehicle analysts believe that used car prices could be down as much as 10 to 20% next year. So overall, we expect core PCE - or personal consumption expenditures inflation - to slow from 5% this year, to 2.9% in 2023, and further to 2.4% in 2024.
Throughout 2022, rising interest rates have raised borrowing costs, which has weighed on consumption. And we expect that to continue into 2023 as the cumulative effects of past policy hikes continue to flow through to households. On the income side, we expect a rebound in real disposable income growth in 23, because inflation pressures abate while job growth continues to be positive. So if I put those together, slower consumption and rising incomes should lift the savings rate from 3.2% this year, to 5.1% in 2023, and 6.2% in 2024. So households will start to rebuild that cushion.
Now we're in the midst of a sharp housing correction, and we expect a double digit decline in residential investment to continue. But we don't expect a commensurate drop in home valuations. Our housing strategies predict just a 4% drop in national home prices in 2023, and further price declines are likely in the years ahead, but that's a much milder drop in home valuations compared with the magnitude of the drop off in housing activity. So we think that residential wealth, real estate wealth will continue to be a strong backdrop for household balance sheets. Now going forward, mortgage rates will start to fall again after reaching these peaks around 7%. And with healthy job gains, and that increase in real disposable income growth affordability should begin to ease somewhat, we think starting in the back half of 2024.
Turning to the labor market, while signs of falling inflation is important to the Fed, so are signs that the labor market is softening and we expect softer demand for labor and further labor supply gains to create the slack in the labor market the Fed is looking for. So we expect job growth will likely fall below the replacement rate by the second quarter of 2023, pushing up the unemployment rate to 4.3% by the end of next year and 4.4% by the end of 2024.
In sum, we think the U.S. economy is at a turning point, but not a turning point toward recession, a turning point toward what is likely to prove to be two sluggish years of growth in the economy. The Fed's hiking cycle is working as it should. The labor market is softening. The inflation rate is coming down. And we think that puts the U.S. economy on track for a soft landing in 2023.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
As Asia and Emerging Markets move from a year of major adjustment in 2022 towards a less daunting 2023, investors may want to change their approach for the beginning of a new bull market.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, in this episode on our 2023 outlook, I'll focus on why we recently turned more bullish on our coverage. It's Thursday, 1st of December at 8 a.m. in Singapore.
2022 was a year of major adjustment, with accelerating geopolitical shifts towards a multipolar world, alongside macro volatility caused by a surge in developed markets inflation, and the sharpest Fed tightening cycle since the Paul Volcker era 40 years ago. This took the U.S. dollar back to early 1980s peaks in real terms, and global equities fell sharply, with most markets down by double digit percentages. North Asian markets performed worse as a slowdown in tech spending, and persistently weak growth in China, weighed on market sentiment. But structural improvement in macro stability and governance frameworks was rewarded for Japan equities, as well as markets in Brazil, India and Indonesia.
Our 2023 global macro outlook paints a much less daunting picture for equity markets, despite a slower overall GDP growth profile globally than in 2022. Current market concerns are anchored on inflation and that central banks will keep hiking until the cycle ends with a deep recession, a financial accident en route, or perhaps worse - that they leave the job half done. But, and crucially, our economists forecast that U.S. core PCE inflation will fall to 2.5% annualized in the second half of next year. Alongside slowing labor market indicators, our team sees January as the last Fed hike, with rates cuts coming as soon as the fourth quarter of 2023, down to a rate of 2.375% at the end of 2024.
Meanwhile, inflation pressures in Asia remain more subdued than elsewhere. This top down outlook of growth, inflation and interest rates all declining in the U.S. and continued reasonable growth and inflation patterns in Asia should lead to a weaker trend in the U.S. dollar, which tends to be associated with better performance from Asia and emerging market equities.
Meanwhile, for the China economy, we think a gradual easing of COVID restrictions and credit constraints on the property sector deliver a cyclical recovery, which drives growth reacceleration from 3.2% in 2022 to 5.0% in 2023. Consumer discretionary spending, which is well represented in the offshore China equity markets, should show the greatest upturn year on year as 2023 progresses. Crucially, this means that we expect corporate return on equity in China, which has declined in both absolute and relative terms in recent years, to pick up on a sustained basis from the current depressed level of 9.5%.
We also think that end market weakness in semiconductors and technology spending, consequent upon the reversal of the COVID era boom, should gradually abate. Our technology and hardware teams expect PC and server end markets to trough in the fourth quarter of this year, whereas smartphone has already bottomed in the third quarter. They recommend looking beyond the near-term weakness to recognize upside risks, with valuations for the sector now at prior market troughs and the current pain and fundamentals priced in by recent earnings estimates downgrades in our view. We therefore upgraded Korea and Taiwan and the overall Asia technology sector in early October and expect these parts of our coverage to lead the new bull market into 2023.
Finally, given greater GDP growth resilience and less sector exposure to global downturns, Southeast Asian markets such as Singapore, Malaysia, Indonesia and Thailand, collectively ASEAN, tend to outperform emerging markets in Asia during bear markets, but underperform in bull markets given their low beta nature. Having seen a sharp spike in ASEAN versus Asia, relative performance in the prior bear market, which we think is now ending, our view is that the trend should reverse from here.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.
As China tries to smooth out its COVID caseload, investors should take note of the impacts those COVID policies have on global economies and key markets.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, November 30th, at 11 a.m. in New York.
Investors remain intently focused on China's COVID policies, as the tightening and loosening of travel and quarantine policies has implications for key drivers of markets. Namely the outlook for global inflation, monetary policy and global growth. We're paying close attention, and here's what we think you need to know.
Importantly, our China economics team thinks that China's restrictive COVID zero policy will be a thing of the past come spring of 2023, but there will be many fits and starts along the way. Increased vaccination, availability of medical treatment and public messaging about the lessening of COVID dangers will be signposts for a full reopening of China, but we should expect episodic returns to restrictions in the meantime as China tries to smooth out its COVID caseload.
This dynamic is important to understand for its implications to the outlook for the global economy and key markets. For example, the economic growth story for Asia should be weak in the near term, but begin to improve and outperform the rest of the world from the second quarter of 2023 through the balance of the year. In the U.S., the reopening of the China economy should help ease inflation as the supply of core goods picks up with supply chains running more smoothly. This, in turn, supports the notion that the Fed will be able to slow and eventually pause its rate hikes in 2023, even if headline inflation sees a rebound via higher gas prices from higher China demand for oil. And where might this overall economic dynamic be most visible to investors? Look to the foreign exchange markets. China's currency should relatively benefit, particularly if reopening leads investors back to its equity markets. The U.S. dollar, however, should peak, as the Fed approaches pausing its interest rate hikes and, accordingly, ceasing the increase in the interest rate advantage for holding U.S. dollar assets versus the rest of the world.
Of course, the evolution of the COVID pandemic has been anything but straightforward. So we'll keep monitoring the situation with China and adjust our market views as needed.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Traditional ESG investing strategies highlight companies with top scores across ESG metrics, but new research shows value in focusing instead on those companies who have a higher rate of change as they improve their ESG metrics.
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Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research. Along with my colleagues, bringing you a variety of perspectives, today I'll focus on our new approach to identifying opportunities that can generate both Alpha and ESG impact. It's Tuesday, November 29th, at 10 a.m. in New York.
On previous episodes of this podcast we've discussed how, although sustainable investing has been a trend over the past decade, it has faced significant pushback from critics arguing that ESG strategies - or environmental, social and governance - sacrifice long term returns in favor of the pursuit of certain ESG objectives. We have done some new work here at Morgan Stanley, suggesting that it is possible to identify opportunities that can deliver excess returns, or alpha, and make an ESG impact.
Our research found that what we call "ESG rate of change", companies that are leaders on improving ESG metrics, should be a critical focus for investors looking to identify companies that meet both criteria. What do we mean by "ESG rate of change"? Traditional ESG screens focus on "ESG best-in-class" metrics. That is, companies that are already scoring well on sustainability factors. But there is a case to be made for companies that are making significant improvements. For example, we find that there are companies using innovative technologies that can reduce costs and improve efficiency. These companies, which we call deflation enablers, generally screen very favorably on a range of ESG metrics and are reaping the financial benefits of improved efficiency. A surprisingly broad range of technologies are dropping in cost to such an extent that they offer significant net benefits, both financial and ESG oriented. Some examples of such technologies are very cheap solar, wind and clean hydrogen, energy storage cost reductions, cheaper carbon capture, improved molecular plastics recycling, more efficient electric motors, a wide range of recycling technologies, and a range of increasingly inexpensive waste to energy technology.
To get even more specific, as we look at these various technologies and the sectors they touch, we think the utility sector is arguably the most advantaged among the carbon heavy sectors in terms of its ESG potential. Why is that? Because many utilities have the potential to create an "everybody wins" outcome in which customer bills are lower, CO2 emissions are reduced, and utility earnings per share growth is enhanced. This is a rare combination. In the U.S. utility sector many management teams are shutting down expensive coal fired power plants and building renewables, energy storage and transmission, which achieve superior earnings per share growth. Many of these stocks would screen negatively on classic ESG metrics such as carbon intensity, but these ESG improvers may be positioned to deliver superior stock returns and play a critical role in the transition to clean energy.
As with most things, applying this new strategy we're proposing isn't simply a matter of looking at companies with improving ESG metrics. It's about really understanding what's driving these changes. Here's where sector specific expertise is key. In fact, we believe that in the absence of fundamental insight, ESG criteria can be misapplied and could lead to unintended outcomes. The potential for enhanced performance, in our view, comes from a true marriage of ESG investing principles and deep sector expertise.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
As we head into a new year, Europe faces multiple challenges across inflation, energy and financial conditions, meaning investors will want to keep an eye on recession risk, the ECB, and European equities. Chief European Equity Strategist Graham Secker and Chief European economist Jens Eisenschmidt discuss.
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Graham Secker Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist.
Jens Eisenschmidt And I'm Jens Eisenschmidt, Morgan Stanley's Chief European Economist.
Graham Secker And on this special episode of the podcast, we'll discuss our 2023 outlook for Europe's economy and equity market, and what investors should pay close attention to next year. It's Monday, November the 28th, at 3 p.m. in London.
Graham Secker So Jens, Europe faces multiple challenges right now. Inflation is soaring, energy supply is uncertain, and financial conditions are tightening. This very tricky environment has already impacted the economy of the euro area, but is Europe headed into a recession? And what is your growth outlook for the year ahead?
Jens Eisenschmidt So yes, we do see a recession coming. In year-on-year terms we see negative growth of minus 0.2% next year. There's heterogeneity behind that, Germany is most affected of the large countries, Spain is least affected. In general, the drivers are that you mentioned, we have inflation that eats into real disposable income that is bad for consumption. We have the energy situation, which is highly uncertain, which is not great for investment. And we do have monetary policy that's starting to get restrictive, leading to a tightening in financial conditions which is actually already priced into markets. And, you know, that's the transmission lack of monetary policy. So that leads to lower growth predominantly in 23 and 24.
Graham Secker And maybe just to drill into the inflation side of that a little bit more. Specifically, do you expect inflation to rise further from here? And then when you look into the next 12 months, what are the key drivers of your inflation profile?
Jens Eisenschmidt So inflation will rise, according to our forecast, a little bit further, but not by an awful lot. We really see it peaking in December on headline terms. Just to remind you, we had an increase to 10.7 in October that was predominantly driven by energy and food inflation, so around 70% of that was energy and food. And of course, it's natural to look into these two components to see what's going to happen in the future. Here we think food inflation probably has still some time to go because there is some delayed response to the input prices that have peaked already at some point past this year. But energy is probably flat from here or maybe even slightly falling, which then gets you some base effects which will lead and are the main driver of our forecast for a lower headline inflation in the next year. Core inflation will be probably more sticky. We see 4% this year and 4% next. And here again, we have these processes like food inflation, services inflation that react with some lag to input prices coming down. So, it will take some time. Further out in the profile, we do see core inflation remaining above 2% simply because there will be a wage catch up process.
Graham Secker And with that core inflation profile, what does that mean for the ECB? What are your forecasts for the ECB's monetary policy path from here?
Jens Eisenschmidt We really think that the ECB needs to have seen the peak in inflation, and that's probably you're right, both core and headline. We see a peak, as I said, in December, core similarly, but at a high level and, you know, convincingly only coming down afterwards. So, the ECB will have to see it in the rear mirror and be very, very clear that inflation now is really falling before they can stop their rate hike cycle, which we think will be April. So, we see another 50 basis point increase in December 25, 25 in February, in March for the ECB then to really stop its hiking cycle in April having reached 2.5% on the deposit facility rate, which is already in restrictive territory. So, Graham, turning to you, bearing in mind all that just said about the macro backdrop, how will it impact European equities both near-term and longer term?
Graham Secker Having been bearish on European equities for much of this year, at the beginning of October we shifted to a more neutral stance on European equities specifically. But we've had pretty strong rally over the course of the last couple of months, which sets us up, we think, for some downside into the first quarter of next year. In my mind, I really have the profile that we saw in 2008, 2009 around the global financial crisis. Then equity valuations, the price to earnings ratio troughed in October a weight, the market rallies for a couple of months, but then as the earnings downgrades kicked in the start of 2009, the actual index itself went back down to the lows. So, it was driven by earnings and that's what we can see happening again now. So perhaps Europe's PE ratio troughed at the end of September. But once the earnings downgrades start in earnest, which we think probably happens early in 2023, we can see that taking European equities back down towards the lows again. On a 12-month view from here we see limited upside. We have 1-2% upside to our index target by the end of next year. But obviously, hopefully if we do get that correction in the first quarter, then there'll be more to play for. We just got a time entry point.
Jens Eisenschmidt Right. So how should I, as an investor, be positioned then in the year ahead?
Graham Secker From a sector perspective, we would be underweight cyclicals. We think European earnings next year will fall by about 10% and we think cyclicals will be the key area of earnings disappointment. So, we want to be underweight the cyclicals until we get much closer to the economic and earnings trough. Having been positive on defensives for much of this year, we've recently moved them to neutral. We've upgraded the European tech sector, the medtech sector, and also luxury goods as well.
Jens Eisenschmidt So what are the biggest risks then to your outlook for 23, both on the positive and the negative side?
Graham Secker So on the positive side, I'd highlight two. Firstly, we have the proverbial soft landing when it comes to the economic backdrop, whether that's European and or global. That would be particularly helpful for equities, if that was accompanied by a bigger downward surprise on inflation. So, if inflation falls more quickly and growth holds up, that would be pretty positive for equity markets. A second positive would be any form of geopolitical de-escalation that would be very helpful for European risk appetites. And then on the negative side, the first one would be a bigger profit recession. If earnings do fall 10% next year, which is our projection, that would be very mild in the context of previous downturns. So in our base case, we see European earnings falling 20%, not the 10% decline that we see in that base case. The other negatives that I think a little bit about is whether or not what we've seen in the UK over the last couple of months could happen elsewhere. I.e., interest rates start to put more and more pressure on government finances and budget deficits, and we start to see a shift in that environment. So that could be something that could weigh on markets next year as well.
Graham Secker But, Jens, thanks for taking the time to talk today.
Jens Eisenschmidt Great speaking with you, Graham.
Graham Secker And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
As we enter the holiday shopping season, the challenges facing consumers and retailers look quite different from 2021, so how will inflation and high inventory impact profit margins?
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Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley's U.S. Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss our outlook for holiday spending in the U.S. It's Friday, November 25th, at 1 p.m. in New York.
With the holiday shopping season just around the corner, we collaborated with the Morgan Stanley U.S. economics team and several of the consumer teams, namely airlines, consumer goods, e-commerce and electronics, to analyze our consumer survey data around holiday spending. The big takeaway is that this year's holiday shopping season is going to be quite different from the one we had last year.
In 2021, we saw major supply chain malfunctions that impacted inventories and caused shoppers to start buying much earlier in the season. Limited supplies also gave companies a lot of pricing power, and this year the situation looks like it is shaping up to be the exact opposite. High inventory levels should push stores to offer discounts as they attempt to clear merchandise off shelves. Companies offering the biggest discounts will be able to grab the largest wallet share, but this will likely be a hit to their profit margins.
Additionally, inflation has weighed heavily on consumers throughout the year, and it remains their number one concern heading into the holiday shopping season. This year, we're likely to see a very bargain savvy consumer. Our survey showed that 70% of shoppers are waiting for stores to offer discounts before they begin their holiday shopping, and the majority are waiting to see deals in excess of 20%. Additionally, consumers are likely to be more price sensitive this year. About a third of consumers said they would buy a lot less gifts and holiday products if stores raise prices.
U.S. consumers are largely expecting to spend about the same amount on holiday gifts and products this year versus last year. So retailers will be competing for a similarly sized pool of revenue as last year, and will have to offer competitive prices to get shoppers to choose their products. This creates a really tough environment for profit margins.
We also asked consumers specifically if they are planning to spend more or less this year in a variety of popular gift areas. The biggest spending declines are expected for luxury gifts, sports equipment, home and kitchen and electronics, all areas where we saw overconsumption during lockdown.
Looking at the industry implications, services are expected to hold up better than goods overall. Department stores and specialty retailers, consumer durable goods, large volume retailers and tech hardware are all likely to face a more challenging season. On the other hand, demand for travel and flights remains very strong, and the Morgan Stanley transportation team remains bullish on the U.S. airlines overall, as they believe travel interest remains resilient despite consumer and macro fears.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While the recent meeting between U.S. President Biden and China’s President Xi has signaled near term stability for the relationship between the two countries, investors will need to understand what this means for future economic disconnection.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, November 23rd, at 10 a.m. in New York.
Last week, many of my colleagues and I were in Singapore meeting with clients for Morgan Stanley's annual Asia Pacific Summit. Top of mind for many was the recent meeting between U.S. President Biden and China's President Xi. In particular, there was much Thanksgiving that the two sides seemed to agree on a few points that would create some near-term stability in the relationship. But we caution investors not to read more into their meeting beyond that, and accordingly continue to prepare for a multipolar world where the U.S. and China disassociate in key economic areas.
True, there were statements of respect for each other's position on Taiwan, a return to key policy dialogs, and a recognition on both sides of the importance of the bilateral relationship to the well-being of the wider world. But that doesn't mean the two sides found a way to remain interconnected economically. Rather, it just signals that economic disconnection may be orderly and spread out as opposed to disorderly and quick. Look beyond the soothing statements from the meeting, and you see policies on both sides showing work toward economic disconnection with industrial policies and trade barriers aimed at creating separate economic and technological ecosystems. An orderly transition to this state may be costly, but it need not be disruptive.
This dynamic still leaves plenty of cross-currents for markets. It's good news overall for the macroeconomic outlook as it takes a potential growth shock off the table. It's also good for key geographies that will benefit from investment towards supply chain realignment, such as Mexico, as we recently highlighted in collaborative research with our Mexico strategist. But it poses challenges for companies that will be compelled to take on higher labor and CapEx costs as the U.S. seeks distance from China on key technologies. Semiconductors have been and will continue to be a key space to watch as the sector incrementally shifts production to higher cost areas in order to comply with U.S. regulatory demands.
So bottom line, we should all feel a bit better about the outlook for markets following the Biden/Xi meeting, but just a bit. The U.S.-China relationship isn't going back to its inter-connected past, and the cost of disconnecting in key areas is sure to hurt some investments and help others.
With Thanksgiving this week, I want to take a moment to thank you, our listeners, for sharing this podcast with your friends and colleagues. As we pass another exciting milestone of 1 million downloads in a single month, we hope you continue to tune in to thoughts on the market as we navigate our ever changing world. Happy Thanksgiving from all of us here at Morgan Stanley.
The year ahead outlook is a process of collaboration between strategists and economists from across the firm, so what were analysts debating when thinking about 2023, and how were those debates resolved? Chief Cross-Asset Strategist Andrew Sheets and Head of Fixed Income Research Vishy Tirupattur discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset Strategist.
Vishy Tirupattur: And I am Vishy Tirupattur, Morgan Stanley's Head of Fixed Income Research.
Andrew Sheets: And on this special episode of the podcast, we'll be discussing some of the key debates underpinning Morgan Stanley's 2023 year ahead outlook. It's Tuesday, November 22nd at 3 p.m. in London.
Vishy Tirupattur: And 10 a.m. in New York.
Andrew Sheets: So Vishy, within Morgan Stanley research we collaborate a lot, but I think it's not an exaggeration to say that when we sit down to write our year ahead outlooks for strategy and economics, it's probably one of the most collaborative exercises that we do. Part of that is some pretty intense debate. So that's what I was hoping to talk to you about, kind of give listeners some insight into what are the types of things that Morgan Stanley research analysts were debating when thinking about 2023 and how we resolved some of those issues. And I think maybe the best place to start is just this question of inflation, right? Inflation was the big surprise of 2022. We underestimated it. A lot of forecasters underestimated inflation. As we look into 2023, Morgan Stanley's economists are forecasting inflation to come down. So, how did that debate go? Why do we have conviction that this time inflation really is going to moderate?
Vishy Tirupattur: Thanks, Andrew. And it is absolutely the case that challenging each other's view is critically important and not a surprise that we spent a lot of time on inflation. Given that we have many upside surprises to inflation throughout the year, you know, there was understandable skepticism about the forecasts that US inflation will show a steady decline over the course of 2023. Our economists, clearly, acknowledge the uncertainty associated with it, but they took some comfort in a few things. One in the base effect. Two, normalizing supply chains and weaker labor markets. They also saw that in certain goods, certain core goods, such as autos, for example, they expect to see deflation, not just disinflation. And there's also a factor of medical services, which has a reset in prices that will exert a steady drag on the core inflation. So all said and done, there is significant uncertainty, but there are still clearly some reasons why our economists expect to see inflation decline.
Andrew Sheets: I think that's so interesting because even after we published this outlook, it's fair to say that a lot of investor skepticism has related to this idea that inflation can moderate. And another area where I think when we've been talking to investors there's some disagreement is around the growth outlook, especially for the U.S. economy. You know, we're forecasting what I would describe as a soft landing, i.e., U.S. growth slows but you do not see a U.S. recession next year. A lot of investors do expect a U.S. recession. So why did we take a different view? Why do we think the U.S. economy can kind of avoid this recessionary path?
Vishy Tirupattur: I think the key point here is the U.S. economy slows down quite substantially. It barely skirts recession. So a 0.5% growth expectation for 2023 for the U.S. is not exactly robust growth. I think basically our economists think that the tighter monetary policy will stop tightening incrementally early in 2023, and that will play out in slowing the economy substantially without outright jumping into contraction mode. Although we all agree that there is a considerable uncertainty associated with it.
Andrew Sheets: We've talked a bit about U.S. inflation and U.S. growth. These things have major implications for the U.S. dollar. Again, I think an area that was subject to a lot of debate was our forecast that the dollar's going to decline next year. And so, given that the U.S. is still this outperforming economy, that's avoiding a recession, given that it still offers higher interest rates, why don't we think the dollar does well in that environment?
Vishy Tirupattur: I think the key to this out-of-consensus view on dollar is that the decline in inflation, as our economists forecast and as we just discussed, we think will limit the potential for US rates going much higher. And furthermore, given that the monetary policy is in restrictive territory, we think there is a greater chance that we will see more downside surprises in individual data points. And while this is happening, the outlook for China, right, even though it is still challenging, appears to be shifting in the positive direction. There's a decent chance that the authorities will take steps towards ending the the "zero covid" policy. This would help bring greater balance to the global economy, and that should put less upward pressure on the dollar.
Andrew Sheets: So Vishy, another question that generated quite a bit of debate is that next year you continue to see quantitative tightening from the Fed, the balance sheet of the Federal Reserve is shrinking, it's owning fewer bonds and yet we're also forecasting U.S. bond yields to fall. So how do you square those things? How do you think it's consistent to be forecasting lower bond yields and yet less Federal Reserve support for the bond market?
Vishy Tirupattur: Andrew, there are two important points here. The first one is that when QT ends, really, history is really not much of a guide here. You know, we really have one data point when QT ended, before rate cuts started happening. And the thinking behind our thoughts on QT is that the Fed sees these two policy tools as being independent. And stopping QT depends really on the money market conditions and the bank demand for reserves. And therefore, QT could end either before or after December 2023 when we anticipate normalization of interest rate policy to come into effect. So, the second point is that why we think that the interest rates are going to rally is really related to the expectation of significant slowing in the economic growth. Even though the U.S. economy does not go into a contraction mode, we expect a significant slowing of the U.S. economy to 0.5% GDP growth and the economy growing below potential even into 2024 as the effects of the tighter monetary policy conditions begin to play out in the real economy. So we think the rally in U.S. rates, especially in the longer end, is really a function of this. So I think we need to keep the two policy tools a bit separate as we think about this.
Andrew Sheets: So Vishy, I wanted us to put our credit hats on and talk a little bit about our expectations for default rates. And I think here, ironically, when we've been talking to investors, there's been disagreement on both sides. So, you know, we're forecasting a default rate for the U.S. of around 4-4.5% Next year for high yield, which is about the historical average. And you get some investors who say, that expectation is too cautious and other investors who say, that's too benign. So why is 4-4.5% reasonable and why is it reasonable in the context of those, you know, investor concerns?
Vishy Tirupattur: It's interesting, Andrew, when you expect that some some people will think that the our expectations are too tight and others think that they are too wide and we end up somewhat in the middle of the pack, I think we are getting it right. The key point here is that the the maturity walls really are pretty modest over the next two years. The fundamentals, in terms of coverage ratios, leverage ratio, cash on balance sheets, are certainly pretty decent, which will mitigate near-term default pressures. However, as the economy begins to slow down and the earnings pressures come into play, we will expect to see the market beginning to think about maturity walls in 2025 onwards. All that means is that we will see defaults rise from the extremely low levels that we are at right now to long-term average levels without spiking to the kinds of default rates we have seen in previous economic slowdowns or recessions.
Andrew Sheets: You know, we've had this historic rise in mortgage rates and we're forecasting a really dramatic drop in housing activity. And yet we're not forecasting nearly as a dramatic drop in U.S. home prices. So Vishy, I wanted to put this question to you in two ways. First, how do we justify a much larger decrease in housing activity relative to a more modest decrease in housing prices? And then second, would you consider our housing forecast for prices bullish or bearish relative to the consensus?
Vishy Tirupattur: So, Andrew, the first point is pretty straightforward. You know, as mortgage rates have risen in response to higher interest rates, affordability metrics have dramatically deteriorated. The consequence of this, we think, is a very significant slowing of housing activity in terms of new home sales, housing starts, housing permits, building permits and so on. The decline in those housing activity metrics would be comparable to the kind of decline we saw after the financial crisis. However, to get the prices down anywhere close to the levels we saw in the wake of the financial crisis, we need to see forced sales. Forced sales through foreclosures, etc. that we simply don't expect to see happen in the next few years because the mortgage lending standards after the financial crisis had been significantly tighter. There exists a substantial equity in many homes today. And there's also this lock-in effect, where a large number of current mortgage holders have low mortgage rates locked in. And remember, US mortgages are predominantly fixed rate mortgages. So the takeaway here is that housing activity will drop dramatically, but home prices will drop only modestly. So relative to the rest of the street, our home price forecast is less negative, but I think the key point is that we clearly distinguish between what drives home pricing activity and what drives housing activity in terms of builds and starts and sales, etc.. And that key distinction is the reason why I feel pretty confident about our housing activity forecast and home price forecast.
Andrew Sheets: Vishy, thanks for taking the time to talk.
Vishy Tirupattur: Always a pleasure talking to you, Andrew.
Andrew Sheets: Happy Thanksgiving from all of us at Thoughts on the Market. We have passed yet another exciting milestone: over 1 million downloads in a single month. I wanted to say thank you for continuing to tune in and share the show with your friends and colleagues. It wouldn't be possible without you, our listeners.
While the outlook for 2023 may seem relatively unexciting, investors will want to prepare for a volatile path to get there, and focus on some key inflection points.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 21st, at 11 a.m. in New York. So let's get after it.
Last week, we published our 2023 U.S. equities outlook. In it, we detail the path to our 2023 year end S&P 500 price target of 3900. While the price may seem unexciting relative to where we're currently trading, we think the path will be quite volatile with several key inflection points investors will need to trade to make above average returns next year. The main pushback in focus from investors has centered around the first inflection - the near-term tactical upside call we made about a month ago.
Let's review a few key points of the call as we discuss how the rest of the year may play out. First, the primary tactical driver to our bullish call was simply respecting the 200 week moving average. As noted when we made the call last month, the 200 week moving average does not give way for the S&P 500 until a recession is undeniable. In short, until it is clear we are going to have a full blown labor cycle where the unemployment rate rises by at least 1-1.5%, the S&P 500 will give the benefit of the doubt to the soft landing outcome. A negative payroll release also does the trick.
Second, in addition to the 200 week moving averages key support, falling interest rate volatility led to higher equity valuations that are driving this rally. Much like with the 200 week moving average, though, this factor can provide support for the higher PE's achieved over the past month, but is no longer arguing for further upside. In other words, both the 200 week moving average and the interest rate volatility factors have run their course, in our view.
However, a third factor market breadth has emerged as a best tactical argument for higher prices before the fundamentals take over again. Market breadth has improved materially over the past month. As noted last week, both small caps and the equal weighted S&P 500 have outperformed the market weighted index significantly during this rally. In fact, the equal weighted S&P 500 has been outperforming since last year, while the small caps have been outperforming since May. Importantly, such relative moves by the small caps and average stocks did not prevent the broader market from making a new low this fall. However, the improvement in breadth is a new development, and that indicator does argue for even higher prices in the broader market cap weighted S&P 500 before this rally is complete.
Bottom line tactically bullish calls are difficult to make, especially when they go against one's fundamental view that remains decidedly bearish. When we weigh the tactical evidence, we remain positive for this rally to continue into year end even though the easy money has likely been made. From here, we expect more choppiness and misdirection with respect to what's leading. For example, from the October lows it's been a cyclical, smallcap led rally with the longer duration growth stocks lagging. If this rally is to have further legs, we think it will have to be led by the Nasdaq, which has been the laggard.
In the end, investors should be prepared for volatility to remain both high intraday and day to day with swings in leadership. After all, it's still a bear market, and that means it's not going to get any easier before the fundamentals take over to complete this bear market next year.
As we approach the holiday, I want to say a special thank you to our listeners. We've recently passed an exciting milestone of over 1 million downloads in a single month, and it's all made possible by you tuning in and sharing the podcast with friends and colleagues. Happy Thanksgiving to you and your families.
At the recent 20th Party Congress in China, policy makers made economic growth a top priority, but what are the roadblocks that may be of concern to global investors?
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Welcome to Thoughts on the Market. I'm Robin Xing, Morgan Stanley's Chief China Economist. Along with my colleagues, bringing you a variety of perspectives, today I will discuss the outlook for China after the 20th Party Congress. It's Friday, November 18th, at 8 a.m. in Hong Kong.
China's Communist Party convenes a national Congress every five years to unveil mid to long term policy agenda and reshuffle its leadership. The one concluded two weeks ago marks the 20th Congress since the party's founding in 1921. One of the key takeaways is that economic growth remains the Chinese government's top priority, even as national security and the supply chain self-sufficiency have gained more importance. The top leadership's goal is to grow China to an income level on par with medium developed country by 2035. We think this suggests a per capita GDP target of $20,000, up from $12,000 today, and it would require close to 4% average growth in GDP in the coming decade.
Well, this growth target is achievable, but only with continued policy focus on growth. While China's economy has grown 6.7% a year over the last decade, its potential growth has likely entered a downward trajectory, trending toward 3% at the end of this decade, there is aging of the Chinese population, which is a main structure headwind. That could reduce labor input and the pace of capital accumulation. Meanwhile, productivity growth might also slow as geopolitical tensions increase the trend towards what Morgan Stanley terms slowbalization. The result of which is reduced foreign direct investment, particularly among sectors considered sensitive to national security. In this context, we believe Beijing will remain pragmatic in dealing with geopolitical tensions because of its reliance on key commodities and the fact exports account for a quarter of Chinese employment. So China is very intertwined with global economy and it relies a lot on the access to global market.
Another issue of concern to global investors is China's regulatory reset since 2020 and its impact on the private sector. It seems to have entered a more stable stage. We don't expect major regulatory surprises from here considering that the party Congress didn't identify any new areas with major challenges domestically, except for population aging and the self-sufficiency of supply chain.
As investors adopt a "seeing is believing" mentality towards their long term concerns around China's growth, policy, geopolitics, the more pressing near-term risk remains COVID zero. This is likely the biggest overhang on Chinese economic growth and the news flow around reopening have tended to trigger market volatility. We see rising urgency for an exit from COVID zero in the context of its economic cost, including lower income growth, elevated youth unemployment and even fiscal sustainability risks. We think Beijing will likely aim for a calibrated COVID exit, and the three key signposts are necessary to facilitate a smooth reopening, elderly vaccination, availability of domestic COVID treatment pills and facilities, and continued effort to steer public opinion away from fear of the virus.
Considering it could take 3 to 6 months for the key signposts to play out, we expect a full reopening next spring at the earliest. This underpins our forecast of a modest recovery starting in the second quarter of 2023, led by private consumption. Before a full reopening, we see growth continue to muddle through at the subpar level, sustained mainly by public CapEx.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With risks to both home sales and home prices continuing to challenge the housing market, investors will want to know what is keeping the U.S. housing market from a sharp fall mirroring the great financial crisis? Co-heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.
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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow: And I'm Jay Bacow, the other Co-head of U.S. Securities Products Research.
Jim Egan: And on this episode of the podcast, we'll be discussing our year ahead outlook for the U.S. housing market for 2023. It's Thursday, November 17th, at 1 p.m. in New York.
Jay Bacow: So Jim, it's outlook season. And when we think about the outlook for the housing market, we’re not just looking in 2023, people live in their houses for their whole lives.
Jim Egan: Exactly. We are contemplating what's going to happen to the housing market, not just in 23, but beyond in this year's version of the outlook. But just to remind the listeners, we have talked about this on this podcast in the past, but our view for 2023 hasn't changed all that much. What we think we're going to see is a bifurcation narrative in the housing market between activity, so home sales and housing starts, and home prices. The biggest driver of that bifurcation, affordability. Because of the increase in prices, because of the incredible increase in mortgage rates that we've seen this year, affordability has been deteriorating faster than we've ever seen it. That's going to bring sales down. But the affordability for current homeowners really hasn't changed all that much. We're talking about deterioration for first time homebuyers, for prospective homebuyers. Current homeowners in a lot of instances have locked in very low 30 year fixed rate mortgages. We think they're just incentivized to keep their homes off the market, they're locked into their current mortgage, if you will. That keeps supply down, that also means they're not buying a home on the follow, so it means that sales fall even faster. Sales have outpaced the drop during the great financial crisis. We think that continues through the middle of next year. We think sales ultimately fall 11% next year from an already double digit decrease in 2022 on a year over year basis. But we do think home prices are more protected. We think they only fall 4% year over year next year, but when we look out to 2024, it's that same affordability metric that we really want to be focused on. And, home prices plays a role, but so do mortgage rates. Jay, how are we thinking about the path for mortgage rates into 2024?
Jay Bacow: Right. So obviously the biggest driver of mortgage rates are first where Treasury rates are and then the risk premium between Treasury rates and mortgages. The drive for Treasury rates, among other things, is expectations for Fed policy. And our economists are expecting the Fed to cut rates by 25 basis points in every single meeting in 2024, bringing the Fed rate 200 basis points lower. When you overlay the fact that the yield curve is inverted and our interest rate strategists are expecting the ten year note to fall further in 2023, and risk premia on mortgages is already pretty wide and we think that spread can narrow. We think the mortgage rate to the homeowner can go from a peak of a little over 7% this year to perhaps below 6% by 2024. Jim, that should help affordability right, at least on the margins.
Jim Egan: It should. And that is already playing a role in our sales forecasts and our price forecasts. I mentioned that sales are falling faster than they did during the great financial crisis. We think that that pace of change really inflects in the second half of next year. Not that home sales will increase, we think they'll still fall, they're just going to fall on a more mild or more modest pace. Home prices, the trajectory there also could potentially be more protected in this improved affordability environment because I don't get the sense that inventories are really going to increase with that drop in mortgage rates.
Jay Bacow: Right. And when we look at the distribution of mortgage rates in America right now, it's not uniformly distributed. The average mortgage rate is 3.5%, but right now when we think how many homeowners have at least 25 basis points of incentive to refinance, which is generally the minimum threshold, it rounds to 0.0%. If mortgage rates go down to 4%, about 2.5 points below where they are right now, we're still only at about 10% of the universe has incentive to refinance. So while rates coming down will help, you're not going to get a flood of supply.
Jim Egan: We think that’s important when it comes to just how far home prices can fall here. The lock in effect will still be very prevalent. And we do think that that continues to support home prices, even if they are falling on a year over year basis as we look out beyond 2023 into 2024 and further than that. Now, the biggest pushback we get to this outlook when we talk to market participants is that we're too constructive. People think that home prices can fall further, they think that home prices can fall faster. And one of the reasons that tends to come up in these conversations is some anchoring to the great financial crisis. Home prices fell about 30% from peak to trough, but we think it's important to note that that took over five years to go from that peak to that trough. In this cycle home prices peaked in June 2022, so December of next year is only 18 months forward. The fastest home prices ever fell, or the furthest they ever fell over a 12 month period, 12.7% during the great financial crisis. And that took a lot of distress, forced sellers, defaults and foreclosures to get to that -12.7%. We think that without that distress, because of how robust lending standards have been, the down 4% is a lot more realistic for what we could be over the course of next year. Going further out the narrative that we'll hear pretty frequently is, well, home prices climbed 40% during the pandemic, they can reverse out the entirety of that 40%. And we think that that relies on kind of a faulty premise that in the absence of COVID, if we never had to deal with this pandemic for the past roughly three years, that home prices would have just been flat. If we had this conversation in 2019, we were talking about a lot of demand for shelter, we were talking about a lack of supply of shelter. Not clearly the imbalance that we saw in the aftermath of the pandemic, but those ingredients were still in place for home prices to climb. If we pull trend home price growth from 2015 to 2019, forward to the end of 2023, and compare that to where we expect home prices to be with the decrease that we're already forecasting, the gap between home prices and where that trend price growth implies they should have been, 9%. Till the end of 2024 that gap is only 5%. While home prices can certainly overcorrect to the other side of that trend line, we think that the lack of supply that we're talking about because of the lock in effect, we think that the lack of defaults and foreclosures because of how robust lending standards have been, we do think that that leaves home prices much more protected, doesn't allow for those very big year over year decreases. And we think peak to trough is a lot more control probably in the mid-teens in this cycle.
Jay Bacow: So when we think about the outlook for the U.S. housing market in 2023 and beyond, home sale activity is going to fall. Home prices will come down some, but are protected from the types of falls that we saw during the great financial crisis by the lock in effect and the better outlook for the credit standards in the U.S. housing market now than they were beforehand.
Jay Bacow: Jim, always greatv talking to you.
Jim Egan: Great talking to you, too, Jay.
Jay Bacow: And thank you all for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcasts app, and share the podcast with a friend or colleague today.
In looking ahead to 2023, the big dynamics of this year are poised to shift and investors will want to look for safety amidst the coming uncertainty. Chief Cross Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.
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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's global chief economist.
Andrew Sheets: And I'm Andrew Sheets, Morgan Stanley's chief cross-asset strategist.
Seth Carpenter: And on part two of this special two-part episode of the podcast, we're going to focus on Morgan Stanley's Year Ahead strategy outlook. It's Wednesday, November 16th, at 10 a.m. in New York.
Andrew Sheets: And 3 p.m. in London.
Seth Carpenter: Andrew, on the first part of this, you spent a bunch of time asking me questions about the outlook for the global economy. I'm going to turn the tables on you and start to ask you questions about how investors should be thinking about different asset prices going forward. There really was a big change this year, we came out of last year with big growth, things slowed down, but inflation surprised everyone to the upside. Central banks around the world started hiking rates aggressively. We've seen massive moves in FX markets, especially in the dollar. Things look very, very different. If you were to say, looking forward from here to the next year, what the biggest conviction call you have in terms of asset allocation, what would it be?
Andrew Sheets: Thanks, Seth. It's that high grade bonds do very well. You know, I think this is a backdrop where 2022 was defined by surprisingly resilient growth, surprisingly high inflation, and surprisingly hawkish monetary policy relative to where I think a lot of investors thought the year would start. And, you know, if I think about 2023 and what you and the economics team are forecasting, it's big shifts to all three of those dynamics. It's much softer growth, it's softer inflationary pressure. And it's central banks pausing their tightening cycles and then ultimately easing as we look further ahead. So, you know, 2022 is exceptionally bad for high grade bonds, investment grade rated bonds, whether they're governments or mortgages or securitized bonds or municipals. So as the economy slows, as investors are looking for some safety amidst all that economic uncertainty, we think high grade bonds will be the place to be.
Seth Carpenter: What is it that's so special about investment grade bonds as opposed to, for example, high yield bonds? And what is it about fixed income securities instead of equities that you think is so attractive?
Andrew Sheets: Yeah. Thanks, Seth. So I do think there's an important distinction here because, you know, if I think about a lot of different assets in the market, I think there are a lot of assets that are primarily concerned at the moment with rate uncertainty or policy uncertainty. When will the ECB finally stop hiking rates? When will the Fed finally stop hiking rates? How high will Fed funds go? Now there's another group of assets, and I think you could put the S&P 500 here, U.S. high yield bonds here that are concerned about those questions of interest rates. Obviously, interest rates matter for these markets, but those markets are also concerned about the economic slowdown and how much will the economy slow. So I think when people look into the year ahead, what you want to focus on are assets that are much more about whether or not rate uncertainty falls than they are about how much will the economy decelerate. So we think of high grade bonds as a perfect example of an asset class that cares quite a bit about interest rate uncertainty while being a lot less vulnerable to the risk that the economy slows. And I think emerging market assets are also an example of an asset class that's really sensitive, maybe more sensitive to the question of how high will the Fed hike rates? And just given where it's currently priced, given how much it's already declined this year, might be a lot less sensitive of that question of, you know, whether or not the U.S. goes into recession or whether or not Europe goes into recession. So good for high grade bonds and then we think good for emerging market assets.
Seth Carpenter: Okay. That makes a lot of sense. High grade bonds, fixed income, obviously, you talked a little bit about where some of the risks are. And whenever I think about fixed income securities and I think about risk, how are you advising clients to think about market-based risks around the world as we're going into the next year?
Andrew Sheets: I think you a point that you and your team have made that central banks, especially the Fed, are very aware of the liquidity risks around quantitative tightening and might modify it if they felt it was starting to lead to less functional markets. I think that's important. I think if that's our assumption, then investors shouldn't avoid these markets simply because there's a possibility that they could have a more liquidity challenge backdrop. Secondly, and I think this is also an important point, while central banks are going to be backing away from the government bond markets, we think there's a good chance that households and other investors will be moving towards these markets. So, you know, we think that there's actually some pretty good potential for households to do a little bit of reallocation, to have less money in equities, to have a little bit more money in bonds, and that the much higher yields that these households are seeing could be a catalyst for that.
Seth Carpenter: We're sitting here having a conversation, looking around the world. One of the natural topics to get on to if you're thinking globally is about currencies and exchange rates. How should we be thinking about where currency markets will be going from here forward into next year? What's the outlook for different currencies? Is there a set of currencies that might outperform? Are there ones where investors still need to be very wary?
Andrew Sheets: Yeah. So I think when talking about currencies, we have to start with the dollar, which in some ways is the benchmark against which everything else is measured. And you know, our foreign exchange strategists do think the dollar has peaked. Looking into next year, if we see slower growth, less inflation, less hawkish policy, you know, we think that will be less good for the dollar, maybe even negative for the dollar. So we see the dollar peaking and declining over the course of 2023. We think the euro does better, as we do think investors will look to reengage in European assets next year and so investment flows can be more supportive. We do think some of the more cyclical currencies, things like the Australian dollar and New Zealand dollar can do a little bit better as the market gets maybe a little bit more optimistic about better Chinese growth next year. And we think some of the large EM currencies can also outperform relative to their forward.
Seth Carpenter: That makes a lot of sense. I guess the other point that you and I discussed in the first part of this podcast is about inflation and how commodity prices have factored into the evolution of inflation over the past couple of years. How should we be thinking about commodities for investors going into 2023 as a place to step back from risk? What do you think?
Andrew Sheets: So commodities were an asset class that we liked at this time last year when we wrote our 2022 outlook. It was an asset class that we were overweight and we maintained that position through this year. But I think that picture is changing a little bit. You know, first, the attractiveness of other asset classes is now better because those other asset classes have fallen a lot relative to commodities over the course of 2022. And, you know, commodities are an asset class that can be sensitive to when growth actually slows. They tend to be less anticipatory. And so they've held up well, I think even as other asset classes have become more worried about the prospect of a recession. And so if the odds of a recession are rising, even if they're not the base case in the US and then they are the base case in Europe, maybe that presents a little bit more danger. But that needs to be balanced against the fact that commodities do have a number of attractive properties. They provide a hedge against inflation and some commodities, especially energy commodities, pay a quite high carry or a quite high yield for holding them, buying them on a forward basis and holding them to maturity. In the case of oil, we think prices will come in well ahead, more than 20% ahead of where kind of the market is implying the price next year. So it's a more nuanced story. It's a story where we think energy continues to outperform metals within the commodities complex, but more of a relative value story than a directional story for the year ahead.
Seth Carpenter: So what I'm taking away from what you've told me so far, that if a shift to a year of fixed income, maybe the dollar has peaked, and then a more nuanced story when it comes to commodities, what would you leave our listeners with as a closing story? Where would you want to wrap things up in terms of leaving our listeners with advice? Where do they need to be the most cautious? And are we going to go into a year where volatility finally comes down from the sort of tumult that we've seen this year?
Andrew Sheets: So I think this idea that we might not have an all clear on recession risk in the US kind of well into the start of 2023, the idea that Europe will be in recession at the start of 2023, I think that makes us a little bit cautious to buy cyclical assets here and I think that applies to things like metals, copper, that applies to high yield bonds and loans. And then we think the S&P 500 will also be tricky. So we think the S&P 500 is probably worse risk reward than other asset classes. It doesn't fall over the course of the year on our forecasts, but it has a very choppy range. And when we think about sector and style, I think it's being open to having different preferences depending on where you're looking. And we think EM assets will be on the leading edge of any recovery. That is where we're more favorable towards early cycle sectors like tech and tech hardware. You know, in Europe you're kind of in the middle. That's where we like banks and energy kind of deep value sectors that have quite high dividend yields. And in the US we're more defensive. But you know, something that links all of those themes is that both US defensive, equities, banks and energy in Europe, and tech and semis and Asia, they're all quite high yielding sectors. And so we do think this is a backdrop where the idea of gaining income is not just about high grade bonds, that there are a lot of different pockets of the market where, you know, this is a year to look for the more solid income candidate and income strategy on a cross asset basis. You know, don't swing for the fences yet in terms of buying cyclicality, and we think we'll wait for a better opportunity to do that as we move into 2023.
Seth Carpenter: All right, Andrew. Well, I have to say, that was a great summary at the end. I really appreciate you taking the time to talk.
Andrew Sheets: Great speaking with you, Seth.
Seth Carpenter: And thank you to our listeners. If you enjoy thoughts on the market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As we look ahead to 2023, we see a divergence away from the trends of 2022 in key areas across growth, inflation, and central bank policy. Chief Cross Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's chief cross-asset strategist.
Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's global chief economist.
Andrew Sheets: And on the special two-part episode of the podcast, we'll be discussing Morgan Stanley's Global Year Ahead outlook for 2023. Today, we'll focus on economics, and tomorrow we'll turn our attention to strategy. It's Tuesday, November 15th at 3 p.m. in London.
Seth Carpenter: And it's 10 a.m. in New York.
Andrew Sheets: So, Seth I think the place to start is if we look ahead into 2023, the backdrop that you and your team are forecasting looks different in a number of important ways. You know, 2022 was a year of surprisingly resilient growth, stubbornly high inflation and aggressively tightening policy. And yet as we look ahead, all three of those elements are changing. I was hoping you could comment on that shift broadly and also dig deeper into what's changing the growth outlook for the global economy into next year.
Seth Carpenter: You're right, Andrew, this year, in 2022, we've seen growth sort of hang in there. We came off of last year in 2021, a super strong year for growth recovering from COVID. But the theme this year really has been a great deal of inflation around the world, especially in developed markets. And with that, we've seen a lot of central banks everywhere start to raise interest rates a great deal. So what does that mean as we end this year and go into next year? Well, we think we'll start to see a bit of a divergence. In the developed market world where we've seen both a lot of inflation and a lot of central bank hiking, we think we get a great deal of slowing and in fact a bit of contraction. For the euro area and for the U.K, we're writing down a recession starting in the fourth quarter of this year and going into the beginning of next year. And then after that, any sort of recovery from the recession is going to be muted by still tight monetary policy. For the US, you know, we're writing down a forecast that just barely skirts a recession for next year with growth that's only slightly positive. That much slower growth is also the reflection of the Federal Reserve tightening policy, trying to wrench out of the system all the inflation we've seen so far. In sharp contrast, a lot of EM is going to outperform, especially EM Asia, where the inflationary pressures have been less so far this year, and central banks, instead of tightening aggressively to get restrictive and squeeze inflation out, they're actually just normalizing policy. And as a result, we think they'll be able to outperform.
Andrew Sheets: And Seth, you know, you mentioned inflation coming in hot throughout a lot of 2022 being one of the big stories of the year that we've been in. You and your team are forecasting it to moderate across a number of major economies. What drives a change in this really important theme from 2022?
Seth Carpenter: Absolutely. We do realize that inflation is going to continue to be a very central theme for all sorts of markets everywhere. And the fact that we have a forecast with inflation coming down across the world is a really important part of our thesis. So, how can we get any comfort on the idea that inflation is going to come down? I think if you break up inflation into different parts, it makes it easier to understand when we're thinking about headline inflation, clearly, we have food, commodity prices and we've got energy prices that have been really high in part of the story this year. Oil prices have generally peaked, but the main point is we're not going to see the massive month on month and year on year increases that we were seeing for a lot of this year. Now, when we think about core inflation, I like to separate things out between goods and services inflation. For goods, the story over the past year and a half has been global supply chains and we know looking at all sorts of data that global supply chains are not fixed yet, but they are getting better. The key exception there that remains to be seen is automobiles, where we have still seen supply chain issues. But by and large, we think consumer goods are going to come down in price and with it pull inflation down overall. I think the key then is what goes on in services and here the story is just different across different economies because it is very domestic. But the key here is if we see the kind of slowing down in economies, especially in developed market economies where monetary policy will be restrictive, we should see less aggregate demand, weaker labor markets and with it lower services inflation.
Andrew Sheets: How do you think central banks respond to this backdrop? The Fed is going to have to balance what we see is some moderation of inflation and the ECB as well, with obvious concerns that because forecasting inflation was so hard this year and because central banks underestimated inflation, they don't want to back off too soon and usher in maybe more inflationary pressure down the road. So, how do you think central banks will think about that risk balance and managing that?
Seth Carpenter: Absolutely. We have seen some surprises, the upside in terms of commodity market prices, but we've also been surprised at just the persistence of some of the components of inflation. And so central banks are very well advised to be super cautious with what's going on. As a result. What we think is going to happen is a few things. Policy rates are going to go into restrictive territory. We will see economies slowing down and then we think in general. Central banks are going to keep their policy in that restrictive territory basically over the balance of 2023, making sure that that deceleration in the real side of the economy goes along with a continued decline in inflation over the course of next year. If we get that, then that will give them scope at the end of next year to start to think about normalizing policy back down to something a little bit more, more neutral. But they really will be paying lots of attention to make sure that the forecast plays out as anticipated. However, where I want to stress things is in the euro area, for example, where we see a recession already starting about now, we don't think the ECB is going to start to cut rates just because they see the first indications of a recession. All of the indications from the ECB have been that they think some form of recession is probably necessary and they will wait for that to happen. They'll stay in restrictive territory while the economy's in recession to see how inflation evolves over time.
Andrew Sheets: So I think one of the questions at the top of a lot of people's minds is something you alluded to earlier, this question of whether or not the US sees a recession next year. So why do you think a recession being avoided is a plausible scenario indeed might be more likely than a recession, in contrast maybe to some of that recent history?
Seth Carpenter: Absolutely. Let's talk about this in a few parts. First, in the U.S. relative to, say, the euro area, most of the slowing that we are seeing now in the economy and that we expect to see over time is coming from monetary policy tightening in the euro area. A lot of the slowing in consumer spending is coming because food prices have gone up, energy prices have gone up and confidence has fallen and so it's an externally imposed constraint on the economy. What that means for the U.S. is because the Fed is causing the slowdown, they've at least got a fighting chance of backing off in time before they cause a recession. So that's one component. I think the other part to be made that's perhaps even more important is the difference between a recession or not at this point is almost semantic. We're looking at growth that's very, very close to zero. And if you're in the equity market, in fact, it's going to feel like a recession, even if it's not technically one for the economy. The U.S. economy is not the S&P 500. And so what does that mean? That means that the parts of the U.S. economy that are likely to be weakest, that are likely to be in contraction, are actually the ones that are most exposed to the equity market and so for the equity market, whether it's a recession or not, I think is a bit of a moot point. So where does that leave us? I think we can avoid a recession. From an economist perspective, I think we can end up with growth that's still positive, but it's not going to feel like we've completely escaped from this whole episode unscathed.
Andrew Sheets: Thanks, Seth. So I maybe want to close with talking about risks around that outlook. I want to talk about maybe one risk to the upside and then two risks that might be more serious to the downside. So, one of the risks to the upside that investors are talking about is whether or not China relaxes zero COVID policy, while two risks to the downside would be that quantitative tightening continues to have much greater negative effects on market liquidity and market functioning. We're going through a much faster shrinking of central bank balance sheets than you know, at any point in history, and then also that maybe a divided US government leads to a more challenging fiscal situation next year. So, you know, as you think about these risks that you hear investors citing China, quantitative tightening, divided government, how do you think about those? How do you think they might change the base case view?
Seth Carpenter: Absolutely. I think there are two-way risks as usual. I do think in the current circumstances, the upside risks are probably a little bit smaller than the downside risks, not to sound too pessimistic. So what would happen when China lifts those restrictions? I think aggregate demand will pick back up, and our baseline forecast that happens in the second quarter, but we can easily imagine that happening in the first quarter or maybe even sometime this year. But remember, most of the pent-up demand is on domestic spending, especially on services and so what that means is the benefit to the rest of the global economy is probably going to be smaller than you might otherwise think because it will be a lot of domestic spending. Now, there hasn't been as much constraint on exports, but there has been some, and so we could easily see supply chains heal even more quickly than we assume in the baseline. I think all of these phenomena could lead to a rosier outlook, could lead to a faster growth for the global economy. But I think it's measured just in a couple of tenths. It's not a substantial upside. In contrast, you mentioned some downside risks to the outlook. Quantitative tightening, central banks are shrinking their balance sheets. We recently published on the fact that the Fed, the Bank of England and the European Central Bank will all be shrinking their balance sheet over the next several months. That's never been seen, at least at the pace that we're going to see now. Could it cause market disruptions? Absolutely. So the downside risk there is very hard to gauge. If we see a disruption of the flow of credit, if we see a generalized pullback in spending because of risk, it's very hard to gauge just how big that downside is. I will say, however, that I suspect, as we saw with the Bank of England when we had the turmoil in the gilt market, if there is a market disruption, I think central banks will at least temporarily pause their quantitative tightening if the disruption is severe enough and give markets a chance to settle down. The other risk you mentioned is the United States has just had a mid-term election. It looks like we're going to have divided government. Where are the risks there? I want to take you back with me in time to the mid-term elections in 2010, where we ended up with split government. And eventually what came out of that was the Budget Control Act of 2011. We had split government, we had a debt limit. We ended up having budget debates and ultimately, we ended up with contractionary fiscal policy. I think that's a very realistic scenario. It's not at all our baseline, but it's a very realistic risk that people need to pay attention to.
Andrew Sheets: Seth, thanks for taking the time to talk.
Seth Carpenter: Andrew, I always like getting a chance to talk to you.
Andrew Sheets: And thanks for listening. Be sure to tune in for part two of this episode where Seth and I will discuss Morgan Stanley's year ahead. Strategy Outlook. If you enjoy thoughts of the market, please leave us a review on Apple Podcasts and share this podcast with a friend or colleague today.
As we transition away from our fire and ice narrative and into the late cycle stage, investors will want to change up their strategies as we finish one cycle and begin another.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, chief investment officer and chief U.S. equity strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 14th, at 11 a.m. in New York. So let's get after it.
Last year's fire and ice narrative worked so well, we decided to dust off another Robert Frost jewel to describe this year's outlook, with The Road Not Taken. As described by many literary experts, and Frost himself, the poem presents the dilemma we all face in life that different choices lead to different outcomes, and while the road taken can be a good one, these choices create doubt and even remorse about the road not taken. For the year ahead, we think investors will need to be more tactical with their views on the economy, policy, earnings and valuation. This is because we are closer to the end of the cycle at this point, and that means that trends in these key variables can zig and zag before the final path is clear. In other words, while flexibility is always important to successful investing, it's critical now.
In contrast, the set-up was so poor a year ago that the trends in all of the variables mentioned above were headed lower in our view. Therefore, the right choice or strategy was about managing or profiting from the new downtrend. After all, Fire and Ice the poem is not a debate about the destination, it's about the path to that destination. In the case of our bear market call, it was a combination of both fire and ice - inflation and slowing growth, a bad combination for stocks. As it turned out, the cocktail has been just as bad for bonds, at least so far. However, as the ice overtakes the fire and inflation cools off, we're becoming more confident that bonds should beat stocks in this final verse that has yet to fully play out. That divergence can create new opportunities and confusion about the road we are on, and why we have recently pivoted to a more bullish tactical view on equities.
In the near term, we maintain our tactically bullish call as we transition from fire to ice, a window of opportunity when long term interest rates typically fall prior to the magnitude of the slowdown being reflected in earnings estimates. This is the classic late cycle period between the Fed's last hike and the recession. Historically, this period is a profitable one for stocks. Three months ago, we suggested the Fed's pause would coincide with the arrival of a recession this cycle, given the extreme inflation dynamics. In short, the Fed would not be able to pause until payrolls were negative, the unequivocal indicator of a recession, but too late to kick save the cycle or the downtrend for stocks. However, the jobs market has remained stronger for longer, even in the face of weakening earnings. More importantly, this may persist into next year, leaving the window open for a period when the Fed can slow or pause rate hikes before we see an unemployment cycle emerge. That's what we think is behind the current rally, and we think it can go higher. We won't have evidence of the hard freeze for a few more months, and markets can dream of a less hawkish Fed, lower interest rates and resilient earnings in the interim. Last week's softer than expected inflation report was a critically necessary data point to fuel that dream for longer. We expect long duration growth stocks to lead the next phase of this rally as interest rates fall further. That means Nasdaq should catch up to the Dow's outsized move higher so far.
Unfortunately, we have more confidence today than we did a few months ago in our well below consensus earnings forecast for next year, and that means the bear market will likely resume once this rally is finished. Bottom line, the path forward is much more uncertain than a year ago and likely to bring several twists and periods of remorse for investors wishing they had traded it differently. If one were to take our 12 month S&P 500 bear, base and bull targets of 3500, 3900, and 4200 at face value, they might say it looks like we are expecting a generally boring year. However, nothing could be further from the truth. In fact, we would argue the past 12 months have been boring because a bear market was so likely we simply set our defensive strategy and stayed with it. That strategy has worked well all year, even during this recent rally. But that kind of strategy won't work over the next 12 months, in our view. Instead, investment success will require one to turn over the portfolio more frequently as we finish one cycle and begin another.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Education technology, or EdTech, saw significant adoption during the COVID-19 pandemic, yet opportunity remains in this still young industry if one looks long-term. Head of Products for European Equity Research Paul Walsh and Head of the European Internet Services Team Miriam Josiah discuss.
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Paul Walsh:] Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Products for European Equity Research.
Miriam Josiah: And I'm Miriam Josiah, Head of the European Internet Services Team within Morgan Stanley Research.
Paul Walsh: And on this very special episode of the podcast series, we'll be talking about the long-term outlook for education technology, or EdTech. It's Friday, it's the 11th of November, and it's 2 p.m. here in London.
Paul Walsh: So Miriam, next week you'll be heading to Barcelona for Morgan Stanley's annual Tech, Media and Telecom Conference, which focuses on key debates and trends in these industries. EdTech, while still in its infancy, is a segment where your team sees a lot of potential for growth. But before we get there, let's please start with the basics. What exactly is EdTech?
Miriam Josiah: So people often think of it as online learning for K-12 or university students. But we found EdTech to be quite a broad term for the digitalization of learning. So there are actually dozens of segments within EdTech. One of them is workforce education, which we think is particularly interesting and underappreciated.
Paul Walsh: And certainly many of us got a firsthand look at EdTech during COVID-19 lockdowns, whether through our children—as was the case for me personally—work related training or for our own amusement. And not surprisingly, companies in the education technology space saw a huge spike from pandemic-driven demand. So what's happening now that schools and businesses have reopened?
Miriam Josiah: So here's one of the reasons our team looked closely at EdTech. Essentially, even as we've returned to in-person training and education, the demand for remote learning hasn't dropped off. Yes, COVID 19 accelerated industry growth by about two years, but the global EdTech market, currently valued at $300 billion, is still expected to grow at an annual rate of 16% to reach $400 billion by 2025. So this demand is here to stay.
Paul Walsh: It sounds like it, and that's tremendously interesting. So can you explain why that is, please?
Miriam Josiah: So we think there are a few reasons EdTech demand will continue to grow. Firstly, the pandemic changed our behaviors in many ways, including how we think about learning. For example, in many classrooms, students watch the lecture on their own time and use the classroom for more hands-on learning. This is one reason demand is still growing, particularly within K-12 education.
Paul Walsh: And if we take a step back, Miriam, does a challenging macroeconomic environment help or hurt the outlook for EdTech? And can you help us understand why?
Miriam Josiah: So, in many ways, we think it helps. You have global teacher shortages, rising school costs and, in the case of workplace, there's a need to reskill and upskill workers. So these are a few of the important drivers. Meanwhile, there's a few other positives for EdTech, such as a growing global population and lower penetration rates. To put things in perspective, global spending on education is around $6.5 trillion a year and even with double digit growth over the next few years, EdTech will only represent around 5% of total education spending in 2025. Suffice to say, we are in the very early stages of growth.
Paul Walsh: Yeah, absolutely. It sounds like it. And thinking about stock valuations, they soared for companies that saw surging demand during the pandemic. And since then, we've seen that trend reverse, in some cases really quite dramatically. So where does that leave us today?
Miriam Josiah: So one thing to note is that this segment is very fragmented with many small companies, some of which are not publicly traded. Among the larger players in the space, we've seen a similar trend with stock prices soaring and now correcting. And so valuations are attractive. And we think this is a good entry point for investors, especially if they have a longer time horizon. At the same time, the market's seeing a fair bit of M&A activity, which may present opportunities for upside for investors.
Paul Walsh: Absolutely no doubt. Industries that are fragmented, hard to define and still in their infancy can really be fertile ground for investors who have the time and the wherewithal to research and invest in individual companies. So what are the biggest risks to your growth outlook for the EdTech industry?
Miriam Josiah: So firstly, as I mentioned, a lot of the sector is made up of private companies and a lot of these are loss-making startups. So in an environment of tighter access to capital, this may be a growth inhibitor for some of the startups and we're already seeing companies starting to trim headcount as a way to cut costs. Another risk is government budget cuts. Remember, education spending is around 4% of GDP, and so cuts here could impact the B2B market in particular. The counter is that tighter budgets could lead to schools turning to EdTech instead, but this still does remain a risk. And then finally, the consumer willingness to pay is also being questioned in a recessionary environment.
Paul Walsh: Miriam, that's really clear. I want to thank you very much for taking the time to talk. It's obviously been quite educational. Good luck with the TMT Conference in Barcelona next week.
Miriam Josiah: Thank you. Great chatting with you, Paul.
Paul Walsh: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
It’s almost two full days after the midterm elections in the U.S. and while we still don’t know the outcome, markets may know enough to forecast its impact.
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Welcome to Thoughts on the Market. I'm Michael Jesus, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Thursday, November 10th, at 3 p.m. in New York.
It's nearly two full days after polls closed across America, and we still don't know which party will control Congress. But for investors, we very likely know all we need to know at this point. Let me explain.
It may take several days, maybe weeks to determine which party will control the Senate. But knowing which party controls the Senate won't matter much if Republicans gain a majority in the House of Representatives, as they appear likely to do as of this recording. That's because Republicans controlling at least one chamber of Congress is enough to yield a divided government, meaning that the party in control of the White House is not also in control of Congress and so can't unilaterally choose its legislative path.
For bond markets, this is a mostly friendly outcome. It takes off the table the scenario that could have led to fiscal policy from Congress that would cut against the Fed's inflation goals. That scenario would have been one where Democrats keep control of the House and expand their Senate majority. That outcome might have suggested inflation was less a political and electoral concern than previously thought, and through a broader Senate majority, given Democrats more room to legislate. If markets perceived that combination of a willingness and ability to legislate as increasing the probability of enacting spending measures, like a child tax credit, that would support aggregate demand in the US economy, then investors would also have to price in the possibility of a higher than expected peak Fed funds rate, pushing Treasury yields higher. Of course, this appears not to be what happened.
So, the bottom line, the election outcome is important and still up in the air, but markets may know enough to move on.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Critics of sustainable investing have said that Environmental, Social, and Governance strategies require investors to sacrifice long-term returns, but is this really the case?
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Welcome to Thoughts on the Market. I'm Stephan Kessler, Morgan Stanley's Global Head of Quantitative Investment Strategies. Along with my colleagues bringing you a variety of perspectives, today I'll discuss the value of a quantitative approach to low carbon investing. It's Wednesday, November 9th, at 2 p.m. in London.
Sustainable investing has been a hot trend over the past decade, and most recently the new Inflation Reduction Act in the U.S. has brought it into even sharper focus. Short for environmental, social and governance, ESG covers a broad range of topics and themes, for example, carbon emissions, percentage of waste recycled, employee engagement scores, human rights policies, independent board members, and shareholder rights. This breadth, however, has made defining sustainable investing a key challenge for investors. Furthermore, critics of ESG have also pushed back, arguing that ESG strategies sacrifice long term performance in favor of alignment with what has been disparagingly termed "woke capitalism".
This ongoing market debate shows no sign of abating any time soon, and so investors are looking for rigorous ways to assess ESG factors, with decarbonization being top of mind. In some recent work by quant analyst Jacob Lorenzen and myself, we decided to focus on climate change and more specifically carbon emissions as the key metric. Our systematic approach uses mathematic modeling to analyze how investors can integrate a low carbon tilt in various strategy portfolios and what kind of results they can expect.
So what did this analysis tell us? Essentially, we found little evidence that incorporating an ESG tilt substantially affects a risk adjusted performance of equity portfolios, positively or negatively. While potentially disappointing to investors looking for outperformance via ESG overlays, this conclusion may be encouraging to others because it suggests that investors can create low carbon portfolios without sacrificing performance. In other words, our results for equity benchmark, smart beta and long/short portfolios argue that environmentally aware investing could be considered one of the few "free lunches" in finance.
Our framework focused on carbon reduction portfolios, but also takes other ESG aspects into account. When screening companies for environmental harm, fossil fuel revenue, or non ESG climate considerations, our results are robust. This result is important as it shows that investors can focus on a broad range of ESG criteria or carbon alone- in all cases, the performance impact on portfolios is minimal. Thus, investors can adapt our framework to their objectives without needing to worry about returns.
And so what does the future hold for ESG investing? While overall we find ESG to have a minor impact on performance, their investment strategies and time periods of the past decade where it did matter and created positive returns. One possible explanation for this effect is a build up of an ESG valuation premium. ESG may have been riding its own wave as global investors increasingly incorporated ESG into their investments, whether for value alignment or in search of outperformance. As we look ahead, the long run outperformance of broad ESG strategies may be more muted. In fact, ESG guidelines and requirements may even require companies causing significant environmental harm to pay a premium for market access. However, we do believe there are potential alpha opportunities using specialized screens, or in specific industries such as utilities and clean tech.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Increasingly, consumers are moving from traditional cable and satellite subscriptions to connected TV devices, so where do the advertisers go from here? U.S. Media Analyst Ben Swinburne and U.S. Internet Analyst Brian Nowak discuss.
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Ben Swinburne: Welcome to Thoughts on the Market. I'm Ben Swinburne, Morgan Stanley's U.S. Media Analyst.
Brian Nowak: And I'm Brian Nowak, Morgan Stanley's U.S. Internet Analyst.
Ben Swinburne: On this special episode of the podcast we'll focus on connected TV and the changing television space. It's Tuesday, November 8th, at 10 a.m. in New York.
Ben Swinburne: Consumer behavior in the television space has been changing rapidly over the past decade, and the COVID pandemic further accelerated this trend. While most people still watch traditional linear TV through their cable and satellite subscription, consumers are shifting to streaming at a rapid pace. In fact, most of our listeners probably use some sort of connected TV, or CTV device at home that allows their television to support video content streaming. As our media analyst, I've watched how this has led to widespread "cord cutting", as an increasing number of customers cancel their traditional subscriptions in favor of only using these streaming or video on demand formats. So let's dig into the opportunities and challenges within the connected TV space and particularly interconnected TV advertising. Brian, let's start with some definitions. What is CTV advertising, what's so great about it?
Brian Nowak: CTV advertising is nothing more than adding advertising to all that streaming engagement that you mentioned earlier. You talked about how people are increasingly watching connected television through streaming devices, through their televisions. The idea of showing ads around it is CTV advertising. As far as what's so great about it, for years traditional linear television has largely been driven by branded advertising to reach people. The hope with connected television over time is that not only will connected television enable you to have reach and strong branding capabilities, but also the potential for better targeting, a more direct link between an advertising dollar and an actual transaction from those ads. And the vision of connected television advertising over time is we may be able to have broad based performance advertising across all of the streaming television engagement. So with that as a backdrop Ben, who benefits in your view, from connected television? And which companies may be most at risk from this transition?
Ben Swinburne: Well Brian, you talked about both targeting and performance ads, things that are not typically associated with broadcast or linear television advertising. So I have to say the biggest beneficiary of the shift to connected TV from an advertising point of view are marketers. Not only are marketers looking for ways to spend their money with a better return on an advertising spend, but they're facing rapidly declining audiences, meaning it's harder and harder to reach the audiences that they want to reach. Connected TV brings the promise of both greater audience, particularly "cord cutters", but also reaching them more effectively with performance based and targeting tools that don't exist in linear. Speaking of which, when we think about who may be at risk, well we don't think it's a complete zero sum game. And we do think connected TV expands the television ad market over the long term. We think the largest area of market share risk is linear television.
Brian Nowak: So let's dig a little more into your point about linear television Ben. How do you think about the market share between linear television and connected television the next 5 to 10 years? And what role do sports and live sports play into that overall market share?
Ben Swinburne: So we expect connected TV advertising to reach and ultimately surpass linear television by the end of the decade. It could happen faster, particularly we're focused on local markets, which right now connected TV doesn't really reach. And it it could also happen faster if sports moves quickly over from linear into streaming. Right now, live sports really dominates linear television. It is the by far source of the largest audiences, and those audiences are live, and it's really holding up the linear bundle more than any other kind of programing. But we are certainly starting to see sports content leak out into streaming services, which has both the potential to erode those live audiences that advertisers value so much, but also bring them into a streaming environment which would create more opportunities to use targeting and performance based tools. Brian, what are some of the challenges of connected TV advertising relative to linear?
Brian Nowak: In the near term macro. Over the longer term proof that the technology works. As with any new, less proven advertising media, weaker macro backdrops can prove to be challenging. It is more difficult for advertisers to move large amounts of experimental dollars into new media when macro times are weaker. And if we think 2023 will be a more challenging macro backdrop, that could lead to slower overall adoption within the connected TV space. Over the long term, the technology has to be proven to work. We talked earlier about proving performance based advertising better, more directly linking advertising dollars to transactions. That technology has to be proven and built out. When you see an ad and you see an ad for a product directly linking that ad to the person actually buying that product is something that still has to be developed by some of the connected TV leaders. And so we're going to need to have better tools with more targeting, better attribution and scalability of the ad buys to really hit some of our longer term connected TV ad forecasts.
Ben Swinburne: So Brian, you mentioned some of the macro weakness that we're seeing in the marketplace. What is the size of connected TV advertising right now, given that macro backdrop? And what's your near-term and long term outlook for online advertising more broadly and connected TV within that?
Brian Nowak: In the United States the connected TV advertising market is currently about $17 billion. And as we look ahead, we expect the overall industry to grow at sort of a mid-teens rate, reaching $30 billion plus by 2026. And from a market share perspective, we do think that the largest four players across traditional media and big tech are going to drive a majority of that overall growth.
Ben Swinburne: Brian, thanks for taking the time to talk.
Brian Nowak: Great speaking with you, Ben.
Ben Swinburne: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
With the Fed continuing to focus on inflation and the upcoming midterm elections suggesting market volatility, investors may be wondering, is the U.S. equity market rally really over?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 7th, at 11 a.m. in New York. So let's get after it.
Last week's pullback in major U.S. stock indices was not a surprise as the Fed remained committed to its mandate of getting inflation under control. However, if our tactical rally in U.S. stocks is going to have legs, 10 year U.S. Treasury yields will need to come down from current levels. Otherwise, it will be difficult to see higher prices for the S&P 500, given how sensitive this large cap growth index is to interest rates. Furthermore, we remain of the view that 2023 earnings forecasts are as much as 20% too high, so it will be difficult for stocks to move higher without valuations expanding.
Does this mean the U.S. equity rally is over? We don't think so, but it's going to remain very noisy in the near term. First, we have two more important events this week to contend with: the Consumer Price Index release on Thursday and the midterm elections on Tuesday. On the former, we aren't that focused on it because it tells us little about the trajectory of inflation going forward. Nevertheless, we appreciate that the bond market remains fixated on such data points and will trade it. Therefore, it's likely to keep interest rate volatility high through Thursday. If interest rate volatility falls with the passing of these data, equity valuations can then expand further.
In terms of interest rate levels, we think next week's midterms could play a bigger role. Should the polls prove correct, the Republicans are likely to win at least one chamber of Congress. This should throw a wrench into the aggressive fiscal spending plans the Democrats would still like to get done. Furthermore, Republican leadership has talked about freezing spending via the debt ceiling, much like they did with the Budget Control Act in 2011. 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. Such a decisive win should invoke the kind of rally and 10 year Treasury bonds to keep the equity market moving higher. One caveat to consider is that the election results may not be clear on Tuesday night, given the delay in counting mail in ballots. That means we can expect price volatility in equity markets will remain high and provide fodder for bears and bulls alike.
Bottom line, we remain tactically bullish on U.S. equities, assuming longer term interest rate levels begin to fall. This week's midterm elections provide a potential catalyst in that regard. If the Republicans win decisive control of both the House and Senate, as some polls and betting markets are suggesting. 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.
Last week we said that 3700 on the S&P 500 is our stop loss level for this rally, and markets traded exactly to that level after Friday's strong labor report before recovering nicely. For this week, we think that level could be challenged again given the uncertainty around election results. Anxiety around the Consumer Price Index Thursday morning is another reason to think both interest rate and equity volatility will remain high. Therefore, we are willing to give a bit more wiggle room to our stop loss level for next week, something like 3625 to 3650, assuming the 10 year Treasury yields don't make a new high. Conversely, if 10 year Treasury yields do trade about 4.35% and the S&P 500 tests 3625, we would suggest clients to exit bullish trades at that point. In short, the bear market rally is likely to hang around for longer than most expect if it can survive this week's test.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
As prices for bonds go down and yields go up, investors may be asking why the price is so low, and what this shift may do to the broader market and asset allocation.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, November 4th, at 2 p.m. in London.
The market is a funny thing. Relative to January 1st of this year, the U.S. 30 year Treasury bond is set to pay out all of the same coupons, and return the exact same amount of principal when it matures in 2052. But the market has decided that that same bond today is worth 36% less than at the start of the year.
So what happened? Well, yields rose. That 30 year U.S. bond might be the exact same entity, but investors now need all of those future payments to yield 4.2% per year, not the 1.9% they needed on January 1st. It's another way of saying that there's been a major change in what's considered the minimal accepted return on safe assets. And that large jump in yields has led to the largest drop in bond prices that we've seen in recorded history.
But the implications are broader. Many assets have bond-like characteristics, where you pay money today for a string of payments in the future. Whether it's an office building, a rental unit or a company with a future set of earnings, you can get very different current values for the exact same asset today by varying what sort of yield it's required to produce. And so if bonds are now priced lower to generate higher returns in the future, so should many other assets that have similar bond-like characteristics.
For markets, we see a couple of implications. First, these rising yields have made bonds increasingly competitive relative to stocks. Currently, $100 of the S&P 500 is expected to yield about $6.25 of earnings next year. $100 of U.S. 1 to 5 year corporate bonds yields about $6 of interest, despite having just one sixth the volatility of the stock market. It's been 14 years since the earnings yield on stocks and the yield on corporate bonds has been so similar.
Higher yields on safe assets may also shift broader asset allocation decisions. At this time last year, 30 year BBB- rated investment grade bonds yielded just 3.3%. Given such low returns, it's no wonder that many asset allocators, especially those with longer time horizons, pushed into alternative asset classes and private markets in an effort to generate higher returns.
But that calculus now looks different. Yields on those same investment grade bonds have risen from that 3.3% to 6.3%. With public markets now offering many more opportunities for a safe, reliable, long run return, we'd expect asset allocators to start to swing back in this direction, especially favoring various forms of investment grade debt.
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As developed markets heal from the pandemic, labor force participation has recovered in some areas faster than others, so how will a return to work impact the broader economy in places like the U.K. and the U.S.? U.S. Economist Julian Richers and European Economist Markus Guetschow discuss.
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Julian Richers: Welcome to Thoughts on the Market. I'm Julian Richers from the Morgan Stanley U.S. Economics Team.
Markus Guetschow: And I'm Markus Guetschow from the European Economics Team.
Julian Richers: On this special episode of the podcast, we'll focus on the issue of labor force participation across developed markets and its broader economic implications. It's Thursday, November 3rd, at 10 a.m. in New York.
Markus Guetschow: And 3 p.m. in London.
Markus Guetschow: It's no secret that the COVID pandemic profoundly disrupted labor markets across the globe. Labor shortages, rather than unemployment, have now become the key challenge to economies everywhere, and the 'great resignation' has become a catchphrase. In the U.K. and U.S. in particular, are experiencing a slow recovery in labor participation post-COVID, which is adding to an already complex set of policy trade offs by the Fed and the Bank of England. At the same time, Europe looks like a bright spot. So Julian, 'nobody wants to work anymore' has become a punchline. What kind of picture do the data on labor supply really paint in the U.S.?
Julian Richers: In the U.S. at least we have seen a massive decline in labor force participation at the onset of the pandemic and really an incomplete recovery so far. Less immigration and more retirements have been major contributors to that drop initially, but since then it also is that prime age workers, so workers age 25 to 54, have been slow to come back. Now in contrast to the U.S., I think your analysis shows that labor supply in the euro area has already fully recovered to pre-pandemic levels. What drove that faster rebound and what's your outlook for the euro area from here? Can we learn something about what this may mean for other countries?
Markus Guetschow: We've seen a remarkably quick bounce back in the labor market in the euro area after the pandemic recession, with participation already one percentage point above pre-pandemic levels by mid 22, and also about the level implied by pre-crisis trends. We think that furlough schemes that kept workers in the jobs during COVID were a key supporting factor here. We don't expect to return to pre-crisis labor supply growth, however, with increasing headwinds from immigration and demographics increasingly a factor in the euro area. The U.K. had a similarly generous furlough scheme, but dynamics are in many ways more similar to the U.S., with participation almost one percentage point below 4Q 19 levels in the middle of 2022. Post-Brexit migration flows are one obvious reasons, but we also point to a record number of workers out of the labor force due to health reasons. But let me turn back to the U.S. What makes the US labor market so challenging right now, and how would a potential rise in labor supply affect the economic growth outlook and the Fed's monetary policy?
Julian Richers: Well, really, the U.S. labor market has just remained extremely resilient, even though the overall economy has clearly slowed. The U.S. economy is also now producing a lot more output with about the same amount of workers as we did before the pandemic. So structurally, labor demand is still high. At the same time, a lot of the losses in participation among older workers will not reverse. But prime age workers have been coming back and there is still more room for them to go. So prime age, labor force participation should be increasing and that will be key for some relaxation in the labor market. For the Fed that's key, right? Removing pressure from the labor market is very important to feel more confident about the inflation outlook. Wage growth has been extremely high because there still is a pretty significant shortage of workers, and workers are quitting at high rates to go to higher paying jobs. Now, as the economy slows more and labor demand begins to cool, that should lessen. But really, getting more people into the labor force is just going to be key to see wage growth moderate and the unemployment rate go up for good reasons and not for job cuts. So an expansion in labor supply in particular, if it's coming from more primary workers, is really key to manage a soft landing the Fed is looking for. Marcus, how about the ECB in the Bank of England? Maybe walk us through the thinking there and give us a sense of the outlook for the U.K. and the euro area into 2023.
Markus Guetschow: So the ECB is facing a different set of issues altogether. Labor market supply is closely monitored, but with rates growth really rather modest to date, despite record low unemployment, much less of a focus for monetary policy. Instead, with rates still arguably in stimulating territory, the near-term focus continues to be on policy normalization, eventually also QT, while fending off concerns about fragmentation. The picture for the Bank of England is somewhat more similar to the one faced by the Fed. The more labor supply bounces back, the less the Bank of England has to lean against demand. With recession ahead and a bearish outlook on participation, most of the slackening will likely be done via the demand channel, however.
Julian Richers: Marcus, thanks for taking the time to talk.
Markus Guetschow: Great speaking to you, Julian.
Julian Richers: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
This coming Tuesday is the midterm election in the U.S., so what should investors watch out for as the results roll in? And which outcomes might influence market moves?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, November 2nd at 10 a.m. in New York.
On Tuesday, Americans will cast their ballots for members of Congress. Well, most Americans will. Many will have already voted by mail. And that's important to know, because it means that, like in 2020, investors may have to wait days to reliably know who will control Congress. And that uncertainty could spell volatility in the bond markets, under the right conditions. Allow me to explain.
Like in 2020, the increased use of vote by mail means that early vote counts reported may not be a good indicator of who's winning a particular race, especially in races expected to be close. Mailin ballots are typically cast more often by Democrats than Republicans, and in many jurisdictions are counted after in-person voting. That means that early reported results may look favorable to Republicans, but like in 2020, leads can vanish over time. And so we'll need to reserve judgment on which party seems poised to control Congress.
While that uncertainty is playing out, it helps to know which outcomes would be market movers and which ones might have no immediate impact. For example, let's consider what it would mean if Republicans take back control of one or both houses of Congress, which polls and prediction markets are pointing to as the most likely outcome. We wouldn't anticipate this 'divided government' outcome being a market mover, at least not in the near term. That's because the most we can take away from this are some hypothetical concerns. A divided government tends to deliver a weaker fiscal response to a recession. And Republicans have publicly touted their intent to use the debt ceiling and government funding deadlines as negotiating points to reduce government spending in 2023 and 2024. But in recent years, markets have dismissed those types of negotiations as political theater. So perhaps these events would only matter in the moment if the economy and or markets were already showing substantial weakness.
But what if instead Democrats do what the polling data suggests they're very unlikely to do, not only keep control of Congress, but expand their majorities. If the early vote counting makes this seem like a real possibility, perhaps because Democrats outperform in early tallies in places like Pennsylvania, then expect market gyrations, particularly in the bond market. That's because if Democrats were to pull off such an outcome, bond markets could come to see a risk that fiscal policy will be pulling in a different direction than monetary policy, meaning the Fed could have to hike rates even more than currently expected to bring inflation down to target. Expanded Democratic majorities could be a signal that inflation was not the electoral challenge many feared. Without that political constraint, investors could equate these expanded majorities with an increased chance that Democrats would revisit many of their previously abandoned spending plans.
So bottom line, be prepared. The polls are showing Democrats are unlikely to expand majorities, but the history of markets is rife with examples of unexpected outcomes creating market volatility.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us for a view on Apple Podcasts. It helps more people find the show.
Over the last decade private markets have outperformed versus public markets, but given the recent public market volatility, will private markets continue to attract investors? Head of Brokers, Asset Managers, and the Exchanges Team Mike Cyprys and Head of European Asset Managers, Exchanges, and Diversified Financials Research Bruce Hamilton discuss.
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Mike Cyprys: Welcome to Thoughts on the Market. I'm Mike Cyprys, Morgan Stanley's Head of Brokers, Asset Managers and Exchanges Team.
Bruce Hamilton: And I'm Bruce Hamilton, Head of European Asset Managers, the exchanges and Diversified Financials Research.
Mike Cyprys: And on this special episode of the podcast, we'll talk about our outlook on the private markets industry against an uncertain macro backdrop and market upheaval. It's Tuesday, November 1st at noon in New York.
Bruce Hamilton: And 4 p.m. in London.
Mike Cyprys: We spend most of our time on this podcast talking about public markets, which are stocks and bonds traded on public exchanges like Nasdaq and Euronext. But today, we're going to talk a little bit about the private markets, which are equity and debt of privately owned companies. You probably know it as private equity, venture capital and private credit, but it also encompasses private real estate and infrastructure investments, all of this largely held in funds owned by institutions such as pension funds and endowments and increasingly high net worth investors. Today, there is nearly 10 trillion of assets held across these funds globally. But despite the different structure, private markets have been faced with the same macro challenges facing public markets here in 2022. So Bruce, before we get into some of the specifics, let's maybe set the context for our listeners. How have private markets fared vis a vis public markets over the last decade?
Bruce Hamilton: So the industry has grown at around 12% per annum on average over the past decade in terms of asset growth and a faster 17% over the past three years, driven by increasing allocations from institutional investors attracted to the historic outperformance of private markets versus public markets, a smoother ride on valuations given that assets are not mark to market, unlike public markets, and an ability to source a more diversified set of exposures, including the faster growth in earlier stage companies.
Mike Cyprys: And what are some of the near-term specific risks facing private markets right now amidst this challenging market backdrop?
Bruce Hamilton: The near-term concerns really focus around the implications of a tougher economic environment, impacting corporate earnings growth at the same time that increasing central bank interest rates across the globe are feeding into increased borrowing costs for these companies. This raises questions on how this will impact the profitability and investment returns from these companies and whether investors will continue to view the private markets as an attractive place to allocate capital. The uncertain economic outlook has dramatically reduced the appetite to finance new private market deals. However, there are factors that mitigate the risks forced to refinance in the short term. Secondly, corporate balance sheets are in relatively good health in terms of profits to cover interest payments or interest cover. Moreover, flexibility built into financing structures such as hedging to lock in lower interest rates should reduce the impact of rising rates. Importantly, the private market industry also has significant dry powder, or available capital, to invest in new opportunities or protect existing investments. For players active in the private markets. We think that there are undoubtedly risks in the near term, linked to congested fundraising with many private market firms seeking to raise capital from clients against a decline in public markets, which has left clients with less money in their pockets. From the performance of existing portfolio companies, given the more difficult market and economic environment and from subdued company disposal and investment activity linked to the more difficult financing markets. This has kept us pretty cautious on the sector this year.
Bruce Hamilton: But Mike, despite these near-term risks and concerns, you remain convicted in your bullish outlook on the next five years. In a recent work, you've outlined five key themes that you see lifting private markets to your 17 trillion assets under management forecast. What are these themes and how do you see them playing out over time?
Mike Cyprys: Look, clearly, I would echo your concerns in the short term. And I do think growth moderates after an exceptional period here. But we do see a number of growth drivers that we feel are more enduring. Specifically, five key engines of growth, if you will. First is democratization of private markets that we think can spur retail growth and unlock a $17 trillion addressable market or TAM. This is the single largest growth contributor to our outlook. Product development, investor education and technological innovation are all helping unlock access here as retail investors look to the private markets for income and capital appreciation in addition to a smooth ride with lower volatility versus the public markets. The second growth zone is private credit that we think is poised to penetrate a $23 trillion TAM as traditional bank lenders retrench, providing an opportunity for private lenders to step in. For corporate issuers, private credit offers greater flexibility on structure and terms, and provides greater certainty of execution. For investors, it can provide higher yields and diversification from public credit. The third growth zone is infrastructure investing, which we think can help solve for decades-long underinvestment and addresses a $15 trillion funding gap over the next 20 years. This is underpinned by structural tailwinds for the 3 Ds of digitization, decarbonization and deglobalization. The fourth growth zone is around liquidity solutions. As you know, the private markets are illiquid. And so as the asset class grows, we do expect some investors will want to find ways to access some degree of liquidity over time. And that's where solutions such as secondaries and NAV based lending can be helpful. The fifth and final growth zone is around impact in ESG investing. In public markets, we've seen significant asset flows into ESG and impact investing strategies as investors look to have a positive impact on society. And we expect that this will also play a role in the private markets, though it's a bit earlier days. Today we estimate about 200 billion invested in private market impact strategies, and we think that can reach about 850 billion in five years time.
Mike Cyprys: So for investors, this does boil down to an impact on publicly traded companies. Given the specific challenges of the current environment, Bruce, which business models do you think are best positioned to succeed both near-term and longer term? And what should investors be looking at?
Bruce Hamilton: Well, Mike, whilst we think the challenging macro conditions could continue to weigh on the sector near-term, we think that investors may want to look at companies with the best exposure to the five growth themes that you mentioned, who are building out global multi-asset investment franchises with diverse earnings streams, a high proportion of durable management fee related earnings—rather than heavy reliance or more volatile carry or performance fees—and deployment skewed to inflation protected sectors like infrastructure or real estate.
Mike Cyprys: Bruce, thanks for taking the time to talk.
Bruce Hamilton: Great speaking with you, Mike.
Mike Cyprys: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Despite companies beginning to report earnings misses and poor stock performance, the S&P 500 is on the rise, leading many to wonder how the Fed will react to this new data in their coming meeting.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 31st at 11 a.m. in New York. So let's get after it.
Two weeks ago, we turned tactically bullish on U.S. equities. Some clients felt this call came out of left field, given our well-established bearish view on the fundamentals. To be clear, this call is based almost entirely on technicals rather than the fundamentals which remain unsupportive of most equity prices and the S&P 500.
Today, we will put some meat around the fundamental drivers for why this call can work for longer than most expect. Last week was the biggest one for third quarter earnings season in terms of market cap reporting. More specifically it included all of the mega-cap tech stocks that make up much of the S&P 500. On one hand, these companies did not disappoint the fundamental bears like us who've been expecting weaker earnings to finally emerge. In fact, several of these large tech stocks reported third quarter results that were even worse than we were expecting. Furthermore, the primary driver of the downside was due to negative operating leverage, which is a core part of our thesis on earnings as described in the fire and ice narrative. However, these large earnings misses and poor stock performance did not translate into negative price performance for the S&P 500 or even the NASDAQ 100.
This price action is very much in line with our tactical bullish call a few weeks ago. In addition to the supportive tactical picture we discussed in prior notes, we fully expected third quarter results to be weak. However, we also expected most companies would punt on providing any material guidance for 2023, leaving the consensus forward 12 month earnings per share estimates relatively unchanged. This is why the primary index didn't go down in our view, and actually rose 4%.
The other driver for why the S&P 500 rose, in our view, is tied to the upcoming Fed meeting this week. While the Fed has hawkishly surprised most investors this year, we've now reached a point where both bond and stock markets may be pricing in too much hawkishness. First, other central banks are starting to slow their rate of tightening. Second, there are growing signs the labor market is finally at risk of a downturn as earnings disappoint and job openings continue to fall. Third, the 3 month 10 year yield curve is finally inverted, and that is one item Fed Chair Jay Powell has said he's watching closely as a sign the Fed has gone far enough.
However, the best evidence the Fed has already done enough to beat inflation comes from the simple fact that money supply growth has collapsed over the past year. Money supply is now growing just 2.5% year over year. This is down from a peak of 27% year over year back in March of 2021. A monetarist which suggests inflation is likely to fall just as rapidly as it tends to lag money supply growth by 16 months. This means longer term interest rates are likely to follow, which can serve as a driver of higher valuations until the forward earnings per share estimates fall more meaningfully.
What this all means for equity markets is that we have a window where stocks can rally on the expectation inflation is coming down, which allows the Fed to pause its rate hikes at some point in the near future, if not this week. Moreover, this pause must occur while earnings forecasts remain high. The bottom line is that we continue to think there's further upside toward 4000 - 4150 from the current 3900 level. However, for that to happen, longer term interest rates will need to come down, and that will likely require a less hawkish message from the Fed. That puts a lot of pressure on this week's Fed meeting for our tactical call to keep working. If the Fed comes in hawkish and squashes any hopes for a pause before it's too late, the rally could very well be over. More practically, anyone who jumped on board this tactical trade should use 3700 on the S&P 500 as a stop loss for remaining bullish. Conversely, should longer term interest rates fall after Wednesday's meeting, we would gain more confidence in our 4150 upside target for the trade and even consider further upside depending on the message from the Fed.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
As the U.K. grapples with structural, political, and economic issues, how are markets affected across assets, and what stories may look better for investors than others? Chief Cross-Asset Strategist Andrew Sheets and U.K. Economist Bruna Skarica discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan stanley's Chief Cross-Asset Strategist.
Bruna Skarica: And I'm Bruna Skarica, Morgan Stanley's U.K. Economist.
Andrew Sheets: And on part two of this special two part edition of the podcast, we'll be talking about the market implications of the latest political, economic and market developments in the U.K. It's Friday, October. 28th at 2 p.m. in London.
Bruna Skarica: So Andrew, we already discussed the economic outlook for the U.K., and today I'd like to turn our conversation to you and your cross asset views. Obviously the current economic and political situation in the U.K. has a very significant impact on both macro and micro markets. Let's start with one of the number one investor questions around the U.K., which is the mortgage market. Roughly one in four mortgages has a variable rate and current estimates suggest that more than a third of UK mortgage holders will see their rates rise from under two to over 6% over the next year. What is your outlook for the mortgage market and its impact on the U.K. consumer, especially amid what is already severe cost of living crisis?
Andrew Sheets: Like the U.S. most household debt in the U.K. is held in the form of mortgages. Unlike t,vhe U.S., though, those mortgages tend to have a quite short period where the rate is fixed. The typical U.K. mortgage, the rate is only fixed for 2 to 5 years. Which means that if you bought a house in 2020 or 2021, a lot of those mortgages are coming due for a reset very soon. And that reset is large. The mortgage, when it was taken out in 2020, might have had a rate of 2%. The current rate that it will reset to is closer to 6%. So that's a tripling of the interest rate that these homeowners face. So this is a very severe consumer shock, especially if you layer it on top of higher utility bills. This is, I think, a big challenge that, as you correctly identified in our conversation yesterday, that the Bank of England is worried about. And, you know, this is one reason why we think the pound will weaken. I'm sure we'll talk about the pound more, but if rate rises in the U.K. work their way into the household much faster because the mortgage fixed period is much shorter, maybe that means the Bank of England can't hike as much as markets expect. Whereas the Fed can because the dynamics in the mortgage market are so much different.
Bruna Skarica: Indeed. Now, aside from that, U.K. rates have also seen a historical level of volatility this year. The pound as well has been weak all year, even though it has rallied a bit recently. Perhaps let's focus on the currency first. How do you see the pound from here? Do you think the downside risks have subsided or the structural risks still remain?
Andrew Sheets: So the pound is a very inexpensive currency. It's inexpensive on a number of the different valuation measures that we look at, purchasing power parity, a real effective exchange rate and it's certainly fallen a lot. But our view is that the pound will fall further and that this temporary bounce that the pound has enjoyed in the aftermath of another new leadership team in the country is ultimately going to be short lived. A lot of the economic challenges that were there before the mini budget are still there. Weak economic growth, a large current account deficit, trade friction coming out of Brexit. And also I think this part about the Bank of England maybe not raising rates as much as the market expects, there's that much less interest income for investors for holding the pound. We forecast a medium term level for the pound relative to the dollar, about 1.05, so still lower from here. And we do think the pound will be the underperformer across U.K. assets.
Bruna Skarica: Now aside from the pound I've mentioned, investors have been very focused on the UK rates market where we have indeed seen a lot of volatility in recent weeks. Now what do valuations look like here after all the fiscal U-turns? And is Morgan Stanley still bearish on gilts?
Andrew Sheets: It's common to talk about historic moves in the global market and sometimes you realize you're talking about a market that's been around for 10 years or 20 years. The U.K. bond market's been around for hundreds of years. And we saw some of the largest moves in that history over the last 2 months. So these have been really extreme moves, both up and down, as a result of the fallout from that mini budget. But going forward we think U.K. rates will rise further from here, we think bonds will underperform and there are a couple of reasons for that. One is that the real interest rate on U.K. gilts, the yield above expected inflation, it's not very high, it's about zero actually. Whereas if I invest in a U.S. inflation protected security, I get about 1.5% more than the inflation rate. And then I think you add on this challenge of it's a smaller market, you add on the challenge of there's more political uncertainty, and then you add in the the risk that inflation stays higher than the Bank of England expects, that core inflation remains more persistent. And I think all of these are reasons why the market could inject a little bit more risk premium into the gilt market. One other thing that's been highlighted by our colleagues in interest rate strategy, is just simply there's a lot of supply gilts. There's supply of gilts not just because the governments running a deficit, but there's supply because the Bank of England was a major buyer and a major holder of gilts during the year of quantitative easing and it's shifting towards quantitative tightening. So heavy supply, low real rates, and I think a potential for kind of a higher risk premium are all reasons why we think gilts underperform both bonds and treasuries.
Bruna Skarica: Now that you mentioned quantitative tightening, of course, the Bank of England is planning to sell its credit holdings as well. What is the situation in the sterling credit market? Can you walk us through the challenges and opportunities there right now for both domestic and foreign investors?
Andrew Sheets: Yeah. So I think the credit market in the U.K. is actually one of the better stories in this market. Now it's not particularly liquid. But I think where sterling credit has some advantages is, one, it's actually a relatively international market. Only about half of it references U.K. companies, the other half of it is global companies, including a lot of U.S. issuers. So the credit market is not a particularly domestically focused index to the extent people are worried about the U.K. domestic situation. It's a market that trades at a spread discount to the U.S., both because of some of the recent volatility and the fact it's a little bit less liquid. this is a market that yields around 6.5% - 6.75% on investment grade credit. That's, I think, a pretty good return relative to expected inflation, relative to where we think credit risk is in that market. So, you know, amidst some other more difficult stories, we think the credit market might end up being a relatively better one.
Bruna Skarica: Finally, let's take a step back perhaps, and take a look at some of the U.K.'s structural vulnerabilities. The U.K. has a very weak net international investment position, it's reliant on foreign money to fund some of its deficit and despite the recent fiscal U-turns, the U.K.'s fiscal deficit is still relatively large. In the context of these vulnerabilities, can you maybe discuss how recent events have affected foreign investors' confidence, and how do you see things going forward?
Andrew Sheets: Yes, so I think this is a really important issue and maybe a good one to close on. The U.K., as you just mentioned, runs a very large current account deficit. It imports much more than it exports, and when you do that you need to attract foreign capital to make up that difference. Now the U.S. also imports more than it exports, the U.S. also runs a large current account deficit, but because the U.S. is this large deep capital market, it's seen as a relative winner in the global economy in terms of both the makeup of its companies and its longer term growth it tends to have an easier time attracting that foreign capital. The U.K. has more challenges there. It's a much smaller market, it doesn't have the same sort of tech leadership that you see in the U.S. and in terms of attracting the foreign capital into the equity market, well, that's been more difficult because you've had some uncertainty over what U.K. corporate tax policy will be. The U.K. equity market also tends to be quite energy and commodity focused. So in an ESG focused world, it's more complicated to attract inward investment. And then on the bond market side, the U.K.'s bonds don't yield more than U.K. inflation at the moment. So again, that's probably worked against attracting foreign investment. So maybe one other factor there that is important and we've touched this in a glancing way throughout this conversation, is brexit. That the U.K.'s exit from the European union does still present a number of big uncertainties around how U.K. companies and the U.K. economy will operate relative to its largest trading partner. And so, again, we can see a scenario where just simply higher risk premiums or lower valuations are ultimately needed to clear the market.
Andrew Sheets: So Bruna, thanks for taking the time to talk.
Bruna Skarica: Thanks, Andrew.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As the U.K. deals with a bout of market volatility, political transitions, and sticky inflation, how will policy makers and the Bank of England respond, and where might the U.K. economy be headed from here? Chief Cross-Asset Strategist Andrew Sheets and U.K. Economist Bruna Skarica discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist.
Bruna Skarica: And I'm Bruna Skarica, Morgan Stanley's U.K. Economist.
Andrew Sheets: And on this special two part edition of the podcast, we'll be focused on the latest political, economic and market developments in the United Kingdom and how investors should think about the situation now and going forward. It's Thursday, October 27th at 2 p.m. in London.
Andrew Sheets: So Bruna, the world's eyes have been on the U.K. over the last couple of months, not only because it's the world's sixth largest economy, but because it's been experiencing an unprecedented level of market volatility, and it also has had an unusually large amount of political volatility. So I think a good place to start this discussion is just taking a step back. How would you currently frame the economic challenges facing the U.K.?
Bruna Skarica: Indeed, the level of volatility has truly been historic, both in the macro space, in the market and in politics. Now, in terms of what Prime Minister Sunak has on his tray coming into number 10, first let me mention the fiscal challenges. Chancellor Hunt, who's currently in number 11, has already reversed nearly all the measures from the mini budget, which was the catalyst of all this turbulence. Still, there is more to come. We think another £30 billion of fiscal tightening will be needed to stabilize debt to GDP ratio in the medium term. So more austerity, which of course, will be negative for growth. Now, this fiscal tightening, of course, comes in order to facilitate Bank of England's monetary tightening and help return inflation to the 2% target. The Bank of England has already hiked the bank rate to 2.25%, and we expect further hikes to come. So a lot of monetary tightening weighing on growth, too. And all of this is coming in the context of a very large external shock, that is the energy price move that has led to a spike in utility bills that the state is helping to counter, but that is weighing on UK's disposable income.
Andrew Sheets: Given all of these challenges, how do you think the Bank of England is going to react? They have an upcoming meeting on November 3rd, and they’re facing a backdrop where on the one hand the U.K. has some of the highest core inflation in the developed world, and on the other hand it has a number of these risks to growth which you just outlined. How do you think they try to thread that needle and what do you think they ultimately do?
Bruna Skarica: Indeed, the Bank of England has this year had a really complicated task at its hand. What started as the energy shock to inflation first impacting headline inflation, then spread on to pretty much every part of the consumer basket. The Bank of England we think has no choice but to tighten further from here. Chief Economist Pearl, in the aftermath of the mini budget, said that there will be a significant monetary response to the fiscal news and financial market volatility. As I mentioned, the mini budget was almost entirely scrapped, volatility subsided and so we think this significant response on November 3rd will come in the form of a 75 basis point hike. And we also see clear messaging from the Bank of England next week that this should be perceived as a one off level shift and that the pace of tightening will slow from December, as a lot of monetary tightening has already been delivered. We're expecting a 50 basis point move from the bank then and then two more 25 basis points hikes in the first quarter of next year, leaving the terminal rate at 4%.
Andrew Sheets: In the Bank of England's thinking, how does inflation come down? You know, because you still have imported inflation from a weak currency, you still have some of the higher friction cost to trade coming through from Brexit, you still have quite high core inflation. What do you think the Bank of England is looking at that gives it conviction? Alternatively, what do you think is the most likely way those predictions could be wrong?
Bruna Skarica: Well, the first thing to mention is the energy price inflation. It is true that our in-house Morgan Stanley view is that energy prices, for example natural gas prices, will not meaningfully correct from here. However, even if they stay at their current levels, inflation itself is going to slow and that's going to be a big drag on headline inflation over the course of next year and more so into 2024 and 2025. Additionally, the U.K. has seen a very sharp increase in traded goods inflation and our Morgan Stanley in-house view is that some of this is going to come off next year in the U.S. and the DM space more broadly, which we think will help lower U.K.'s headline and core inflation over the course of next year too. We do think services inflation will remain stickier. We think it's going to average around 5% next year actually, because our labor market's very tight and wage growth will remain at levels that are not consistent with meeting the 2% inflation target. However, the traded goods and energy prices we think should help with lowering headline inflation, and that is what the Bank of England is reflecting in its forecasts.
Andrew Sheets: So Bruna you mentioned the strength of the U.K. labor market holding up despite, you know, a number of these macroeconomic challenges. What's going on there? What do you think explains the strength and how big of a problem do you think that is for the Bank of England's policy challenges?
Bruna Skarica: That's a great question because our employment levels are actually not yet back to where they were pre-COVID. So a question arises as to why is our labor market this tight? And it's all about supply, really. The U.K.'s participation rate has been very subdued in the aftermath of the COVID shock. Some of it has to do with Brexit, a slowdown in migration flows from the EU from 2020 onwards because of course we've seen COVID and the Brexit shock coincide. However, much of it is to do with the drop in participation of U.K. born labor. For example, we now have a record high number of potential workers out with the labor force due to self-reported health issues. The health care backlog and NHS waiting lists are at an all time high and we now seem to have very limited fiscal space to address this. So we actually took down our own labor supply growth forecasts recently. This means that we do expect the slowdown in employment growth and when the recession comes shedding of employees over the course of next year, and that to be the main factor driving the rise in the unemployment rate.
Andrew Sheets: So you have been calling for a recession around the end of the year in the U.K. and weak growth really through the middle of 2023. Is that still your forecast and what are the most likely factors that could change it?
Bruna Skarica: Yes, that is still the case. We are looking for a 1% contraction in 2023 and for a recession to kick off in the second half of 2022. In terms of positive catalysts, I would say if natural gas prices fall further, the government will have more fiscal space to support the economy as opposed to using the funds to counter the external energy price hit. It would, of course, help with keeping the inflation somewhat lower. More resilient consumer spending, perhaps as some of those pandemic excess savings are spent, is another upside risk. But we see a very low probability of this happening. And finally, a more aggressive global disinflation, something I've mentioned when it comes to global traded goods inflation, leading to a faster return to positive real income growth, that's another factor to think about, and that would be beneficial for consumers and of course for overall U.K. GDP growth. So those are the main positive factors, I would say.
Andrew Sheets: Bruna, thanks for taking the time to talk.
Bruna Skarica: Great speaking with you, Andrew.
Andrew Sheets: And thanks for listening. Be sure to tune in for the upcoming Part two of our conversation about the U.K. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As the U.K. attempts stabilize its debt to GDP ratio, as well as curb inflation, the question becomes, to what extent will the Bank of England continue to tighten monetary policy?
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about recent developments in the U.K. and what the implications might be for other economies. It's Wednesday, October 26th, at 10 a.m. in New York.
The political environment in the U.K. is fluid, to say the least. For markets, the most important shift was the fiscal policy U-turn. The tax cuts proposed by former Chancellor Kwarteng have been withdrawn apart from two measures related to the National Health Service and property taxes. In total, the reversal of the mini budget tax cuts brings in £32 billion of revenue for the Treasury. Media reports suggested that Chancellor Hunt was told by the fiscal watchdog, the OBR, that medium term stability of the debt to GDP ratio would require about £72 billion of higher revenue. There's a gap of about £40 billion implying tighter fiscal policy to come.
The clearest market impact came from the swings in gilt yields following the original fiscal announcement. The 80 basis point sell off in 30 year gilts prompted the Bank of England to announce an intervention to restore financial stability for a central bank about to start actively selling bonds to change course and begin buying anew was a delicate proposition. But so far, the needle appears to have been threaded.
And yet, despite the recent calm, the majority of client conversations over the past month have included concern about other possible market disruptions. Part of the proposed fiscal plan was meant to address surging energy prices. Inflation in the UK is 10.1% of which only 6.5% is core inflation. The large share of inflation from food and energy prices works like a tax. From a household perspective, the average British household has a disposable income of approximately £31,000 a year and went from paying just over £1,000 a year for electricity and gas to roughly £4,000. Households lost 10% of their disposable income.
Of course, the inflation dynamics in the U.K. resemble those in the euro area, in the latter headline inflation is 10%, but core inflation constitutes just under half of that. The hit to discretionary income is even larger for the continent. Our Europe growth forecasts have been below consensus for this reason. We look for more fiscal measures there, but our basic view is that fiscal support can only mitigate the depth of the recession, not avoid it entirely.
Central banks are tightening monetary policy to restrain demand and thereby bring down inflation. The necessary outcome, then, is a shortfall in economic activity. For the U.K. the structural frictions from Brexit exacerbate the issue and the Bank of England, like our U.K. team, expect the labor force itself to remain inert. Consequently, after the recession, even when growth resumes, we expect the level of GDP to be about one and a half percent below the pre-COVID trend at the end of 2023.
For the Bank of England, we are looking for the bank rate to rise to 4%, below market expectations. The shift in the fiscal stance tipped the balance for our U.K. economist Bruna Skarica. She revised her call for the next meeting down to 75 basis points from 100 basis points. And so while the next meeting may be a close call, in the bigger picture we think there will be less tightening than markets are pricing in because of the tighter fiscal outlook.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The Biden administration recently imposed new trade restrictions on exports to China, but what sectors will be impacted and will we continue to see more policy pressure from the U.S. to China?
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Welcome to Thoughts on the market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, October 25th, at 10 a.m. in New York.
On October 7th, the Biden administration announced another round of controls on the export of advanced computing and semiconductor equipment to China. The stated goal is to protect U.S. national security and foreign policy interests by limiting China's ability to develop cutting edge chip and computing technology. This news drove volatility in equity markets in China recently, but we think it shouldn't come as a surprise to investors. In fact, we argue that investors should expect the U.S. to continue pressing forward with trade restrictions on China.
It's all part of our slowbalization and multipolar world frameworks. In short, as China's economy grows into a legit challenger to U.S. hegemony, U.S. policy has changed to protect its economic and military advantages. Export controls are one of those policies springing from a law passed in 2018, one of the few pieces of legislation that received bipartisan support during the Trump administration. And this law gives broad authority to the executive branch to decide what's in scope for export restrictions. So as the competition between the U.S. and China grows and new technologies over time become old technologies, expect export controls and other non-tariff barriers to spread across multiple industries. Other policy barriers could arise, too. As we've stated in prior podcasts, we still see scope for Congress to create an outbound investment control function for the White House. All in all, the net result is a managed delinking of the U.S. and China economies in some key sectors.
For investors, the read through is clear; the policy pressure from the U.S. and China is unlikely to abate any time soon. The bad news from this? It means new costs to fund the supply chains that will have to be built, a particular challenge for tech hardware companies globally. The good news? This isn't a hard decoupling of the U.S. and China. Slowly but surely, these measures set up new rules of engagement and coexistence for the U.S. and China economies, meaning the worst outcomes for the global economy are likely to be avoided.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As equities enjoy their best week since the summer highs in June, investors seem at the mercy of powerful market trends, so when might these trends take a turn to the downside?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 24th, at 11:30 a.m. in New York. So let's get after it.
Last week, we made a tactically bullish call for U.S. equities, and stocks did not disappoint us. The S&P 500 had its best week since June 24th, which was the beginning of the big summer rally. As a reminder, this is a tactical call based almost purely on technicals rather than fundamentals, which remain unsupportive of higher equity prices over the next 3 to 6 months. Furthermore, the price action of the markets has become more technical than normal, and investors are forced to do things they don't want to, both on the upside and the downside. Witness September, which resulted in the worst month for U.S. equities since the COVID lockdowns in March of 2020. The same price action can happen now on the upside, and one needs to respect that in the near term, in our view.
As noted last week, the 200 week moving average is a powerful technical support level for stocks, particularly in the absence of an outright recession, which we don't have yet. While some may argue a recession is inevitable over the next 6 to 12 months, the market will not price it, in our view, until it's definitive. The typical signal required for that can only come from the jobs market. While nonfarm payrolls is a lagging indicator that gets revised later, the equity market tends to be focused on it. More specifically, it usually takes a negative payroll reading for the market to fully price a recession. Today, that number is a positive 265,000, and it's unlikely we get a negative payroll number in the next month or two. Of course, we also appreciate the fact that if one waits for such data to arrive, the opportunity to trade it will be missed. The question is one of timing. In the absence of hard data from either companies cutting guidance significantly for 2023 or unemployment claims spiking, the door is left open for a tactical trade higher before reality sets in.
Finally, as we begin the transition from fire to ice, falling inflation expectations could lead to a period of falling interest rates that may be interpreted by the equity market as bullish, until the reality of what that means for earnings is fully revealed. Given the strong technical support just below current levels, the S&P 500 can continue to rally toward 4000 or 4150 in the absence of capitulation from companies on 2023 earnings guidance. Conversely, should interest rates remain sticky at current levels, all bets are off on how far this equity rally can go beyond current prices. As a result, we stay tactically bullish as we enter the meat of what is likely to be a sloppy earnings season. We just don't have the confidence that there will be enough capitulation on 2023 earnings to take 2023 earnings per share forecasts down in the manner that it takes stocks to new lows. Instead, our base case is, that happens in either December when holiday demand fails to materialize or during fourth quarter earnings season in January and February, when companies are forced to discuss their outlooks for 2023 decisively. In the meantime, enjoy the rally.
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The U.K.’s economy continues to face a host of challenges, including high inflation and a weak currency, and while these problems are not insurmountable, they may weigh significantly on the economic outlook.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 21st at 2 p.m. in London.
The eyes of the financial world remain on the United Kingdom, the world's 6th largest economy that is facing a complicated, interwoven set of challenges. We talked about the U.K. several weeks ago on this program, but I wanted to revisit it. It's a fascinating cross-asset story.
First, among these challenges is inflation. High U.K. Inflation is partly due to global factors like commodity prices, but even excluding food and energy core inflation is about 6.5%. And since the U.K. runs a large current account deficit, importing much more than it exports, a weak currency is driving even higher costs through all those imported items. Meanwhile, Brexit continues to reduce the supply of labor and increase the costs of trade, further boosting inflation and reducing the benefit that a weaker currency would otherwise bring.
The circularity here is unmissable; high inflation is driving currency weakness and vice versa. High inflation has depressed U.K. real interest rates, making the currency less attractive to hold. And high inflation relative to other countries undermines valuations. On an inflation adjusted basis, also known as purchasing power parity, the British pound hasn't fallen that much more than, say, the Swiss franc over the last year.
If inflation is high, why doesn't the Bank of England simply raise rates to slow its pace? The bank is moving, but the Bank of England has raised rates by less than the market expected in 6 of the last 8 meetings. The Bank of England's hesitation is understandable, most UK mortgage debt is only fixed for 2 to 5 years, which means that roughly $100,000 loans are resetting every month. The impact is that higher rates can flow through into the economy unusually fast, much faster than, say, in the United States.
Another way to slow inflation will be through tighter fiscal policy. But here we've seen some rather volatile recent political headlines. The U.K. government initially proposed a plan to loosen fiscal policy, but following a volatile market reaction has now changed course and reversed a number of those proposals. It still remains to be seen exactly what policy the U.K. government will settle on and what response the markets will have.
The UK's problems are not insurmountable, but for now they remain significant. Our U.K. interest rate strategists think that expectations for 5 year inflation can move higher, along with yields. While our foreign exchange strategists are forecasting a lower British pound against the dollar.
The one bright spot for the U.K. might be its credit market. Yielding over 7%, U.K. investment grade credit actually represents issuers from all over the world, including the United States. While less liquid than some other markets, we think it looks increasingly attractive as a combination of stability and yield amidst an uncertain environment.
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While European earnings have been remarkably resilient this year, and consensus estimates for earnings and corporate margins remain high, there may be reason to believe there’s further yet to fall.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for European earnings for the upcoming third quarter reporting season and beyond. It's Thursday, October the 20th, at 2 p.m. in London.
Having been cautious on European equities for much of this year, we have recently started to flag the potential for more two-way price action in the near-term, reflecting a backdrop of low investor positioning, coupled with the potential for an inflection in U.S. inflation and interest rates over the next few months. To be clear, we haven't seen either of these two events occur yet, however we are conscious that each week that passes ultimately takes us closer to just such an outcome. Given that high inflation and rising interest rates have been the key drivers pushing equity valuations lower this year, any sign that these two metrics are peaking out would suggest that we are approaching a potential floor for equity PE ratios. However, while this is good news to a degree, history suggests that we need to be closer to a bottom in the economic and earnings cycle before equity markets put in their final price low.
So far this year, European earnings have stood out for their remarkable resilience, with the region enjoying double digit upgrades on the back of currency weakness and a doubling of profitability for the energy sector. Looking into the third quarter reporting season, we expect this resilience to persist for a bit longer yet. Currency effects are arguably even more supportive this quarter than last, and the global and domestic economies have yet to show a more material slowdown that would be associated with recessionary conditions. Our own third quarter preview survey also points to a solid quarter ahead, with Morgan Stanley analysts expecting 50% of sectors to beat consensus expectations this quarter versus just 13% that could miss.
Longer term, however, this same survey paints a more gloomy picture on the profit outlook, with our analysts saying downside risks to 2023 consensus forecasts across 70% of European sectors and upside risks in just 3; banks, insurance and utilities. In the history of this survey, we have never seen expectations this low before, nor such a divergence between the short term and longer term outlooks.
From our own strategy perspective, we remain cautious on European earnings and note that most, if not all of our models are predicting a meaningful drop in profits next year. Specifically, consensus earnings look very optimistic in the context of Morgan Stanley GDP forecasts, current commodity prices, dividend futures and the latest readings from the economic indicators we look at, such as the purchasing managers indices.
In addition to a likely top line slowdown associated with an economic recession, we see significant risks around corporate margins, too. Over the last 12 to 18 months, inflation has positively contributed to company profitability, as strong pricing power has allowed rising input costs to be passed on to customers. However, as demand weakens, this pricing power should wane, leaving companies squeezed between rising input costs and slowing output prices. In this vein, our own margin lead indicator suggests that next year could see the largest fall in European margins since the global financial crisis. However, consensus estimates assume that 16 out of 20 European sectors will actually see their margins expand next year.
Our concern around overly optimistic earnings and margin assumptions next year is shared by many investors we speak to. However, this doesn't necessarily mean that all of the bad news is already in the price. Analyzing prior profit cycles suggests that equity markets tend to bottom 1 to 2 months before earnings revisions trough, and that it takes about 7 to 8 months for provisions to reach their final low. If history repeats itself in this cycle, this would point to a final equity low sometime in the first quarter of 2023, even if price to earnings ratios bottom later this year.
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As the EU puts new regulations on sustainability funds, how will categorization of these funds be impacted, and how might that change investment strategies? Head of Global Thematic and Public Policy Research Michael Zezas and Head of Fixed Income and ESG Research Carolyn Campbell discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of Global Thematic and Public Policy Research.
Carolyn Campbell: And I'm Carolyn Campbell, I lead our Fixed Income and ESG Research Team.
Michael Zezas: And on this special episode of Thoughts on the Market, we'll focus on sustainability funds and their investment strategies within an evolving regulatory context. It's Wednesday, October 19th, at 10 a.m. in New York.
Michael Zezas: There are just over 1400 dedicated fixed income sustainability funds with assets under management, around $475 billion off from a peak of $545 billion at the end of 2021. This is a sizable market, but as EU regulators weigh in on what these funds can and can't own, it begs the question what kinds of bonds might they start buying? So Carolyn, let's maybe start with the essentials behind the EU Sustainable Finance Disclosure Regulation, SFDR, and what it requires of financial market participants. Specifically, what are Article 8 and Article 9 products?
Carolyn Campbell: So under the SFDR, fund managers are required to classify their funds in one of three ways. The first, Article 8, or what's known as a light green fund, is a sustainability fund that promotes environmental or social characteristics. The dark green funds, which are Article 9 funds, invest in sustainable investments and have an environmental or a social factor as an objective. They also, importantly, cannot do significant harm to other environmental or social objectives. And then lastly, we have the non sustainability funds which are Article 6.
Michael Zezas: And despite the regulator's goal to increase transparency and accountability, there's still a high degree of uncertainty in the regulatory landscape around what can and should be included in sustainability funds. What does this uncertainty mean for the types of products that are currently being included in these funds, and how might that change in the future?
Carolyn Campbell: So by and large, the regulatory uncertainty has meant that funds are more likely to take a conservative approach when constructing their holdings for fear of regulatory repercussions or just reputational risk. In particular, where investors need to have a "sustainable investment" that does not do significant harm to other environmental objectives, which is what we have in Article 9, we expect to see them gravitate increasingly towards high quality green bonds. And as a reminder, green bonds are different from regular bonds because the net proceeds of those bonds goes towards green projects. Think of it as retrofitting buildings to be more environmentally friendly, investing in climate change adaptation solutions, or building out clean transportation infrastructure. Green bonds fit pretty neatly into these Article 9 funds because they're demonstrably sustainable investments. And since you know where the proceeds are going, it's less likely that they're violating that last part, the ‘do no significant harm’. So some of the Article 9 funds are full green bond funds. But the ones that are not actually only hold around an average of 10% of their fund in green bonds or other types of ESG label bonds like social or sustainability bonds. And we see similar figures in the Article 8 funds as well. So we expect that green bonds of higher quality, meaning that they're aligned with the more rigorous EU green bond standard that report on impact have limited amounts of proceeds going towards refinancing, have limited look back periods etc.. Those stand to benefit from an increased appetite from these sustainability funds for the best types of green bonds.
Michael Zezas: Carolyn, you've noted that most ESG funds currently favor low emission sectors, particularly financials. What about sectors that were previously maligned by ESG funds, the so-called high emitting or hard to abate sectors? What is the rate of change approach that might benefit these sectors?
Carolyn Campbell: So the SFDR is structured in a way to favor the low emitting sectors because they have to report on the principal adverse impacts and because they can't do significant harm. But what we're increasingly hearing is an appetite to invest directly in the transition. So allocating funds to the higher emitting companies, but those that have viable decarbonization plans and for which an improvement on different ESG metrics may drive better financial performance. When we look to the fund holdings of the fixed income sustainability funds, we see that they're currently underweight these sectors despite some real opportunity from the transition. As ESG has evolved this year, so too should the types of strategies that we see adopted across the funds. And companies that are leading the way in their sectors stand to benefit from increased demand from sustainability funds that adopt these approaches, particularly in those sectors that are hard to abate or traditionally high emitting.
Michael Zezas: Finally flows into fixed income sustainability funds increased throughout 2021, topping out at $17 billion in February. But inflows have been on a downward trajectory throughout the first half of 2022. What are the key drivers behind this decrease and what's your outlook for the secular growth story for ESG, both near-term and longer term?
Carolyn Campbell: So there are a couple of things driving those declining inflows. First and foremost, the macro backdrop has significantly changed this year versus last year. We've seen regular large rate hikes from central banks around the world to combat high inflation, increased market volatility. It's a tougher environment all around this year in general, and it's not just sustainability funds that are seeing slowing inflows and even outflows. In fact, sustainability fund flows have held up remarkably well given all of this. Then you add in the fact that ESG is facing a bit of a reckoning. There's more vocal pushback in the press, from politicians and from those in the industry themselves on what ESG is and what are its merits. But we don't think this will hurt the growth of ESG in the long term. Rather, we think that sustainability strategies are undergoing an evolution towards more nuance and rigor, away from more simplistic approaches that we've seen adopted in the past. Climate change and sustainability more broadly will be a defining trend for at least the next decade, and this transition requires significant capital. That provides an interesting and unique opportunity for investors, and we've seen sustained demand from both institutional and retail clients for these different types of ESG strategies.
Michael Zezas: So Carolyn, thanks for taking the time to talk.
Carolyn Campbell: Great speaking with you, Michael.
Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
As U.S. Public Debt continues to break records, should investors be concerned by the amount debt has risen? Or are there other, more influential factors at play?
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy. Along with my colleagues, bringing you a variety of perspectives, today I'll be talking about how macro investors may want to view rising U.S. public debt. It's Tuesday, October 18th, at 10 a.m. in New York.
U.S. public debt made breaking news headlines this month by rising above $31 trillion for the first time. In a decade, it's projected to hit $45 trillion, according to the Congressional Budget Office or CBO. By the time new hires today are ready to retire, U.S. debt to GDP could be at 185%.
The CBO argues that high and rising debt could increase the likelihood of a fiscal crisis, because investors might lose confidence in the U.S. government's ability to service and repay its debt. They also believe that it could lead to higher inflation expectations, erode confidence in the U.S. dollar as a reserve currency, and constrain policymakers from using deficits in a countercyclical way.
The government debt load in Japan has stood as a notable counterpoint to concerns of this nature for decades. With gross debt a whopping 263% of GDP, and no fiscal crisis that has occurred or appears to be on the horizon, Japan's situation should mitigate some of the CBO's concerns.
Still, the amount of debt matters, especially to those invested in it. As both the level of debt and interest rates rise further, net interest income for U.S. households may contribute more to total income over time.
Nevertheless, the level of government debt vis a vis the size of the economy and its contribution to societal income, are not the most pressing issues. The problem with debt has always been predicting the price at which it gets bought and the value it provides investors. The current size of the debt at $31 trillion is just a distraction. This staggering number fundamentally diverts attention from what matters most here.
So what does matter the most here? First, the speed at which the debt accumulates. Second, the risk characteristics of the debt that investors will buy. Third, the price at which investors will buy it and the value it provides at that price. And fourth, the major drivers of the yields in the marketplace for it.
The amount of debt, the Federal Reserve's retreat from buying it, and foreign investors' waning appetite have left some analysts and investors wondering who will buy at all. The relevant question for macro investors, however, is not who will buy the securities, but at what price. The marginal buyer or seller moves prices, not the largest. Consider that at least 3.5% of outstanding U.S. Treasuries change hands every single day. That's an open invitation for many investors, including those who use leverage, to move prices.
So what determines the level of Treasury yields over time? In the end, the most important factor, at least over the past 30 years, has been the Fed's interest rate policy and forward guidance around it.
So, bottom line, macro investors should pay more attention to the Fed and the economic data that the Fed care most about than the overall amount of government debt investors will need to purchase or which investors will do the buying.
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Last week's September inflation data brought a subsequent rally in stocks, but can this rally hold while the bond market continues to follow the Fed?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 17th, at 1 p.m. in New York. So, let's get after it.
No rest for the weary as days feel like weeks and weeks feel like months in terms of price action in the financial markets. While there's always a lot going on and worth analyzing, it's fair to say last week was always going to be about the September inflation data one way or another.
From our vantage point, inflation has peaked. While 8% is hardly a rate the Fed can live with, the seeds have been sown for lower prices in many goods and services. Housing is at a standstill, commodity prices have fallen substantially since April, and inventory is starting to balloon at many companies at a time when demand is falling. That means discounting should be pervasive this holiday shopping season. Finally, the comparisons get much more challenging next year, which should bring the rate of change on inflation down substantially on a year-over-year basis.
At the end of last year, the bond market may have looked to be the most mispriced market in the world. That underpricing of inflation and rates was a direct result of Fed guidance. Recall that last December the Fed was suggesting they would only hike 50 basis points in 2022. More surprisingly, the bond market bought it and ten-year yields closed out the year at just 1.5%. Fast forward to today and we think the bond market is likely making the same mistake but on the other side.
We think inflation is peaking, as I mentioned, and we think it falls sharply next year. Shouldn't the rates market begin to ignore Fed guidance and discount that? We can't be sure, but if rates do fall under that premise, it will give legs to the rally in stocks that began last Thursday. As we have been noting in our last few podcasts, the downside destination of earnings-per-share forecasts for next year is becoming more clear, but the path remains very uncertain. More specifically, we're becoming skeptical this quarter will bring enough earnings capitulation from companies on next year's numbers for the final price lows of this bear market to happen now. Instead, we think it may be the fourth quarter reporting season that brings the formal 2023 guidance disappointment.
So how far can this rally in stocks run? We think 4000 on the S&P 500 is a good guess and we would not rule out another attempt to retake the 200-day moving average, which is about 4150. While that seems like an awfully big move, it would be in line with bear market rallies this year and prior ones. The other factor we have to respect is the technicals. As noted two weeks ago, the 200-week moving average is a formidable level for the S&P 500 that's hard to take out without a fight. In fact, it usually takes a full-blown recession, which we do not yet have.
Bottom line, we think a tradable bear market rally has begun last Thursday. However, we also believe the 200-week moving average will eventually give way, like it typically does when earnings forecasts fall by 20%+. The final price lows for this bear are likely to be closer to 3000-3200 when companies capitulate and guide 2023 forecasts lower during the fourth quarter earnings season that's in January and February.
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When investing in overseas markets, 'hedging' one's investment not only offers potential protection from the fluctuations of the local currency but potentially may also lead to higher returns.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 14th, at 2 p.m. in London.
How much is the Japanese stock market down this year? That seems like a pretty basic question and yet, it isn't. If you're a Japan-based investor who thinks about the world in Japanese yen, the market has dropped about 6% year-to-date, a pretty mild decline, all things considered. But if you're a U.S. investor, who thinks about the world in U.S. dollars, the market has fallen 26%.
That's a big difference, and it's entirely linked to the fact that when investing overseas, your return is a function of both the changes in that foreign market and the changes in its currency's value versus your own. When a U.S. investor buys Japanese equities, the actual transaction will look something like this. The investor sells their dollars for yen and then uses those yen to buy Japanese stocks. When the investor eventually goes to sell their investment, they need to reverse those steps, selling yen and buying the dollars back. This means that the investor is ultimately exposed to fluctuations in the value of the yen.
Given this, there's an increased focus on investing overseas but removing the impact of currency fluctuations, that is, 'hedging' the foreign exchange exposure. There are a few reasons that this can be an attractive strategy for U.S. based investors.
First, it reduces a two-variable problem to a one-variable problem. We reckon that most stock market investors are more comfortable with stocks than they are with currencies. An unhedged investment, as we just discussed, involves both, while a hedged investment will more closely track just the local stock market return, the thing the investor likely has a stronger opinion on.
Second, our deep dive into the historical impact of currency hedging shows encouraging results, with hedging improving both returns and diversification for U.S. investors when investing overseas. Historically, this has been true for stocks, but also for overseas bonds.
Third, investors don't always need to pay extra to hedge. Indeed, hedging can provide extra yield. The general principle is that if you sit in a country with a higher interest rate than the country you're investing in, the hedge should pay you roughly the interest rate difference. One-year interest rates in the U.S. are about 4.5% higher than one-year rates in Japan. Buying Japanese stocks and removing the fluctuations of the yen will pay an investor an extra 4.5% for their trouble, give or take.
So why is that? The explanation requires a little detour into foreign exchange pricing and the theory behind it.
Foreign exchange markets price with the assumption that everything is in balance. So, if one country has higher one-year interest rates than another, its currency is assumed to lose value over the next year. So, if we think about the investor in our example, they still take their U.S. dollars, exchange them for yen and buy the Japanese equity market. But what they'll also do is go into the foreign exchange market where the dollar is expected to be 4.5% cheaper in one year's time and buy that foreign exchange forward, and 'hedge' the dollar at that weaker level. That means when they go to unwind their position in a year's time, sell their yen and buy dollars, they get to buy the dollar at that favorable lower locked-in exchange rate.
Hedging comes with risks. If the US dollar declined sharply, investors may wish that they had more exposure to other currencies through their foreign holdings. But given wide interest rate differentials, volatile foreign exchange markets and the fact that the goal of most U.S. portfolios is to deliver the highest possible return in dollars, investing with hedging can ultimately be an attractive avenue to explore when looking for diversification overseas.
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Increasing ESG pervasiveness has led to increasing confusion, in particular around how investors might apply these criteria to the utility sector. Head of Sustainability Research and Clean Energy Stephen Byrd and Equity Analyst for the Power and Utilities Industry Dave Arcaro discuss.
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Stephen Byrd Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research and Clean Energy.
Dave Arcaro And I'm Dave Arcaro, Equity Analyst for the Power and Utilities Industry.
Stephen Byrd And on this special episode of the podcast, we'll be discussing a new framework for investors to approach ESG analysis within the utility space. It's Thursday, October 13th, at noon in New York.
Stephen Byrd Our listeners are no doubt well aware that ESG criteria—that is environmental, social and governance criteria—have become an increasingly important part of the investment process. This growth has been spurred by a continual search for better long term financial returns, as well as a conscious pursuit of better alignment with values. Yet despite ESG's seeming pervasiveness within the financial ecosystem, there's been a genuine confusion and even controversy among investors about how to apply ESG metrics to the utility sector in particular. And so, in an effort to bring clarity to this key market debate, today we're going to share an innovative framework designed to drive both Alpha, which is the returns aspect, and impact, which is the societal benefit. So Dave, let's start with the problem. What causes this investor confusion and how does the new ESG framework address this problem?
Dave Arcaro There are a few sources of confusion or debate that we're hearing from investors. The first seems to be centered on the lack of a clear distinction between ESG criteria that are likely to have a direct impact on stock performance, and then those that are more focused on achieving the maximum positive impact on ESG goals. Secondly, there is too much focus directly on carbon emissions, and there isn't enough focus on the social and governance criteria in the utility space. These can also have an impact on stocks and on key utility constituents, things like lobbying, operations, customer relationships. The new ESG framework that we've introduced here addresses these issues. It expands the environmental assessment, incorporates specific social and governance criteria that are most relevant for utilities, like customer and lobbying metrics, and it adds a new perspective. For each of these metrics, we assess which ones truly have an impact on alpha generation and which ones have the largest purely societal impact.
Stephen Byrd And stepping back, Dave, we've seen that the utility sector is arguably the best positioned among the carbon heavy sectors in terms of its ESG potential. Can you walk us through that thought?
Dave Arcaro Utilities are in a unique position because they can often create an outcome in which everybody wins when it comes to decarbonizing. This is because when utilities shut down coal and replace it with renewables, it often has three benefits; carbon emissions decline, customer bills are reduced because renewables have gotten so cheap and the utility also grows its earnings. So, it's a strong incentive for utilities to set ambitious plans to decarbonize their fleets.
Stephen Byrd Now Dave, typically, when considering the E, that is environmental criteria, ESG analysis tends to focus solely or primarily at least on carbon dioxide. Is this a fair approach or should investors be considering other factors?
Dave Arcaro We think other factors should come into play here, and we recommend investors consider the rate of change in carbon emissions, the CO2 intensity of the fleet, risks from climate change, and also impacts on biodiversity. Some of these are more readily available than others, but we think the environmental assessment should expand beyond a simple look at carbon emissions.
Dave Arcaro So, Stephen, I want to turn it to you. The E part of ESG is always drawing attention when investors talk about utilities. But so far it seems that there's been little focus on the S, social, and G, governance, criteria when assessing U.S. utilities. What are some of the key areas that investors should concentrate on?
Stephen Byrd The utility sector really is one of the most heavily regulated sectors, so both social and governance factors can impact the success of the utility business and drive stock performance as well. The short list of metrics that we found to have a clear linkage to share price performance would be one, corporate spending on lobbying activities, especially through 501c4 entities. Two, operational excellence, which for utilities really reflects safety and reliability. Three, risk of customer defection due to high bills and worsening grid reliability. And four, impacts to low-income communities. So, we use these metrics to round out a holistic ESG assessment of the industry.
Dave Arcaro And last but not least, how does the new Inflation Reduction Act legislation figure within the kind of ESG framework Morgan Stanley is proposing here?
Stephen Byrd Yeah, the Inflation Reduction Act really is a big deal for our sector. To be specific, the Inflation Reduction Act provides significant, wide-ranging support for decarbonization technologies really across the board, including wind, solar, storage and clean hydrogen. As a result, this legislation could accelerate progress for utility decarbonization strategies in a way that also drives earnings and alpha. For that reason, within our framework, we specifically consider whether a utility is a beneficiary of the Inflation Reduction Act, given the potentially very large positive impacts on both the business and the environment.
Stephen Byrd David, thanks for taking the time to talk.
Dave Arcaro Great speaking with you, Stephen.
Stephen Byrd And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As consumption of goods slows post COVID, companies are experiencing a build up in inventory that could have far reaching implications. Head of Global Thematic and Public Policy Research Michael Zezas and U.S. Equity Strategist Michelle Weaver discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of Global Thematic and Public Policy Research.
Michelle Weaver: And I'm Michelle Weaver from the U.S. Equity Strategy Team.
Michael Zezas: And on this special episode of Thoughts on the Market, we'll focus on what we see as an inventory problem with far reaching implications. It's Wednesday, October 12th, at 10 a.m. in New York.
Michael Zezas: Michelle, can you start by taking us through some of the background on how we ended up with this problem of companies carrying high inventories, which could pressure them to discount prices leading to weaker earnings.
Michelle Weaver: I'm sure listeners remember the COVID lockdowns when many of us overspent on a number of goods, especially things like furniture, tech products and leisure equipment. But now, with the recovery from COVID and supply chain bottlenecks easing, we're seeing a new challenge, inventory build coupled with slowing demand. Throughout 2022, we've been dealing with really high inflation, rising interest rates and declining consumer confidence. And while consumer confidence has rebounded from the all time lows that we saw this summer, it remains weak and we think consumers are still going to pare back spending in the face of macro concerns. We think inventory is one of the key problems that will weigh on S&P 500 earnings, and supports our negative call on earnings for the market.
Michael Zezas: And how broad based is this problem? Which industries are most at risk?
Michelle Weaver: This is a pretty broad problem for publicly traded companies. Inventory to sales for the median U.S. company have been on the rise since the financial crisis and are now at the highest level since 1990. And it's especially a problem for consumer staples, tech and industrials companies. We also looked at the difference between growth rates for inventory and sales. For the S&P 500 overall, there's an 8% mismatch between inventory growth and sales growth, meaning the median company is growing their inventory 8% faster than their growing sales. The median company within goods producing industries has a whopping 19% mismatch between inventory and sales growth. Consumer retailers face some of the biggest risks from these problems, and companies there are already seeing inventory pile up. They have already turned to discounting to try and move out some of this excess inventory. This is also a big problem for tech hardware companies, consumer markets and PCs have been the first to see excess inventory given how much overconsumption these goods saw during COVID. And the tech hardware team is expecting this to broaden out and start causing issues for enterprise hardware.
Michael Zezas: And are there any beneficiaries from the current inventory situation? And if so, what drives the advantage for them?
Michelle Weaver: Machinery is one industry where inventories remain tight and they're still seeing really strong demand. Inventories across machinery are still in line or below their longer term averages and there's especially big problems in agriculture equipment. Off price retailers who sell their excess inventory from other brands are another area that are expected to benefit from excess inventories.
Michael Zezas: And Michelle, how do you expect companies to deal with the glut of inventory they're facing and how will this impact them in the final quarter of this year and into next year?
Michelle Weaver: It's likely going to take several quarters for inventory to normalize, but it really varies by industry and we expect inventory to remain an issue for the market into 2023. Faced with a glut of inventory, companies are going to need to decide whether they want to accept high costs to keep holding inventory, destroy inventory, try and keep prices high and take a hit on the number of units sold, or slash prices to stimulate demand. And we think many are going to turn to aggressive discounting to solve their inventory issue. This could spark a race to the bottom as retailers try and cut prices faster than peers and move out as much inventory as possible. And this dynamic will weigh heavily on margins and fuel the earnings slowdown we are predicting.
Michael Zezas: Well, Michelle, thanks for taking the time to talk.
Michelle Weaver: Great speaking with you, Mike.
Michael Zezas: As a reminder, if you enjoy Thoughts on the Market please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
All over the world elections are taking place that will have profound effects on both local and global economies, so where are policy moves being made and how might investors use these moves to anticipate economic shifts?
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about political economy and how elections have consequences. It's Tuesday, October 11th, at 8 a.m. in New York.
Economics is a relatively new field, born in 1776 after the publication of Adam Smith's 'Wealth of Nations'. But until the 1900s, everyone called it political economy. Politics and economics are still hard to separate. Fiscal policy is only sometimes the result of economic events, but almost always a driver of economic outcomes. And because of its power, uncertainty about policy can be a drag all by itself.
Brazil has a second round ballot on October 30th between the incumbent Bolsonaro and former President Lula. Both candidates are likely to change or scrap an existing fiscal rule that caps government spending, but most observers think that Lula is likely to have a looser fiscal stance of the two. And so while our LatAm team questions not whether fiscal deficits will increase, but by how much, last week's congressional elections could lead to a split government which is taken to mean a smaller size of any deficit widening. So our LatAm team is pointing to a different risk that a possible President Lula, and he currently leads in most polls, that there might be an unwinding of recent reforms for state owned enterprises, the public sector and labor markets that were meant to enhance Brazil's competitiveness. As is often the case, politics here is more about the medium term than the immediate.
In the U.K., it wasn't exactly the same thing. The newly appointed UK Prime Minister, Liz Truss, announced an ambitious fiscal package, including an energy price freeze and the biggest set of tax cuts since the 1970s. The echo to 1980s supply side economics was plain in terms of politics. In terms of economics, boosting productivity might allow more growth and lower inflation at a time where the opposite of each is at hand. But in a country with a 95% debt to GDP ratio and following on fiscal expansion that drove inflation through demand, the lack of details on how to pay for the tax cuts and the energy subsidies elicited a sharp, immediate market reaction. The gilt curve sold off sharply, and the pound reached an all time low of 103 against the dollar. The Bank of England intervened, buying gilts to contain volatility and to lower rates. And in the wake of that turmoil, Chancellor Kwarteng scrapped the tax cuts for the top bracket but kept the rest, leaving about £43 billion a year of additional cost. The outcome now seems to be a faster pace of hiking by the bank and an awareness that the U.K. will not have the fiscal space needed to avoid a recession. Barring unorthodox moves like scrapping the remuneration of bank reserves at the Bank of England, the Chancellor is going to need to find 30 to £40 billion in spending cuts to stabilize the debt to GDP ratio over the next five years.
In Italy, elections brought a center right populist coalition led by Giorgia Meloni to a majority in both the lower house and the Senate. The Coalition's stated policy goals are expansionary. More social spending and labor tax cuts are top priorities, along with increasing pension benefits. Our economists estimate that the proposed measures would increase the deficit by roughly 2 to 4 percentage points of GDP, boosting the debt to GDP ratio next year. Such policies will prove difficult during a time of rising interest rates and heightened market scrutiny about debt dynamics. So, Maloney recently expressed her willingness to respect the EU budget rules, but reconciling that view with the policy priorities is going to be a challenge. Our main concern is less a repeat of the U.K. experience, but rather medium term debt sustainability.
So let me finish up back home. For the U.S. midterm elections polls have been shifting but most point to at least one house of the Congress changing hands, thus a split government. Our base case from my colleague Mike Zezas as a result is gridlock, but divided governments do not always lead to such benign outcomes. I was a Treasury official during a government shutdown. It was not fun. And in fact, following the 2010 midterms, divided government led to a debt ceiling standoff, government shutdown, and ultimately contractionary policy in the form of the Budget Control Act. Such an outcome is easily conceivable after this midterm election, and with inflation high, even with weak growth, we could easily see another installment of contractionary policy. With growth only expected to be barely positive, that's a real risk. Policy always matters.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Last week stocks rallied quickly but dropped just as fast as markets continue to hope for a more dovish Fed, but will this 2-way risk continue as evidence for a drop in earnings continues to accumulate?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 10th, at 1:30 p.m. in New York. So let's get after it.
Last week started with one of the biggest 2 day rallies in history, only to give most of it back by Friday's close. The culprit for this higher 2-way volatility is a combination of deteriorating fundamentals with oversold technicals. As noted last week, September was one of the worst months in what's been a difficult year, and the equity market was primed for a rally, especially with the S&P 500 closing right at its 200 week moving average on the prior Friday. Low quality stocks led the rally as further evidence the rebound was just bear market action rather than the beginning of a new bull. There is also still lingering hope for a Fed pivot, but the economic data that matters the most for such a pivot, jobs and inflation, continue to dash any hopes for a more dovish Fed.
The sellout of momentum and retail, to some degree, does keep 2-way risk alive in the short term as it gets quiet for the next few weeks on the earnings front. Over the past month, there has been evidence that our call for lower earnings next year is coming to fruition. Large, important companies across a wide swath of industries have either reported or preannounced earnings and guided significantly lower for the fourth quarter. Some of these misses were as much as 30%, which is exactly what's needed for next year's estimates to finally take the step function lower, we think is necessary for the bear market to be over. The question is, will enough of this happen during third quarter earnings season, or will we need to wait for fourth quarter reporting in January and February when companies tend to formally guide for the next year? We think the evidence is already there and should be strong enough for this quarter for bottoms up consensus estimates have finally come down to reality, but we just don't know for sure. Therefore, over the next two weeks, stocks could continue to exhibit 2-way risk and defend that 200 week moving average at around 3600.
One interesting development that supports our less optimistic view on 2023 earnings is in the dividend futures market. More specifically, we've noticed that dividend futures have traded materially lower, even as forward earnings per share forecasts have remained sticky to the upside. One reason this might be happening now is that cash flows are weakening. This is tied to the lower quality earnings per share we predicted earlier this year as companies struggled with the timing and costs versus revenues as the economy fully reopened. Things like inventory, labor costs and other latent expenses are wreaking havoc on cash flow. Accrual accounting earnings per share will likely follow 6 to 12 months later. In short, it's just another sign that our materially lower than consensus earnings per share forecasts next year are likely to be correct. If anything, we are now leaning more toward our bear case on S&P 500 earnings per share for next year, which is $190. The consensus is at $238.
Bottom line, the valuation compression in equity markets this year is due to interest rates rising rather than concern about growth. This is evidenced by the very low equity risk premium, currently 260 basis points, that we still observe. The bear market will not be over until either earnings per share forecasts are more in line with our view, or the valuation better reflects the risk via the equity risk premium channel. Bear markets are about price and time, price takes your money, time takes your patience. Let the market wear everybody else out. When nobody is calling for the bottom, you will then know it's finally time to step in.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
While China’s policy objectives strive for common prosperity, the country’s strict COVID management poses risks to employment and income, so when might Chinese policymakers start to reopen and recover?
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be focusing on the expected reopening of China's economy. It's Friday, October 7th, at 8:30 a.m. in Hong Kong.
When my colleagues and I discuss Asia's growth outlook with investors, one of the top questions we get is, when will China reopen and what the roadmap will look like. We believe a reopening will happen not because the rest of the world is now living with COVID, but because the effects of China's strict COVID management are now increasingly at odds with its policy objective of achieving common prosperity.
The challenges of a sharp rise in youth unemployment and significantly lower income growth, especially for the low income segments of the population, have become more pronounced this year ever since the onset of Omicron. To put this in context, the youth unemployment rate is at 19% and our wage growth proxy has decelerated from around 9% pre-COVID, to just about 2.2% year on year.
These issues are further exacerbated by the intensifying spillover effects from weaker exports and a continued drag from property sector. Over the next five quarters, growth in developed markets will likely remain below 2% year on year. The continued shift in DM consumer spending towards services will mean global goods demand will deflate further. And as exports weaken, manufacturing CapEx will also follow suit, which will further weigh on employment creation. As for the property market, the pace of resolution of funding issues and uncompleted projects are still relatively sluggish. With the outlook for the drivers of GDP growth weakening, we think the only meaningful policy lever is a shift in COVID management aimed at reopening, reviving consumption and allowing services sector activity to lift aggregate demand towards a sustainable recovery.
As things stand, several steps are necessary for a smooth reopening. They are, number one, renewed campaign to lift booster vaccination rates, especially amongst the elderly population. Number two, shaping the public perception on COVID. And number three, ensuring adequate medical facilities, equipment and treatment methods in the next 3 to 6 months. We therefore anticipate that policymakers will, in the spring of 2023, with the peak COVID and flu season behind us, be able to proceed with a broader reopening plan. Of course, we think that reopening in China will be gradual, as policymakers will remain mindful of the potential burden on the health care system.
Against this backdrop, we see the recovery strengthening from second quarter of 2023 onwards. In the next two quarters, we estimate GDP growth will be subpar at around 3%. But as China reopens from the spring of 2023, we expect GDP growth will strengthen to 5.5% in the second half of the year.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As month over month data begins to show a downturn in home prices, will overall price growth and sales begin to fall steeper than expected? Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.
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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow: And I'm Jay Bacow, the other Co-head of U.S. Securitized Products Research.
Jim Egan: And on this episode of the podcast, we'll be discussing why home prices could turn negative in 2023. It's Thursday, October 6th, at 3 p.m. in New York.
Jay Bacow: Jim, it seems like every month the housing data is getting worse when we look at the sales activity. But, now I think I just saw something about home prices falling? What's going on there? I thought we call it home price appreciation, now we're seeing home price depreciation?
Jim Egan: There is a lot going on out there. There's a lot of volatility, things are moving fast, and yes, there are home price indices that are showing negative numbers. I would caveat that a lot of those negative numbers are month over month, not the year over year that we've typically talked about here. But that doesn't mean it isn't important.
Jay Bacow: In the past we've talked about this bifurcation narrative where we were going to get a big drop in home sales and housing starts, which we've seen, but home prices were more protected. Do you still believe that?
Jim Egan: We do still believe in the bifurcation narrative, but the levels of the forecasts have changed, and they've changed for a couple of reasons. I think one reason is that there have been a number of forecast changes, expectations for 2023 are different. Our U.S. economics team has raised their hiking forecast 25 basis points in each of the next three meetings, and our interest rate team on the back of that forecast change has moved up their expectations for the 10 year Treasury. What that move means for us is that the incredible affordability deterioration that we've seen, probably isn't going to get a whole lot better next year. And that's happening in a world in which you mentioned some home prices turning negative. The home price deceleration that we were calling for, from plus 20% all the way down to plus 3% at the end of next year, that relied upon or I can say we expected home prices to fall month over month, but we thought that was going to start in September. It started in July. Sales volumes have been coming in weaker than we thought they would. When we take that weaker than expected housing data, we marry that with different expectations for affordability next year, the forecasts have to change.
Jay Bacow: And so what exactly are we forecasting for this year and next year?
Jim Egan: So in this world, we do think that sales are going to fall steeper than we thought. We think that starts are going to fall steeper than we thought, and that next year a single unit starts are going to be lower in 2023 than they were in 2022. We had originally been forecasting a return to growth in 2023, but the change to the forecast that's getting the most attention is that we went from plus 3% year over year growth in December of 2023 to -3% year over year growth by the end of next year.
Jay Bacow: So if I buy a house today, it might be lower a year from now? That seems worrisome.
Jim Egan: Yes. And I think there is a positive and a negative headline to that, right. The negative headline, the worrisome, if you will, that you mentioned is that not only is it down 3% next year, but that's down 7% from where we are right now. The positive headline is that even with that decrease in home prices from today, that only brings us back to January of 2022. That's 32% above where they were in March of 2020.
Jay Bacow: All right, that doesn't seem so bad, given that stocks are a lot lower than where they were in January of 2022. So it's more stalling out than a real correction in home prices. But, why wouldn't home prices fall further from there?
Jim Egan: We haven't seen anything in the data that changes kind of the underlying narrative that we've been discussing on this podcast in the past. In particular, two things. The first is how robust credit standards have been. If anything, lending standards, which were pretty tight to begin with in the first quarter of 2020, have tightened substantially since then. What that means, again, it constrains sales volumes. We think sales are going to fall more than home prices, but it also means that the likelihood of defaults and foreclosures is limited. And it is those distressed transactions, those forced sellers that we would need to see a leg down in prices. The other point is, away from defaults and foreclosures, actual inventory is still incredibly low. And because current homeowners sit on 30 year fixed rate mortgages, well below the current mortgage rate, when we talk about affordability deteriorating, we're not talking about it deteriorating for current homeowners. They're much more likely to stay in their home, much less likely to list their home for sale, they're not going to be selling into depressed bids. So that credit availability and those tight lending standards, we think that keeps home prices supported.
Jay Bacow: So home prices are protected because we're not going to get the forced sellers that we saw during the financial crisis and the fundamentals of the housing market are in much stronger footing. What would actually get you, though, to forecast more of a real correction than just the stalling out?
Jim Egan: I'm going to make this really complicated and say the supply and demand. If demand were to be weaker than we already think it is, and that could happen because the historic deterioration we've seen in affordability has a bigger impact than we think it will. Maybe because the unemployment rate picks up faster than we're expecting it to next year. If you have a much weaker demand environment than we're already envisioning, and you combine that with more supply, perhaps people who'd be a little bit more willing to part with their home at slightly lower prices than we expect them to, people who've owned their home for 10, 15, 20 years and might be looking to downsize. That's where you might have a little bit more of a marriage between uneconomic sellers and depressed demand that could bring home prices lower than we expect. Now, how does all of that, if we think about the implications to investors, what does all that mean for the MBS market?
Jay Bacow: I'm going to make this really complicated, too. A lot of it comes down to supply and demand. The lack of housing activity and the lower home prices means that there's going to be less supply for mortgage investors to buy. That's good for the mortgage market. The rapid increase in unaffordability has been because of the rapid increase in implied volatility, which is bad for mortgage investors. This has brought nominal spread to the Treasury curve for agency mortgages to levels that are basically at the post GFC wides. And we think that move is a little bit overdone. And so for institutional investors we think this is an opportunity to own agency mortgages versus treasuries as a way to fade some of these moves, and take advantage of some of the more forward looking supply projections that we think will be coming as supply slows down.
Jay Bacow: But Jim, it's always great talking to you.
Jim Egan: Great talking to you too, Jay.
Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.
As globalization slows and companies begin to nearshore their supply chains, investors may be wondering what the costs and benefits are of bringing manufacturing back home.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, October 5th, at 10 a.m. in New York.
We speak often here about the themes of slowing globalization, or slowbalization, and the shift to a multipolar world. It's important to understand these megatrends, as they will likely impact global commerce for decades to come and in many ways we cannot yet anticipate. But one impact we have anticipated is multinational companies spending money to shift their supply chains. Whereas globalization meant companies could focus on lowering their labor and transportation costs through 'just in time' logistics, 'just in case' logistics are the watchword of the multipolar world. Companies will have to invest money to nearshore or friend shore to protect their supply chains from seizing up due to geopolitical conflicts, be it war, such as Russia invading Ukraine leading to sanctions, or the proliferation of policies by Western governments, preventing companies from producing and/or sourcing sensitive technologies overseas.
Now, we're increasingly seeing evidence that this dynamic is already at play. Take Apple, for example, which, according to the Wall Street Journal, recently released a supplier list showing that in September of 2021, 48 of its suppliers had manufacturing sites in the U.S., up from 25 just a year before. The article goes on to cite several semiconductor chip makers who have recently opened US based sites. One company recently agreed to invest as much as $100 billion in a semiconductor manufacturing facility in upstate New York. Another announced plans to invest $20 billion for chip factories in Ohio.
So it's clear that companies are starting to respond to geopolitical incentives. The long term public policy benefits of these moves could prove to be quite sound, but in the short term they're a challenge to markets. These investments cost money and represent elevated costs relative to what these companies would have enjoyed had the geopolitical environment not become more challenging. That means investors have to price in yet another margin pressure on top of the ones our colleague Mike Wilson continues to highlight in U.S. equities, from labor costs and the fed hiking rates to engineer slower economic growth.
So bottom line for investors, shifting to a new geopolitical world order may be necessary, but it will cost something along the way. And for the moment, that means extra pressure on a U.S. equity market that's already got its fair share.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
With investors becoming pervasively bearish on stocks and bonds in the face of a worsening growth outlook, can the U.S. investment grade credit market provide shelter from the storm?
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Global Director of Fixed Income Research. Along with my colleagues, bringing you a variety of perspectives, today I'll share why corporate credit markets may be a sheltering opportunity amid current turbulence. It's Tuesday, October 4th, at 11 a.m. in New York.
At a September meeting, the Federal Open Market Committee delivered a third consecutive 75 basis point rate hike, just as consensus had expected. The markets took this to mean a higher peak and a longer hiking cycle, resulting in sharp spikes in bond yields and a sell off in equities.
At the moment, both 2 and 10 year Treasury yields stand at decade highs, thanks to pervasively bearish sentiment among investors across both stocks and bonds. As regular listeners may have heard on this podcast, Morgan Stanley's Chief Global Economist, Seth Carpenter, has said that the worst of the global slowdown is still likely ahead. And our Chief U.S. Equity Strategist, Mike Wilson, recently revised down his earnings expectations for U.S. equities.
Navigating this choppy waters is a challenge in both risk free and risky assets due to duration risk in the former, and growth or earnings risks in the latter. Against this backdrop, we think the U.S. investment grade corporate bonds, IG, particularly at the front end of the curve, which is to say 1 to 5 year segment, could provide a safer alternative with lower downside for investors looking for income, especially on the back of much higher yields.
But investors may wonder, wont credit fundamentals deteriorate if economy slows, or worse, enters the recession and company earnings decline. Here is where the starting point matters. After inching higher in Q1, median investment grade leverage improved modestly in the second quarter and is well below its post-COVID peak in the second quarter of 2020. Gross leverage is roughly in line with pre-COVID levels. Notably, while median leverage is back to pre-COVID levels, the percentage of debt in the leverage tail has declined meaningfully. But if earnings were to decline, as our equity strategists expect, leverage ratios may pick back up.
That said, interest coverage is the offsetting consideration. Given the amount of debt that investment grade companies have raised at very low coupons over the years, their ability to cover interest has been a bright spot for some time. Despite sharply higher rates, median interest coverage improved in the second quarter and is around the highest levels since early 1990. This modest improvement in interest coverage comes down to the fact that even though yields on new debt are higher than the average of all outstanding debt, the bonds that are maturing have relatively high coupons. Therefore, most companies have not had to refinance at substantially higher funding levels. In fact, absolute dollar level of interest expense paid out by IG companies actually declined in the quarter and is now well below the peaks of 2021. With limited near-term financing needs, higher rates are unlikely to dent these very healthy interest coverage ratios.
The combination of strong in-place investment grade fundamentals, relatively low duration for the 1 to 5 year segment and yields at decade highs, suggests that this part of the credit market offers a relatively safe haven to weather the storms that are coming for the markets. History provides some validation as well. Looking back to the stagflationary periods of 1970s and 80's, while we saw multiple decisions and volatility in equity markets, IG credit was relatively stable with very modest defaults. And while history doesn't repeat, it does sometimes rhyme, so we look to the relative safety of IG credit once again in the current environment.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With rates and currency markets experiencing increasing volatility, the state of global U.S. dollar supply has begun to force central bank moves, leaving the question of when and how the Fed may react up for debate.
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Welcome to Thoughts on the market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 3rd, at 11 a.m. in New York. So let's get after it.
The month of September followed its typical seasonal pattern as the worst month of the year, and given how bad this year has been, I don't say that lightly. But as bad as stocks have been, rates and currency markets have been even more volatile.
With volatility this severe, some of the cavalry has been called in. The Bank of England's surprise move last week was arguably necessary to protect against a sharp fall in U.K. bonds. Some may argue the U.K. is in a unique situation, and so this doesn't portend other central banks doing the same thing. However, this is how it starts. In other words, investors can't be as adamant the Fed will choose or be able to follow through on its tough talk. Like it or not, the world is still dependent on U.S. dollars, which provide the oxygen for global economies and markets. Former U.S. Treasury Secretary John Connolly's famous quote that "the dollar is our currency, but it's your problem" continues to ring true. It's also one of the primary reasons why several countries have been working so hard to de-dollarise over the past decade.
The U.S. dollar is very important for the direction of global financial markets, and this is why we track the growth of global dollar supply so closely. In fact, the primary reason for our mid-cycle transition call in March of 2021 was our observation that U.S. dollar money supply growth had peaked. Indeed, this is exactly when the most speculative assets in the marketplace peaked and began to suffer. Things like cryptocurrencies, SPACs, recent IPOs and profitless growth stocks trading at excessive valuations. Now we find global U.S. dollar money supply growth negative on a year over year basis, a level where financial and economic accidents have occurred historically. In many ways, that's exactly what happened in the U.K. bond market last week, forcing the Bank of England's hand.
There are many reasons why a U.S. dollar liquidity is so tight; central banks raising rates and shrinking balance sheets, higher oil prices and inflation in many goods bought and sold in dollars, incremental regulatory tightening and lower velocity of money in the real economy as activity dries up in critical areas like housing. In short, U.S. dollar supply is tight for many reasons beyond Fed policy, but only the Fed can print the dollars necessary to fix the problem quickly.
We looked at the four largest economies in the world, the U.S., China, the Eurozone and Japan, to gauge how much U.S. dollar liquidity is tightening. More specifically, money supply in U.S. dollars for the Big Four is down approximately $4 trillion from the peak in March. As already mentioned, the year over year growth rate is now in negative territory for the first time since March of 2015, a period that immediately preceded a global manufacturing recession. In our view, such tightness is unsustainable because it will lead to intolerable economic and financial stress, and the problem can be fixed very easily by the Fed if it so chooses. The first question to ask is, when does the U.S. dollar become a U.S. problem? Nobody knows, but more price action of the kind we've been experiencing should eventually get the Fed to back off. The second question to ask is, will slowing or ending quantitative tightening be enough? Or will the Fed need to restart quantitative easing? In our opinion, the answer may be the latter if one is looking for stocks to rebound sustainably. Which leads us to the final point of this podcast - a Fed pivot is likely at some point given the trajectory of global U.S. dollar money supply. However, the timing is uncertain and won't change the downward trajectory of earnings, our primary concern for stocks at this point.
Bottom line, in the absence of a Fed pivot, risk assets are likely headed lower. Conversely, a Fed pivot, or the anticipation of one, can still lead to sharp rallies like we are experiencing this morning. Just keep in mind that the light at the end of the tunnel you might see if that happens, is actually the train of the oncoming earnings recession that even the Fed can't stop.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Amidst increased volatility across credit, equity and FX markets, many investors this week are wondering, what is the path ahead for Fed intervention? Chief Cross Asset Strategist Andrew Sheets, Global Chief Economist Seth Carpenter and Head of Thematic and Public Policy Research Michael Zezas discuss.
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Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley.
Seth Carpenter: And I'm Seth Carpenter. Morgan Stanley's Global Chief Economist.
Michael Zezas: And I'm Michael Zezas, Head of Global Thematic and Public Policy Research.
Andrew Sheets: And on this special edition of the podcast, we'll be talking about intervention, inflation and what's ahead for markets. It's Friday, September 30th at 9 a.m. in San Francisco.
Michael Zezas: So, Andrew, Seth, we've been on the road all week seeing clients and that's come amidst some very unusual moves in the markets and interventions by a couple of central banks. Andrew, can you put in a context for us what's happened and maybe why it's happened?
Andrew Sheets: Thanks, Mike. So I think you have the intersection of three pretty interesting stories that have been happening over the last couple of weeks. The first, and probably most important, is that core inflation in the U.S. remains higher than the Federal Reserve would like, which has kept Fed policy hawkish, which has kept the dollar strong and U.S. yields moving higher. Now, one of the currencies that the dollar has been strongest against is the Japanese yen, which has fallen sharply in value this year. Now we saw Japan finally intervene into the currency markets to a limited extent to try to support the yen but that support was short lived and we saw the dollar continue to strengthen. The other story that we saw occurred in the U.K., a country we discussed on this podcast recently about some of its unique economic challenges. The U.K. has also seen a weak currency against the dollar. But in addition to that, because of the market's reaction to recent fiscal policy proposals, we saw a very large rise in U.K. bond yields, which caused market dislocations and pushed the Bank of England to intervene in bond markets in a way that drove some of the largest moves in U.K. interest rates, really in recorded history. So a lot's been going on, Mike, it's been a very busy couple of weeks, but it's a story at its core about inflation leading to intervention, but ultimately not really changing a core backdrop of higher U.S. yields and a stronger U.S. dollar.
Seth Carpenter: I completely agree with you on that, Andrew. And I think it brings up some of the questions that you and I have got in our client meetings this week, which is, 'where can this end?' Any trend that's not sustainable won't last forever, as the saying goes. So what would cause sort of an end to the dollar's run? And I think a natural place to look is, what would cause the Fed to stop hiking? I think the first thing that's worth strongly emphasizing is, from the Fed's perspective, a narrow monetary policy mandate, the rising dollar is actually a good thing. A stronger dollar means lower imported inflation. A stronger dollar means less demand for U.S. exports from the rest of the world. The Fed is fighting inflation by hiking interest rates, trying to slow the economy and thereby reduce inflationary pressures. Right now, this run in the dollar is doing their job for them.
Michael Zezas: I would add to that that we've been getting a lot of questions about, 'when would the Fed or the Treasury see this weakness and want to intervene on behalf of markets?' And I think the answer is it's unlikely to happen anytime soon. And there's really kind of two reasons for that. One, doing so would contradict the Fed and the Treasury's own stated goals of fighting inflation right now. I think there are heavy political and policy incentives that haven't changed that support that being the policy direction for those institutions. And then the second is, even if you intervened right now, our FX research team has pointed out it's probably unlikely to work. At the moment, there aren't a tremendous amount of FX reserves in the system with which to intervene. And so any intervention would probably deliver short term results. So long story short, if the intervention is against your goals and wouldn't likely work anyway, it's probably not going to happen. So, Andrew, I think this kind of brings the conversation back around to you. If there really isn't going to be any net change in the Federal Reserve's stance towards monetary policy, then what should investors expect going forward?
Andrew Sheets: So at the risk of sounding simplistic, if we're not going to see a change in policy response from the Fed, then we shouldn't expect a major change in market dynamics. Core inflation remains higher than we think the Fed is comfortable with. That will keep pressure on the Fed to keep making hawkish noises that should keep upward pressure on the front end of the curve and keep the curve quite inverted. We think that helps support the dollar because while the dollar might be expensive in many measures of foreign exchange valuation, the dollar is still paying investors much more than currencies like the yen or the UK pound in real interest rates. And that differential is powerful, that differential is important. And I think that differential will keep investors looking for the safety and stability and higher yields of the U.S. dollar. Look, taking a step back, I think markets are adjusting to this dynamic where the Fed is not your friend as an investor. Which is the pattern that we saw through most of financial market history, but was different in the post global financial crisis era, when the level of stress on the markets was so severe that the level of policy support had to be extraordinary. And so that is a dynamic that's shifting now that we're facing a stronger economy, now that we're facing much stronger consumer and corporate demand, we're facing the more normal tradeoff where strong labor markets, strong consumer demand leads to a Federal Reserve that's really trying to tighten the reins and slow the economy down, slow financial market activity down. So, you know, investors are still sailing into that headwind. We think that presents a headwind to risky assets. We think that presents a headwind to the S&P 500. And we think, with the Fed still sounding quite serious on inflation, still erring on the side of caution, that will lead investors to continue to think more rate hikes are possible and support the U.S. dollar against many other currencies in the developed market, which still have lower yields, especially on an inflation adjusted basis.
Seth Carpenter: So, Andrew, I think I want to jump in on that because I think what you're saying is, for now, nothing's changing and so we should expect the same market dynamics. Which brings up the question that you and I have got this week as we've been seeing clients, which is, 'what would cause the Fed to pivot? What would cause the Fed to change its policies?' And I think there, I would break it into two parts. Going back to my first point about what the rising interest rates and the rising dollar have been doing, they've been doing exactly what the Fed wants, limiting demand in the United States, slowing growth in the United States, and, as a result, putting downward pressure on inflation. If we get to the point where the US economy is clearly slowing enough, if we get data that is convincing that inflation is on a downward trajectory, that's what the Fed is looking for to pause their hiking cycle. So I think that's the first answer. The other version, though, is the market volatility that we're seeing is being driven by some of this policy action. We could get feedback loops, we could get increasing bouts of volatility where markets start to break, we could get credit markets breaking, we could get more volatility and interest rate markets like we saw in the U.K.. I think at some point we can see where there's a feedback loop from financial market disruptions globally that threatens the United States. And at some point, that kind of feedback could be enough to cause the Fed to take a pause.
Andrew Sheets: So Seth, that's a great point. And actually, I want to push you on specifics here. How do you and the economics team think about a scenario where, let's say inflation is 3/10 lower than expected next month, or where we go from a very strong level of reading in the labor market? What would be an indication of the type of market stress that the Fed would care about relative to something it would see as more the normal course of business?
Seth Carpenter: I don't think one month's worth of data coming in softer than forecast would be enough to completely change the Fed's mind, but it would be enough to change the Fed's tone. I think in those circumstances, if both nonfarm payrolls and CPI came in substantially below expectations, you would hear Chair Powell at the November meeting saying things like, 'We got some data that came in softer and for now, we're going to monitor the data to see if this same downward trajectory continues.' I think that kind of language from Powell would be a signal that a pivot is probably closer than you might have thought otherwise. Conversely, when it comes to financial markets, I think the key takeaway is that it has to be the type of financial market disruptions that the Fed thinks could spill back to the U.S. and hurt overall growth enough to slow the economy, to bring inflation down. Credit market disruptions are a key issue there. Sometimes we've seen global risk markets and global funding markets get disrupted. I think it's very hard to say ex-ante what it would take. But the key is that it would have to be severe enough that it would start to affect U.S. domestic markets.
Andrew Sheets: So, Seth, Mike, it's been great to talk to you. So just to wrap this up, we face a backdrop where inflation still remains higher than the Federal Reserve would like it. We think that keeps policy hawkish, which keeps the dollar strong. And even though we've seen some market interventions to a limited degree, we don't see much larger interventions reversing the direction of the dollar. And we don't think such interventions, at the moment, would be particularly effective. We think that keeps the dollar strong and we think that means headwinds for markets, which leaves us cautious on risky assets in the near term. As always, this is a fast evolving story and we'll do our best to keep you up to date on it.
Andrew Sheets: Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Asia and EM equities are on the verge of the longest bear market in their history, so what is the likelihood that a sharp fall in prices follows soon after?
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing the ongoing bear market in Asia and Emerging Market equities. It's Thursday, September the 29th at 8 a.m. in Singapore.
We have repeatedly emphasized that patience may be rewarded during what will likely, by the end of this month, become the longest bear market in the history of Asia and Emerging Market equities. Indeed, we argued that the August Jackson Hole speech by Fed Chair Powell, and the mid-September upside surprise in U.S. CPI inflation likely accelerated a downward move towards our bear case targets near term. And in recent weeks, the MSCI Emerging Markets Index has indeed given back almost all of the gains it had recorded from the COVID recession lows. To our mind, this raises the likelihood that a classic capitulation trough, a sudden sharp fall in prices and high trading volumes, could be forming in a matter of weeks.
Now, all cycles are not made alike, and this one is unusual in a number of key regards. Most notably, the dislocations in the supply side of the global economy caused by COVID and geopolitics. Moreover, China is not easing policy to the same extent as helped generate troughs in late 2008 and early 2016. Thus, caution is warranted in drawing too firm a set of conclusions from relationships that have held in the past.
That said, by the end of this month, the current bear market will likely become the longest in the history of the asset class, overtaking in days duration that triggered by the dot com bust in the early 2000's. And after a more than 35% drawdown, the MSCI Emerging Markets Index is now trading close to prior trough valuations at only 10x price to consensus forward earnings.
Our experience covering all previous bear markets back to 1997/1998 suggests to us ten sets of indicators to monitor. We've recently undertaken an exercise to score each indicator from 1, which equates to a trough indicator not enforced at all to 5, which indicates a compelling trough indicator already in place. Currently, the sum of the scores across the factors is 32 out of a maximum of 50, which we view as suggesting that a trough is approaching but not yet fully conclusive at this stage. In our view, the U.S. dollar, which continues to rise, including after the most recent FOMC meeting, gives the least sign of an impending trough in EM equities. Whilst the underperformance of the Korean equity market and the semiconductor sector, the recent sharp fall in oil price and the fall in the oil price relative to the gold price give the strongest signs.
In this regard, we would note that within our coverage we recently downgraded the energy sector to neutral, upgrading defensive sectors, including telecoms and utilities. We intend to update the evolution of these indicators as appropriate as we attempt to help clients move through the trough of this unusually long Asia and Emerging Markets equity bear market.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.
As the Fed continues to increase their peak rate of interest, the path for a soft landing narrows, so what deflationary indicators need to show up in the real economy to take the pressure off of policy tightening?
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Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the narrowing path for a soft landing for the U.S. economy. It's Wednesday, September 28, at 10 a.m. in New York.
Last week, we revised our outlook to reflect the expectation that the Fed will take its policy rate to a higher peak between 4.5% to 4.75% by early next year. And that's 75 basis points additional tightening than what we had envisioned previously. Tighter policy should push the real economy further below potential and substantially slow job gains. And while higher interest rates are needed to create that additional slack in the economy, this dynamic raises the risk of recession. There's still a path to a soft landing here, but it seems clear to us that path has narrowed.
Now beyond directly interest sensitive sectors such as housing and durable goods, we've seen little evidence that the real economy is responding to the Fed's policy tightening. Just think about how strong monthly job gains remain in the range of 300,000. So in the absence of a broader slowdown, and facing persistent core inflation pressures such as a worrisome acceleration in rental prices, the Fed is on track to continue tightening at a faster pace than we had originally anticipated. Looking to the November meeting, we expect the Fed to hike rates by 75 basis points, and then begin to step down the pace of those rate hikes to 50 basis points in December and 25 basis points in January. We then expect the Fed to stay on hold until the first 25 basis point rate cut in December 2023.
While inflation has remained stubborn, the growth environment has softened, and the lagged effect of monetary policy on economic activity points to further slowing ahead. So in response to substantially more drag from higher interest rates, we've lowered our 2023 growth forecast to just 0.5%. We then think a mild recovery sets in in the second half of 2023, but growth remains well below potential all year.
In our forecast, weakness in economic activity will be spread more broadly, and monetary policy acts with a 2 to 3 quarter lag on interest rate sensitive sectors such as durable goods. So the sharper slowdown we envision in 2023 predominantly reflects a downshift in consumption growth. Business investment also tends to respond with a lag and will become a negative for growth in the first half of 2023.
With growth falling more rapidly below potential, the labor market is on track to follow suit. We now see job gains bottoming at 55,000 per month by the middle of 2023. Lower job growth in combination with a rising participation rate, lifts the unemployment rate further to 4.4% by the end of next year.
Inflation pressures have still not turned decisively lower, in particular because of rising shelter costs. High frequency measures point to eventual deceleration, though it should be gradual, even as the labor market loosens on below potential growth. We see core PCE inflation at 4.6% on a year over year basis in the fourth quarter of this year, and slow to 3.1% year over year in the fourth quarter of next year. So inflation is a good deal lower by the end of next year, but that's still too high to allow for rate cuts much before the end of 2023.
Turning to risks, we think the risk to the outlook and monetary policy path now skew to the downside and a policy mistake is coming into focus. At the Fed's current pace of tightening uncertainty as to how the economy will respond a few months down the line is high. The labor market tends to be slow moving, but we and frankly monetary policymakers have no experience with interest rate changes of this magnitude. And activity could come to a halt faster than expected. Essentially, the higher the peak rate of interest the Fed aims for, the greater the risk of recession.
We are already moving through sustained below potential GDP growth. We now need to see job gains slow materially over the next few months to ease the pressure on the pace of policy tightening.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While the global oil market has seen a decrease in demand, supply issues are still prevalent, leaving investors to question where oil prices are headed next.
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Welcome to Thoughts on the Market. I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the current state of the global oil market. It's Tuesday, September 27th, at 2 p.m. in London.
U.S. consumers have no doubt noticed and appreciated a welcome relief from the recent pain at the gas pump. Up until last week, U.S. gas prices had been sinking every day for more than three months, marking the second longest such streak on record going back to 2005. This gas price plunge in the U.S. was driven in part by the unprecedented releases of emergency oil by the White House. But what else is happening globally on the macro level?
Looking at the telltale signs in the oil markets, they tell a clear story that physical tightness has waned. Spot prices have fallen, forward curves have flattened, physical differentials have come in and refining margins have weakened. A growth slowdown in all main economic blocks has pointed to weaker oil demand for some time, and this is now also visible in oil specific data. China has been a particularly important contributor to this.
However, prices have also corrected substantially by now. Adjusted for inflation, Brent crude oil is back below its 15 year average price. In this context, the current price is not particularly high. Also, the Brent futures curve has in fact flattened to such an extent that current time spreads would have historically corresponded with much higher inventories expressed in days of demand. That means, in short, that the market structure is already discounting a significant inventory built and/or a large demand decline.
Then there is still meaningful uncertainty over what will happen to oil supply from Russia once the EU import embargo kicks in later this year for crude oil, and early next year for oil products. The EU still imports about three and a half million barrels a day of oil from Russia. Redirecting such a large volume to other buyers, and then redirecting other oil back to Europe is possible over time, but probably not without significant disruption for an extended period. For a while, we suspect that this will lead to a net loss of oil supply to the markets in the order of one and a half million barrels a day. To attract enough other oil to Europe, European oil prices will need to stay elevated. The relative price of oil in Europe is Brent crude oil.
Elsewhere, there are supply issues too. We started off the year forecasting nearly a million barrels a day of oil production growth from the United States. But so far this year, actual growth in the first six months of the year has just been half that level. We still assume some back end loaded growth later this year, but have lowered our forecast already several times. Then Nigerian oil production has deteriorated much faster than expected, currently at the lowest level since the early 1970s. Kazakhstan exports via the CBC terminal are hampered, OPEC's spare capacity has fallen to just over 1%, and the rig count recovery in the Middle East remains surprisingly anemic.
The long term structural outlook for the oil market still remains one of tightness, but for now this is overshadowed by cyclical demand challenges. As long as macroeconomic conditions remain so weak, oil prices will probably continue to linger on. However, that should not be taken as a sign that the structural issues in the oil market around investment and capacity are solved. As we all know, after recession comes recovery. Once demand picks up, the structural issues will likely reassert themselves. We have lowered our near-term oil price forecast, but still see a firmer market at some point in 2023 again.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
After last week’s Fed meeting and another rate hike, both stocks and bonds dropped back to June lows. The question is, will this turn to the downside continue to accelerate?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, September 26, at 11 a.m. in New York. So let's get after it.
Last week's Fed meeting gave us the 75 basis point hike most investors were expecting, and similar messaging to what we heard at Jackson Hole a month ago. In short, the Fed means business with inflation and is willing to do whatever it takes to combat it. So why was there such a dramatic reaction in the bond and stock markets? Were investors still hoping the Fed would make a dovish pivot? Whatever the reason, both stocks and bonds are right back to their June lows, with many bellwether stocks and treasuries even lower. As we wrote a few weeks ago, we think investor hopes for a Fed pivot were misplaced, and Chair Powell has now made that crystal clear.
Secondly, we noted last week that the only remaining hope for stocks would be if the bond market rallied at the back end on the view that the Fed was finally ahead of the curve and would win its fight against inflation, while slowing the economy materially. Instead, interest rates spiked higher, squelching any hopes for stocks. While 15.6x price earnings ratio is back to the June lows, that P/E still embeds what we think is a mispriced equity risk premium given the risk to earnings.
Said another way, with a Fed pivot now off the table, the path on bond and equity prices will come down to growth - economic growth for bonds and earnings growth for stocks. On both counts we are pessimistic, particularly on the latter as supported by our recent cuts to earnings forecasts. We have been discussing these forecasts with clients for the past several weeks and while most are in agreement that consensus 2023 earnings estimates are too high, there is still a debate on how much. Suffice it to say, we are at the low end of client expectations. Interestingly, recent economic data have kept the economic soft landing view alive, and interest rates have moved above our rates team's year end forecast. From an equity market standpoint, that means no relief for valuations as earnings come down. This is a major reason why stocks sank to their June lows on Friday.
Ultimately, we do think economic surprise data will likely disappoint again, but until it does there is no end in sight for the rise in 10 year yields, especially with the run off of the Fed's balance sheet increasing. As such, our rates team has raised its year end target for 10 year Treasury yields to 4% from 3.5%. This is a very tough backdrop for stocks and epitomizes our fire and ice thesis to a T. In other words, rising cost of capital and lower liquidity in the face of slower earnings growth or even outright declines.
Finally, the Fed's historically hawkish action has led to record strength in the U.S. dollar. On a year over year basis the dollar is now up 21% and still rising. Based on our analysis that every 1% change in the dollar has a .5% impact on S&P 500 earnings growth, fourth quarter S&P 500 earnings will face an approximate 10% headwind to growth all else equal. This is in addition to the other challenges we've been discussing for months, like the pay back in demand and higher cost from inflation to name a few.
Bottom line Part 2 of our Fire and ice thesis is now on full display, with rates and the U.S. dollar ratcheting higher, just as the negative revisions for earnings appear set to accelerate to the downside. In our view, the bear market in stocks will not be over until the S&P 500 reaches the range of our base and bear targets, i.e. 3000 to 3400 later this fall.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
After another Fed meeting and another historically high rate hike, it’s clear that the Fed is committed to fighting inflation, but how and when will the real economy see the effects? Chief Cross-Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.
Andrew Sheets:] And on this special edition of the podcast, we'll be talking about the global economy and the challenges that central banks face. It's Friday, September 23rd at 2 p.m. in New York.
Andrew Sheets: So, Seth, it's great to talk to you. It's great to talk to you face to face, in person, we're both sitting here in New York and we're sitting here on a week where there was an enormous amount of focus on the challenges that central banks are facing, particularly the Federal Reserve. So I think that's a good place to start. When you think about the predicament that the Federal Reserve is in, how would you describe it?
Seth Carpenter: I think the Federal Reserve is in a such a challenging situation because they have inflation that they know, that everyone knows, is just simply too high. So they're trying to orchestrate what what is sometimes called a soft landing, that is slowing the economy enough so that the inflationary pressures go away, but not so much that the economy starts to contract and we lose millions of jobs. That's a tricky proposition.
Andrew Sheets: So we had a Federal Reserve meeting this week where the Fed raised its target interest rate by 75 basis points, a relatively large move by the standards of the last 20 years. What did you take away from that meeting? And as you think about that from kind of a bigger picture perspective, what's the Fed trying to communicate?
Seth Carpenter: So the Federal Reserve is clear, they are committed to tightening policy in order to get inflation under control, and the way they will do that is by slowing the economy. That said, every quarter they also provide their own projections for how the economy is likely to evolve over the next several years, and this set of projections go all the way out to 2025. So, a very long term view. And one thing I took away from that was they are willing to be patient with inflation coming down if they can manage to get it down without causing a recession. And what do I mean by patient? In their forecasts, it's still all the way out in 2025 that inflation is just a little bit above their 2% target. So they're not trying to get inflation down this year. They're not trying to get inflation down next year. They're not trying to get inflation down even over a two year period, it's quite a long, protracted process that they have in mind.
Andrew Sheets: One question that's coming up a lot in our meetings with investors is, what's the lag between the Fed raising interest rates today and when that interest rate rise really hits the economy? Because, you are dealing with a somewhat unique situation that the American consumer, to an unusual extent, has most of their debt in a 30 year fixed rate mortgage or some sort of less interest rate sensitive vehicle relative to history. And so if a larger share of American debt is in these fixed rate mortgages, what the Fed does today might take longer to work its way through the economy. So how do you think about that and maybe how do you think the Fed thinks about that issue?
Seth Carpenter: It's not going to be immediate. In round terms, if you take data for the past 35 years and come up with averages, you know, probably take something like two or three quarters for monetary policy to start to affect the real side of the economy. And then another two or three quarters after that for the slowing in the real side of the economy to start to affect inflation. So, quite a long period of time. Even more complicated is the fact that markets, as you know as well as anyone, start to anticipate central bank. So it's not really from when the central bank changes its policy tools when markets start to build in the tightening. So that gives them a little bit of a head start. So right now, the Fed just pushed its policy rate up to just over 3%, but markets have been pricing in some hiking for some time. So I would say we're already feeling some of the slowing of the real side of the economy from the markets having priced in policy, but there's still a lot more to come. Where is it showing up? You mentioned housing. Mortgage rates have gone up, home prices have appreciated over the past several years, and as a result we have seen new home sales, existing home sales both turnover and start to fall down. So we are starting to see some of it. How much more we see and how deep it goes, I think remains to be seen.
Andrew Sheets: So Seth, another issue that investors are struggling with is on the one hand, they're seeing all of these quite large moves by global central banks. We're also seeing a reduction in the central bank balance sheet, a reversal of the quantitative easing that was done to support the economy during COVID, the so-called quantitative tightening. How do you think about quantitative tightening? What is it? How should we think about it?
Seth Carpenter: I have to say, during my time at the Federal Reserve, I wrote memos on precisely this topic. So what is quantitative tightening? It is in some sense the opposite of quantitative easing. So the Federal Reserve, after taking short term interest rates all the way to zero, wanted to try to stimulate the economy more. And so they bought a lot of Treasury securities, they bought a lot of mortgage backed securities with an eye to pushing down longer term interest rates even more to try to stimulate more spending. So quantitative tightening is finding a way to reverse that. They are letting the Treasury securities that they have on their balance sheet mature and then they're not reinvesting, and so their balance sheet is shrinking. They're letting the mortgage backed securities on their balance sheet that are prepaying, run off their balance sheet and they're not reinvesting it. And when they make that choice, it means that the market has to absorb more of these types of securities. So what does the market do? Well, the market has to make room for it in someone's portfolio, and usually what that means is to make room on a portfolio prices have to adjust somewhere. Now, markets have been anticipating this move for a long time, and I suspect our colleagues who are in the Rate Strategy Group suspect that most of the effect of this unwind of the balance sheet is already in the price. But the proof is always really in the pudding, and we'll see over time, as the private sector absorbs all these securities, just how much more price adjustment there has to be.
Andrew Sheets: And then, I imagine this is a hard question to answer, but if the Fed started to think that it was tightening too much, if the economy was slowing a lot more than expected or there was more stress in the system than expected - do we think it's more likely that they would pause quantitative tightening or that they would pause the rate hikes that the market's expecting?
Seth Carpenter: I feel pretty highly convicted that if the slowing in the economy that they're seeing is manageable, if it's within the range of what they're expecting, it's interest rates. Interest rates are, to refer once again to what Chair Powell has said many times, the primary tool for adjusting the stance of monetary policy. So they're hiking rates now, at some point they'll reduce the size of those rate hikes and at some point they'll stop those rate hikes. Then the economy, hopefully in their mind, will be slowing to reduce inflationary pressure. They might judge that it's slowing too much if they feel like the adjustment they have to make is to lower interest rates by 25 basis points, maybe 50 basis points, even a little bit more than that if it happens over the course of a year, I still think the primary tool is short term interest rates. However, if the world changes dramatically, if they feel like, oh my gosh, we totally misjudged that. Then I think they would curtail the run off of the balance sheet.
Andrew Sheets: Seth, thanks for taking the time to talk.
Seth Carpenter: Andrew, It's always my pleasure to talk to you.
Andrew Sheets: And thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen, and leave us a review. We'd love to hear from you.
With high returns in mind, investors may be looking to get in on the ground floor with the next ambitious and disruptive technology, but how are these ‘moonshots’ identified and which ones could make a near-term impact? Head of Thematic Research in Europe Ed Stanley and Head of the Global Autos and Shared Mobility Team Adam Jonas discuss.
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Ed Stanley: Welcome to Thoughts on the Market. I'm Ed Stanley, Morgan Stanley's Head of Thematic Research based in London.
Adam Jonas: And I'm Adam Jonas, Head of the Global Autos and Shared Mobility Team.
Ed Stanley: And on this special episode of the podcast, we'll be discussing the bold potential of moonshot technologies, and particularly in the face of deepening global recession fears. It's Thursday, the 22nd of September, at 4 p.m. in London.
Adam Jonas: And 11 a.m. in New York.
Adam Jonas: Let me start with an eye popping number. Since 2000, 1% of companies have generated roughly 40% of shareholder returns by developing moonshots, that is ambitious and radical solutions to seemingly insurmountable problems using disruptive technology. So here at Morgan Stanley Research, we naturally spend a lot of time wondering what are the potential moonshots of the next decade? What's the next light bulb, airplane, satellite, internet? What technologies are developing literally as I record this that we'll be focused on in 2032? So Ed, I know you really want to dig into the specifics of some of the sectors that are touched on in the Moonshot Technologies report you wrote, but first can you maybe explain the framework for identifying these moonshots?
Ed Stanley: So this is a totally different horizon and way of thinking to what most investors are used to. Typically, when looking for investable themes or technologies in public markets, we focus on those that are at or have surpassed a 20% adoption rate, those essentially with the wind at their back already. But clearly, with moonshots, we're looking much, much earlier, but with a much greater risk reward skew. There are a number of potentially groundbreaking technologies out there incubating right now. The next iPhone moment is out there, is being developed, and it should be all of our job to sniff out what, when and where that pivotal product will come from. But the question we've received is how do you whittle that funnel of potential technologies down? So we come at it from first principles. Academic research, either by individuals, governments or companies, tends to be the genesis for most groundbreaking ideas. This then feeds patenting, or in other words R&D, for small and big companies alike to build a moat around that research they pioneered. And then venture capital comes in to support some of those speculative innovations, but importantly, only those that have product market fit, which is what we focus on.
Adam Jonas: So Ed, why do you think now is such an interesting time to be thinking about moonshots, given such a challenging macro backdrop?
Ed Stanley: It's a great question. So if you take a step back, there are always reasons to be concerned in the markets. But moments of peak anxiety in hindsight tend to be the moments of peak opportunity. I'll steal an overused cliche, necessity is the mother of invention. We're more likely to see breakthroughs in energy technology, for example, at the moment, at the point of peak acute pain than five years ago when there was no real impetus. This is exactly why some of the most innovative companies are born during or just after recession or inflationary periods. In fact, if you look at the stats, one third of Fortune 500 companies were born in the handful of recessionary years over the last century. So macro may be getting worse, but we remain pretty committed to uncovering long term, game changing themes and investments.
Adam Jonas: Can you give us a summary of the output and to which moonshots really stood out to you as having the potential for profound change over the medium term?
Ed Stanley: Sure. So there are clearly some that are not only profound but frankly unfathomable in terms of their potential impacts. Things like life extension, a startup developing artificial general intelligence, also known as a singularity, and Web3 remains a fascinating sandbox of crypto and blockchain experiments. So there's a wealth of fascinating moonshots in there, but I'd focus on two that have more prescient implications for investors near-term. First is pre-fab housing. It's nothing new as a concept. It's essentially the process of bringing construction into the factory to increase efficiency. But we're now moving from 2D assemblies of walls and roof panels to the real moonshot, which is 3D assembly of the entire house, pre-made, and that is now happening. These pre-built whole houses can be 40 to 50% cheaper and quicker, and so coming back to your question around why now? Moonshots like this have little momentum in good years, but construction input costs up 20% year on year, suddenly you have the catalyst for innovative, greener, low waste pre-fab solutions. And the second one, I think is really fascinating and few people are well versed in it, is deepfakes and the new era of synthetic reality. These are livestream videos and voice renderings to create the impression that you are watching or speaking to someone that you are not. And I think by highlighting this, we are also trying to show that not all moonshots are good news. At the moment, the risk is fake news, but that is the tip of the iceberg. But with that said, Adam, I want to jump to you. You're the perfect person to speak to given your knowledge of EVs in particular. And just like the smartphone market, those were once considered to be far fetched moonshots by some people, and yet they're heading towards ubiquity. So you've written a lot in the last couple of years around the "muskonomy", as you call it. Before we get into some moonshots you're interested in, can you explain to us what the "muskonomy" is?
Adam Jonas: We're referring to the portfolio of businesses and endeavors of Elon Musk, of course, across EVs and batteries and renewable energy and autonomous vehicles. Of course, his efforts in space and tunneling technology. Taken together we think he's in a position where any improvement in one of those businesses can help the advancement and accelerate development of the other three domains and then kind of feedback on itself and create a bit of velocity. But the point is, these businesses address huge physical markets. Markets that address the atomic economy, what I mean by that, the periodic table not the not the metaverse. Right, we need to kind of sort reality out here. These are high CapEx businesses, high moat businesses where trillions and trillions of capital will need to be redeployed with regulatory oversight, environmental planning, supply chain, industrialization, standards setting and of course, taxpayer involvement along the way.
Ed Stanley: It's a fascinating point, which we touched on in some of our other research around the innovation stack and how building technology on top of other layers of technology accelerates the disruption. I'm keen to understand from an investability perspective, what time horizons do you think we could expect some of these breakthroughs in? And where are the tailwinds coming from?
Adam Jonas: Right now, of course his efforts in EVs are well known. What I think is less appreciated is changing how manufacturing is done. Elon wants to make a car, ideally out of a single piece of injected molded aluminum in a 12,000 ton giga press. To really make a fuselage of a car and take the parts count down dramatically. And he wants to inject into this fuselage his structural battery pack, his 4680 battery battery pack. And so changing how vehicles are made and designing the battery into the car is something that really excites us in terms of finally getting that price of EVs down. So the other thing I would highlight that makes us very excited is his tunneling technology, we would watch that. And so we pay attention to Los Angeles and Las Vegas and Austin, Texas and San Antonio and Fort Lauderdale, Miami. These city, city pairs in states where we think Elon Musk can yield influence and we think this could be really the next big thing in infrastructure, not in a 2 to 3 year period, but certainly in a 5 to 10 year period with investment being attracted and relevant right now.
Ed Stanley: Well, that's a fantastic synopsis. Plenty to whet the appetite on moonshots of the next 5 to 10 years. Adam, thanks very much for taking the time to talk.
Adam Jonas: Great speaking with you, Ed.
Ed Stanley: And thanks for listening. If you enjoyed Thoughts on the Market, please leave a review on Apple Podcasts and share the podcast with a friend or a colleague today.
Though the Fed continues to raise interest rates, inflation is still high year over year, so why haven’t rate hikes begun to bring inflation down yet?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, September 21st at 10 a.m. in New York.
The Fed continues to hike interest rates, but inflation is still running hot in the U.S. as demonstrated by last week's 8.3% year over year growth in the Consumer Price Index. When and how the Fed will eventually succeed in dampening inflation is an important consideration for markets, but investors should also focus on another question. Why hasn't fed hiking worked to bring down inflation yet?
Well, there's a strong case to be made that the U.S. economy is less sensitive to changes in interest rates today than it has been in the past. In total, about 90% of all household debt today is fixed rate, meaning that as the Fed hikes rates and market rates rise, consumers’ debts don't cost them more to service. If they did, then rising interest rates would dampen economic growth by dampening aggregate demand. Those higher rates would in theory crimp consumption, as households direct less of their money toward buying goods and services and more toward paying their debts. That, in turn, would ease inflation.
Understanding this dynamic is important for investors in a few ways. Take the housing market, for example. After the housing crisis that touched off the global financial crisis in 2008 and 2009, adjustable rate mortgages only now make up a small fraction of all mortgages. Sure, higher mortgage rates means buying a new home is effectively more expensive, but with so many more mortgages in the U.S. carrying a fixed rate and issued to individuals with higher credit scores, the cost of owning a home to current owners hasn't changed. That means there's little incentive for homeowners to sell and or reduce the asking price for their home. Hence, our housing strategists expect home sales to decline meaningfully, but you may not see a lot of price deterioration in the aggregate.
The bond market is another place we see this dynamic on display. Our interest rate strategy team expects you'll see the yield curve continue to flatten and invert, with shorter maturity yields rising faster than longer ones. Why? Because shorter maturities typically track the Fed funds rate, which the Fed has clearly stated will continue going higher until there's clear evidence of inflation deceleration, which could take longer given the economy's lessened sensitivity to rising rates. For bond investors, the bottom line is you should consider something that historically has been pretty unusual - longer maturities might perform better even as rates go higher.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As the global economic outlook turns toward a slowdown in growth, some investors may look to China for stability, but, when they do, what will they find?
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Welcome to Thoughts on the Market. I'm Robin Xing, Morgan Stanley's Chief China Economist. Along with my colleagues, bringing you a variety of perspectives, today I will discuss whether China can stabilize global growth amid recession fears. It's Tuesday, September 20th at 9 AM in Hong Kong.
The global economic outlook is dimming, and my colleagues have already discussed their expectations for slowdown in developed market economies driven by surging prices and aggressive monetary policy tightening. In this context, investors are likely to turn their attention to China, perhaps hoping it can once again stabilize global growth as it did after the 2008 global financial crisis. China's economy, however, appears to be fragile. While it has bottomed after the contraction due to Shanghai lockdown in the second quarter, it is still modeling not yet through. And we forecast a below consensus 2.8% GDP growth this year, and only a modest rebound to slightly above 5% in 2023.
To date, China has deployed the monetary policy easing and the infrastructure investment spending. But these steps have not got a lot of traction because of two key hurdles; continuing COVID restrictions and the trouble in its housing market. We see growth rebounding in next year, but that recovery depends heavily on policy addressing these two key hurdles. Hence, we look for a more concerted policy response in the housing market, and a clearer path towards reopening post the upcoming 20th Party Congress in October.
First, to limit the fallout from the housing sector, Beijing will likely ramp up policy support. It is true that China's aging population has pushed the housing market into a structural downward trajectory, but the pace of the recent collapse vastly exceeds that trend. The choke point is homebuyers lack of confidence in developers ability to deliver the pre-sold house, which shrinks new home sales and puts more stress on developers liquidity. We think that Beijing will provide additional funding and intervention to ensure contracted home construction is completed. This, combined with more home purchases, stimulus and the liquidity support to surviving developers could break the negative feedback loop.
Second, we expect a gradual exit from COVID-zero next spring. With the more transmissive Omicron, the rolling lockdowns in China are taking their toll on consumption and even posing challenges to supply chains. The renewed lockdowns in several major cities and the recent slowdown in vaccination progress suggest that COVID-zero would not end swiftly after the Party Congress in October. But the key metrics to watch by then will be, first, the pace of vaccination, second, wider adoption of domestic covid treatment and finally shift in public opinion from fearing the virus to a more balanced assessment.
Provided that policy can address these two hurdles I just described, China's economic recovery should firm up from second quarter 2023 onwards, with growth of slightly above 5% for next year are our numbers. But even with this rebound, the positives spill over to the rest of the world is unlikely to be on par with history. Construction activities might improve with the stabilizing property sector, which is a familiar driver of Chinese imports. But the key driver will be a turnaround in domestic private consumption, particularly of services, so that demand pull from other economies will be somewhat muted.
Thus, while we doubt that China would tip the global economy into recession, neither do we see China at its salvation.
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From Europe, to China, to the U.S., global economies are facing unique challenges as the brewing storm of recession risks seem to still indicate a slowdown ahead.
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the rising risks of global recession and what might be ahead. It's Thursday, September 22nd at 10 a.m. in New York.
About a year ago, I wrote about the brewing storm of recession risks around the world. Some downbeat economics news has come in since then, but the worst of the global slowdown is ahead of us, not behind us. We have an outright recession as our baseline forecast in the euro area and the U.K. The Chinese economy is on the brink with such weak growth that whether we have a global recession or not might just turn out to be a semantic distinction.
First, Europe. It's hardly out of consensus at this point to call for a recession there, but we have been forecasting a recession since the start of the summer. The energy crisis caused by the Russian invasion of Ukraine has created a cost shock that is now effectively locked into the outlook for the next couple of quarters. Consumer bills will stay high, sapping purchasing power, fiscal deficits will take a hit and industries are already rationing energy use.
For the UK, leaving Europe has not left behind the energy crisis across the channel. And the UK is also suffering from structural changes to its labor supply and trade relationships, and that's dragging down growth beyond these cyclical movements. That said, new leadership in Parliament is pointing to a huge fiscal stimulus that will mitigate the pain to households and reduce the depth of the recession.
Now turning to China, markets have looked at China as a possible buoy for global growth, but this time any such hope really needs to be tempered, China's economy is in a fragile position. In our forecasts growth this year will be about 2.75%, below consensus and well below the potential growth of the economy. And then we think there'll be a rebound in growth next year, we're only looking for a modest 5.25% next year. Those sorts of numbers are not the real game changers people hope for. So far, the fiscal and monetary policy that has been deployed has not got a lot of traction.
There are two key restraints on the Chinese economy right now; trouble in the housing market and continuing COVID restrictions. After the party Congress in mid-October things should probably start to change, but we're not expecting a quick fix. Right now construction and delivery of new homes is not getting done, so the cash flow is drying up, creating an adverse feedback loop. So far, the PBOC has rolled out about 200 billion renminbi bank loans to support this delivery, and we expect more intervention and funding over time. So as easy as it is to be gloomy on the outlook, a catastrophic collapse in housing doesn't seem likely. As for COVID, we are now expecting only a gradual exit from COVID zero next spring. The key metrics to watch will be the pace of vaccinations and wider adoption of domestic COVID treatments and a shift in public opinion. In particular, we think getting the over 60 population to at least an 80% booster vaccination rate next spring will flag the removal of restrictions.
If there is a silver lining, it's that we still think the U.S. avoids a near-term recession. Despite notching a technical recession in the first half of the year, the U.S. outlook is somewhat brighter. For the first half of the year nonfarm payrolls averaged almost 450,000 per month, that's hardly the stuff of nightmares. But we don't want to be too cheerful. From the Fed's perspective, the economy has to slow to bring down inflation. They are raising interest rates expressly to slow the economy. So far, the housing market has clearly turned, but payrolls have only slowed a bit, and the moderation in wage inflation is probably not as much as the Fed is looking for. To date, we have not seen much slowing in consumer durables, so the economy remains beyond its speed limit and the Fed will keep hiking. How much? Well, depends on how strong the economy stays. So there really isn't much upside, only downside. The Fed is committed to hiking until the demand pressures driving inflation back off, so one way or another, the economy is going to slow.
Thanks for listening. If you enjoy this show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While credit and equities have both suffered this year, economic conditions in the U.S. and Emerging Markets may lead to credit having a bit more stability in the coming months.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, September 16th, at 3 p.m. in London.
Year-to-date, both credit and equities have suffered. Looking ahead, we think credit is better positioned in both the U.S. and emerging markets, given the outlook for growth, policy and relative valuations.
Conventional wisdom can change quickly in markets. Two months ago, there was widespread concern that the United States was already in a recession, given weak readings of quarterly GDP and some of the lowest levels of consumer confidence since the 2009 financial crisis. That weakness drove hope over July and August. Maybe the Federal Reserve had raised interest rates enough. Maybe it was nearly done.
But the data since points to an American economy that continues to trundle along. The labor market continues to look extremely healthy, with about 315,000 jobs added last month and over 3.5 million jobs added year-to-date. Manufacturing activity has expanded every month this year. And consumer spending remains solid, one of the reasons core inflation remains elevated.
In short, if the U.S. economy is going to slow down, that risk lies ahead of us, not behind us. And as long as the data remains solid and core inflation remains elevated, the Federal Reserve will face pressure to air on the side of caution and keep raising rates to tamp down on inflationary pressure.
For investors this backdrop, where economic activity is still solid but might slow in the future, where inflation is high and the central bank is hiking, and where the labor market is tight and the yield curve is inverted, is what's commonly referred to as a "late cycle" environment.
It's a set of conditions that has historically been challenging for future returns overall, but it's often been worse for equities relative to credit over the following 12 months, as the former is more sensitive to a potential slowdown in growth that hasn't happened yet.
In addition to the economic conditions, relative valuations have also moved in favor of credit markets relative to equities. In the US, 1 to 5 year corporate bonds now yield about 4.9%, rapidly nearing the current earnings yield of the S&P 500 at about 5.9%. Despite just a 1% difference in yield, those short dated bonds have about one fifth of the volatility of stocks over the last 30 days.
We hold a similar view on Emerging Markets. The sovereign debt index yields about 7.7%, just 1% less than the earnings yield of the MSCI Emerging Market Equity Index. Not only is EM sovereign debt less volatile than EM equities, but it has more exposure to the countries our analysts think provide the better risk reward.
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The White House recently announced a student loan forgiveness program, prompting questions about implementation, economic implications, and whether the program will have an impact on consumer spending. Sarah Wolfe of the U.S. Economics team and Arianna Salvatore of the U.S. Public Policy team discuss.
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Sarah Wolfe: Welcome to Thoughts on the Market. I'm Sarah Wolfe from Morgan Stanley's U.S. Economics Team.
Ariana Salvatore: And I'm Ariana Salvatore from Morgan Stanley's U.S. Public Policy Research Team.
Sarah Wolfe: And on this episode of the podcast, we'll focus on student loans, in particular the recent student loan forgiveness program, and we'll dig into the impact on consumers and the economy. It's Thursday, September 15th, at 12 p.m. in New York.
Sarah Wolfe: So, Ariana, the White House recently announced plans to forgive individuals up to $20,000 in federal student loans and extend the moratorium on interest payments. However, there was some confusion earlier in the year as both President Biden and Speaker Pelosi expressed doubts about the president's authority to cancel student debt. So is this something that requires an act of Congress, or can the president really do it alone?
Ariana Salvatore: As you mentioned, prior to the announcement, there was some unresolved questions out there surrounding the legality of canceling student debt. In revealing the program, the administration cited authority from a 2003 law called the 'Heroes Act' that gives the executive the power to reduce or eliminate student debt during a national emergency, “when significant actions with potentially far reaching consequences are often required”. That being said, don't expect it to go over quietly. Reporting indicates that some Republican attorneys general are looking to bring legal challenges to the plan, which could present a risk to execution.But let's put questions about implementation aside for a second. What does reduced student debt impact more, longer term planning or immediate spending? And how do you quantify the impact on consumer spending?
Sarah Wolfe: Thanks, Ariana. I'd like to just take a step back for a second before I talk about the economic impact, just so we could size up the program a bit. We estimate that there's going to be $330 to $390 billion in debt directly forgiven as part of this program. However, we estimate that the fiscal multiplier is actually quite small. So every dollar of debt that's forgiven that's going to get spent and put back into the economy, is really estimated at only 0.1. This is really small when you consider the fiscal multiplier of the COVID stimulus programs. So for example, the stimulus checks, supplemental unemployment benefits, that had a fiscal multiplier of 0.5 to 0.9. So it was much larger. The reason for this is because our survey work shows that people who have their student debt forgiven don't actually change their immediate spending patterns. Instead, it really impacts longer term planning. We're talking about paying down other debts, planning for retirement, perhaps buying a house or having a child earlier, and so there's not really an immediate spending impact on the economy. What does have a larger fiscal multiplier is forbearance coming to an end. Prior to COVID, people were on average paying $260 a month in student loan payments. That's been on hold for two and a half years. So when that resumes again in January, it's likely going to be less than $260 a month because of the loan forgiveness and other measures passed by the White House to limit loan payments per month. However, that's an immediate impact to discretionary income, and as a result, we're going to see a lot of households adjust their spending in the near term to make these new loan payments. Arianna, speaking of student loan forbearance, which I mentioned is set to end at the end of this year after a number of extensions, the White House is hoping that forgiveness is going to kick in right when forbearance comes to an end. Can we actually count on the timing working out like this?
Ariana Salvatore: So there's definitely a risk that the program is delayed because of normal implementation hurdles, right. Things like determining eligibility for cancellation among millions of borrowers. The Department of Education memo that was released following the announcement says that 8 million borrowers may be eligible to receive relief automatically because relevant income data is already available. However, the department is also in the process of creating an application so borrowers can apply for forgiveness on their own, but that hasn't gone live yet. The DOE said it would be ready no later than when the pause on federal student loan repayments expires at the end of this year. Unfortunately, there's no real way to know when exactly that will be.
Sarah Wolfe: So let me just get this clear. The Department of Education only has the information on 8 million student loan borrowers right now. So they're going to need to gather the information for the remaining borrowers up to 43 million in order to start this forgiveness program.
Ariana Salvatore: Yeah, exactly. And that's why we tend to see large scale government programs like this take a little bit of time to ramp up rollout and have impacts on the economy.So in the event that all of those eligible to take advantage of the forgiveness program actually do so, let's focus in on the macroeconomic impacts. In this high inflation environment, wouldn't student loan forgiveness also have an additional inflationary effect?
Sarah Wolfe: Definitely at face value, student loan forgiveness is inflationary. However, as I mentioned earlier, because it doesn't impact near-term spending decisions and is more about longer term planning, the inflationary impact, I think, is less than people would think. It's estimated to only add 0.1 to 0.5 percentage points to inflation 12 months following the cancellation. However, the forbearance program, as I mentioned, since that's going to have more of an immediate impact on spending decisions, that's going to have a deflationary impact. And it's estimated that forbearance programs are going to shave 0.2 percentage points off inflation over the 12 months following forbearance starting again. And so if you think about forgiveness being inflationary and forbearance being disinflationary, it's likely that forbearance is going to outweigh some of the inflationary impact, if not all of it, from forgiveness.
Ariana Salvatore: Okay, so bringing it back to a more micro level. Last question for you here, Sarah. What are the implications for consumer credit and consumer ABS?
Sarah Wolfe: We think that student loan payments restarting in January pose quite a bit of risk to consumer credit quality. Although we're seeing consumer credit quality today is very healthy and delinquencies are low, we are starting to see delinquencies rise for subprime borrowers in recent months. Also, if we dig into the data and look at how student loan borrowers have been paying down their student loans over the last 2.5 years versus those who haven't been, the credit quality for those who have not been is much worse than those who have been. That leads us to believe that come January, when everybody needs to start paying down their student loans, that in particular these more subprime, lower income borrowers are really going to struggle and it's going to deteriorate credit quality.
Sarah Wolfe: Well, Ariana, thanks for taking the time to talk.
Ariana Salvatore: Great speaking with you, Sarah.
Sarah Wolfe: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
With only 60 days to go until the U.S. midterm elections, investors will want to know how different outcomes could impact markets, both locally and globally.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, September 14th, at 10 a.m. in New York.
We're less than 60 days from the U.S. midterm elections and investors should pay attention. A lot has changed since we published our midterm election guide earlier this year, so here's what you need to know now.
First, there's still key policies in play. Sure, Democrats have had more legislative success in recent months than many expected. By enacting corporate tax increases, a prescription drug negotiation plan, a major appropriation to clean energy transformation, and the China competition bill, Democrats took off the table many of the policy variables whose outcomes would have relied on the outcome of the election. But some key policy variables remain that matter to markets. In particular tech regulation, crypto regulation and tougher China competition measures, such as outbound investment controls, become more possible if Democrats manage to keep control of Congress. That would give them a greater opportunity to enact policies that could otherwise be held up or watered down by partisan disagreement.
Second, this means there's a lot at stake for some pockets of global markets. Tech regulation would be a fundamental challenge to the U.S. Internet sector. Crypto regulation could be a key support for financial services by putting the crypto industry on the same regulatory playing field as the banks. And outbound investment controls could be a clear challenge for China equities by putting a substantial amount of foreign direct investment at risk.
Finally, investors should understand these impacts aren't just hypotheticals, because, unlike earlier this year, Democrats electoral prospects have improved. Better showings in polls on key Senate races and the generic ballot have translated into prediction markets and independent models, marking Democrats as a modest favorite to keep Senate control, though they're still rated as an underdog to keep control of the House of Representatives. While it's difficult to pinpoint what's driven this change, voter discontent with the Supreme Court's Roe decision, as well as easing of some inflation pressures, may have contributed.
Bottom line, the midterm election remains a market catalyst and it's coming up quickly. We'll keep tracking developments and potential market impacts and keep you informed.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As various global markets contend with high inflation, recession risks, and monetary policy tightening, Japanese equities may provide some opportunities to diversify away from other developed markets.
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Welcome to Thoughts on the Market. I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the resilience of Japanese equities in the face of an expected global downturn. It's Tuesday, September 13, at 8 a.m. in Singapore.
As Morgan Stanley's Chief Global Economist Seth Carpenter noted in mid-August, the clouds of recession are gathering globally. In the U.S., the Fed is hiking rates and withdrawing liquidity. Europe is suffering from high inflation, looming recession and an energy shortage. And China is facing a rocky path to recovery. In this global context, the external risks for Japan are rising quickly. And yet, compared to the turbulence in the rest of the world, Japanese equities are enjoying rather calm domestic, macro and policy waters.
In Japan, we see support for this cycle coming from three sources; domestic policy, the Japanese yen and capital discipline at the corporate sector. First, the monetary policy divergence between the Bank of Japan and global peers has been remarkable, and in our view justified by differences in inflation and growth backdrops. Japanese core inflation is just 1.4%, and if we strip out food and energy, inflation is a mere 0.4% year over year. And so we don't expect any tightening from the Bank of Japan or of fiscal policy over the next six months. Secondly, the Japanese yen is acting as a funding currency and a buffer for earnings, rather than the typical safe haven that historically tends to amplify earnings drawdowns in an economic downturn. And third, improving capital discipline is contributing to newfound earnings resilience and insulating the return on equity, with buybacks tracking at a record pace of ¥10 trillion annualized year to date.
In addition to monetary and fiscal policy, Japan's more cautious approach to reducing COVID restrictions and employment focused stimulus programs have meant that the economy is in a different phase vis-a-vis other developed markets. Our expectation for Japan's economy is low but steady growth of 1.3% on average over 2022 and 2023.
As for the Japanese yen, we believe that a weaker yen is still a tailwind for TOPIX earnings. As a result of policy and real rate divergence, as well as the negative terms of trade shock from higher commodity prices, the yen has fallen to fresh record lows on a real effective exchange rate basis. The impact of a historically weak currency on the overall economy is still the subject of some debate, but one of the largest transmission channels of a weaker yen into supporting domestic services and employment is through tourism activity, which has been constrained to date by COVID policies. But looking ahead, the combination of reopening and a highly competitive tourism offering should set up a very strong recovery in passenger volumes and spending, as we saw during the European summer this year.
So where do all these global and domestic cross-currents leave us with respect to Japanese equities? We remain overweight on the TOPIX index versus our MSCI Asia-Pacific, ex-Japan and emerging markets coverage. We've been above consensus in forecasting an exceptional recovery in TOPIX earnings per share, but we acknowledge that to date it has been largely driven by export oriented stocks.
But currently, the external environment for Asia's major exporters is weakening as a result of tighter policies, slower growth and a revision in spending from goods to services. So while this trend will impact, we think, Taiwan, Korea and Singapore more so, China and Japan will also feel the impacts given their large goods trade surpluses. But with all this said, the Japanese market still provides liquid opportunities to diversify away from the U.S. and Europe, where Morgan Stanley strategists are cautious.
So while Japanese equities have historically underperformed in global downturns, the current setup leaves us more optimistic on Japan in particular, compared with other regions like the U.S. and Europe.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Even as the European equity market contends with inflation, a slowing economy and a climate of decreased earnings, there are positives to be found if you know where to look.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for European equity markets for the remainder of this year. It's Monday, September 12th, at 2 p.m. in London.
After a brief rally in European equities earlier in the summer, reality has reasserted itself over the last month with markets unable to escape a tricky macro backdrop characterized by central banks speeding up rate hikes into what is a deepening economic slowdown. In the last couple of weeks alone, our economists have raised their forecasts for ECB rate hikes and cut their GDP numbers to signal a deeper upcoming recession.
So let's dig into the investment implications of these challenges in a bit more detail. First on rates, over the last 20 years there has been a close relationship between interest rates and equity valuations, whereby higher rates lead to lower price to earnings ratios. Hence, the fact that central banks are still in the early stages of their hiking cycle suggests a high probability that PE ratios have further to fall. In addition to higher base rates, the pace of quantitative tightening is also speeding up, and our bond strategists forecast higher sovereign yields ahead. Here in Europe, they see ten year bond yields rising to 2% or more later this year, which will be consistent with a further fall in Europe's PE ratio to around 10x or so. That would imply 15% lower equity prices from here.
Second, we expect the European economy to slow over the next couple of quarters and this should put pressure on corporate profits which have been resilient so far this year, thanks to strong commodity sector upgrades and a material boost from the weakness we've seen in the euro and sterling. Looking forward, our models are flagging large downside risks to consensus earnings estimates for the next 12 to 18 months and we are 16% below consensus by the end of 2023. To provide some additional context, we note that consensus expects European earnings, excluding the commodity sectors, to grow faster next year than this year. This acceleration looks odd to us when you consider that our economists see slower GDP growth in 23 than 22, and our own margin lead indicator is suggesting we could face the largest year on year drop in corporate margins since the global financial crisis.
Our concern on earnings is a significant factor behind our continued preference for defensives over cyclicals. While some investors argue that the latter group are now sufficiently cheap to buy, we question the sustainability of the earnings that is underpinning the low PE ratios given the, first, we have seen very few downgrades so far. Second, margins are currently at record highs for many of these cyclical sectors. And then lastly, cyclicals tend to see larger earnings declines during downturns than the wider market. This gives rise to the old adage that investors should buy cyclicals on high PE ratios, not low ones.
Consistent with this view, we have recently downgraded three cyclical sectors to underweight from our top down perspective, these being autos, capital goods and construction. We are also underweight chemicals and retailing. So what do we like instead? Sectors with more defensive characteristics, such as health care, insurance, telecoms, utilities and energy. We also like stocks that offer a high and secure cash return yield, whether that be driven by dividends, buybacks or both. To end on a positive note, the level of buyback activity in Europe has never been stronger than what we are seeing today, whether we measure it by the number of companies that are repurchasing their shares or the amounts of money they are spending to do so. In addition, we note that those European companies who have offered a healthy buyback yield over time have been consistent outperformers.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As the world turns to the U.K., the country faces a host of domestic and international economic challenges, but there may yet be some bright spots for investors.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape, and how we put those ideas together. It's Friday, September 9th at 2:00pm in London.
Queen Elizabeth II passed away yesterday. She was the only monarch most in Britain have ever known, a steady constant over a period of enormous global change. She defined an era, and will be missed.
The eyes of the world have now turned to the United Kingdom, and they do so at a time when the country is facing an unusually high level of uncertainty.
The U.K. economy, which was recently surpassed in size by India, is still the worlds sixth largest. But it’s currently being buffeted by a host of economic challenges. Some are domestic, some are international, but combined they create one of the trickiest stories in the global economy.
First among these challenges is inflation. Rising costs for energy have driven Consumer prices in the U.K. up 10% year-over-year, but even excluding volatile food and energy, U.K. core inflation is still over 6%. And elevated inflation is not expected to be fleeting. Market-based estimates of U.K. inflation, over the next 10 years, are the highest since 1996.
Those elevated prices have driven U.K. interest rates higher, but even so, U.K. rates relative to inflation are still some of the lowest of any major economy, which makes holding the currency less attractive. That has weakened the British Pound, but since the U.K. runs a current account deficit, and imports more than it exports, imported things have become more expensive, creating even more inflationary pressure.
The U.K’s decision to leave the European Union, its largest trading partner, is another complication. By restricting the movement of labor, it’s created a negative supply shock and increased costs. And it has increased the fiction in trading abroad, especially with Europe, making it harder for U.K. exporters to take advantage of the country’s weaker currency.
The response to all this high inflation will likely be further rate hikes from the bank of England. But this has the potential to feed back into the economy unusually fast. Over here, many student loan payments are tied to the bank of England rate. And the rate on U.K. mortgages is often fixed for only 2 to 5 years, in contrast to the 30 year fixing common in the United States. That means the impact of higher interest rates into higher mortgage costs could be felt very soon.
For U.K. assets, the fact that a 10 year U.K. Government bond yields less than a 6-month U.S. Treasury bill, and much less than U.K. inflation, creates poor risk/reward. The Pound could continue to weaken, given all of these myriad economic challenges. But one bright spot might be the equity market, the FTSE 100. Trading at about 9x next year earnings, and benefiting from a weaker currency as many of these companies sell product abroad, we forecast stocks in the U.K. to outperform those in the Eurozone.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We’d love to hear from you.
The impact of quantitative monetary policies is hard to understand, for investors and academics alike, but why are these impacts so complex and how might investors better understand the market implications?
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, September 8th, at 10 a.m. in New York.
QT is the talk of the town. QT stands for quantitative tightening, which is meant to contrast it with QE, or quantitative easing. QT sounds intimidating, especially when respected investors mention the term and, at the same time, ring the fire alarm on financial news networks.
Unfortunately, the exact workings of QT and QE and their ultimate impact on markets aren't well understood. And that's not just a comment about the general public's understanding. It even applies to investors who have long dealt with quantitative policies and for academics who have long studied them.
There are four reasons why the impact of quantitative monetary policies, as the Fed has implemented them, is hard to understand. First, different institutions take the lead in determining the impact of QE versus QT. The Fed determines the first round impact of quantitative easing, while the U.S. Treasury and mortgage originators determine the first round impact of quantitative tightening.
Second, as the phrase "first round impact" implies, there are second round impacts as well. In the case of quantitative easing, the first round occurs when the Fed buys a U.S. Treasury or Agency mortgage backed security, also known as an agency MBS, from an investor. The second round occurs when that investor uses the cash from the Fed to buy something else.
In the case of quantitative tightening, the first round occurs when an investor sells something in order to raise the cash that it needs. What does it need the cash for? Well, to buy a forthcoming Treasury Security or agency MBS. The second round occurs when the U.S. Treasury auctions that security or when a mortgage originator issues an agency MBS in order to raise the cash that the Fed is no longer providing.
Third, QE and QT affect different markets in different ways. QE affects the Treasury and agency MBS markets directly in the first round. But in the second round, investor decisions about how to invest that cash could affect a wide variety of markets from esoteric loan products to blue chip equities.
In that sense, some of the impact of QE is indirect and could affect some markets more than others. Similarly with QT, investor decisions about what to sell could affect a large number of markets, again some more than others. In addition, what the U.S. Treasury issues and what mortgage originators sell can change over time with financing needs and different market environments.
Finally, markets price these different effects with different probabilities and at different times. For example, when the Fed announces a QE program, we know with near certainty that the Fed will buy Treasuries and agency MBS and generally know how much of each the Fed will buy. So investors can price in those effects relatively soon after the announcement.
But we don't know, with nearly the same probability, what the sellers of those treasuries and agency MBS will do with the cash until they actually get the cash from the Fed. And that could be months after the announcement when the Fed actually buys the securities.
Figuring out the effect on markets from QT is even more complicated because even though we know what the Fed will no longer buy, we don't know exactly what or how much the U.S. Treasury or mortgage originators will sell.
If all of this sounds complex, believe me it is. There are no easy conclusions to draw for your investment strategies when it comes to QT. So the next time someone rings the fire alarm and yells QT, first look for where there might be smoke before running out of the building or selling all of your risky assets.
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While home price appreciation appears to be slowing, and a rapid increase in supply is hitting the market, how will housing prices fare through the rest of the year and into 2023? Co-Heads of U.S. Securitized Products Research Jay Bacow and Jim Egan discuss.
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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow: And I'm Jay Bacow. The other Co-Head of U.S. Securities Products Research.
Jim Egan: And on this episode of the podcast, we'll be discussing supply and demand in the U.S. housing market. It's Wednesday, September 7th, at 3 p.m. in New York.
Jay Bacow: All right, Jim. Housing headlines have started to get a little more bleak. Home price appreciation slowed pretty materially with last week's print. Now, your call has been that activity is going to decrease, but home prices are going to keep growing. Where do we stand on that?
Jim Egan: We would say that the bifurcation narrative still holds. We think housing activity metrics, and when we say housing activity we're specifically talking about home sales and housing starts, have some continued sharp declines in the months to come. But we do think that home prices are going to continue growing on a year over year basis, even despite a disappointing print that you mentioned from last week.
Jay Bacow: But I have to askv, what are you looking at that gives you confidence in your home price call? Where could you be wrong given the slowdown we just saw?
Jim Egan: We say a lot of fancy sounding things when we talk about the housing market, but ultimately they're just different ways of describing supply and demand. Demand is weakening. That's that drop in activity we're forecasting. But supply is also very tight and that contributes to our view that while home price growth needs to slow, it should remain positive on a year over year basis.
Jay Bacow: All right, but haven't some metrics of supply been moving higher?
Jim Egan: Look, we knew we were not going to be able to say that supply was historically tight forever. Existing inventories are now climbing year over year for the first time in 37 months. And another very popular metric of supply, months of supply, is effectively getting a 1-2 punch right now. Months of supply measures how much the current supply of housing listed for sale, would take to clear at current demand levels. So in a world in which supply is increasing and demand is falling, you have a numerator climbing and a denominator falling, so you're effectively supercharging months of supply, if you will. We were at a cycle low of 2.1 months of inventory, the lowest we've seen in at least three and a half decades, in January of this year. We're at 4.1 months of supply just six months later.
Jay Bacow: So that number is a lot higher, but 4.1 months of supply is still really low. Isn't there some old saying that anything less than six months of supply is a seller's market? So wouldn't that be good for home prices?
Jim Egan: Yes. And given recent work that we've done, we think that that saying is there for good reason. If we go back to the mid 1980s, so the Case-Shiller index that we're forecasting here that's as far back as this index goes. And every single time that months of supply has been below six, the Case-Shiller index was still appreciating six months forward. Home prices were still climbing, six months forward. So the absolute level of inventory is in a pretty healthy place despite the recent increases. However, that rate of change is a little concerning. We've gone from 2.1 months to 4.1 months over just six months of actual time, and when we look at that rate of change historically, it actually does tend to predict falling home prices a year forward. So, absolute level of inventory leaves us confident in continued home price growth, but the rate of change of that underlying inventory calls continued home price growth in 2023 into question.
Jay Bacow: So we're going to have more inventory, but the pace has been accelerating. How do we think about the pace of that increase?
Jim Egan: If that pace were to continue at its current levels, that would make us really concerned about home prices next year. But we do think the pace of inventory growth is going to slow and we think that for two main reasons. The two biggest inputs into inventory are new inventories and existing. New inventories, and we've talked about this on the podcast before, we think they're about to really slow down. Homebuilder confidence is down 43% from cycle peaks in November of 2020. Part of that's the affordability deterioration we talked about earlier, but it's also because of a backlog in the building process. Single unit starts are back to 1997 levels. Units under construction, so between starts and completions, are back to 2004 levels - it is taking longer to finish those homes. And we have had a forecast that we thought that was going to lead to single unit starts slowing down, it finally has over the past two months after plateauing for almost a year. We think they're going to continue to fall pretty precipitously in the back half of this year, which should mean that new inventory stop climbing at the same pace that they've been climbing. Existing inventories also should stop their current pace of climb because of the lock in effect that we've talked about here before. Effectively, current homeowners have been able to lock in very low mortgage rates over the course of the past two years. They're not going to be incentivized to list their homes at similar rates to historical places because of that lock in effect. So for both of those reasons, we think the pace of increase in inventory is going to slow, and that's why we continue to think that home prices are going to grow on a year over year basis. They're just going to slow from 18% now, to 9% by the end of this year, to 3% by the end of 2023.
Jay Bacow: Okay. So effectively the low amount of absolute supply is going to keep home prices supported. The change in the amount of supply makes us a little bit more cautious on home prices on a longer term outlook. But we think that pace of that change is going to slow down.
Jay Bacow: Jim, always a pleasure talking to you.
Jim Egan: Great talking to you too, Jay.
Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcasts app and share the podcast with a friend or colleague today.
While interest rates have already weighed on asset markets this year and growth continues to slow, the Fed seems poised to continue on its tightening path, meaning investors may need to prepare for part two of our Fire and Ice narrative.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, September 6th, at 9 a.m. in New York. So let's get after it.
At the risk of stating the obvious, 2022 has been a challenging year for stock investors of all stripes. The Russell 3000 is down approximately 18% year to date, and while growth stocks have underperformed significantly it's been no picnic for value investors either. As far as sectors only energy and utilities are up this year, and just 24% of all stocks in the Russell 3000 are in positive territory. To put that into context, in 2008, 48% of the Russell 3000 stocks were up on the year as we entered the month of September and then the bottom dropped out. Suffice it to say, this year has been historically bad for stocks. However, that is not a sufficient reason to be bullish in our view.
As bad as has been for stocks, it's been even worse for bonds on a risk adjusted basis. More specifically, 20 year Treasury bonds are now down 24% year to date, and the Barclays AG Index is off by 11%. Finally, commodities have been a mixed bag too, with most commodities down on the year, despite heightened concerns about inflation. For example, the CRB RIND Index, which measures the spot prices of a wide range of commodities, is down 7% year to date. Cash, on the other hand, is no longer trash, especially if one has been able to take advantage of higher front end rates.
So what's going on? In our view, asset markets are behaving right in line with the fire and ice narrative we laid out a year ago. In short, after ignoring the warning signs from inflation last year and thinking the Fed would ignore them too, asset markets quickly woke up and discounted the Fed's late but historically hawkish pivot to address the sharp rise in prices. Indeed, very rarely has the Fed tightened policy so quickly. Truth be told, as one of the more hawkish strategists on the street last December, I never would have bet the Fed would be doing multiple 75 basis point hikes this year, but here we are. And remember, don't fight the Fed.
While the June low for stocks and bonds was an important one, we've consistently been in the camp that it wasn't the low for the S&P 500 in this bear market. Having said that, we are more confident it was the low for long term treasuries in view of the Fed's aggressive action that has yet to fully play out in the real economy. It may have also been the low for the average stock, given how bad the breadth was at that time and the magnitude of the decline in certain stocks.
Our more pessimistic view on the major index is based on analysis that indicates all the 31% de-rating in the forward S&P 500 P/E that occurred from December was due to higher interest rates. We know this because the equity risk premium was flat during this period. Meanwhile, forward earnings estimates for the S&P 500 have come down by only 1.5%, and price earnings ratio's back up 9% from where it was. With interest rates about 25 basis points below the June highs, the equity risk premium has fallen once again to just 280 basis points. This makes little sense in a normal environment, but especially given these significant earnings cuts we think are still to come.
With the Fed dashing hopes for a dovish pivot on this policy a few weeks ago, we think asset markets may be entering fire and ice part two. In contrast with part one, this time the decline in stocks will come mostly through a higher equity risk premium and lower earnings rather than higher interest rates. In fact, our earnings models are all flashing red for the S&P 500, and we have high confidence that the decline in forward S&P 500 earnings forecasts is far from over.
In short, part two will be more icy than fiery, the opposite of the first half of the year. That's not to say interest rates don't matter, they do and we expect bonds to perform better than stocks in this icier scenario. Importantly, if last Thursday marked a short term low for long duration bonds, i.e. a high in yields, the S&P 500 and many stocks could get some relief again as rates come down prior to the next rounds of earnings cuts that won't begin until later this month.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
There has been a lot of market movement in recent months, so as we exit the summer, what are the market stories and valuations that investors should be aware of?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, September 2nd at 3 p.m. in London.
As summer draws to a close, there is quite a bit that investors are coming back to. Here's a state of play of our global economic story, and where cross-asset valuations sit today.
The global economy faces challenges, but these challenges differ by region. The U.S. economy is seeing elevated inflation and still strong growth, as evidenced by today's report that the U.S. economy added another 315,000 new jobs last month. That makes it likely that the Federal Reserve will have to air on the side of raising rates more to bring inflation down, which would further invert the U.S. yield curve and, in our view, support the U.S. dollar.
Europe also has high inflation, but of a different kind. Europe's inflation isn't nearly as pronounced in so-called core elements, and it isn't showing up in wages. Instead, Europe is in the midst of a major energy crunch, that in our base case will push the economy into a mild recession. Markets expect that the European Central Bank will raise rates significantly more than the U.S. Federal Reserve over the next 12 months, but given our risks to growth we disagree, a reason we forecast a weaker euro. The economic situation in the UK is also very challenged, leaving us cautious on gilts and the UK pound.
China and Japan are very different and core inflation in both countries is less than 1%. China continues to face dual uncertainties from a weakening property market and zero-covid policy, factors that lead us to think it is still a bit too soon to buy China's equity market, despite large losses this year that have driven much better valuations. We remain more optimistic on Japanese equities on a currency hedged basis, given that it remains one of the few developed market economies where the central bank is not yet tightening policy.
To take a closer look at those global equity markets we enter September with the U.S. S&P 500 stock index trading at about 17x earnings. That's down from over 20x earnings at the start of the year, but it's still above average. U.S. small cap valuations, at about 11x earnings, are less extreme. Stocks in Europe, Australia, Japan, China and emerging markets all trade at about 11 to 12x forward earnings at the index level. Of all of these markets our forecasts imply the highest returns, on a currency hedged basis, in Japan.
In bonds, it's important to appreciate that yields remain much higher than they were a year ago. As we discussed last week, investors can now earn about 3.3% on 6 month U.S. government treasury bills, U.S. investment grade bonds yield almost 5% and U.S. high yield yields over 8.5%. In Europe, yields on European investment grade credit and Italian 10 year bonds are pretty similar, a spread at which we think European investment grade bonds are more attractive.
Markets have been moving over the summer. We hope our listeners have managed some time to rest and recharge and that this discussion has given some helpful context to where the different stories and valuations in the market currently sit.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
As consumers around the globe scale back on goods spending, how are Asian export markets impacted and where might opportunities lie?
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanly's Chief Asia Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll be focusing on the challenging landscape for Asia's exports post-COVID. It's Thursday, September 1st, at 8:30 a.m. in Hong Kong.
As listeners of the show are no doubt aware, the post-COVID recovery around the world has not been uniform, and each region is facing its own specific challenges. In Asia, one of those challenges is that the Asia export engine seems to be losing steam as goods demand continues to deflate. For instance, real export growth decelerated to just an average of 3% on a year on year basis in the past six months, as compared to a peak of 30% in April 2021.
Whichever way you slice and dice Asia's exports, it is evident that the underlying trends are soft everywhere. Whether by destination or by product, there is simply pervasive weakness. Let's start with product: when we look at Asia exports by product across the different categories of consumer, capital and intermediate goods exports, we are seeing a synchronized slowdown. Commodities are the only product category which is holding up, supported by trailing elevated prices. But with industrial commodity prices falling by some 30% since their March peak, we think there is every chance that commodity exports will slow significantly too in the coming months.
Now let's turn to destination. Demand is slowing in 70% of Asia's export destinations. While exports to the U.S. are still holding up, we expect that the slowing in the U.S. economy plus the continued normalization in goods spending, will weigh on exports to the U.S. too. Against this backdrop of weak aggregate demand, we see more downside for Asia's exports to the U.S. in the coming months.
One of the reasons why Asia's exports are deflating rapidly is because developed markets consumers are shifting back into spending on services after an outsized spending on goods earlier during the pandemic. As a case in point, US spending on goods had risen by 20% between January 2020 and March 2021. Since reaching its peak in March 21, goods spending has been on a decelerating path, declining by 5%. We expect further weakness in goods spending as the share of goods spending still has not normalized back towards pre-COVID levels.
Against this backdrop, investors should look at countries where domestic demand offsets the weakness in external demand. We continue to be constructive on India, Indonesia and Philippines as they are well placed to generate domestic demand alpha.
Within this group, we believe that India is the best placed economy within the region for three reasons. First, we see a key change in India's structural story. Policymakers have made a clear shift in that approach towards lifting the productive capacity of the economy and creating jobs while reducing the focus on redistribution. Second, the India economy is lifting off after a prolonged period of adjustment. The corporate sector has delivered and the balance sheet in the financial sector has also been cleaned up. This backdrop of healthy balance sheets and rising corporate confidence bodes well for the outlook for business investment. Third, against this backdrop, we are seeing unleashing of pent up demand, especially in areas like housing and consumer durables.
Finally, what about China - the largest economy in Asia? Typically when export slows down, we would expect China to be able to stimulate domestic demand. But in this cycle, while easing is already underway, the recovery in domestic demand is being held back by the housing market problem and its COVID management approach. We think that China domestic demand recovery should pick up pace by early next year as the full effects of its stimulus kicks in and private confidence lifts, thanks to China's anticipated shift to a living with COVID stance.
Thanks for listening. If you enjoy the show, please leave us a review on Apple podcasts, and share Thoughts on the Market with a friend or a colleague today.
While markets wrestle with high inflation and recession worries, investors will want to keep an eye on the rise in risk premiums and the outlook for long-run returns.
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Welcome to Thoughts on the Market. I'm Serena Tang, Morgan Stanley's Head of Cross-Asset Strategy for North America. Along with my colleagues, bringing you a variety of perspectives, today I'll focus on the current state of global cross-asset risk premiums. It's Wednesday, August 31st at 10 a.m. in New York.
Markets in 2022 have been incredibly turbulent, and global cross-asset risk premiums have shifted dramatically year to date. Various markets have been buffeted by higher inflation and tighter policy, geopolitical risks and worries about recession. Some impacted much more than others. What this means is that there are segments of markets where risk premiums, that is the excess returns an investor can expect for taking on additional risk, and long-run expected returns look much more attractive than they were at the beginning of the year. And while expected returns and risk premiums have broadly risen, the improvements have been uneven across asset classes and regions. For example, we believe that compared to U.S. stocks, rest-of-world equities have seen equity risk premiums move much higher since December, and currently have an edge over U.S. equities in terms of risk reward, in line with our relative preferences.
So let me put some actual numbers around some key regional disparities. Our framework, which incorporates expectations on income, inflation, real earnings growth and valuations, see U.S. equities returning about 7.5% annually over the next decade, compared to just 5.7% at the start of the year. However, a steep climb in U.S. Treasury yields from historical lows mean that from a risk premium perspective, U.S. equities is still below its 20 year historical average by nearly one percentage point. This is in contrast to other regions whose risk premiums have increased significantly more during the sell off. Notably, European equity risk premiums are 8.9%, close to a 20 year high, similarly for emerging markets at 5.3%, and Japanese equity risk premiums at 4.7%, also above average. And remember, higher risk premiums typically signal that it's a good time to invest in riskier assets.
For fixed income, with nominal yields rising on the back of more persistent inflationary pressures and quantitative tightening, long-run expected returns are now higher than they were 12 months ago. In fact, we're now back to levels last seen in 2019. Our framework now predicts that ten year U.S. Treasuries can return 3.7% annually over the next decade, up from 2.2% just a year ago.
Credit risk premiums, such as for corporate bonds, have also readjusted year to date. As with risk free government bonds, rising yields mean that long run expected returns for these bonds have improved significantly since the start of the year. In terms of numbers, our model forecasts for U.S. high yield risk premium, at 188 basis points compared to near nothing 12 months ago.
So what does all this mean? Well, for one thing, as my colleague Andrew Sheets has pointed out in a previous Thoughts on the Market episode, lower prices, wider risk premiums and higher 10 year expected returns have raised our long-run expected returns forecasts for a portfolio of 60% equity and 40% high quality bonds to the highest it's been since 2019, above the 10 year average. So we believe that the case for a 60/40 type of approach remains.
For another, it means that the opportunities for investors right now lie in relative value rather than beta, given our strategists macro outlook for the next 12 months is more cautious than our long-run expected forecast. So for example, based on our long-run expected returns, our dollar optimal portfolios favor segments of the markets with more credit risk premium, like high yield and emerging market bonds. And similarly, as I've mentioned before, our current cross-asset allocation has a preference for ex-U.S. equities versus the U.S. because of former's higher equity risk premium. The rest of 2022 will likely continue to be turbulent, but there is good news for investors with a longer term focus.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Amid global shocks across supply, commodities and the U.S. Dollar, central banks continue to fight hard against inflation, leading many to wonder if a global recession is imminent.
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's chief global economist, along with my colleagues, bringing you a variety of perspectives. Today, I'll be revisiting a topic that's front and center: concerns about a global recession. It's Tuesday, August 30th, at 2p.m. in New York.
One key market narrative right now is that the clouds of recession have been gathering globally. And the question that I get from clients every day, 'is a global recession upon us?'
A recession is our baseline scenario for the Euro area. The flow of natural gas from Russia has been restricted and energy prices, as a result, have surged. We expect a recession by the fourth quarter but, as is so often the case, the data will be noisy. A complete gas cutoff, which is our worst-case scenario. That's still possible. On the other hand, even if somehow we had a full normalization of the gas flows, the relief to the European economy would only be modest. Winter energy prices are already partly baked in, and we've got the ECB with an almost single-minded focus on inflation. There are going to be more interest rate hikes there until the hard data force them to stop.
Now, I am slightly more optimistic about the U.S. The negative GDP prints in the first two quarters of this year clearly cast a pall but those readings are misleading because of some of the details. Now, bear with me, but a lot of the headline GDP data reflects inventories in international trade, not the underlying domestic economy. Household spending, which is the key driver of the U.S. economy, averaged about 1.5% at an annual rate in the first half and the July jobs report printed at a massive 520,000 jobs. Since the 1970s, the U.S. has never had a recession within a year of creating so many jobs. But the path forward is clearly for slowing. Consumption spending was slammed by surging food and energy prices and more importantly, the Fed is hiking interest rates specifically to slow down the economy.
So what is the Fed's plan? Chair Powell keeps noting that the Fed strategy is to slow the economy enough so that inflation pressures abate, but then to pivot or, as he likes to say, 'to be nimble.' That kind of soft landing is by no means assured. So, we're more optimistic in the U.S., but the Fed is going to need some luck to go along with their plan.
The situation in China is just completely different. The economy there contracted in the second quarter amid very stringent COVID controls. The COVID Zero policies in place are slowly starting to get eased and we think more relaxation will follow the party Congress in October. But will freedom of mobility be enough to reverse the challenges that we're seeing on consumer spending because of the housing market? The recent policy action to address the housing crisis will probably help some but I fully expect that a much larger package will be needed. Ultimately, we'll need the consumer to be confident in both the economy and the housing market before we can make a rapid recovery.
The world has been simultaneously hit by supply shocks, commodity shocks and dollar shocks. Central banks are pulling back on demand to try to contain inflation. Even if we avoid a global recession, it's really hard to see how economic activity gets all the way back to its pre-COVID trend.
It's still the summertime, so I hope it's sunny where you are. You can worry about the storm later.
Thanks for listening. If you enjoy this show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
With Fed messaging making it clear they’re not yet done fighting inflation, the market is left to contend with the recent rally and prepare to adjust growth expectations.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, August 29th, at 11 a.m. in New York. So let's get after it.
After the Fed's highly anticipated annual meeting in Jackson Hole has come and gone with a very clear message - the fight against inflation is far from over, and the equity markets did not take it very well. As we discussed in this podcast two weeks ago, the equity markets may have gotten too excited and even pre traded a Fed pivot that isn't coming. For stocks, that means the bear market rally is likely over.
Technically speaking, the rally looks rather textbook. In June, we reached oversold conditions with breadth falling to some of the lowest readings on record. However, the rally stalled out exactly at the 200-day moving average for the S&P 500 and many key stocks. On that basis alone, the sharp reversal looks quite ominous to even the most basic tactical analysts.
From a fundamental standpoint, having a bullish view on U.S. stocks today is also challenging. First, there is valuation. As we have discussed many times in our research, the Price/Earnings ratio is a function of two inputs; 10 year U.S. Treasury yields and the Equity Risk Premium. Simplistically, the U.S. Treasury yield is a cost of capital component, while the Equity Risk Premium is primarily a function of growth expectations. Typically, the Equity Risk Premium is negatively correlated to growth. In other words, when growth is accelerating, or expected to accelerate, the Equity Risk Premium tends to be lower than normal and vice versa. Our problem with the view that June was the low for the index in this bear market is that the Equity Risk Premium never went above average. Instead, the fall in the Price/Earnings ratio from December to June was entirely a function of the Fed's tightening of financial conditions, and the higher cost of capital.
Compounding this challenge, the Equity Risk Premium fell sharply over the past few months and reached near record lows in the post financial crisis period. In fact, the only time the Equity Risk Premium has been lower in the past 14 years was at the end of the bear market rally in March earlier this year, and we know how that ended. Even after Friday's sharp decline in stocks, the S&P 500 Equity Risk Premium remains more than 100 basis points lower than what our model suggests. In short, the S&P 500 price earnings ratio is 17.1x, it's 15% too high in our view.
Second, while most investors remain preoccupied with the Fed, we have been more focused on earnings and the risk to forward estimates. In June, many investors began to share our concern, which is why stocks sold off so sharply in our view. Companies began managing the quarter lower, and by the time second quarter earnings season rolled around positioning was quite bearish and valuations were more reasonable at 15.4x. This led to the "bad news is good news" rally or, as many people claim, "better than feared" results. Call us old school, but better than feared is not a good reason to invest in something if the price is high and the earnings are weak. In other words, it's a fine reason for stocks to see some relief from an oversold condition, but we wouldn't commit any real capital to such a strategy. Our analysis of second quarter earnings showed clear deterioration in profitability, a trend we believe is just starting. In short, we believe earnings forecast for next year remains significantly too high.
Finally, last week's highly anticipated Fed meeting turned out to be a nonevent for bonds, while it appeared to be a shock for stock investors. Ironically, given the lack of any material move in yields, all of the decline in the Price/Earnings ratio was due to a rising Equity Risk Premium that still remains well below fair market levels.
The bottom line, we do think Friday's action could be the beginning of an adjustment period to growth expectations. That's good. In our experience, such adjustments to earnings always take longer than they should. Throw on top of that, the fact that operating leverage is now more extreme than it was prior to COVID, and the negative revision cycle could turn out to be worse than usual. Next week, we will attempt to quantify more specifically how challenging the earnings outcome might be based on an already reported macro data.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Though returns offered by cash have been historically bad over the last 10 years, the tide has begun to turn on cash yields and investors will want to take note.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 26, at 2 p.m. in London.
For much of the last 12 years, the question of whether to hold cash in a portfolio was really a question of negativity. After all, for most of that time, holding cash yielded nothing or less than nothing for those in Europe. Holding it implied you believed almost every other investment option was worse than this low bar.
Unsurprisingly, the low returns offered by cash over this period led to... low returns. For 8 of the 10 years from 2010 through 2020, holding cash underperformed both U.S. stocks and U.S. Treasuries. And while cash is often like stocks and bonds over time, the returns to holding cash since 2010 were historically bad.
But that's now changing, because cash no longer yields nothing. As central banks have raced to raise rates in the face of high inflation, the return on holding cash or near cash investments has jumped materially. One year ago, a 6 month U.S. Treasury bill yielded 0.04%. It now yields 3.25%.
That is 3.25% for an investment with very low volatility backed by the full faith and credit of the U.S. government. That's a higher yield than a U.S. 10 year Treasury bond. It is more than double the dividend yield of the S&P 500 stock index. And it's just a quarter of a percentage point less than the dividend yield on U.S. real estate investment trusts.
It's important to note that not all short term liquid investments are created equal. While six month U.S. T-bills now yield 3.25%, the average yield on 6 month bank CD's is less than 1%, and the average U.S. savings account yields just 0.2%. In other words, it pays to shop around. And for those in the business of managing money market and liquidity funds, we think this is a good time to add value and grow assets.
What are the market implications? For equity markets, if investors can now receive higher yields on low risk cash, we think it's reasonable to think that that should lead investors to ask for higher returns elsewhere, which should lower valuations on stocks. My colleague Michael Wilson, Morgan Stanley's Chief Investment Officer and Chief U.S. Equity Strategist, sees poor risk reward for U.S. equities at current levels.
More broadly, we think it supports holding more U.S. dollar cash in a portfolio. That's true for U.S. investors, but also globally, as we forecast the U.S. dollar to continue to strengthen. Holding cash isn't necessarily a sign of caution, it may simply be efficient allocation to an asset that has recently seen a major jump in yield.
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This year has seen a sharp rally in the oil and gas markets, leading to high prices and a delicate balancing act for global supply and demand.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Markets. I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist and the Head of the European Energy Research Team. Along with my colleagues, bringing you a variety of perspectives, today I'll be giving you an update on global oil and the European gas market. It's Thursday, the 25th of August, at 4 p.m. in London.
As the world emerged from COVID, commodities have rallied strongly. Between mid 2020 and mid 2022, the Bloomberg Commodity Index more than doubled, outperforming equities significantly and fulfilling its traditional role as an inflation hedge.
However, this rally largely ran out of steam in June, even for oil. For nearly two years, the oil market was significantly undersupplied. For a while, storage can help meet the deficit, but at some point, supply and demand simply need to come into balance. If that can't happen via the supply side quick enough, it must happen via the demand side, and so the oil markets effectively searched for the demand destruction price.
The price level where that happens can be hard to estimate, but in June we clearly got there. For a brief period, gasoline reached $180 per barrel and diesel even reached $190 a barrel. Those prices are difficult for the global economy to absorb, especially if you take into account that the dollar has been strengthening at the same time. With the world's central banks hiking interest rates in an effort to slow down the economy as well, oil demand has started to soften and prices have given up some of their recent strength.
Now these trends can take some time to play out, possibly even several quarters. As long as fears of a recession prevail, oil prices are likely to stay rangebound. However, after recession comes recovery. There is still little margin of safety in the system, so when demand starts to improve again, there is every chance the strong cycle from last year repeats itself. This time next year we may need to ask the question, 'What is the demand destruction price?' once again.
Now, one commodity that has defied all gravity is European natural gas. Over much of the last decade, Europe was accustomed to a typical natural gas price of somewhere between sort of $6 to $7 per million British thermal units. Recently, it reached the eye-watering level of $85 per MMBtu. On an energy equivalent basis, that would be similar to oil trading at nearly $500 per barrel.
Now, the reason for this is, of course, the sharp reduction in supply from Russia. As the war in Ukraine has unfolded, Russia has steadily supplied less and less natural gas to Europe. Now total volumes have already fallen by around about 75%. Furthermore, Gazprom announced that flows through the critical Nord Stream 1 pipeline would temporarily stop completely later this month for maintenance to one of its turbines. In principle, this will only last three days, but the market is clearly starting to fear that this is a harbinger of a much longer lasting shutdown.
These exceptional prices are already leading to large declines in demand. During COVID, industrial gas consumption in Europe fell only 2 or 3%. Last month, industrial gas use was already down 19% year-on-year. With these demand declines, Europe can probably manage with the reduced supply, but to keep demand lower for longer gas prices need to be higher for longer. The gas market has clearly noticed. Even gas for delivery by end 2024 is now trading at close to $50 per MMBtu, 10x the equivalent price in the United States.
The full implications of all of this for the European economy going forward are yet to become clear, but we'll be sure to keep listeners up to date on the latest developments.
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As Asia and EM equities continue to experience what may end up being the longest bear market in the history of the asset class, looking to past bear markets may give investors some insight into when to come off the sidelines.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing whether we're nearing the end of the current bear market in Asia and emerging market equities. It's Wednesday, August the 24th, at 8 a.m. in Singapore.
The ongoing bear market in Asia and EM equities is the 11th which I've covered as a strategist. And in this episode I want to talk about some lessons I've learned from those prior experiences, and indeed how close we may be to the end of this current bear market.
A first key point to make is that this is already the second longest in duration of the 11 bear markets I've covered. Only that which began with the puncturing of the dot com bubble by a Fed hike cycle in February 2000 was longer. This is already a major bear market by historical standards.
My first experience of bear markets was one of the most famous, that which took place from July 1997 to September 1998 and became known as the Asian Financial Crisis. That lasted for 518 days, with a peak to trough decline of 59%. And as with so many others, the trigger was a tightening of U.S. monetary policy at the end of 1996 and a stronger U.S. dollar. That bear market ended only when the U.S. Federal Reserve did three interest rate cuts in quick succession at the end of 1998 in response to the long term capital management and Russia defaults.
Indeed, a change in U.S. monetary policy and/or a peak in the U.S. dollar have tended to be crucial in marking the troughs in Asia and EM equity bear markets. And that includes the two bear markets prior to the current one, which ended in March 2020 and October 2018. However, changes in Chinese monetary policy and China's growth cycles, starting with the bear market ending in October 2008, have been of increasing importance in recent cycles. Indeed, easier policy in China in late 2008 preceded a turn in U.S. monetary policy and helped Asia and EM equities lead the recovery in global markets after the global financial crisis.
Although China has been easing policy for almost a year thus far, the degree of easing as measured by M2 growth or overall lending growth is smaller than in prior cycles. And at least in part, that's because China is attempting to pull off the difficult feat of restructuring its vast and highly leveraged property sector, whilst also pursuing a strategy of COVID containment involving closed loop production and episodic consumer lockdowns. Those key differences are amongst a number of factors which have led us to recommend staying on the sidelines this year, both in our overall coverage in Asia and emerging markets, but also with respect to China. We have preferred Japan, and parts of ASEAN, the Middle East and Latin America.
Finally, as we look ahead I would also note that one feature of being later on in a bear market is a sudden fall in commodity prices. And certainly from mid-June there have been quite material declines in copper, iron ore and more recently, the oil price. Meanwhile, classic defensive sectors are outperforming. And that sort of late cycle behavior within the index itself raises the question of whether by year end Asia and EM equities could once again transition to offering an interesting early cycle cyclical play. That more positive scenario for next year would depend on global and U.S. headline inflation starting to fall back, whether we would see a peak in the U.S. dollar and Fed rate hike pricing.
For the time being, though, as the clock ticks down to the current bear market becoming the longest in the history of the asset class, we still think patience will be rewarded a while longer.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.
The Inflation Reduction Act represents the single biggest climate investment in U.S. history, so how will these provisions influence consumers' pocketbooks and the clean energy market? Head of Global Thematic and Public Policy Research Michael Zezas and Global Head of Sustainability Research Stephen Byrd discuss.
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of Global Thematic and Public Policy Research.
Stephen Byrd And I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research.
Michael Zezas And on this special episode of Thoughts on the Market, we'll focus on the Inflation Reduction Act's bold attempt to stem the tide of climate change. It's Tuesday, August 23rd at noon in New York.
Michael Zezas Regular listeners may have heard our previous episodes on the potential impact for the U.S. economy and on taxes from the Inflation Reduction Act. Today, we'll focus on another essential aspect of this new legislation, namely its sweeping support for clean energy, which represents the single biggest climate investment in U.S. history. So, Stephen, there's a ton of important issues to address here. Let's start with an immediate pain point that most of us deal with on a daily basis, the cost of energy. How does the Inflation Reduction Act aim to lower energy costs for Americans?
Stephen Byrd The simplest way to think about this is that in the past decade, wind and solar costs in the U.S. declined every year by double digits. What's exciting about the IRA is that there are really important investments that will increase the scale of manufacturing. So, the fundamental point in terms of the benefit of the IRA really is support for a variety of clean energy investments that's going to increase efficiency, reduce per unit costs. This is becoming really essentially a very big business. To put this in context, in the last 12 months utility bills in the U.S. and most of the U.S. have increased by sometimes well into the double digits. And yet clean energy costs remain quite low. Given some of the near-term COVID supply chain dynamics, costs aren't dropping as quickly as they normally would, but before long we're going to see those reductions continue. That should result in lower power costs for customers across the U.S. and that's the single biggest benefit from a sort of deflationary point of view that I can think of around the IRA.
Michael Zezas And the IRA also has a stated aim to increase American energy security. In what ways does it attempt to do that?
Stephen Byrd Yeah, Michael, it's really interesting. The IRA has some very broad areas of support for domestic manufacturing of all kinds, of not just clean energy but related technologies like energy storage. And we do think that's going to likely result in quite a bit of onshoring of manufacturing activity. That is good for American energy security, that brings our sources of energy production right back home, creates jobs, reduces dependency on other governments. So, for example, the subsidy for solar manufacturing is really very large. It can be as high as essentially $0.17 a watt, and to put that into context, the selling price at the wholesale level for many of these products is around $0.30 a watt. So that subsidy for domestic manufacturing should result in real investment decisions in real U.S. factories, and that will help to improve American energy security.
Michael Zezas Now, another aspect of this legislation is its attempt to substantially limit carbon emissions in the U.S. What are some of the measures that are aimed at doing this?
Stephen Byrd Decarbonization is a major area of focus, just as you said, for the IRA and this shows up in many ways. I'd say the most direct way would be providing a number of incentives to increase the growth of wind and solar. So, we'll see a great deal of growth there as a result. However, there are other elements that are really interesting. One example is support for nuclear. I think the drafters really wanted to ensure that we didn't lose any additional nuclear power plants. Those plants provide obviously zero carbon energy, but they also provide really important grid reliability services so that's helpful. There is also quite a bit of capital for carbon capture, which should reduce the emissions profile of other sectors as well. There's quite a bit of support for electric vehicles that will help with the pace of electrification. And that's kind of a nice double benefit in the sense that if more consumers choose electric vehicles and the grid becomes cleaner then we get a double benefit. So, we're really seeing very broad-based support for decarbonization in the IRA.
Michael Zezas Now, one of the methods here to incentivize decarbonization is through tax credits. What are some of these tax credits? How do they work?
Stephen Byrd We have a lot of tax credits in this IRA for what I think of as wholesale players, that is the big clean energy developers. There are tax credits for wind and solar that get extended well into the next decade. We have a new tax credit for energy storage. We have tax credits that have been enhanced for carbon capture and utilization, which is very exciting because that's at a level needed to incent quite a bit of investment in carbon capture. We have a new very large tax credit for green hydrogen. That's great, because today hydrogen is made in a process called ‘gray hydrogen’ that does have quite a high carbon profile. So, a variety of tax credits essentially at the wholesale level or at the developer level, but also that could benefit consumers as well, such as on electric vehicles and those are quite sizable as well.
Michael Zezas Now these tax credits and the other efforts in the Inflation Reduction Act aimed at carbon reduction, they represent a major pickup in spending on clean technologies. Can you give us some perspective on that? And is the industry ready to supply all the equipment and labor needed to make this a reality?
Stephen Byrd I think what we're seeing with many technologies here in clean energy is that the demand is starting to grow very rapidly. Now the industry is really pushing very hard to keep pace, essentially. The limit on growth for some of our companies is really down to people. That is, how many people can they hire and train. So, for some of those companies, that growth rate caps out at about 25% per year. You know, that's quite good and we'll see that continue for many years. I think we're going to see a lot of increased efforts on education. And you'll see also within the IRA a lot of language around prevailing wage and ensuring that employees get paid a fair wage. On top of that, though, there are some areas of shortage. So in energy storage, for example, demand is very high across the U.S., not just for electric vehicles, but also to help with grid reliability. A good example would be in Texas during the winter storm, parts of the Texas grid failed and quite a few people were without power during very cold conditions. That was very challenging. And as a result, a lot of customers, both individuals and corporations, want to have storage. There are limits, there is a shortage essentially globally in terms of energy storage, and that's going to take years to address. That said, the IRA does make important headway in terms of providing incentives and financial support to bring a lot of manufacturing back to the U.S. so we have better control of manufacturing. We'll be able to scale up more quickly and also avoid a lot of the logistics and supply chain issues that have plagued some of our companies that have dealt with very complex and challenging global supply chains.
Michael Zezas So, for investors, then, what's the takeaway? Is this perhaps a boon for the clean tech sector, or is it maybe too much, too soon?
Stephen Byrd I think this is a boon for not just the clean tech sector. I think ultimately this is going to translate into much more rapid adoption of clean energy, which fundamentally is very much a deflationary force. So what we're going to see is further innovation, further manufacturing in the U.S. That means more jobs in the U.S, that means a faster pace of innovation and a faster rate of cost reduction. So that does look to us to be a virtuous cycle that's going to benefit not just the decarbonization of the U.S. economy but benefit the consumer and provide jobs as well.
Michael Zezas Stephen, thanks for taking the time to talk.
Stephen Byrd Great speaking with you, Michael.
Michael Zezas As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
While stocks and bonds have rallied since June, investors should be asking if this bear market rebound is a sign that economic growth is on its way up, or if there are negative earning revisions yet to come.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, August 22nd at 11 a.m. in New York. So let's get after it.
Taking a few weeks off can sometimes provide a fresh perspective on markets needed at times like today. The fact that it happens to be August, the most popular time for vacations of the year, can also play into that perspective. Over the past 6 weeks many financial markets have had a strong rebound. As an example, both stocks and bonds have rallied sharply from their June lows. The question that equity investors must ask themselves is how much of the rally in stocks is due to the fall in interest rates versus a real improvement in the prospects of a soft landing in the economy?
For better or worse our view has remained consistent since April that the primary concern for stocks was no longer inflation, or the Fed's reaction to deal with it, but rather the outlook for growth. In May, the consensus moved strongly into our camp, with the cries for a recession reaching a fever pitch in June. Equity markets became very oversold and the stage was set for a powerful rally. Truth be told, this rally exceeded our expectations for a normal counter trend bear market rally. However, in order to set the stage for the next leg lower, the rally needed to be convincing enough to change the very bearish sentiment to outright bullish. Based on what I have seen in the press and from our peers around the street, that sentiment has flipped with many declaring the end of the bear market and the increasing likelihood of new all time highs as soon as later this year.
While there are some strong indications that inflation has peaked from a rate of change standpoint, it's too soon for the Fed to declare victory in our view. In other words, the rising hope for the Fed to pivot away from rising rates or curtailing its balance sheet reduction remains optimistic. Nevertheless, this is the primary justification for why equity markets have rallied and why it can continue.
However, even if that were true, there are very few data points suggesting we have reached a trough in growth, either economically or from an earnings growth standpoint. In fact, our growth is suggesting the opposite, with earnings revision breadth accelerating to the downside, along with our other leading indicators. To put it more bluntly, rarely have we been more confident that consensus growth expectations for earnings over the next 12 months are too high. More importantly, the equity market almost never rallies if forward earnings estimates are falling, unless the valuation is completely washed out. In June, one could have credibly argued valuations were discounting a sharp decline in growth and the risk of a recession. At the lows the forward price earnings ratio reached 15.4x and was down almost 30% from the end of last year. At 15.4x is almost exactly our year end target price earnings multiple at the beginning of this year based on our view that the Fed would have to tighten aggressively to combat inflation.
The problem with assuming 15.4x was a washed out level for valuations is that all of the degradation was a result of higher interest rates, while the equity risk premium remained flat to down over that time frame. In other words, at no time did the price earnings multiple discount a material slowdown in growth. Now, with the price earnings multiple exceeding 18x last week, valuations are inappropriate if one agrees with our view that earnings estimates are too high. On Friday, stocks reversed lower and that seems to be carrying into this week. Many are once again blaming the Fed and perhaps acknowledging its work in fighting inflation remains unfinished. We agree. However, with price earnings multiples still 17.4x as I record this podcast, valuations are not discounting that resolve, nor is it discounting the negative earnings revisions still to come.
The bottom line stocks have experienced a classic bear market rebound after having reached a near record oversold condition on many metrics. With the Fed still very much in the picture and earnings estimates likely to fall further, equity markets are almost as unattractive as they were at the beginning of the year.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
In the past two years Emerging Market sovereign debt has seen rising risks given increased borrowing, higher interest rates and a greater number of defaults, leading investors to wonder, are we heading towards an EM debt crisis?
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly incidental to general coverage of the relevant Russian economic sector as germane to its overall financial outlook, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the market. I'm Simon Waever, Morgan Stanley's Global Head of EM Sovereign Credit Strategy. Along with my colleagues, bringing you a variety of perspectives, today, I'll address the possibility of an emerging markets debt crisis. It's Friday, August 19th, 12p.m. in New York.
The most frequent question I get from investors right now is, 'are we heading towards an EM debt crisis?' It's not unreasonable to ask this. After all, a lot of the ingredients that led to prior EM debt crises are in place today. First, EM countries have taken on a lot of debt, not just since the pandemic, but in the past ten years, meaning most countries are at or near multi-decade highs. Second, global central banks are quickly hiking rates, with the Fed in particular a key driver in tightening global financial conditions. Third, which is related, is that servicing and rolling over that debt has suddenly become much more expensive, driven not just by a stronger dollar, but also much higher bond yields. And then fourth, which is perhaps the most important one, is that today we are as close to an extended sudden stop in flows to EM as we have been in a long time. That means that many countries have lost access to markets, so that even if they were willing to pay up to borrow, there's just no demand.
Markets are telling us the risks are rising as well. Outside of the 2008 Global Financial Crisis and the 2020 pandemic, you'd have to go back 20 years to find EM sovereign credit spreads trading as wide. And high yield credit spreads are much wider than investment grade spreads, so markets are differentiating already.
Finally, just looking at actual sovereign defaults and restructurings, they're already higher than in recent history. We have had six in the past two years and now already three in 2022, namely Russia, Belarus and Sri Lanka.
From here, there are likely to be more defaults, but three key points are worth making. One, the countries at risk now are very different to the prior debt crisis in EM. Two, none would be systemic defaults. And three, they would not all happen at the same time.
Large countries like Brazil, Mexico, South Africa, Indonesia and Malaysia don't seem to be at risk of defaulting. They are completely different to what they were 20 to 30 years ago. They're now inflation targeters, have mostly free-floating currencies, meaning imbalances are less likely to build up, have large effects reserves and have the majority of that debt in local currency.
Instead, the concern now is mostly with the newer issuers that benefited from the abundant global liquidity in the past ten years. And by this I mean the frontier credits, many of which are in Africa, but also in Asia and Central America. And then it's key to actually look at who has upcoming Eurobond maturities, as not all countries do. But even among these credits, the International Monetary Fund stands ready to help and there are FX reserves that can be used. So, it's not clear to me that you're going to see multiple defaults and even if you were to see two or more defaults among them, they're very unlikely to be systemic.
But, all in, while there's no denying that EM countries are facing debt sustainability issues, let's not paint all EM with the same brush. The nuances should make for some exciting years ahead for sovereign debt analysts and should also open up the potential for significant alpha within the asset class.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The Inflation Reduction Act includes a variety of provisions regarding tax policy, so how will these policy changes affect corporations and what should investors be aware of? Head of Public Policy Research and Municipal Strategy Michael Zezas and Head of Global Valuation, Accounting, and Tax Todd Castagno discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of Public Policy Research and Municipal Strategy.
Todd Castagno: And I'm Todd Castagno, Morgan Stanley's Head of Global Valuation, Accounting and Tax Research.
Michael Zezas: And on this special episode of Thoughts on the Market we'll focus on what you need to know about some significant changes to tax policy from the Inflation Reduction Act. It's Thursday, August 18th, at noon in New York.
Michael Zezas: President Biden has now signed the Inflation Reduction Act, or IRA, into law. As our listeners may remember, last week we discussed the potential impact of the IRA on the U.S. economic outlook. Today we want to dig deeper into a specific area of this new law, namely taxes. So Todd, there's been some criticism of the IRA with regard to the 15% minimum tax on the largest corporations. What are your thoughts on this provision?
Todd Castagno: Thanks, Michael. Let's first discuss how this 15% minimum corporate tax operates. So the law now intends for large corporations that earn on average of $1 billion or more over a three year period to pay at least 15%. Now, what's important is what is that profit base to tax that 15% and its derived from financial statement net income with certain adjustments. That is why this tax is commonly referred to as a book tax, that is primarily based on book or financial statement measures of income. So if you peel back a few layers of what's driving the criticism, there's a recognition that this tax effectively just overrides incentives or timing differences that Congress consciously enacted. Critics will say that Congress should just fix certain areas of the tax codes directly. However, the politics of fixing specific policies directly can be extremely difficult politically. The other point of criticism is that taxing authority has effectively been ceded to independent accounting standards setters. Changes in the accounting rules may now affect changes in minimum tax revenue. There have been some concerns from investors over earnings quality as the tail now wags the dog where accounting can now drive the economics. So those are just a few of the criticisms. It's also important to note, Michael, that we've had a version of a book tax back in the 1980s, so it would be interesting to see longevity of this tax as that tax only lasted effectively 2 to 3 years.
Michael Zezas: And another piece of the legislation is a softening and reduction of the Corporate Alternative Minimum Tax on advanced manufacturing activities such as automation, computation, software and networking. What can you tell us about that?
Todd Castagno: Good question. When Senator Sinema announced a carve out for advanced manufacturing, we were scratching our heads of what that actually meant. Well, it's quite broader and it really affects most manufacturing. So what the adjustment is, is you start with book income and you'd make an adjustment to basically replace what we book for accounting depreciation with tax depreciation. And so tax depreciation is usually front run it and it's usually accelerated versus book. So what that will mean for manufacturers is that their minimum tax base will be lower given this adjustment.
Michael Zezas: And also in the IRA is a 1% stock buyback tax for companies that are repurchasing their own shares. Todd, is that likely to impact corporate profits or change behavior in a meaningful way?
Todd Castagno: Overall, we don't believe at a 1% level this will materially affect the level of buybacks or corporate behavior. You could see a modest tilt towards dividends as a more preferential form of capital return. You could also see perhaps some buybacks being pulled forward into 22 as the law takes effect in 2023. You know, we think the bigger risk is that 1% rate skews higher in the future if a future Congress needs more revenue. We should also note that it's net of issuances, so that's important. A lot of firms have large amounts of stock based compensation and they repurchase their shares in order to prevent dilution. And so effect of that issuance will also really reduce the amount of the buyback tax.
Michael Zezas: And finally, let's talk about tax credits. Which tax credits stand out to you from this bill and how material might their impact be?
Todd Castagno: I think this one is in the eye of the beholder. The reality is that the IRA increased credits significantly across the board for clean energy investment, whether that's electric vehicles, decarbonization. Also, the structure of many of those credits has evolved where they can be monetized more upfront, whether that's the refund ability or transferability to other taxpayers. So I think the magnitude of the investment, the magnitude of the credits, outweighs any specific credit or provision.
Michael Zezas: Todd, thanks for taking the time to talk.
Todd Castagno: Great speaking with you, Michael.
Michael Zezas: As a reminder, if you enjoy Thoughts on the market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
While shifts in stock and bond correlation have increased the volatility of a 60:40 portfolio, investors may still find some balance in diversification. Chief Cross Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: And on part two of this special episode, we'll be continuing our discussion of the foundational 60/40 portfolio. It's Wednesday, August 17th at 4:00 PM in London.
Lisa Shalett: And it's 11:00 AM here in New York.
Andrew Sheets: So Lisa, I know the positive correlations won't lift the 60:40 portfolio’s volatility too much, but would you say that investors have been inclined to accept more equity risk in recent decades because the cushioning effect of fixed income and this idea that if anything goes wrong, the Fed will kind of ride to the rescue and support markets?
Lisa Shalett: Yes I do. And I think, you know, part of the issue has been that we've been not only in a regime of falling interest rates, which has supported overall equity valuations, but we've lived in a period of suppressed volatility with regard to the direction of policy. We've been in this forward guidance regime, if you will, from the central bank where not only was the central bank holding down the cost of capital but they were telegraphing the speed and order of magnitude and pace of things which took a huge amount of volatility out of the market for both stocks and bonds and permitted risk taking. I mean, my goodness, you know, when was the last time in history that we had such negative “term premiums” in the pricing of bonds? That was a part of this function of this idea that the Fed's going to tell us exactly what they're going to do and there's this Fed put, and any time something unexpected happens, they will, you know, “come to save the day.”
And so I think we're at the beginning, we're literally in my humble opinion in the first or second innings of the market fundamentally wrapping their heads around what it means to no longer be in a forward guidance regime. Where the central bank, in their ambitions to normalize policy to crush inflation have to inherently be more data dependent and data dependency is inherently more volatile. And so I do think over time we are going to see these equity risk premiums, which, you know, as we've discussed earlier, had gotten quite compressed, widen back out to something that is more normal for the amount of risk that equities genuinely represent.
Andrew Sheets: And Lisa, I think that's such a great point about the predictability of monetary policy cause you're right, you know, that's another interesting similarity with the period prior to 2000. That period was a period of a much more unpredictable Fed between, you know, 1920 and the year 2000 where in more recent years, the Fed has become very predictable. So, that's another good thing that we should, as investors, think about is does that shifting predictability of Fed action, does the rising uncertainty that the Fed is facing, you know, is that also an important driver of this stock bond correlation. So boiling it all down, how are you talking about all of this to clients to help them reposition portfolios to navigate risk and potential return?
Lisa Shalett: I think at the end of the day you know, the most important thing that we're sitting with clients and talking about is that these fundamental building blocks of asset allocations, stocks and bonds, while they may correlate to one another differently, while they're each inherent volatilities may move up and therefore the volatility of that 60:40 portfolio may readjust some, the reality is, is that they’re still very important building blocks that play different roles in the portfolio that are both still required. So, you know, your stocks are still going to be that asset class that allows you to capture unexpected growth in the economy and in the overall profit stream, while fixed income and your rates market is still going to be that opportunity to cushion, if you will, disappointments in growth.
As we know that they, come over the course of a cycle. In that regard, as we look to this repricing of interest rates and what it may mean, we are encouraging our clients to look much more deliberately, actively, at being diversified across styles, across factors, across market capitalizations because these dynamics are changing. If we look back over the last 13 years, because the narrative around falling interest rates and Fed forward guidance and low volatility, and these correlations, these very stable correlations, and everything's going our way, you didn't need to look very far beyond just owning that passive S&P 500 index. Now, as things begin to normalize and get more inherently volatile and idiosyncratic, we look at where there may be, “value” in the traditional factor sense, to look down the market capitalization scheme to smaller and mid-cap stocks, to look at more cyclical oriented stocks that may be responding to this higher interest rate, higher inflation regimes. And so we're encouraging maximum levels of diversification within these building blocks and very active management of risk
Andrew Sheets: Lisa as always, thanks for taking the time to talk.
Lisa Shalett: It's my pleasure, Andrew.
Andrew Sheets: And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
In the current era of tighter Fed policy, the status quo of stock and bond correlation has changed, calling the foundational 60:40 portfolio into question. Chief Cross Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: And on part one of this special episode, we'll be discussing the foundational 60/40 stock bond portfolio. In an era of tighter policy, is a diversified portfolio of stocks and bonds fundamentally broken? It's Tuesday, August 16th at 4:00 PM in London.
Lisa Shalett: And it's 11:00 AM here in New York.
Andrew Sheets: Lisa, it's so good to talk to you again. So, you know, one of the most important, fundamental building blocks of asset allocation is the so-called 60/40 portfolio, a portfolio of 60% stocks and 40% bonds, and both of us have been writing about that this year because this strategy of having diversified stocks and bonds worked unusually well for the 40 years up through 2021, but this year has suffered a real historical reversal, seeing some of the worst returns for this diversified balanced strategy we've seen in 40 or 50 years. So when you think about these dynamics, when you think about the historically poor performance, can you give some context of what's been happening here and what our listeners should make of it?
Lisa Shalett: Sure, absolutely. I think as we know, we've gone through this 13-year period through the pandemic when the narrative was very much dominated by Federal Reserve intervention repression and keeping down of interest rates and in fact, falling interest rates, that produced financial market returns both for stocks and for bonds. But as we know, entering 2022, that narrative that was so concentrated on the direction of interest rates, you know, faced a major pivot from the Federal Reserve itself who, as we know, was facing an inflation fight which meant that they were going to have to move the federal funds rate up pretty significantly. The implication of that was pretty devastating for both stocks and bonds, that combined 60/40 portfolio delivered aggregate returns of about -12 to -13% on average that's the performance for that diversified portfolio benchmark in over 50 years. But again, we have to remember a lot of that performance was coming from a starting point where both stocks and bonds had been extraordinarily valued with those valuations premised on a continuation of Federal Reserve policy that unfortunately because of inflation has had to change
Andrew Sheets: Lisa I'm so glad you mentioned that starting point of valuations because, you know, it matters, I think in two really important ways. One, it helps us maybe understand better what's been happening this year, but also, you know, usually when prices fall, and this year prices are still down considerably from where they started, that means better valuations and better returns going forward. So, you know, could you just give a little bit more context of you and your team run a lot of estimates for what asset classes can return potentially over longer horizons. You know, maybe what that looked like for a 60/40 portfolio at the start of this year, when, as you mentioned, both stocks and bonds were pretty richly valued, and then how that's been developing as the year has progressed.
Lisa Shalett: Yeah. So, fantastic question. And, you know, we came into 2022 quite frankly, on a strategic horizon given where valuations were, not very excited about either asset class. You know for bonds, we were looking for maybe 0-2% or somewhat below coupon, because of the pressures of repricing on bonds. And for stocks we were looking for something in the, you know, 4-5% range, which was significantly below what historical long term capital market assumptions, you know, might expect for many institutional clients who benchmark themselves off of a 7.5 or 8% return ambition. So, when we entered this bear market, this kind of ferocious selloff, as we noted, from January through June, there were many folks who were hoping that perhaps valuations and forward looking expectations of returns were improving. Importantly, however, what we've seen is that hasn't been the case because what you have to do when you're thinking about valuation is you've gotta look at stock valuations relative to the level of interest rates.
And we're now in a scenario where, you know, the terminal value for the US economy may be something very different than it was and that means somewhat lower valuations. So, you know, if I had to put a number on it right now, my expectations for equity returns going forward from the current mark to market is really no better, unfortunately, than perhaps where it was in January. For bonds on the other hand, we've made some progress. And so to me, you know, I, I could see our estimates on bonds being a little bit more constructive than where they were with the 10 year yield somewhere in the, in the 2.8 zip code.
Lisa Shalett: So Andrew we've talked about the stock bond correlation as keying off the direction of inflation and the path of Fed policy. With both of those changing, do you view a positive correlation as likely over the longer term?
Andrew Sheets: Yeah. Thanks. Thanks, Lisa. So I think this issue of stock bond correlation is, is really interesting and, and gets a lot of attention for, for good reasons. And then, I think, can also be a little bit misinterpreted. So the reason the correlation is important is, I think, probably obvious to the listeners, if you have a diversified portfolio of assets, you want them to kind of not all move together. That's the whole point of diversification. You want your assets to go up and down on different days, and that smooths the overall return. Now, you know, interestingly for a lot of the last hundred years, the stock bond correlation was positive. Stock and bond prices tended to move in the same direction, which means stock and bond yields tended to move in the opposite direction. So higher yields meant lower stock prices.
That was the history for a lot of time, kind of prior to 2000. The reason I think that happened was because inflation was the dominant fear of markets over a lot of that period and inflation was very volatile. And so higher yields generally meant a worsening inflation backdrop, which was bad for stock prices and lower bond yields tended to mean inflation was getting back under control, and that was better for stocks. Now, what's interesting is in the 90s that dynamic really kinda started to change. And after 2000, after the dot-com bubble burst, the fear really turned to growth. The market became a lot less concerned about inflationary pressure, but a lot more concerned about growth. And that meant that when yields were rising, the market saw that as growth being better. So the thing they were afraid of was getting less bad, which was better for stock prices.
So, you had this really interesting flip of correlation where once inflation was tamed really in the 90s, the markets started to see higher yields, meaning better growth rather than higher inflation, which meant that stocks and bonds tend to have a negative correlation. Their prices tend to more often move in opposite directions. And as you alluded to, that really created this golden age of stock bond diversification that created this golden age of 60/40 portfolios, because both of these assets were delivering positive returns, but they were delivering them at different times. And so offsetting and cushioning each other's price movements, which is really, you know, the ideal of anybody trying to invest for the long run and, and diversify a portfolio. So that's changed this year. It's been very apparent this year that both stock and bond prices have gone down and gone down together in a pretty significant way.
But I think as we look forward, we also shouldn't overstate this change. You know, I think your point, Lisa, about just how expensive things were at the start of the year is really important. You know, anytime an asset is very expensive, it is much more vulnerable to dropping and given that both stocks and bonds were both expensive at the same time and both very expensive at the same time, you know, their dropping together I think was, was also a function of their valuation as much of anything else. So, I think going forward, it makes sense to assume kind of a middle ground. You know, I don't think we are going to have the same negative correlation we enjoyed over the last, you know, 15 years, but I also don't think we're going back to the very positive correlations we had, you know, kind of prior to the 1990s.
And so, you know, I think for investors, we should think about that as less diversification they get to enjoy in a portfolio, but that doesn't mean it's no diversification. And given that bonds are so much less volatile than stocks, you know, bonds might have a third of the volatility of the stock market, if we look at kind of volatility over the last five years. That still is some pretty useful ballast in a portfolio. That still means a large chunk of the portfolio is moving around a lot less and helping to stabilize the overall asset pool.
Andrew Sheets: Thanks for listening. Tomorrow I’ll be continuing my conversation with Lisa Shalett, and as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Based on July reports inflation may finally be cooling down, and the labor market remains strong, so how might this new data influence policy changes in the September FOMC meeting?
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Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be catching you up to speed on U.S. inflation, the labor market and our outlook for Fed policy. It's Monday, August 15th, at 11 a.m. in New York.
Let me start with some encouraging news. If we look at the July readings for both the Consumer Price Index data and the Producer Price Index, inflation finally appears to be cooling. And that should take some pressure off the Fed to deliver another 75 basis point hike in September. So that's the good news. However, inflation is still elevated and that suggests the Fed still has a lot of work to do, even if there's a reduced need for a third consecutive 75. We're forecasting a 50 basis point hike at the September and November meetings and 25 basis points in December for a peak interest rate of 3.625%.
Okay, let's look a bit more under the hood. July CPI on both headline and core measures surprised to the downside, and the PPI came in softer as well. Together, the reports point to a lower than previously anticipated inflation print that will be released on August 26th. Now, the recent blowout July employment report led markets to price a high probability of a 75 basis point hike. But the inflation data then came in lower than expected and pushed the probability back toward 50 basis points.
Based on the outlook for declining energy prices, we think headline inflation should continue to come down and do so quite quickly. However, core inflation pressures remain uncomfortably high and are likely to persist. For the Fed signs of a turn around in headline inflation are helpful and are already showing up in lower household inflation expectations. However, trends in core are more indicative of the trajectory for underlying inflation pressures, and Fed officials came out in droves last week to stress that the steep path for rates remains the base case. Sticky core inflation is a key reason why we expect the Fed to hold at 3.625% Fed funds, before making the first cut toward normalizing policy in December 2023.
Now, let me speak to July's surprising employment report. As the data showed, the labor market remains strong, even though some of the data flow has begun to diverge in recent months. Leading up to the recent release, the market had taken the softening in employment in the household survey, so that is the employment measure that just goes out to households and polls them, were you employed, were you not, were you part time, were you full time, and generally because that's been very weak, the market was taking it as a potential harbinger of a turn in the payrolls data, payrolls data are collected from companies that just ask each company how many folks are on your payrolls. Household survey employment was again softer in July, coming in at 179,000 versus 528,000 for the payroll survey.
Now, this seems like a sizable disparity, but it's actually not unusual for the household and payroll surveys to diverge over shorter periods of time. And these near term divergences largely reflect methodological differences. But what's interesting here and worth noting is that these differences in data likely reflect a shift in the form of employment.
While the economy saw a large increase in self-employment in the early stages of the pandemic, the data now suggest workers may be returning to traditional payroll jobs, potentially because of higher nominal wages and better opportunities. If the economy is increasingly pulling workers out of self-employment and into traditional payroll jobs, similar pull effects are likely reaching workers currently out of the labor force.
And this brings me to one of our key expectations for the next year and a half, which is a continued increase in labor force participation, in particular driven by prime age workers age 25 to 54. Higher wages, better job opportunities and rising cost of living will likely bring workers back into the labor force, even as overall job growth slows. Fed researchers, in fact, have recently documented that a delayed recovery in labor force participation is quite normal, and that's something we think is likely to play out again in this cycle.
Thanks for listening. If you enjoy the show please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
As inflation persists, economic concerns such as recession rise, and consumer spending patterns begin to shift, is there any evidence to suggest consumers are already trading down to value and discount products? U.S. Softlines Analyst Kimberly Greenberger and Hardlines, Broadlines and Food Retail Analyst Simeon Gutman discuss.
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Kimberly Greenberger: Welcome to Thoughts on the Market. I'm Kimberly Greenberger, Morgan Stanley's U.S. Softlines Analyst.
Simeon Gutman: And I'm Simeon Gutman, Hardlines, Broadlines and Food Retail Analyst.
Kimberly Greenberger: And on this special episode of Thoughts on the Market, we'll be discussing shifting consumer spending patterns amid persistent inflation and concerns about the economy. It's Friday, August 12th, at 11 a.m. in New York.
Kimberly Greenberger: As our listeners are no doubt aware, many retail segments were big pandemic beneficiaries with record sales growth and margins for 2+ years. But now that spending on goods is normalizing from high levels and consumers are facing record high inflation and worrying about a potential recession, we're starting to see signs of what's called "trade down", which is a consumer migration from more expensive products to value priced products. So Simeon, in your broad coverage, are you seeing any evidence that consumers are trading down already?
Simeon Gutman: We're seeing it in two primary ways. First, we're seeing some reversion away from durable, high ticket items away to consumable items. And the pace of consumption of some of these high ticket durable items is waning and pretty rapidly. Some of these are items that were very strong during the pandemic, electronics, some sporting goods items, home furnishings, to name a few. So these items we're seeing material sales deceleration as one form of trade down. As another in the food retail sector, we're definitely seeing signs of consumers spending less or finding ways to spend less inside the grocery store. They can do that by trading down from national brands to private brands, buying less expensive alternative, buying frozen instead of fresh and even in the meat counter, buying less expensive forms of protein. So we're seeing it manifest in those two ways. What is the situation in softlines, Kimberly? Is your coverage vulnerable to trade down risk?
Kimberly Greenberger: Absolutely. In softlines retail, which is apparel, footwear, accessories retail, these are discretionary categories. Yes, there's sort of a minimum level of spending that's necessary because clothing is part of the essentials, food, shelter, clothing. But Americans' closets are full and they're full because last year there was a great deal of overspending on the apparel category. So where we have seen trade down impact our sector this year, Simeon, is we have seen consumers budget cutting and moving away from some of those more discretionary categories like apparel especially. We just have not yet seen any benefits to some of the more value oriented retailers that we would expect to see in the future if this behavior persists.
Simeon Gutman: So when we're thinking about the context of our collaborative work with other Morgan Stanley sector analysts around trade down risks, what do you hear, Kimberly, about the impact on segments such as household products and restaurants?
Kimberly Greenberger: We have found most fascinating, actually, the study of those real high frequency purchases. Because in order to understand how consumer behavior is changing at the margin, we think it's most important to look at what consumers were spending on last week, two weeks ago, three weeks ago as a better indication of what they're likely to spend on for the next three or six months. How that behavior has been changing is that on those of very high frequency purchases like the daily tobacco purchase or the daily food at home purchase, as you mentioned, is that there is trade down from higher priced brands and products into more value oriented brands and products. The same thing is happening in fast food. Another category that we consume on a somewhat more frequent basis than, for example, eating in casual dining restaurants where we're sitting down for a meal. So now we've got a good number of months of evidence that this is, in fact, happening, and that gives us more conviction that it's likely to continue through the second half of the year. So Simeon, in your view, what parts of retail are the likely winners and laggards should this trade down behavior persist and broaden out, particularly if a recession did materialize?
Simeon Gutman: So in the event of a recession, I think the typical answers here are a little bit easier to identify. The two big beneficiaries, the channel beneficiaries, would be the dollar slash discount stores and then secondarily, off price. First, the dollar and discount stores, they are already seeing some initial signs of trade down and that is mostly in the consumable area. That is the place where the consumer feels the pinch immediately. The other piece of it is the discretionary spend. The longer these conditions persist, high inflation and potential other pressures on the consumer, then you'll start to see a more pronounced trade down and shift of discretionary purchases. And that's where off price plays a role.
Kimberly Greenberger: Simeon, thanks so much for taking the time to talk.
Simeon Gutman: Great speaking with you, Kimberly.
Kimberly Greenberger: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
As Bitcoin has been experiencing a steep decline in the last 6 months, investors are beginning to wonder when Cryptocurrencies will finally bottom out and start the cycle anew.
Digital assets, sometimes known as cryptocurrency, are a digital representation of a value that function as a medium of exchange, a unit of account, or a store of value, but generally do not have legal tender status. Digital assets have no intrinsic value and there is no investment underlying digital assets. The value of digital assets is derived by market forces of supply and demand, and is therefore more volatile than traditional currencies’ value. Investing in digital assets is risky, and transacting in digital assets carries various risks, including but not limited to fraud, theft, market volatility, market manipulation, and cybersecurity failures—such as the risk of hacking, theft, programming bugs, and accidental loss. Additionally, there is no guarantee that any entity that currently accepts digital assets as payment will do so in the future. The volatility and unpredictability of the price of digital assets may lead to significant and immediate losses. It may not be possible to liquidate a digital assets position in a timely manner at a reasonable price.
Regulation of digital assets continues to develop globally and, as such, federal, state, or foreign governments may restrict the use and exchange of any or all digital assets, further contributing to their volatility. Digital assets stored online are not insured and do not have the same protections or safeguards of bank deposits in the US or other jurisdictions. Digital assets can be exchanged for US dollars or other currencies, but are not generally backed nor supported by any government or central bank.
Before purchasing, investors should note that risks applicable to one digital asset may not be the same risks applicable to other forms of digital assets. Markets and exchanges for digital assets are not currently regulated in the same manner and do not provide the customer protections available in equities, fixed income, options, futures, commodities or foreign exchange markets.
Morgan Stanley and its affiliates do business that may relate to some of the digital assets or other related products discussed in Morgan Stanley Research. These could include market making, providing liquidity, fund management, commercial banking, extension of credit, investment services and investment banking.
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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, today I address the question everyone seems to be asking about the crypto cycle: when will crypto prices find a bottom? It's Thursday, August 11th, at 5 p.m. in London.
After a 75% peak to trough fall in Bitcoin's price between November 2021 and June this year, it seems like almost everyone in the market is asking the same question. When will crypto prices find the bottom? We will discuss three topics related to this question; the pace of new Bitcoin creation, past Bitcoin cycles and dollar liquidity.
What can Bitcoin's creation tell us about where we are in the crypto cycle? Bitcoin's relatively short history means there is little available data, and yet the data is quite rich. In its short 12 year history, Bitcoin has experienced at least 10 bull and bear cycles. Bitcoin creation follows a 4 year cycle. Within these 4 year cycles, price action has so far followed three distinct phases. First, there is a rapid and almost exponential rise in price. Second, at a peak in price, a bear market follows. And third, prices move sideways, eventually leading into a new bull market.
The question for investors today is, is Bitcoin's price moving out of the second phase and into the third? Only time will tell. There have only been three of these halving cycles in the past, and so it is difficult to conclude that these cycles will repeat in the future.
What about past bear markets? The 75% peak to trough fall in Bitcoin's price and this cycle is currently faring better than previous cycles, in which the falls after peaks in 2011, 2013 and 2017 ranged between 85 and 95%. There is, therefore, speculation about whether this cycle has further to drop.
Previous cycles have shed similar characteristics. In the bull runs there was speculation about the potential of a particular part of the crypto ecosystem. In 2011, it was the excitement about Bitcoin and the development of ecosystem technologies like exchanges and wallets. In 2020 to 2021, this cycle, there were NFTs, DeFi and the rising dominance of the institutional investor.
In previous cycles, the bear runs were triggered by regulatory clampdowns or a dominant exchange being hacked. In 2013, a crackdown in China led to the world's largest exchange at that time, BTC China, stopping customer deposits. In this cycle, the liquidity tap dried up as inflation concerns gripped the market.
Central bank liquidity and government stimulus fueled the speculation driven 2020-2022 crypto cycle. For this reason, day to day crypto traders are focusing on what the U.S. Federal Reserve plans to do with its interest rates and availability of dollars.
To find a bottom, there are two liquidity related factors to look out for. First, market expectations that central banks will continue to tighten the money supply, turn into expectations that central banks will resume monetary expansion. Second, crypto companies increase appetite to build crypto leverage again. Both of these would increase liquidity and drive a new cycle of speculation.
Which brings us back to the question about the bottom of the crypto cycle that almost everyone is asking: are we there yet? To answer that question, look at Bitcoin creation, past cycles and above all, liquidity.
Thanks for listening. If you enjoyed Thoughts on the Market, share this and other episodes with a friend or colleague today.
The Senate just passed the Inflation Reduction Act which seeks to fight inflation on a variety of fronts, but the most pressing question is, will the IRA actually impact inflation?
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of U.S. Public Policy Research and Municipal Strategy.
Ellen Zentner: And I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist.
Michael Zezas: And on this special episode of Thoughts on the Market, we'll discuss the Inflation Reduction Act, or IRA, with a focus on its impact on the U.S. economic outlook. It's Wednesday, August 10th, at noon in New York.
Michael Zezas: So, Ellen, the Senate just passed the Democrats Inflation Reduction Act on a party line vote. And we know this has been a long awaited centerpiece to President Biden's agenda. But let me start with one of the more pressing questions here; from your perspective, does the Inflation Reduction Act reduce inflation? Or maybe more specifically, does it reduce inflation in a way that impacts how the Fed looks at inflation and how markets look at inflation?
Ellen Zentner: So for it to impact the Fed today and how the markets are looking at inflation, it really has to show very near term effects here, where the IRA focuses more on longer term effects on inflation. So today we've got recent inflation report that came out this week showing that inflation moved lower, so softened. Especially showing the effects of those lower energy prices, which everyone notices because you go and gas up at the pump and so, you know right away what inflation is doing. And that's led to some more optimism from households. That at least gives the Fed some comfort, right, that they're doing the right thing here, raising rates and helping to bring inflation down. But there's a good deal more work for the Fed to do, and we think they raise rates by another 50 basis points at their September meeting. The rates market also took note of some of the inflation metrics of late that are looking a little bit better. But still, it's not definitive for markets what the Fed will do. We need a couple of more data points over the next few months. So the IRA is just a completely separate issue right now for the Fed and markets because that's going to be in the longer run impact.
Michael Zezas: So the bill is constructed to actually pay down the federal government deficit by about $300 billion over 10 years, and conventional wisdom is that when you're reducing deficits, you're helping to calm inflation. Is that still the case here?
Ellen Zentner: So it's still the case in general because it means less government debt that has to be issued. But let's put it in perspective, $300 billion deficit reduction spread over ten years is 30 billion a year in an economy that's greater than 20 trillion. And so it's very difficult to see.
Michael Zezas: Okay, so the Inflation Reduction Act seems like it helps over the long term, but probably not a game changer in the short term.
Ellen Zentner: That's right.
Michael Zezas: Let's talk about some of the more specific elements within the bill and their potential impact on inflation over the longer term. So, for example, the IRA extends Affordable Care Act subsidies. It also allows Medicare to negotiate prices for prescription drugs, or at least some prescription drugs, for the first time. How do you view the impacts of those provisions?
Ellen Zentner: So these are really the provisions that get at the meat of impacting inflation over the longer run. And I'll focus in on health care costs here. So specifically, drug prices have been quite high. Being able to lower drug prices helps lower income households, that helps older cohorts, and the cost of medical services gets a very large weight in overall consumer inflation and it gets a large weight because we spend so much on it. The other thing I'd note here, though, is that since it allows Medicare to negotiate prices for some drugs for the first time, well, that word negotiate is key here. It takes time to negotiate price changes, and that's why this bill is more something that affects longer run inflation rather than near term.
Michael Zezas: Right. So bottom line, for market participants, this Inflation Reduction Act might ultimately deliver on its name. But if you want to understand what the Fed is going to do in the short term and how it might impact the rates markets, better off paying attention to incoming data over the next few months. It's also fair to say there's other market effects to watch emanating from the IRA, namely corporate tax effects and spending on clean energy. Those are two topics we're going to get into in podcasts over the next couple of weeks.
Michael Zezas: Ellen, thanks for taking the time to talk.
Ellen Zentner: Great speaking with you, Michael.
Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
As lending standards tighten and banks get ready to make some tough choices, how will the housing market fare if loan growth slows? Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.
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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research.
Jay Bacow: And on this episode of the podcast, we'll be discussing how tightening lending standards could impact housing activity. It's Tuesday, August 9th, at 11 a.m. in New York.
Jim Egan: Now Jay, you published a high level report last week with Vishy Tirupattur, who is the Head of Fixed Income Research here at Morgan Stanley, on the coming capital crunch. Basically, rising capital pressures will mean that banks will have to make tough choices in their lending books. Is that about right?
Jay Bacow: Yeah, that's it. Basically, we don't think that markets have really appreciated the impact of the combination of how rising rates caused losses on banks portfolios, the regulatory changes and the results of the stress test capital buffers. All of these things are going to require banks to look at the composition of not just the assets that they own, but their business models in general. Our large cap banking analyst Betsy Graseck thinks that banks are going to look at things differently to come up with different solutions depending on the bank, but in general across the industry, expects lending standards to tighten for this year and in 2023, and for loan growth to slow. So, Jim, if banks are going to tighten lending standards then what does that mean for housing activity?
Jim Egan: I think, especially if we look at home sales, that's a negative for sales volumes and home sales are already falling. We've talked about affordability deterioration on this podcast a few times now, not just the fact of where affordability is in the housing market, but how rapidly it's deteriorating. If lending standards are going to tighten on top of those affordability pressures, then that just argues for potentially an even more substantial decrease in sales volumes going forward, and we're already seeing this in the data. Through the first half of the year new home sales are down 14% versus the first half of 2021. Purchase applications, that's our highest frequency data point that we have, they're getting progressively weaker each month. They were down 17% year over year in June, 19% year over year in July. Existing home sales, and that's referencing a much larger volume of sales then new home sales, they're down a comparatively strong 8% year to date. But with all of the dynamics that we're discussing, we believe that they're going to see a much more precipitous drop in the second half of the year. We have it down over 15% year over year versus 2021. Now, that's because of affordability pressures. It's because of the potential for tightening lending standards. It's also because of the lock in effect from a rate perspective.
Jay Bacow: On that lock in effect, with just 2% of the market having incentive to refinance, lenders are sitting there and saying, well, what do we do in this environment where we can't just give people a rate refi? Now, you mentioned the purchase activity, that's obviously one area, but Black Knight just reported another quarterly record of untapped equity in the housing market, and consumers would love to be able to tap that. The problem is when you do a cash out refinance, you end up increasing the rate on your entire mortgage. And homeowners don't want to do that. So they'd love to do something like a home equity line of credit or second lien where they're getting charged the higher rate on just the equity they take out. But the problem is it's harder to originate those in an environment where lending standards are tightening, particularly given the capital allocation against those type of loans can be onerous.
Jim Egan: Right. And the level of conversations around an increase in kind of the second lien or the hill market have certainly been picking up over the past weeks and months, both on the originator side, on the investor side, as people look to find ways to access that record amount of equity that you mentioned in the housing market.
Jay Bacow: Thinking about trying, people are still trying to sell houses and you just commented on the housing activity, but what about the prices they're selling at? Some of the recent data was pretty surprising.
Jim Egan: The most recent month of data, I think the point that has raised the most eyebrows was the average or median price of new home sales saw a pretty significant month over month decrease. We continue to see month over month increases in the median and average price of existing home sales at. When we think about average and median prices, there's a mix shift issue there. So month over month, depending on the types of homes that sell things can move. What we actually forecast, the repeat sales index Case-Shiller, we're starting to see a slowdown in growth. The past two months have been consecutive deceleration in the pace of home price growth. I think the thing that we'd highlight most is the growing geographic pervasiveness of the slowdown. Two months ago, 11 of the Case-Shiller 20 city index was showing a deceleration month over month. This past month, it was 16. Now, all 20 cities continue to show home price growth, but again, 16 are showing that pace slowdown. There is some regional specificity to this, the cities that continue to accelerate largely in Florida, Miami and Tampa to name two.
Jay Bacow: Okay. So that's what we've seen. What do we expect to see on a go forward basis?
Jim Egan: We talked about our expectations for sales a few minutes ago. I think the one thing that we do want to highlight is on the starts front, we think that single unit starts are going to start to decrease over the course of the back half of this year. There's a couple of reasons for that. We talked about affordability pressures, another dynamic that's been playing out in the space is that there's been a backlog not just of housing starts, but before those starts to get the completion units under construction has swollen back to 2004 levels, starts themselves are only at 1997 levels. We do think that that is going to kind of disincentivize starts going forward. We're already starting to see it a little bit in the underlying data, trailing 12 month single unit starts had plateaued for largely a year. They've been down the past two months, we think that they're going to continue to fall in the back half of this year. It's already playing through from a sentiment perspective, homebuilder confidence is down 39% from its peak in November of 2020, and that's being driven by their perception of traffic on their sites as well as their perception of future sales conditions. So we do think that starts are going to fall because a number of these dynamics. And we think that home price growth is going to remain positive and we've highlighted this on this podcast before, but the pace is going to start slowing pretty materially in the back half of this year. The most recent print was 19.7%, down from over 20%, but we think it gets all the way to 9% by December 2022, 3% by December 2023. So continued home price growth, but the pace is going to slow pretty materially.
Jim Egan: Jay, thanks for taking the time to talk.
Jay Bacow: Jim. Always a pleasure.
Jim Egan: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
While inflation remains high and the battle to bring it down is top of mind, there may be some opportunities in technologies that could help bring down inflation in some sectors.
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Welcome to Thoughts on the Market. I'm Josh Pokrzywinski, Morgan Stanley's U.S. Electrical Equipment and Multi-Industry Analyst. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about deflationary opportunities in this high inflation environment. It's Monday, August 8th, at 4 p.m. in New York.
As most listeners no doubt know, the battle to bring down inflation is the topic of 2022. But today I want to talk about inflation from a slightly different perspective, and that's how automation and productivity enhancing technologies could actually help bring down inflation in areas such as labor, supply chain procurement and energy.
And while these technologies require capital investment, something that's often difficult when the economy is uncertain, we believe structural changes in demographics, energy policy and security, and an aging capital base make technologies focused on cost reductions and productivity actually more valuable.
So for investors focusing on stocks that enable productivity and cost reduction through automation, efficiency, or their own declining cost curves while maintaining strong barriers to entry and attractive equity risk/reward, is something to consider.
To dig into this, the U.S. Equity Strategy Team and equity analysts across the spectrum at Morgan Stanley Research created a deflation enabler shopping list. And that list is composed of stocks that produce tangible cost savings for their customers, where costs themselves are rising due to inflation, such as labor and energy, or scarcity, for example semiconductors or materials. In many cases, the cost of the product itself has also come down through technology or economies of scale, benefitting the purchaser and therefore adoption on both lower cost to implement and higher cost avoidance through use.
So where should investors look? Although there are a number of deflationary companies across areas such as automation and semiconductors, we identified three major deflationary technologies which permeate across sectors and which are at long term inflection points in their importance for both enterprise and consumer.
The first is artificial intelligence or AI. AI is proving relentless and increasingly deflationary. In biotech, AI could shorten development timelines, lower R&D spend and improve probability of success.
The second is clean energy. My colleague Stephen Burd, who covers clean energy and utilities, has pointed out that against the backdrop of inflationary fossil fuels and utility bills, companies with deflationary clean energy technologies and high barriers to entry will be able to grow rapidly and generate increasing margins.
And finally, mass energy storage and mobility. Although the cost of batteries have been falling for some time, competition in the space has led to heightened investment. In addition, ambitious top down government emissions goals have facilitated an exponential uplift in demand for batteries and their component raw materials.
Although supply chains for batteries remain immature, battery storage technology is only beginning to have profound effects on society mobility, inclusivity and ultimately climate. As investment by automakers rises along with generous European subsidies aimed at staying competitive with U.S. and Chinese investment, the supply chain and innovation in new battery technologies such as solid state mean that the price should continue to fall as innovation and demand rise.
This is extended beyond the personal vehicle market, with the cost savings and efficiency improvements driving profound changes and improvements in the range and cost of heavy duty and long haul trucking EV, and ultimately autonomous, markets.
To sum up, in an inflationary world we believe companies that have developed deflationary products and services will become increasingly valuable, as long as they have significant barriers to entry with respect to those products and services.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The current market pricing can tell investors a lot about what the market believes is coming next, but the future is uncertain and investors may not always agree with market expectations. Chief Cross-Asset Strategist Andrew Sheets explains.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 5th, at 2 p.m. in London.
Trying to predict where financial markets will go is difficult. The future, as they say, is uncertain, and even the most talented investors and forecasters will frequently struggle to get these predictions right.
A different form of this question, however, might be easier. What do markets assume will happen? After all, these assumptions are the result of thousands of different actors, most of which are trying very hard to make accurate predictions about future market prices because a lot of money is on the line. Not only is there a lot of information in those assumptions, but understanding them are table stakes for a lot of investment strategy. After all, if our view only matches what is already expected by the market to happen, it is simply much less meaningful.
Let's start with central banks, where current market pricing can tell us quite a bit. Markets expect the Fed to raise rates by another 100 basis points between now and February to about three and a half percent. And then from there, the Fed is expected to reverse course, reducing rates by about half a percent by the end of 2023. Meanwhile, the European Central Bank is expected to raise rates steadily from a current level of 0 to 1.1% over the next 12 months.
Morgan Stanley's economists see it differently in both regions. In the U.S., we think the Fed will take rates a little higher than markets expect by year end and then leave them higher for longer than markets currently imply. In the U.S., we think the Fed will take rates higher than markets expect by year end and then leave them higher for longer than is currently implied. In Europe, it's the opposite. We think the ECB will raise rates more slowly than markets imply. The idea that the Fed may do more than expected while the ECB does less is one reason we forecast the US dollar to strengthen further against the euro.
A rich set of future expectations also exists in the commodity market. For example, markets expect oil prices to be about 10% lower in 12 months time. Gasoline is priced to be about 15% lower between now and the end of the year. The price of gold, in contrast, is expected to be about 3% more expensive over the next 12 months.
I’d stress that these predictions are not some sort of cheat code for the market. The fact that oil is priced to decline 10% doesn't mean that you can make 10% today by selling oil. Rather, it means that foreign investor, a 10% decline in oil, or a 3% rise in gold will simply mean you break even over the next 12 months.
Again, all of this pricing informs our views. We forecast oil to decline less and gold to decline more than market prices imply. Meanwhile, Morgan Stanley equity analysts can work backwards looking at what these commodity expectations would mean for the companies that produce them. We won't get into that here, but it's yet another way that we can take advantage of information the market is already giving us.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
As investors watch to see if tensions between the U.S. and China will escalate, it’s important to understand the underlying competitive dynamic and how U.S. policy may have macro impacts.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public pPolicy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Thursday, August 4th, at 1 p.m. in New York.
This week, Speaker of the House Nancy Pelosi's Asia trip had the attention of many investors as they watched to see whether her actions would escalate tensions between the U.S. and China. In our view, though, this event wasn't a potential catalyst for tensions, but rather evidence of tensions that persist between the two global powers. Hence, we think investors are better served focusing on the underlying dynamic rather than any particular event.
The U.S.-China rivalry has many complicated causes, many of which we've covered on previous podcasts. But the point we want to reemphasize is this; this rivalry is going to persist. China is interested in asserting its global influence, which in ways can be at odds with how the U.S. and Europe want the international economic system to function. Nowhere is this clearer than in the policies the U.S. has adopted in recent years aimed at boosting its competitiveness with China.
The latest is the enactment of the Chips Plus Bill, which allocates over $250 billion to help US industries, in particular the semiconductor industry, to devolve its supply chain reliance on China for the purposes of economic security and to protect sensitive technologies. Policies like this have more of a sectoral effect than the macro one. But the primary market impact here being a defraying of rising costs for the semiconductor industry. But investors should be aware that there's potential policy changes on the horizon that could have macro impacts. For example, Congress considered creating an outbound investment restriction mechanism in that Chips Plus bill. Such a restriction could have significantly interrupted foreign direct investment in China with substantial consequences for China equity markets.
That provision didn't make it into this bill, and with little legislative time between now and the midterm elections, it's unlikely to resurface this year. That's cause some to conclude that it's likely to be years before such a provision could become enacted, particularly if Republicans take back control of one or both chambers of Congress creating a risk of gridlock.
But we'd caution that's too simple of a conclusion. The concept of outbound investment restrictions enjoys bipartisan support. So we think investors should be on guard for this provision to get serious consideration in 2023. We'll, of course, track it and keep you informed.
Thanks for listening. If you enjoy the show, please share thoughts on the market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
After the July FOMC meeting, markets took a quick dive and then made an immediate recovery, so what happened?
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Wednesday, August 3rd, at 1 p.m. in New York.
In the weeks since the July meeting of the Federal Open Market Committee, or FOMC, rates and currency markets have made quite the round trip. Treasury yields from 2 out to10 year maturities fell by over 25 basis points in the three days that followed the meeting. And the U.S. dollar index declined by 2% over the same period.
However, looking at these markets today, as I sit here recording this podcast, it's almost as if the July FOMC meeting didn't happen. 10 year Treasury yields are about where they were going into the meeting last week, and 2 year yields are a bit higher even. As for the U.S. dollar index, it's back to the range it was in ahead of the meeting.
So what happened? Going into the meeting, investors thought that the Fed would deliver a 75 basis point rate hike, but recognized that there was a tail risk of a larger 100 basis point hike. And even if the tail risk didn't materialize, investors had acknowledged that the additional 25 basis points might be delivered in September instead. And that would make for the third 75 basis point hike in this cycle. In short, investors were positioned for a hawkish outcome.
The FOMC statement and Chair Powell's prepared remarks didn't disappoint. The message was on par with what FOMC participants had been saying over recent weeks and months. Inflation is still top of mind, and more work is needed to bring it down to acceptable levels. If the meeting ended with Powell's prepared remarks, rates and currencies would have likely taken a different path to where they trade today.
However, the meeting didn't end there, and the Q&A session of Powell's press conference struck a more dovish tone. Three messages contributed to this interpretation. First, Powell suggested that rates had achieved a neutral setting, or one that neither puts upward nor downward pressure on economic activity relative to its potential.
Second, he said that because a neutral policy setting had been reached, the pace of subsequent rate hikes could soon begin to slow.
And finally, he suggested that the committee's view of the peak policy rate in the cycle hadn't changed since the last FOMC meeting, even though inflation data since then continued to surprise on the higher side. The reason for this seemed to be focused on the deterioration in activity data or growth data.
In many ways, investors should have expected these statements from Powell, given guidance coming from the June summary of economic projections. In addition, because Fed policy had tightened financial conditions this year, and those financial conditions helped slow economic growth, the case for a less hawkish performance might have been predictable.
The data that arrived in the wake of the meeting underscored the recent themes of slower growth and higher inflation. But the Fedspeak that arrived in the wake of the data, well, it continued to focus on inflation, as it had done before the Fed met in July.
Where does all of that leave the Fed on policy and us on markets? Well, the Fed's job bringing inflation down hasn't yet been accomplished, the bond market is pricing less policy tightening than the Fed is last guided towards, and downside risks to global growth are rising. As a result, we remain neutral on bond market duration, but remain bullish on the U.S. dollar, particularly against the euro.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
As studies begin to show that obesity medications may save lives, will governments and insurances begin to consider them preventative primary care? And how might this create opportunity in pharmaceuticals? Head of European Pharmaceuticals Mark Purcell and Head of U.S. Pharmaceuticals Terence Flynn discuss.
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Mark Purcell: Welcome to Thoughts on the Market. I'm Mark Purcell, Head of Morgan Stanley's European Pharmaceuticals Team.
Terence Flynn: And I'm Terence Flynn, Head of the U.S. Pharmaceuticals Team.
Mark Purcell: And on this special episode of Thoughts on the Market, we'll be talking about the global obesity challenge and our outlook for the next decade. It's Tuesday, August the 2nd, and it's 1 p.m. in London.
Terence Flynn: And 8 a.m. in New York.
Terence Flynn: So Mark, more than 650 million people worldwide are living with obesity as we speak. The personal, social and economic costs from obesity are huge. The World Health Organization estimates that obesity is responsible for 5% of all global deaths, which impacts global GDP by around 3%. Obesity is linked to over 200 health complications from osteoarthritis, to kidney disease, to early loss of vision. So tackling the obesity epidemic would impact directly or indirectly multiple sectors of the economy. Lots to talk about today, but let's start with one of the key questions here: why are we talking about all this now? Are we at an inflection point? And is the obesity narrative changing?
Mark Purcell: Yeah Terence look, there's a category of medicine called GLP-1's which have been used to treat diabetes for over a decade. GLP-1 is an appetite suppressing hormone. It works on GLP-1 receptors, you could think of these as hunger receptors, and it helps to regulate how much food our bodies feel they need to consume. Therefore, these GLP-1 medicines could become an important weapon in the fight against obesity. The latest GLP-1 medicines can help individuals who are obese lose 15 to 20% of their body weight. That is equivalent to 45 to 60% of the excess weight these individuals carry in the form of fat which accumulates around the waist and important organs in our bodies such as the liver. There is a landmark obesity study called SELECT, which has been designed to answer the following key question: does weight management save lives? An interim analysis of this SELECT study is anticipated in the next two months, and our work suggests that GLP-1 medicines could deliver a 27% reduction in the risk of heart attacks, strokes and cardiovascular deaths. We believe that governments and insurance companies will broaden the reimbursement of GLP-1 medicines in obesity if they are proven to save lives. This comes at a time when new GLP-1 medicines are becoming available with increasing levels of effectiveness. It's an exciting time in the war against obesity, and we wanted to understand the implications of the SELECT study before it reads out.
Terence Flynn: So, our collaborative work suggests that obesity may be the new hypertension. What exactly do we mean by that, Mark? How do we size the global opportunity and what's the timeline here?
Mark Purcell: Back in the 1960s and 1970s, hypertension was seen as a lifestyle disease caused by stress and old age. Over time, it was shown that high blood pressure could be treated, and in doing so, doctors could prevent heart attacks and save lives. A new wave of medicines were introduced to the market in the mid 1980s to treat individuals with high blood pressure and doctors found the most effective way to treat high blood pressure was to use combinations of these medicines. By the end of the 1990's, the hypertension market reached $30 billion in sales, that's equivalent to over $15 billion today adjusting for inflation. Obesity is seen by many as a lifestyle disease caused by a lack of self-control when it comes to eating too much. However, obesity is now classified as a preventable chronic disease by medical associations, just like hypertension. Specialists in the obesity field now recognize that our bodies have evolved over hundreds of thousands of years to put on weight, to survive times where there is a lack of food available and a key way to fight obesity is to reset the balance of how much food our bodies think they need. With the availability of new, effective obesity medicines, we believe that obesity is on the cusp of moving into mainstream primary care management. And the obesity market is where the treatment of high blood pressure was in the mid to late 1980s. We built a detailed obesity model focusing on the key bottlenecks, patient activation, physicians engagement and payer recognition. And we believe that the obesity global sales could exceed $50 billion by the end of this decade.
Terence Flynn: So Mark, what are the catalysts aligning to unlock the potential of this $50 billion obesity opportunity?
Mark Purcell: We believe there are full catalysts which should begin to unlock this opportunity over the next six months. Firstly, the SELECT study, which we talked about. It could be stopped early in the next two months if GOP P1 medicines are shown overwhelmingly to save lives by reducing excess weight. Secondly, the demand for GLP-1 medicines to treat obesity was underappreciated by the pharmaceutical industry. But through the second half of this year, GLP-1 medicines, supply constraints will be addressed and we'll be able to appreciate the underlying patient demand for these important medicines. Thirdly, analysis shows that social media is already creating a recursive cycle of education, word of mouth and heightened demand for these weight loss medicines. Lastly, diabetes treatment guidelines are actively evolving to recognize important comorbidities, and we expect a greater emphasis on weight treatment goals by the end of this year.
Terence Flynn: Mark, you mentioned some bottlenecks with respect to the obesity challenge. One of those was patient activation. What's the story there and how does social media play into it?
Mark Purcell: Yes, great question Terence, look it's estimated that less than 10% of individuals suffering from obesity are diagnosed and actively managed by doctors. And that compares to 80 to 90% of individuals who suffer from high blood pressure, or diabetes, or high levels of cholesterol. Once patients come forward to see their doctors, 40% of them are treated with an anti-obesity medicine. And as more effective medicines become available, we just think this percentage is going to rise. Lastly, studies designed to answer the question, what benefit does 15 to 20% weight loss deliver in terms of reducing the risk of high blood pressure, diabetes, kidney disease and cardiovascular disease? Will help activate governments and insurance companies to reimburse obesity medicines. But it all starts with individuals suffering from obesity coming forward and seeking help, and this is where we expect social media to play a really important key role.
Terence Flynn: To a layperson, there's significant overlap between diabetes and obesity. How do we conceptualize the obesity challenge vis a vis diabetes, Mark?
Mark Purcell: Terence, you're absolutely right. There is significant overlap between diabetes and obesity and it makes it difficult and complicated to model. It's estimated that between 80 to 85% of diabetics are overweight. It's estimated that 35% of diabetics are obese and around 10% of diabetics are severely obese. GLP-1 medicines have been used to treat diabetes for over a decade, not only being extremely effective in lowering blood sugar, but also in reducing the risk of cardiovascular events like heart attacks and removing excess body weight, which is being recognized as increasingly important. This triple whammy of benefit means that the use of GLP-1 medicines is increasing rapidly, and sales in diabetes are expected to reach over $20 billion this year, compared to just over $2 billion in obesity. By the end of the decade our work suggests that the use of GLP-1 based medicines in obesity could exceed the use in diabetes by up to 50%.
Terence Flynn: Mark, thanks for taking the time to talk.
Mark Purcell: Great speaking with you again, Terrence.
Terence Flynn: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As the Fed continues to surprise with large and fast interest rate increases, the market must decide, has the Fed done enough? Or is the recession already here?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, August 1st at 11 a.m. in New York. So let's get after it.
Over the past year, the Fed has come under scrutiny for their outlook on inflation, and they've even admitted themselves that they misjudged the call when they claimed inflation would be transient. In an effort to regain its credibility, the Fed has swiftly pivoted to its most hawkish policy action since the 1980s. In fact, while we may have been the most hawkish equity strategists on the street at the beginning of the year, we never expected to see this many rate hikes in 2022. Suffice it to say, it hasn't gone unnoticed by markets with both stocks and bonds off to their worst start in many decades.
However, since peaking in June, 10 year Treasuries have had one of their largest rallies in history, with the yield curve inverting by as much as 33 basis points. Perhaps more importantly, market based five year inflation expectations have plunged and now sit very close to the Fed's long term target of 2%. Objectively speaking, it appears as though the bond market has quickly turned into a believer that the Fed will get inflation under control.
This kind of action from the Fed is bullish for bonds, and one of the main reasons we turned bullish on bonds relative to stocks back in April. Since then, bonds have done better than stocks, even though it's been a flat ride in absolute terms. It also explains why defensively oriented stocks have dominated the leadership board and why we are sticking with it.
Meanwhile, stocks have rallied with bonds and are up almost 14% from the June lows. The interpretation here is that the Fed has inflation tamed, and could soon pause its rate hikes, which is usually a good sign for stocks.
However, in this particular cycle, we think the time between the last rate hike and the recession will be shorter, and perhaps after the recession starts. In technical terms, a recession has already begun with last week's second quarter GDP release. However, we don't think a true recession can be declared unless the unemployment rate rises by at least a few percentage points. Given the deterioration in profit margins and forward earnings estimates, we think that risk has risen considerably as we are seeing many hiring freezes and even layoffs in certain parts of the economy. This has been most acute in industries affected by higher costs and interest rates and where there's payback in demand from the binge in consumption during the lockdowns.
In our conversations with clients over the past few weeks, we've been surprised at how many think a recession was fully priced in June. While talk of recession was rampant during that sell off, and valuations reached our target price earnings ratio of 15.4x, we do not think it properly discounted the earnings damage that will entail if we are actually in a recession right now. As we have noted in that outcome, the earnings revisions which have begun this quarter are likely far from finished in both time or level. Our estimate for S&P 500 earnings going forward in a recession scenario is $195, which is likely to be reached by the first quarter of 2023. Of course, we could still avoid a recession defined as a negative labor cycle, or it might come later next year, which means the Fed pause can happen prior to the arrival of a recession allowing for that bullish window to expand. We remain open minded to any outcome, but our analysis suggests betting on the latter two outcomes is a risky one, especially after the recent rally.
The bottom line, last month's rally in stocks was powerful and has investors excited that the bear market is over and looking forward to better times. However, we think it's premature to sound the all-clear with recession and therefore earnings risk is still elevated. For these reasons, we stayed defensively oriented in our equity positioning for now and remain patient with any incremental allocations to stocks.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
One of the most common standards for investment diversification, the 60:40 portfolio, has faced challenges this year with significant losses and shifting correlations between stocks and bonds. Is this the end of 60:40 allocation?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, July 29th, at 2 p.m. in London.
The so-called 60:40 portfolio is one of the most common forms of diversified investing, based on the idea of holding a portfolio of 60% equities and 40% high-quality bonds. In theory, the equities provide higher returns over time, while the high-quality bonds provide ballast and diversification, delivering a balanced overall portfolio. But recently, we and many others have been talking about how our estimates suggested historically low returns for this 60:40 type of approach. And frequently these estimates just didn't seem to matter. Global stocks and bonds continued to hum away nicely, delivering unusually strong returns and diversification.
And then, all at once, those dour, long term return estimates appeared to come true. From January 1st through June 30th of this year, a 60:40 portfolio of U.S. equities and the aggregate bond index lost about 16% of its value, wiping out all of the portfolio's gains since September of 2020. Portfolios in Europe were a similar story. These moves raise a question: do these large losses, and the fact that they involved stock and bond prices moving in the same direction, mean that diversified portfolios of stocks and bonds are fundamentally broken in an era of tighter policy?
Now, one way that 60:40 portfolios could be broken, so to speak, is that they simply can't generate reasonable returns going forward. But on our estimates, this isn't the case. Lower prices for stocks and higher yields on bonds have raised our estimate for what this type of diversified portfolio can return. Leaving those estimates now near the 20-year average.
A bigger concern for investors, however, is diversification. The drawdown of 60:40 portfolios this year wasn't necessarily extreme for its magnitude—2002 and 2008 saw larger losses—but rather its uniformity, as both stocks and bonds saw unusually large declines.
These fears of less diversification have been given a face, the bond equity correlation. And the story investors are afraid of goes something like this. For most of the last 20 years, bond and equity returns were negatively correlated, moving in opposite directions and diversifying each other. But since 2020, the large interventions of monetary policy into the market have caused this correlation to be positive. Stock and bond prices are now moving in the same direction. The case for diversification is over.
This is a tempting story, and it is true that large central bank actions since 2020 have caused stocks and bonds to move together more frequently. But I think there's also a risk of confusing direction and magnitude. Bonds can still be good portfolio diversifiers, even if they aren't quite as good as they've been before.
Even if stocks and bonds are now positively correlated, that correlation is still well below 1 to 1. That means there are still plenty of days where they don't move together, and this can matter significantly for how a portfolio behaves, and how diversification is delivered, over time.
Another important case for 60:40 style diversification is volatility. Even after one of the worst declines for bond prices in the last 40 years, the trailing one-year volatility of the US aggregate bond index is about 6%. That is one third the volatility of U.S. stocks over the same period. Having 40% of a portfolio in something with one third of the volatility should dampen overall fluctuations. For all these reasons, we think the case for a 60:40 style approach to diversified investing remains.
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Yesterday, the U.S. Federal Reserve raised interest rates by another 75 basis points. What is driving these above average rate hikes and what might the effect on markets be?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, July 28th at 4 p.m. in London.
Yesterday, the Federal Reserve raised rates by 75 basis points, and the Nasdaq market index had its best day since April of 2020, rising over 4%. It was a day of big moves, but also some large unanswered questions.
A 75 basis point rise in Fed funds is large and unusual. In the last 30 years, the Fed has only raised rates by such a large increment three times. Two of those instances were at the last two Federal Reserve meetings, including the one we had yesterday.
These large moves are happening because the Fed is racing to catch up with, and get ahead of, inflation, which is currently running at about 9% in the U.S. In theory, higher fed rate should slow the economy and cool inflationary pressure. But that theory also assumes that higher rates work with a lag, perhaps as long as 12 months. There are a couple of reasons for this, but one is that in theory, higher rates work by making it more attractive to save money rather than spend it today. Well, I checked my savings account today and let's just say the rate increases we've had recently haven't exactly shown up. So the incentives to save are still working their way through the system.
This is part of the Fed's predicament. In hockey terms, they're trying to skate the proverbial puck, aiming policy to where inflation and the economy might be in 12 months time. But both inflation and their policy changes are moving very fast. This is not an easy thing to calibrate.
Given that difficulty, why did the markets celebrate yesterday with both stock and bond prices rising? Well, the Fed was vague about future rate increases, raising market hopes that the central bank is closer to finishing these rate rises and may soon slow down, or pause, its policy tightening as growth and inflation slow. After all, long term inflation expectations have fallen sharply since the start of May, perhaps suggesting that the Fed has done enough.
And as my colleague Michael Wilson, Morgan Stanley's chief investment officer and chief U.S. equity strategist, noted on Monday's podcast, markets have often seen some respite when the Fed pauses as part of a hiking cycle. But it's also important to stress that the idea that the Fed is now nearly done with its actions seems optimistic. The last two inflation readings were the highest U.S. inflation readings in 40 years, and Morgan Stanley's economists expect core inflation, which is an important measure excluding things like food and energy, to rise yet again in August.
In short, the Fed's vagueness of future increases could suggest an all important shift. But it could also suggest genuine uncertainty on growth, inflation and how quickly the Fed's actions will feed through into the economy. The Fed has produced some welcome summer respite, but incoming data is still going to matter, significantly, for what policy looks like at their next meeting in September.
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While midterm polls have shown a preference for republican candidates, this lead is narrowing as the election grows closer, and the full ramifications of this ever evolving race remain to be seen.
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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, July 27th, at 1 p.m. in New York.
We're still months away from the midterm elections, and polls still show strong prospects for Republicans to win back control of Congress. As we previously discussed, such an outcome could result in stalling key policy variables for markets such, as tax changes and regulations for tech and cryptocurrency. But remember not to assume that such an outcome is a sure thing.
Take, for example, recent polls showing voters' preference for Republican congressional candidates over Democrats actually narrowing. A month ago, the average polling lead for Republicans was nearly 3%, it's now closer to 0.5%. Some independent forecasting models even now show the Democrats as a slight favorite to hold the Senate, even as they assess Democrats are unlikely to keep control of the House. The reasons for Democrats' improvement in the polls are up for debate, but that's not the point for investors. In our view, the point is that the race is still evolving and that can have market ramifications.
Even if Democrats don't ultimately keep control of Congress, making it a closer race means markets may have to account for a higher probability that certain policies get enacted. Take corporate tax hikes, for example. Recent news suggests they're off the table, but if Democrats hold Congress, it's likely they'd be revisited as a means of funding several of their preferred initiatives. That could pressure a U.S. equity market already wary of margin pressures from inflation and slowing growth. A more constructive example is the clean tech sector. Again, reports are that the plan to allocate money to clean energy is off the table, but this could be revisited if Democrats keep control. Hence, improved Democratic prospects could benefit the sector ahead of the election.
The bottom line is that the midterm elections are still a market factor over the next few months. We'll keep you in the loop right here about how it all plays out.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As young, digitized consumers have popularized the “Buy Now, Pay Later” payment system across global markets, there may yet be related market opportunities in Latin America.
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Welcome to Thoughts on the Market. I'm Jorge Kuri, Morgan Stanley's Latin America Financials Analyst. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the rise of Buy Now, Pay Later, or BNPL, in Latin America. It's Tuesday, July 26th, at 2 p.m. in New York.
As many of you no doubt remember, the COVID lockdowns of 2020 and 2021 were boom times for e-commerce, as quarantines made us all habitual online shoppers. This period also helped fuel the Buy Now, Pay Later payment method, which allows online shoppers the ability to make a purchase and defer payments over several installments with no fees or interest when paid on time.
Buy Now, Pay Later first gained traction in New Zealand and Australia, then in Europe and most recently in the U.S. and now BNPL could offer a vast market opportunity in Latin America. In fact, we see volumes reaching $23 billion in Mexico and $21 billion in Brazil by 2026.
So let's take a closer look at why. BNPL in Latin America is driven by a number of secular tailwinds, starting with favorable demographics: BNPL appeals to young, digitalized consumers who fuel the electronification of payments and e-commerce. Combine that with low credit penetration, growing consumer awareness and merchant acceptance, and you have a recipe for strong and sustainable multi-year growth. Mexico and Brazil offer the most attractive market opportunities within Latin America.
In Mexico, the population is very young and digitalized - 65% is 39 years old or younger, and smartphone penetration among individuals 18 to 34 years is 83%. Yet the population of unbanked adults is quite large, 51% do not have a bank account and 80% do not have a credit card. Digitalization of payments is a big tailwind, as cash remains by far the most frequently used payment method, while e-commerce penetration is expected to double and reach 20% by 2026.
In Brazil, the situation is a bit different. Similar to Mexico, the population is young and digitalized. But in contrast, credit penetration is higher in Brazil, with 75% of households utilizing at least one form of credit and one or more credit cards. The ubiquity and effectiveness of PIX, the instant payments ecosystem in Brazil, combined with the large and fast growing e-commerce industry and the boom in fintech companies, could facilitate the distribution and acceptance of BNPL in the country.
It's worth noting that the BNPL opportunity does not come without risks. Delinquency risk is obvious given the unsecured nature of the product, adverse selection risks and a challenging macroeconomic environment. Most BNPL providers have some funding disadvantages and competition among both BNPL players and incumbent banks will likely ensue. Despite these various risks, BNPL remains one of the most significant multi-year trends to watch in Latin America financials.
Thanks for listening. If you enjoy this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As markets grapple with pricing in inflation, central bank rate hikes, and slowing growth, can the recent S&P 500 rally help investors gauge what may happen next for equities?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 25th, at 11 a.m. in New York. So let's get after it.
Since the June lows at 3650, the S&P 500 has been range trading between those lows and 3950. However, this past week, the S&P 500 peaked its head above the 50 day moving average, even touching 4000 for a few hours. While we aren't convinced this is anything but a bear market rally, it does beg the question is something going on here that could make this a more sustainable low and even the end to the bear market?
First, from a fundamental standpoint, we are more convicted in our view that S&P 500 earnings estimates are too high, and they have at least 10% downside from the recent peak of $240/share. So far, that forecast has only dropped by 0.5%, making it difficult for us to agree with that view that the market has already priced it. Of course, we could also be wrong about the earnings risk and perhaps the current $238 is an accurate reflection of reality.
However, with most of our leading indicators on growth rolling over, we continue to think this is not the case, and disappointing growth remains the more important variable to watch for stocks at this point, rather than inflation or the Fed's reaction to it. Having said that, we do agree with the narrative that inflation has likely peaked from a rate of change standpoint, with commodities as the best real time evidence of that claim. We think the equity market is smart enough to understand this too, and more importantly, that growth is quickly becoming a problem. Therefore, part of the recent rally may be the equity market looking forward to the Fed's eventual attempt to save the cycle from recession. With time running short on that front.
And looking at past cycles, there's always a period between the Fed's last hike and the eventual recession. More importantly, this period has been a good time to be long equities. In short, the equity market always rallies when the Fed pauses tightening campaign prior to the oncoming recession. The point here is that if the market is starting to think the Fed's about to pause rate hikes after this week’s, this would provide the best fundamental rationale for why equity markets have rallied over the past few weeks despite the disappointing fundamental news and why it may signal a more durable low.
The problem with this thinking, in our view, is it's unlikely the Fed is going to pause early enough to save the cycle. While we appreciate that investors may be trying to leap ahead here to get in front of what could be a bullish signal for equity prices remain skeptical that the Fed can reverse the negative trends for demand that are already now well-established, some of which have nothing to do with monetary policy. Furthermore, the demand destructive nature of high inflation is presenting itself today will not easily disappear even if inflation declined sharply. This is because prices are already out of reach in areas of the economy that are critical for this cycle to extend in areas like housing and autos, food, gasoline and other necessities. Secondarily, high inflation provides a real constraint for the Fed to pause or pivot, even if they decided a risk of recession was imminent. That's the main difference versus more recent cycles and why we think it remains a good idea to stay defensively oriented in one's equity positioning until further earnings disappointments are factored into consensus estimates or equity prices.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
This week the European Central Bank surprised economists and investors alike with a higher than anticipated rate hike, so why this hike and what comes next? Chief Cross-Asset Strategist Andrew Sheets and Chief European Economist Jens Eisenschmidt discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.
Jens Eisenschmidt: And I'm Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist.
Andrew Sheets: And on this special episode of Thoughts on the market will be discussing the recent ECB rate hike and the path ahead. It's Friday, July 22nd at 4 p.m. in London.
Andrew Sheets: So, Jens, I want to talk to you about the ECB's big rate decision yesterday. But before we do that, I think we should start by laying the scene of the European economy. In a nutshell, how is Europe's economy doing and what do you think are the most salient points for investors to be aware of?
Jens Eisenschmidt: Great question, Andrew. We have revised downwards our growth outlook for the euro area economy on the back of the reduced gas flow coming out from Russia into Germany starting at some point in mid-June. And we are now seeing a mild recession for the euro area economy setting in towards the end of this year and the beginning of next. This is in stark contrast to what the ECB, as early as June, has been saying the euro area economy would look like. I think incoming data, since our call for a bit more muted economic outlook, has been on the negative side. So for instance, we just today had the PMIs in contractionary territory. So the PMIs are the Purchasing Managers Indexes, which are soft indicators of economic activity. Soft because are survey evidence they're essentially questions ask industry participants about what they see on their side, and out of these questions an index is derived for economic activity. So all in all, the outlook is relatively muted, as I said, and I think a recession is clearly in the cards.
Andrew Sheets: But Jens, why is growth in Europe so weak? When you think about things like that big decline in PMI that we just saw this week, what's driving that? What do you think is the key thing that maybe other forecasters might be missing in terms of driving this weakness?
Jens Eisenschmidt: I mean, Europe is very, very close to one of the largest, geopolitical conflicts of our time. We have, as a consequence of that, to deal with very high energy prices. The dependance on Russian gas, for instance, is very high in several parts of Western Europe. But you're right, we have still accommodative monetary policy, so, all in all, we still have positive and negative factors, but we think that the negative factors are starting now to have the bigger weight in all this. And we have seen for the first time, as you just mentioned to PMI's in contractionary territory, while we are of course having a bit in the service sector, a different picture which is still driven from reopening dynamics coming out from COVID. So everybody wants to have a holiday after they didn't have one last year and the year before.
Andrew Sheets: So I guess speaking of holidays, it involves a lot of driving, a lot of flying. I think that's a good segway into the energy story in Europe. This has been a really challenging dynamic because you've had obviously the risk of energy being cut off into Europe. When you think about modeling scenarios of less energy being available via Russia, how do you go about modeling that and what could the impact be?
Jens Eisenschmidt: No, that's really the hard part here. Because, ultimately, if the energy is flowing and continues to flow, you can rely on data that goes back and that gives you some relationship between the price and then what the impact on economic activity on that price schedule will be. But if energy is falling to levels where governments have to decide duration, then the modeling becomes so much harder because you have to decide then in your model who gets gas or oil and at what price. That makes it very hard and it also explains why there's a huge range of model outcomes out there showing GDP impact for some economies as deep, in terms of contraction, of 10 to 15%. We are not in that camp. We think that even in a situation of a total cut off of, say, Russian gas, the euro area economy would contract, but not as deeply. Part of that is that we think that some time has elapsed since the threat has first become a possibility and the system has adjusted to some extent. And then what you get is a system that's a little bit more resilient now to a cut than it may have been in March.
Andrew Sheets: Jens. I think that's also a good connection to the inflation story. So on one hand, inflation dynamics in Europe look quite similar to the U.S. On the other hand those inflation dynamics seem somewhat different from the U.S., core inflation is not as high, wage inflation is not as high. Could you kind of walk us through a bit of how you see that inflation story in Europe and how it's similar or different to what we see going on in the U.S.?
Jens Eisenschmidt: There is clearly a difference here, and I think the ECB has never been tiring in stressing that difference that most of the inflation here in Europe is driven by external factors. And here, of course, energy is the big elephant in the room. It's not helped by the fact that we had a depreciation of the Euro against the U.S. dollar and most of the energy is, as we know, a built in U.S. dollar. We also have a significant food inflation, and of course, it's also linked very, very tightly to the conflict in Ukraine, where we have Ukraine as a big food exporter. Just think of oil, think of wheat, all these things that are in the headlines. So that's structurally different from a situation in the U.S. where you do have a significant part of the inflation being internal demand driven. And of course that leads to interconnection with a very tight labor market to a higher core inflation. Now core inflation in the euro area has also been picking up and it's certainly not at levels where the European Central Bank can be happy with. But, you know, all in all, both our set of assumptions and forecasts as well as the ECB's in the end boil down to a slight overshoot in the medium term of their inflation target.
Andrew Sheets: So Jens, all of this brings us back to the main event, so to speak. The European Central Bank raised interest rates yesterday for the first time since 2011, and it was a pretty large increase. It was a half a percentage point increase. So what's driving the ECB thinking here and how is it trying to weigh all these different factors, in a world where rates are rising?
Jens Eisenschmidt: So indeed, the ECB yesterday ended its negative rates policy, which was designed for a completely different environment, an environment of a persistent undershoot of its inflation target. By all available measures, they are now at target or above. So that in itself justifies ending this policy, and this is what they did yesterday. Now, of course, there is a concern that the high inflation that we see today is feeding into wage negotiations, is feeding into a process of more structurally higher inflation, and that risks the anchoring inflation expectations. So there is a need, even if you see the economy going weaker, there is a need to tighten its monetary policy. At the same time, they have this geopolitical conflict just very near to them. They have the risk to growth that we were talking about before. So that also means you cannot just now go out and line out a significant path of rate increases. So that leads to the second component of their decision yesterday. So they were say we will go meeting by meeting and we will be data dependent in our move.
Andrew Sheets: So Jens, let's bring this back to markets. When you look at what markets are currently expecting from the ECB in terms of rate hikes out over the next, say, 18 months, do you think the ECB is likely to deliver more tightening than those rates imply or deliver rates that are lower than those current market expectations?
Jens Eisenschmidt: So if you just talk about where markets see the ECB peaking, that's at 1.5%. We agree, just that we don't agree on the timing. So we, for instance, see the ECB going 50 basis points in September, but then slowing down to 25 in October and another 25 in December. And then we really see the ECB pausing until September next year. And the pause is introduced because the economy is weakening and significantly so, and we see this centered around the end of the year. Now in the markets, there is a bit of an assumption that the ECB will be more aggressive in terms of getting to the 1.5% earlier. Not necessarily still this year, but at some point early next year.
Andrew Sheets: And just from the perspective of markets, you know, this is a reason why Morgan Stanley's foreign exchange team thinks that the euro will continue to weaken against the dollar. It's both a function of Jens your weak growth forecasts, but also potentially this idea that rates won't rise in Europe quite as fast as the market is expecting. Which would mean somewhat less support for the currency.
Andrew Sheets: Jens, thanks for taking the time to talk.
Jens Eisenschmidt: Thanks a lot, Andrew. It was a pleasure being with you.
Andrew Sheets: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Original Release on July 1st, 2022: As inflation continues to be a major concern for the U.S., investors will want to pay attention to how spending, travel and sentiment are changing for consumers.
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Welcome to Thoughts on the Market. I'm Michelle Weaver, a U.S. equity strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be sharing the pulse of the U.S. consumer right now amid elevated inflation and concerns about recession. It's Thursday, July 7th, at 2 p.m. in New York.
Consumer spending represents roughly 65% of total U.S. GDP. So if we're looking for a window into how U.S. companies could perform over the next 12 months, asking consumers how confident they're feeling is a great start. Are consumers planning on spending more next month or less? Are people making plans for outdoor activities and eating out or are they staying at home? Are they changing travel plans because of spending worries?
These are a few of the questions that the equity strategy team asks in a survey we conduct with the AlphaWise Group, the proprietary survey and data arm of Morgan Stanley Research. We recently decided to change the frequency of our survey to biweekly to get a closer look at the consumer trends that will affect our outlook. So today, I'm going to share a few notable takeaways from our last survey, which was right before the July 4th holiday.
First, let's take a look at sentiment. The survey found that inflation continues to be the top concern for two thirds of consumers, in line with two weeks before that, but significantly higher compared to the beginning of the year. Concern over the spread of COVID-19 continues to trend lower, with 25% of consumers listing it as their number one concern versus 32% last month. And 41% of consumers are worried about the political environment in the U.S. versus 38% two weeks ago, a slight tick up. Apart from inflation, low-income consumers are generally more worried about the inability to pay rent and other debts, while upper income consumers over index on concerns over investments, the political environment in the U.S., and geopolitical conflicts.
A second takeaway to note is that consumer confidence in the economy continues to weaken, with only 23% of consumers expecting the economy to get better. That's the lowest percentage since the inception of our survey and down another 3% from two weeks ago. In addition, 59% of consumers now expect the economy to get worse. This lines up with the all-time lows observed in a recent consumer sentiment survey from the University of Michigan.
A third takeaway is that consumers are planning to slow spending directly as a result of rising prices. 66% of consumers said they are planning to spend less over the next six months as a result of inflation. These numbers are influenced by income level, with lower income consumers planning to reduce spending more. We also asked consumers where they were planning to reduce spending in response to inflation. Dining out and take out, clothing and footwear, and leisure travel were among the most popular places to cut back, and all represent highly discretionary spending.
And finally, the survey noted that travel intentions are considerably lower to the same time last year, with 55% of consumers planning to travel over the next six months, versus roughly 64% in the summer of last year. We also asked consumers if they were planning to cancel or delay post-Labor Day travel because of inflation. Generally, planned travel post-Labor Day is in line with broader travel intentions. Cruises and international travel were the most likely to be delayed or postponed.
So what's the takeaway for investors? It is important to allocate selectively as consumer behavior shifts in order to cope with inflation and company earnings and margins come under pressure. Our team recommends defensive positioning, companies with high operational efficiency, and looking for idiosyncratic stories where companies have unique advantages.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Interest in ESG investing has risen exponentially in recent years, leading to increased scrutiny around, and appreciation for, the hard data. Head of U.S. Public Policy Research and Municipal Strategy Michael Zezas and Head of the ESG Fixed Income Research Team Carolyn Campbell discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, head of U.S. Public Policy Research and Municipal Strategy.
Carolyn Campbell: And I'm Carolyn Campbell, head of the ESG fixed income research team at Morgan Stanley.
Michael Zezas: And on this special edition of the podcast, we'll be assessing the next phase of the environmental, social, governance, ESG, market. It's Wednesday, July 20th, at 10 a.m. in New York.
Michael Zezas: As some listeners may have read, in late May of this year, the Securities and Exchange Commission proposed new rules that would require ESG funds to disclose their goals, criteria and strategies, along with data measuring ESG progress. And this tells us that although the market for ESG investing has grown, so has investor desire to see real data and empirical analysis on impact. And this could be seen as really the next phase of the ESG market, that companies and funds won't just claim to be focused on ESG but will provide real proof. So, Carolyn, just to set the stage, I notice that people sometimes use the term sustainable investing and ESG interchangeably. So, I think it might be good to start with what exactly ESG is.
Carolyn Campbell: At its core ESG is about adding a new lens to risk management in our investment practices by looking at environmental, social and governance factors in addition to our traditional financial metrics and whatnot. ESG has been around in some way, shape or form for decades, beginning with what we call negative exclusions. Initially, that looked like excluding companies that conflicted with religious views such as gambling, alcohol or pornography. But it's probably best known more recently for what we would think of as the fossil fuel divestment movement; selling out of coal and oil and gas companies, for example. On the other end of the spectrum, we've got impact investing where money is put towards projects that are both worthy financial investments but are also meant to generate some type of positive impact, whether it be environmental or social. In between, ESG can look like a lot of things, whether that's selecting companies that are best in class or building a portfolio geared towards a certain theme like biodiversity, net zero or gender diversity.
Michael Zezas: Now, you're a fixed income strategist and ESG investing through the bond market is a bit newer and still evolving. What are some of the challenges of investing in ESG through bonds as opposed to stocks?
Carolyn Campbell: Well, so one big difference in fixed income is that there are products that are actually dedicated sustainability assets. Companies, governments and super nationals can issue bonds that are specifically ESG instruments, which isn't something that you can quite do in the stock market. The most common is the green bond. The net proceeds of the issuance go towards green projects, which can be things like retrofitting your buildings to be more energy efficient, building out a solar paneled roof, reducing water waste and so on. There are also social bonds with projects related to decreasing inequality or access to health care and sustainability bonds, which fund both types of projects. We spend a lot of time trying to understand how these instruments trade compared to normal vanilla bonds from the same issuer. A big driver of the difference in price and performance is that there are just a lot fewer of these label bonds and quite a large appetite to invest in them. So those supply and demand dynamics have historically helped these labor bonds trade well, particularly in the primary market. We recently completed some analysis, though, that found that when you strip away a lot of the structural differences, the premium afforded to these green bonds is pretty small over time, just around half a basis point. The big difference comes from green bonds that go the extra mile. These bonds have voluntary external verification, science-based targets, so on and so forth. Investors can see the green criteria of the bond and feel confident that the governance structures are in place to ensure the materiality of the green bond going forward. And these bonds on average trade with higher premiums to their vanilla counterparts than just your regular green bond.
Michael Zezas: So I want to get into some of the challenges I mentioned at the start around the debate over ESG's impact and validity. What's been the catalyst for the increased scrutiny over what's often called 'greenwashing?'
Carolyn Campbell: Yeah, great question. So if we take it back a step, ESG really took off during 2020 with the onset of the pandemic. And there was a surge of focus on, and enthusiasm around, ESG and climate change more broadly. The market's grown exponentially since then, and it was natural that some of these new products and developments would be met with a raised eyebrow. Protests and social unrest in 2020, for instance, marked a turning point for companies with society asking companies to state their values upfront and to start walking the walk. Much of the scrutiny around ESG is ensuring that companies are not taking advantage of ESG as a marketing exercise to generate goodwill and are, in a sense, putting their money where their mouth is. That's really accelerated this year with the war in Ukraine, which is highlighted that within ESG there are some potentially competing priorities, namely the social cost of high energy prices versus the far reaching implications of climate change, or the rising food insecurity versus a more sustainable value chain. Investors have begun to adopt more nuanced views of what ESG is and how it might evolve in a world with higher volatility and decades-high inflation prints. And not everybody has the same definition of what ESG means to them. At the end of the day, the debate centers around, is it affecting change, and if so, by how much?
Michael Zezas: So I certainly understand the clamor for demonstrable proof of impact. But would you say that, even with incidents of greenwashing, has ESG moved the needle on achieving its goals?
Carolyn Campbell: Another great question, and unfortunately, it's probably still too early to tell. ESG is really about playing the long game and moving the market's focus away from its bias towards short-termism. So the effects of these new cleaner investments might not necessarily be realized overnight. I think what is clear, though, is that the global greenhouse gas emissions haven't declined in recent years, despite this push towards more sustainable investing. In fact, 2021 marked the highest amount of global CO2 emissions ever recorded. That being said, while policy development at the federal level on climate might be facing some serious headwinds here in the US, there has been a positive push from the private sector to decarbonize, regardless of a legislative incentive. Just because we haven't seen a decline in emissions yet, doesn't mean it won't happen. It just means that there's a lot more work to do and a lot more money that needs to flow towards these sustainable solutions.
Michael Zezas: So one of your key skills as a strategist is how you apply data and empirical analysis to ESG investments. Can you walk us through your work and your process?
Carolyn Campbell: We start every report with a research question—how do you see factors, impacts, spread performance, for instance, or how much of a premium do these green bonds trade with? Sometimes these questions are commonly discussed and dissected in the news, in academic research and so on. But we try to begin each project with no presupposition of what we might find so that we don't bias our results. We want to let the data and results speak for itself. And we're not trying to push an agenda. We're trying to get to the bottom of complex problems that investors demonstrably care about. ESG data is incredibly tricky because it tends to have a shorter history than most financial metrics and is released slowly and often with lags. That doesn't give us a ton of wiggle room, but once we know the question we're trying to answer, we always start by collecting data, and we'll look for data from myriad sources: public and private, startups, the US government—you name it, we've looked into it. And then sadly, a lot of the work is data cleaning, as any data scientist listening knows all too well. Once we build the dataset, we start tackling that research question. Sometimes we're doing something a bit more simplistic, like standardizing metrics in order to facilitate a comparison of different instruments or companies. This is a big hurdle for ESG in particular, because we don't have anything like GAAP accounting metrics that every company has to report on. Just getting to a point where you can do an apples to apples comparison is not always straightforward. Often though, we look to use different types of regression models or other types of machine learning techniques to understand relationships in the market and to build the confidence in our results. Once we have those results, it's all about visualizing it in a compelling and clear way.
Michael Zezas: If an investor is interested in the ESG space, what should they keep front of mind as they consider their investments?
Carolyn Campbell: ESG is full of tradeoffs and it's rarely straightforward. We mentioned some of these dilemmas before, such as the social cost of the high gas prices and the implications of climate change by continuing to rely on fossil fuels. It's never clear cut. ESG isn't a one size fits all solution, and different investors are going to have different priorities. Understanding your priorities at the outset and keeping those as a guiding light will help keep the investment process on track and drown out some of the noise. That being said, it's also important in this fast evolving space to be flexible to new information and to be adaptable. The world looks very different now than it did a year ago or five years ago, and ESG in particular is rapidly changing with new regulations, new issues and new conflicts every day. Relying on the data and facts and understanding how trends change within the industry will be of utmost importance.
Michael Zezas: Carolyn, thanks so much for talking.
Carolyn Campbell: Great talking with you, Michael.
Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As U.S. Equities continue to face challenges this year, investors may want to look to a more positive story across the world—the reopening of China.
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Welcome to Thoughts on the Market. I'm Michelle Weaver, U.S. equity strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about China's reopening as COVID Zero policies evolve. It's Tuesday, July 19th, at 3 p.m. in New York.
Recently, our China economics team has become more positive on the region due to the relaxation in domestic and international travel policies and signs of gradual reopening. The team believes that in order for China to shift away from COVID Zero, the three necessary conditions will be sufficiently high vaccination coverage, a broadening toolbox to preserve health care capacity and a change in public perception of COVID.
Progress has been made on all of these conditions, and the team expects the economy to reopen more broadly in the back half of the year and that a COVID Zero exit could happen towards year-end.
This is notable for global investors since the broad U.S. equity turmoil of the last few months makes it important to look for stocks whose stories are not levered to the market at large and are more thematic ideas. The potential reopening of a country with 1.4 billion residents hits both of these criteria.
To dig into this, the US equity strategy team, headed by Chief Investment Officer Mike Wilson, and our European Equity Strategy Team, led by Graham Secker, sourced industries and names that could have high revenue exposure to China. We then asked sector analysts which stocks they thought stand to benefit the most from the reopening.
In the US, the biggest beneficiaries were in the consumer discretionary, materials, industrials and information technology sectors. The names who stand to benefit here are American brands that have consumer appeal, benefit from out of home experiences or feature China as a key driver of revenue, where pent up demand could provide tailwinds.
In Europe, the potential beneficiaries are companies that have the highest revenue exposure to China. But it's important to be selective here, as a relatively large number of industrial and commodity focused stocks could be exposed to wider concerns around a global economic slowdown. For that reason, companies who also have exposure to the Chinese consumer may be best positioned.
Narrowing even further from a top-down perspective, we think the most direct beneficiary of a potential reopening narrative in China is the luxury goods sector, also known as consumer durables in MSCI terminology, which has the third highest China exposure of any European sector after semiconductors and materials. Relevant to the reopening angle specifically, the team believes the luxury sector has the highest exposure to the China consumer and is a beneficiary of reduced restrictions around travel. Given this exposure and the recent pullback in government bond yields, they have upgraded the sector to overweight from a top-down strategy perspective.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Some investors think a potential recession is already priced in but given defensive leadership, labor statistics and incoming Fed rate hikes, it may be too early to tell.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 18th, at 11 a.m. in New York. So let's get after it.
Last week, we highlighted how extreme the 12-month price momentum weightings are for defensive sectors. In fact, it's unprecedented for this type of price momentum to occur outside of an economic recession. One reaction to this development we've heard from many clients is that a recession must already be priced based on this relationship. If true, then defensive leadership is likely to reverse with something else taking the lead, like growth stocks or even cyclicals. We disagree and believe defensive leadership will likely persist until either a recession is officially announced, or the risk of a recession is definitively extinguished.
In our view, the first outcome can only be achieved with a series of negative payroll data releases, something that still seems far away given last month's 372,000 new job additions. The second outcome—a soft landing—will also be hard to prove to the market until earnings revisions bottom out and companies stop doing hiring freezes.
With respect to the recession outcome, the odds have been steadily increasing now for months. Morgan Stanley's proprietary economic model is currently suggesting a 36% probability of a recession in the next 12 months. Historically speaking, once it reaches 40%, it's usually a definitive reading that recession is oncoming. Furthermore, jobless claims have been rising the past few weeks. Secondarily, the household survey for total employment peaked in March and has fallen by approximately 400,000 jobs so far. While not the gold standard for measuring labor market health, it's worth watching closely as things can change rapidly for hiring and firing, particularly when profits come under significant pressure, as we expect. Finally, the job openings data has started to roll over, albeit from record high levels, while consumer and business confidence readings remain at record lows.
In the very near term, equity markets seem to be digesting another hot Consumer Price Index release very well, even as concerns rose that the Fed might raise rates as much as 100 basis points next week. Our view is that 75 basis points is still the base case, and that should be plenty to keep the Fed on track to getting ahead of the curve. Importantly, the bond market seems to agree with the yield curve inverting the most since the 2000 cycle, quickly catching up to the defensive leadership of the stock market. The bullish take which this market seems to want to try and run with one more time, is that the Fed can pivot before a recession arrives.
The other positive that has investors excited again is the fact that bank stocks had a strong rally on Friday, even as the earnings results were quite mixed. While this kind of price action is a necessary condition for the bear market to be over, we would caution that second quarter results are likely to be the first of several cuts, not just for banks, but for the market overall.
The bottom line is that this earnings season is likely to be the first of several disappointing ones, especially if a recession is the endgame. Therefore, staying defensively oriented in one's equity positioning should remain the best course of action for the next several months.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
This week brought yet another reading of inflation that exceeded expectations, but if markets and central banks are able to think long-term, there may be some hope on the horizon.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross-asset strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape, and how we put those ideas together.
It's Friday, July 15th at 4:00pm in London.
One of the big stories this week was, once again, a high reading of US inflation that came in above economists’ expectations. If that sounds familiar, it’s because it is. US consumer price inflation was also higher than expected in June, May and April.
These upside surprises to inflation create a trio of problems. First, investors will feel more confident if inflation starts coming down, and this is yet another month where that isn’t the case. Second, the Fed has been adamant that it will keep raising interest rates until inflation moderates, which means that more rate hikes are likely coming. And third, this sets up a real predicament; the Fed wants to bring inflation down, and sees this as key to its credibility, but raising rates today won’t do much for inflation over the short-term. That creates additional uncertainty.
Markets are responding to that uncertainty by raising expectations of how much the Fed will increase rates in the near-term, while simultaneously becoming more worried about medium-term growth, and lowering expectation of rates over the long term. That has inverted the yield curve, something that, while rare, has historically signalled high odds of a recession.
What’s notable, however, is that while there is intense focus on the concerns and negative surprises from the current rate of inflation, the longer-term picture is arguably getting better. One can observe expected rates of inflation over the next 5, 10 or 30 years, also called inflation break-evens. Those expectations have been falling rapidly over the last 2 months.
In the US, markets currently see US Consumer Price Inflation to average about 2.35% over the next decade. That is more than half-a-percent lower than where that same estimate was just two months ago, and it’s similar to where these expectations were in March of 2021. 2.35% is also pretty close to the Fed’s inflation target; markets do not see inflation accelerating in an uncontrolled manner over the long term.
For investors, think of this dynamic as one of short-term pain but longer-term gains. Near-term high inflation, and uncertainty of when it will decline, could keep the Fed cautious and argues against buying the dip.
But looking further out, the market is giving encouraging signs that inflation is a manageable problem, and that central bank actions are working at addressing it. In the autumn, we could see a situation where the inflation data is moderating, while long-term inflation expectations confirm that that moderation continues. For markets, and for central banks, that would be much more helpful.
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Original Release on July 1st, 2022: For the last decade investors have been focused on highflying growth stocks, but this investing environment may be the exception rather than the rule. Chief European Equity Strategist Graham Secker and Global Head of Quantitative Investment Strategies Research Stephan Kessler discuss.
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Graham Secker: Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist.
Stephan Kessler: I am Stephan Kessler, Global Head of Quantitative Investment Strategies Research.
Graham Secker: And on this special episode of the podcast, we'll be talking about the potential return of value investing post its decade long decline since the global financial crisis. It's Friday, July the 1st, at 10 a.m. in London.
Graham Secker: As most listeners of this particular podcast are probably aware, for much of the past decade, investors have had something of a love affair with the highflying growth stocks in the market. Meanwhile, their value priced counterparts, the shares of which tend to trade at relatively low price to earnings multiples and or offering higher dividend yields, have had a considerably rougher time of it. But I believe that the last decade is more the exception to the rule rather than the norm. And I think your analysis, Stephan, shows that this is true, yes?
Stephan Kessler: Yes, I agree. We have looked at the performance of value as an investment style back to the 1920s, and we find that the period between the end of the global financial crisis and the COVID pandemic was only the decade where value did underperform. For me, the why here is really an interesting question to pick apart, which you and I look at through two different lenses. You're the fundamental strategist and I'm the quantitative analyst. So I think my first question to you is, from your fundamental point of view, what were the main drivers of value’s underperformance during this lost decade?
Graham Secker: Yes. So from our perspective, we think there were two main drivers of values underperformance post the GFC. Firstly, a backdrop of low growth, low inflation and low and falling and negative interest rates, created a particularly problematic macro backdrop for value stocks. The former two factors were weighing on the relative profitability of value stocks, while the very low interest rates were actually boosting the PE ratio of longer duration growth stocks. This unpalatable macro backdrop then coincided with a challenging micro backdrop as the broad theme of disruption took hold across markets. This prompted greater hope among investors for the long term growth potential of the disruptors, while undermining the case for mean reversion across other areas of the market whereby cyclical slowdowns were often effectively viewed as structural declines. So, Stephan, you've said that the discount on value stocks cannot be explained fully by fundamentals or justified by the earnings overview. What do you believe are the deeper drivers for this discount?
Stephan Kessler: When you look at the value, it faced over the past few years, a range of challenges really. On the behavioral side, investors have focused on growth stocks and growth opportunities. This led to a substantial and persistent deviation of equities from their fair values and an underperformance of value investors. Next to this more behavioral argument, we find that the environmental, social and governance related aspects or in short, ESG and monetary policy were themes which drove price action. Equity value has a negative exposure to those themes. And finally, when you look at the 2020 period, there was a classical value trap situation. Companies which were most affected by the COVID pandemic sold off and appear cheap based on quite a range of value metrics, while the COVID catalyst continued to disrupt markets and led to companies which were cheaply valued not being able to recover as they had exposure to these disruptors. This only start to resolve in 2021, which is also when we start to see value regain performance. To get back to a more generalist view of the main drivers of values underperformance, I'd like to get back to you, Graham. You've observed a link between the macro and the micro, which created something of a vicious circle for value in the last cycle. Can you talk about how this situation looks going forward?
Graham Secker: Yes, going forward, we think this vicious cycle for value could actually turn to be something more of a virtuous cycle over the next few years. We argue that we've entered a new environment of higher inflation and associated with that higher nominal growth, and that drives a recovery in the profitability of these older economy type companies. And at the same time, a rising cost of capital undermines the case for the disruptors. And that can happen both in terms of lower valuations off the back of higher interest rates, but also as liquidity starts to subside, a lack of capital to fund their future business growth. Stephan, you mentioned two of these key disruptive forces, quantitative easing by the central banks and then the rise of ESG. Can you talk about the impact of these two elements on the equity investment landscape?
Stephan Kessler: ESG is a major theme in financial markets today, and in particular in this 2018-20 period we saw ESG positive names build up a premium, which made them appear expensive in the context of value metrics. These ESG valuation premia then turned out to be persistent and at times even grew. This then goes, of course, against value investors who try to benefit from this missed valuations mean reverting. And to the extent these valuations even turn stronger, that drove their losses. Quantitative easing is another aspect that drove price action. We find that value tends to underperform in time periods of low interest rates and does well in a rising rates environment. The economic driver behind this empirical observation is that the very low rates you saw in the past make proper valuations of firms difficult as discounted cash flow approaches are challenged. And so on the back of that, lower rates simply lead to valuation and value as signals being challenged and not properly priced. So given the historical narrative and all the forces at play during the past decade, what is your preference between value versus growth for the second half of 2022 and beyond that, Graham?
Graham Secker: Yes. So in the short term, a backdrop of continued high inflation and rising interest rates should we think continue to favor value over growth. However, perhaps right towards the end of this year, we do envisage a situation where that could reverse a little bit, albeit temporarily, once inflation has peaked and the economic downturn has materialized, investor attention may start to focus on rates no longer rising, and that will put a little bit of a bid back under the growth stocks again. But I think if we look longer term, actually, I'm beginning to think that what we'll see is the whole value versus growth debate actually becomes a bit more balanced and hence I can see more range bound relative performance thereafter. And Stephan, from your perspective, in a world of rising bond yields and lower or normalized QE, what is your outlook for value going forward, too?
Stephan Kessler: Well, when we look at the two catalysts for value underperformance, ESG and quantitative easing I mentioned earlier, we see that their grip on the market is loosening. For one, markets have moved into rates tightening cycle which means investors focus more on near-term cash flows rather than terminal value. This is a positive for value companies, which tend to well under such considerations. Furthermore, the dynamism of ESG themes has abated compared to the 18-20 period, leading to a lower effect on value. Another angle on this is also a look at the valuation of value as a style. It's quite cheap, so it's a good entry point. This leads to a positive outlook for value, but also for other styles. We like, particularly the combination of value and quality as it benefits from the attractive entry levels for value, as well as the defensiveness of an investment in quality shares.
Graham Secker: So to summarize from a fundamental and quantitative approach, both Stephan and I think that the extreme underperformance of value that we've seen over the prior decade has ended, value looks well-placed to return to its traditional outperformance trends going forward. Stephan, thanks for taking the time to talk today.
Stephan Kessler: Great speaking with you, Graham.
Graham Secker: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
After the recent Supreme Court ruling against the Environmental Protection Agency, Democrats appear poised to respond with a budget reconciliation plan that could impact health care, clean energy, and corporate taxes.
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Welcome to the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, July 13th, at 10 a.m. in New York.
The Supreme Court just finished a busy session, and one of the judgments that investors should pay attention to was for the case, West Virginia vs the Environmental Protection Agency, the EPA. That judgment said the EPA had overreached on some regulations, embracing something called the Major Questions Doctrine, whereby the court suggested regulators should not be using prior legal authority to decide issues of major economic and political significance. Said more simply, the ruling suggests regulators need explicit authorization from Congress rather than just stretching current legal authorization. So the ruling basically punts many of the EPA's climate policies back to Congress for deliberation.
And that matters for investors because it might be a motivating factor in the Democrats getting their budget reconciliation plan over the finish line. Without being able to rely on the EPA to enact climate policies, Democrats may be willing to compromise more within their own party to get done a package of tax increase funded initiatives on climate and health care. And recent news flow suggests Democrats continue to make progress in this direction.
So let's break down what's reportedly in this package that investors should be aware of. There's a plan to let Medicare negotiate the prices it pays for certain prescription drugs. That's a fundamental challenge for the pharma sector. But as our pharma team has noted, it's not an existential one. And so the sector could still be an outperformer in a market that needs to further price in the potential for a recession, an environment where defensive sectors like pharma typically do well.
Also reportedly in the plan is fresh spending on, and tax breaks for, clean energy technologies, a potential demand boost for the clean tech sector which our analysts remain quite constructive on.
But funding that plan is several tax adjustments, including a potential implementation of a corporate book tax, which you can think of as a corporate minimum tax. This could exacerbate corporate margin pressures from inflation in the economic growth slowdown. So while the sectors we just discussed could be outperformers, they would likely do so against the backdrop of a bear market for equities overall. With Congress in session ahead of its August recess, we expect to learn more in the next couple of weeks, and we'll, of course, keep you in the loop.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As Europe continues to curtail Russian gas imports, equity markets are preparing for further downturn in European economic growth, but there may be more risks yet to be priced in.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly incidental to general coverage of the relevant Russian economic sector as germane to its overall financial outlook, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the two key issues that are dominating our current discussions with European equity clients, namely Russia gas supplies and the belated start to a new earnings downgrade cycle. It's Tuesday, July the 12th, at 2 p.m. in London.
Over the last few months, we have been arguing that a curtailment of Russia gas imports represented the biggest risk to European equities and the main catalyst to push us down to our bear case scenario. While we are not yet ready to formally change our bull, base, or bear case index targets, recent news flow does suggest that risks remain skewed to the downside, and we note a further 17% downside from here to our bear case price target for MSCI Europe.
Recent headlines about a reduction in Russia gas flows and the German government's move to level two of their emergency gas plan, has prompted our European economists to further lower their own GDP forecasts, and they now see a mild recession developing over the winter. However, with higher energy costs keeping inflation higher for longer, they make no changes to their European Central Bank forecasts and still expect European interest rates to move out of negative territory over the next few months.
We have been expecting an EPS downgrade cycle to start in the third quarter, even before the recent rise in concerns around Russian gas supplies. While the realization of this risk event would likely drive a materially larger hit to profits, we note that European earnings revisions have already turned negative over the last couple of weeks, i.e. we are now seeing more analysts lowering EPS estimates than raising them.
The sharp fall in equities over the last few months suggests that investors are already anticipating a sizable pullback in European profits. However, we do not think this means all of the bad news is already in the price. Rather, we note that a study of prior downturns suggests the stock markets tend to trough 2 to 3 weeks before earnings revisions bottom and that the minimum time duration between the start of a new downgrade cycle and this trough in earnings revisions is at least 3 months, but more often runs for over 6 months. In short, we are likely starting a 3 to 6 month earnings downgrade cycle and equities are unlikely to trough until we move towards the fourth quarter.
Within the market, we expect the more defensive sectors to continue to outperform over the next couple of months, given their traditionally lower level of earnings volatility into a recession. The recent move lower in bond yields should also encourage some reinvestment into quality and growth stocks, and we have just raised luxury goods to overweight on this theme. In addition, the luxury sector should be a key beneficiary of the recent upturn in investor sentiment towards China. Luxury has a greater exposure to the China consumer than any other European sector.
In contrast, we continue to recommend a more cautious stance on cyclicals, who don't traditionally start to outperform until the market itself troughs. Year to date, cyclical underperformance has been primarily driven by weakness in consumer facing stocks, reflecting the pressure on disposable income from high inflation. However, going forward, we expect to see greater underperformance from industrial cyclicals as weakness in end demand starts to move up the chain. These same companies are also likely to be the most adversely impacted by the disruption to Russia gas supplies, whether this be in terms of top line volumes, profit margins or both. For this reason, we are most cautious on stocks within the industrial, materials and autos sectors that also have a high degree of exposure to European end markets.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While stocks have recently rallied, the strength of the U.S. dollar has risen sharply over the past year, presenting a major potential headwind for equities in the coming earnings season.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 11th, at 11 a.m. in New York.
One of the more popular views over the past decade has been the eventual decline of the U.S. dollar. After all, with the Fed printing so many dollars since the global financial crisis and then doubling down during the COVID pandemic, this idea has merit. However, after the great financial crisis, these printed dollars never made it into the real economy, as they were simply used to patch up broken balance sheets from the housing bust. Therefore, money supply never got out of hand. In fact, during the entire period after the Fed first embarked on quantitative easing in November 2008 through the end of the cycle in March of 2020, money supply growth averaged only 6%, right in line with the long term trend of money supply and nominal GDP growth. As a result, the U.S. dollar maintained its reserve currency status and actually rose 40% during that decade.
However, as we pointed out back in April of 2020, the stimulus provided during COVID was very different. At the time, we suggested that the coordinated fiscal and monetary policy was unprecedented. The result is that money supply growth exploded and since February 2020 has averaged 17%, or three times a long term trend, a truly unprecedented outcome that left us with much more inflation than what was desired. Now, with the Fed reversing course so quickly and the checks having stopped long ago, money supply growth has fallen all the way back to its long term trend of just 6%. Given the projected path for rate hikes and quantitative tightening, money supply growth is likely to fall even further, and the dollar is unlikely to show any signs of decline until the Fed pivots. Such a pivot seems unlikely any time soon, especially after last week's strong jobs report.
So why does this matter so much for stocks? Based on the extreme rally so far this year, the U.S. dollar is now up 16% year over year. This is about as extreme as it gets historically speaking and unfortunately it typically coincides with financial stress on markets, a recession or both. For stocks the stronger dollar is also going to be a major headwind to earnings for many large multinationals. This could not be coming at a worse time as companies are already struggling with margin pressure from cost inflation, higher or unwanted inventories and slower demand. The simple math on S&P 500 earnings from currency is that for every percentage point increase in the dollar on a year over year basis, it's approximately a 0.5 hit to earnings per share growth. Of course, things can change quickly, but it doesn't seem likely until the path of inflation slows enough to warrant a Fed pivot.
The main point for equity investors is that this dollar strength is just another reason to think earnings revisions are coming down over the next few earnings seasons. Therefore, the recent rally is likely to fizzle out before too long.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
As investors in the internet industry have begun to wonder if online dating platforms will sink or swim in the case of a recession, looking back on the last recession may shed some light on a potential shelter from the storm.
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Welcome to Thoughts on the Market. I'm Lauren Schenk, Equity Analyst covering the small and mid-cap Internet Industry. Along with my colleagues, bringing you a variety of perspectives, I'll be giving some insight into consumer spending trends through the lens of online dating. It's Friday, July 8th, at noon in New York.
How does online dating perform in a recession?
Believe it or not, it's the number one question I've heard from investors over the last several weeks. And I think another way of getting at this question broadly, and you can really extrapolate this across many industries, is do consumers view a product as a necessary staple or as non-essential spending?
On one hand amid elevated inflation on indispensable items like gas and groceries, you may think consumers would view online dating as a nonessential item. On the other hand, finding love or a significant other ranks usually pretty high in most people's life goals, so maybe it's a staple.
So that's the question we sought to answer recently when we looked into how online dating platforms perform during a recession. To dig into this, we looked into some historical data from 2007-2010. What we found was that, for one online dating platform, subscriber growth was largely unaffected and actually accelerated slightly in 2008 and 2009. The net impact for this platform was a slight slowdown in organic revenue growth from low double digit growth in 2007, to mid-single digits in 2008 and 2009, and then accelerating to high teens by the end of 2010.
So overall, we found that the continued need for human connection, and the low price of online dating, resulted in minimal business impact during the global financial crisis, despite a significant pullback in consumer spending.
Looking at today, online dating has now become a more widely accepted service to a wider range of people. But how are things different from the last recession? Well, I'll share a few key differences from our research.
First, online is now a primary way for couples to meet, with the percentage of U.S. relationships starting online increasing from 22% in 2009 to 39% in 2017, which makes it more of a staple than discretionary.
Second, we believe there is greater pent up demand for the product today than in 2008 and 2009, given COVID. Which could better insulate online dating, since consumers may be less inclined to cut spending on services that were under consumed during the height of COVID.
Third, the top brands have changed and are now predominantly mobile based versus desktop, and attract a younger user who typically have a lower income than 40 plus year olds.
And finally, given the brand and geography shifts, a la carte revenue from things like profile boosting is a larger percentage of revenue today than during the global financial crisis, which may prove more discretionary than subscriptions.
How does this impact our view of how online dating could perform in a potential recession? Given the 2008-2009 results and the differing macro factors of a potential 2023 recession we have increased confidence in our view that online dating is one of the best consumer internet sub industries to weather a potential recession storm. After all, people still need love and relationships in recession and you can argue they need it more. And the low average monthly cost means it's likely not an item that single consumers would cut first.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As inflation continues to be a major concern for the U.S., investors will want to pay attention to how spending, travel and sentiment are changing for consumers.
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Welcome to Thoughts on the Market. I'm Michelle Weaver, a U.S. equity strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be sharing the pulse of the U.S. consumer right now amid elevated inflation and concerns about recession. It's Thursday, July 7th, at 2 p.m. in New York.
Consumer spending represents roughly 65% of total U.S. GDP. So if we're looking for a window into how U.S. companies could perform over the next 12 months, asking consumers how confident they're feeling is a great start. Are consumers planning on spending more next month or less? Are people making plans for outdoor activities and eating out or are they staying at home? Are they changing travel plans because of spending worries?
These are a few of the questions that the equity strategy team asks in a survey we conduct with the AlphaWise Group, the proprietary survey and data arm of Morgan Stanley Research. We recently decided to change the frequency of our survey to biweekly to get a closer look at the consumer trends that will affect our outlook. So today, I'm going to share a few notable takeaways from our last survey, which was right before the July 4th holiday.
First, let's take a look at sentiment. The survey found that inflation continues to be the top concern for two thirds of consumers, in line with two weeks before that, but significantly higher compared to the beginning of the year. Concern over the spread of COVID-19 continues to trend lower, with 25% of consumers listing it as their number one concern versus 32% last month. And 41% of consumers are worried about the political environment in the U.S. versus 38% two weeks ago, a slight tick up. Apart from inflation, low-income consumers are generally more worried about the inability to pay rent and other debts, while upper income consumers over index on concerns over investments, the political environment in the U.S., and geopolitical conflicts.
A second takeaway to note is that consumer confidence in the economy continues to weaken, with only 23% of consumers expecting the economy to get better. That's the lowest percentage since the inception of our survey and down another 3% from two weeks ago. In addition, 59% of consumers now expect the economy to get worse. This lines up with the all-time lows observed in a recent consumer sentiment survey from the University of Michigan.
A third takeaway is that consumers are planning to slow spending directly as a result of rising prices. 66% of consumers said they are planning to spend less over the next six months as a result of inflation. These numbers are influenced by income level, with lower income consumers planning to reduce spending more. We also asked consumers where they were planning to reduce spending in response to inflation. Dining out and take out, clothing and footwear, and leisure travel were among the most popular places to cut back, and all represent highly discretionary spending.
And finally, the survey noted that travel intentions are considerably lower to the same time last year, with 55% of consumers planning to travel over the next six months, versus roughly 64% in the summer of last year. We also asked consumers if they were planning to cancel or delay post-Labor Day travel because of inflation. Generally, planned travel post-Labor Day is in line with broader travel intentions. Cruises and international travel were the most likely to be delayed or postponed.
So what's the takeaway for investors? It is important to allocate selectively as consumer behavior shifts in order to cope with inflation and company earnings and margins come under pressure. Our team recommends defensive positioning, companies with high operational efficiency, and looking for idiosyncratic stories where companies have unique advantages.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As media reports indicate a possible tariff reduction on imports from China, some investors are wondering if this is signaling a return of modest trade barriers and unfettered investment between the U.S. and China.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, July 6th, at 1 p.m. in New York.
If media reports citing White House sources are to be believed, the U.S. is getting closer to reducing some tariffs on imports from China, motivated at least in part by trying to ease inflation pressures. This has prompted some investors to ask us if we think this is a signal that the U.S./China economic relationship is starting to head back toward what it was before 2018, where trade barriers between the two countries were modest, and U.S. corporate investment in China was largely unfettered. In short, we do not think this is the case and rather expect that the U.S. and China will continue on its current path of drawing up more barriers to commerce between them, particularly in the areas of new and emerging technologies.
Let's break it down. Consider that the scope of the tariff reductions being reported is quite small. One report, citing a Biden administration official, suggested tariffs could be reduced on about $10 billion worth of goods, a sliver of the $370 billion of goods currently under tariff. Given that taking away all the tariffs would only result in shaving a few tenths of a percent off consumer price index growth, this modest change, though reportedly intended to curb inflation, is unlikely to be a meaningful inflation fighter. That suggests the U.S. continues to prioritize its long term competition goals with China over inflation concerns, which is not surprising given continued skepticism among U.S. voters of both parties over the role of China in the global economy.
This leads to another important point, that tariff relief could counterintuitively accelerate U.S. policies that create commerce barriers with China. In line with our expectations, media reports suggest a tariff relief announcement could be paired with news of a fresh Section 301 investigation, which is the process to kick off a new round of tariffs that could be imposed on China. Again, this makes sense when accounting for the long term policy goals of the U.S., as well as the political considerations in a midterm election year.
So bottom line, don't read too much into tariff relief if it's announced. The U.S. and China are likely to continue drawing up barriers, and accordingly rewiring the global economy as companies shift supply chains and end market strategies. This is 'slowbalization' in motion, and it will continue to drive challenges, such as margin pressure for U.S. multinationals, and opportunities, such as for key sectors like semiconductor capital equipment companies benefiting from a new wave of geopolitical CapEx.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Original Release on June 16th, 2022: While many investors may be curious to know what other investors are thinking and feeling about markets, there’s a lot more to the calculation of investor sentiment than one might think.
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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research.
Jay Bacow: And on this episode of the podcast, we'll be discussing the path for both housing prices, housing activity and agency mortgages through the end of the year. It's Thursday, June 16th, at noon in New York.
Jay Bacow: Jim, it seems like every time we come on this podcast, there's another record in the housing market. And this time it's no different.
Jim Egan: Absolutely not. Home prices just set a new record, 20.6% year over year growth. They set a new month over month growth record. Affordability, when you combine that growth in home prices with the increase we've seen in mortgage rates, we've deteriorated more in the past 12 months than any year that we have on record. And a lot of that growth can be attributed to the fact that inventory levels are at their lowest level on record. Consumer attitudes toward buying homes are worse than they've been since 1982. That's not a record, but you get my point.
Jay Bacow: All right. So we're setting records for home prices. We're setting records for change in affordability. With all these broken records, investors are understandably a little worried that we might have another housing bubble. What do you think?
Jim Egan: Look, given the run up in housing in the 2000s and the fact that we,ve reset the record for the pace of home price growth, investors can be permitted a little anxiety. We do not think there is a bubble forming in the U.S. housing market. There are a number of reasons for that, two things I would highlight. First, the pre GFC run up in home prices, that was fueled by lax lending standards that really elevated demand to what we think were unsustainable levels. And that ultimately led to an incredible increase in defaults, where borrowers with risky mortgages were not able to refinance and their only real option at that point was foreclosures. This time around, lending standards have remained at the tight end of historical ranges, while supply has languished at all time lows. And that demand supply mismatch is what's driving this increase in prices this time around. The second reason, we talked about affordability deteriorating more over the past 12 months than any year on record. That hit from affordability is just not as widely spread as it has been in prior mortgage markets, largely because most mortgages today are fixed rate. We're not talking about adjustable rate mortgages where current homeowners can see their payments reset higher. This time around a majority of borrowers have fixed rate mortgages with very affordable payments. And so they don't see that affordability pressure. What they're more likely to experience is being locked in at current rates, much less likely to list their home for sale and exacerbating that historically tight inventory environment that we just talked about.
Jay Bacow: All right. So, you don't think we're going to have another housing bubble. Things aren't going to pop. So does that mean we're going to continue to set records?
Jim Egan: I wouldn't say that we're going to continue to set records from here. I think that home prices and housing activity are going to go their separate ways. Home prices will still grow, they're just going to grow at a slower pace. Home sales is where we are really going to see decreases. Those affordability pressures that we've talked about have already made themselves manifest in existing home sales, in purchase applications, in new home sales, which have seen the biggest drops. Those kinds of decreases, we think those are going to continue. That lack of inventory, the lack of foreclosures from what we believe have been very robust underwriting standards, that keeps home prices growing, even if at a slower pace. That record level we just talked about? That was 20.6% year over year. We think that slows to 10% by December of this year, 3% by December of 2023. But we're not talking about home prices falling and we're not talking about a bubble popping.
Jim Egan: But with that backdrop, Jay, you cover the agency mortgage backed securities markets, a large liquid way to invest in mortgages, how would you invest in this?
Jay Bacow: So, buying a home is generally the single largest investment for individuals, but you can scale that up in the agency mortgage market. It's an $8.5 trillion market where the government has underwritten the credit risk and that agency paper provides a pretty attractive way to get exposure to the housing outlook that you've described. If housing activity is going to slow, there's less supply to the market. That's just good for investors. And the recent concern around the Fed running off their balance sheet, combined with high inflation, has meant that the spread that you get for owning these bonds looks really attractive. It's well over 100 basis points on the mortgages that are getting produced today versus treasuries. It hasn't been over 100 basis points for as long as it has since the financial crisis. Jim, just in the same way that you don't think we're having another housing bubble, we don't think mortgages are supposed to be priced for financial crisis levels.
Jim Egan: Jay, thanks for taking the time to talk.
Jay Bacow: Great speaking with you, Jim.
Jim Egan: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
For the last decade investors have been focused on highflying growth stocks, but this investing environment may be the exception rather than the rule. Chief European Equity Strategist Graham Secker and Global Head of Quantitative Investment Strategies Research Stephan Kessler discuss.
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Graham Secker: Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist.
Stephan Kessler: I am Stephan Kessler, Global Head of Quantitative Investment Strategies Research.
Graham Secker: And on this special episode of the podcast, we'll be talking about the potential return of value investing post its decade long decline since the global financial crisis. It's Friday, July the 1st, at 10 a.m. in London.
Graham Secker: As most listeners of this particular podcast are probably aware, for much of the past decade, investors have had something of a love affair with the highflying growth stocks in the market. Meanwhile, their value priced counterparts, the shares of which tend to trade at relatively low price to earnings multiples and or offering higher dividend yields, have had a considerably rougher time of it. But I believe that the last decade is more the exception to the rule rather than the norm. And I think your analysis, Stephan, shows that this is true, yes?
Stephan Kessler: Yes, I agree. We have looked at the performance of value as an investment style back to the 1920s, and we find that the period between the end of the global financial crisis and the COVID pandemic was only the decade where value did underperform. For me, the why here is really an interesting question to pick apart, which you and I look at through two different lenses. You're the fundamental strategist and I'm the quantitative analyst. So I think my first question to you is, from your fundamental point of view, what were the main drivers of value’s underperformance during this lost decade?
Graham Secker: Yes. So from our perspective, we think there were two main drivers of values underperformance post the GFC. Firstly, a backdrop of low growth, low inflation and low and falling and negative interest rates, created a particularly problematic macro backdrop for value stocks. The former two factors were weighing on the relative profitability of value stocks, while the very low interest rates were actually boosting the PE ratio of longer duration growth stocks. This unpalatable macro backdrop then coincided with a challenging micro backdrop as the broad theme of disruption took hold across markets. This prompted greater hope among investors for the long term growth potential of the disruptors, while undermining the case for mean reversion across other areas of the market whereby cyclical slowdowns were often effectively viewed as structural declines. So, Stephan, you've said that the discount on value stocks cannot be explained fully by fundamentals or justified by the earnings overview. What do you believe are the deeper drivers for this discount?
Stephan Kessler: When you look at the value, it faced over the past few years, a range of challenges really. On the behavioral side, investors have focused on growth stocks and growth opportunities. This led to a substantial and persistent deviation of equities from their fair values and an underperformance of value investors. Next to this more behavioral argument, we find that the environmental, social and governance related aspects or in short, ESG and monetary policy were themes which drove price action. Equity value has a negative exposure to those themes. And finally, when you look at the 2020 period, there was a classical value trap situation. Companies which were most affected by the COVID pandemic sold off and appear cheap based on quite a range of value metrics, while the COVID catalyst continued to disrupt markets and led to companies which were cheaply valued not being able to recover as they had exposure to these disruptors. This only start to resolve in 2021, which is also when we start to see value regain performance. To get back to a more generalist view of the main drivers of values underperformance, I'd like to get back to you, Graham. You've observed a link between the macro and the micro, which created something of a vicious circle for value in the last cycle. Can you talk about how this situation looks going forward?
Graham Secker: Yes, going forward, we think this vicious cycle for value could actually turn to be something more of a virtuous cycle over the next few years. We argue that we've entered a new environment of higher inflation and associated with that higher nominal growth, and that drives a recovery in the profitability of these older economy type companies. And at the same time, a rising cost of capital undermines the case for the disruptors. And that can happen both in terms of lower valuations off the back of higher interest rates, but also as liquidity starts to subside, a lack of capital to fund their future business growth. Stephan, you mentioned two of these key disruptive forces, quantitative easing by the central banks and then the rise of ESG. Can you talk about the impact of these two elements on the equity investment landscape?
Stephan Kessler: ESG is a major theme in financial markets today, and in particular in this 2018-20 period we saw ESG positive names build up a premium, which made them appear expensive in the context of value metrics. These ESG valuation premia then turned out to be persistent and at times even grew. This then goes, of course, against value investors who try to benefit from this missed valuations mean reverting. And to the extent these valuations even turn stronger, that drove their losses. Quantitative easing is another aspect that drove price action. We find that value tends to underperform in time periods of low interest rates and does well in a rising rates environment. The economic driver behind this empirical observation is that the very low rates you saw in the past make proper valuations of firms difficult as discounted cash flow approaches are challenged. And so on the back of that, lower rates simply lead to valuation and value as signals being challenged and not properly priced. So given the historical narrative and all the forces at play during the past decade, what is your preference between value versus growth for the second half of 2022 and beyond that, Graham?
Graham Secker: Yes. So in the short term, a backdrop of continued high inflation and rising interest rates should we think continue to favor value over growth. However, perhaps right towards the end of this year, we do envisage a situation where that could reverse a little bit, albeit temporarily, once inflation has peaked and the economic downturn has materialized, investor attention may start to focus on rates no longer rising, and that will put a little bit of a bid back under the growth stocks again. But I think if we look longer term, actually, I'm beginning to think that what we'll see is the whole value versus growth debate actually becomes a bit more balanced and hence I can see more range bound relative performance thereafter. And Stephan, from your perspective, in a world of rising bond yields and lower or normalized QE, what is your outlook for value going forward, too?
Stephan Kessler: Well, when we look at the two catalysts for value underperformance, ESG and quantitative easing I mentioned earlier, we see that their grip on the market is loosening. For one, markets have moved into rates tightening cycle which means investors focus more on near-term cash flows rather than terminal value. This is a positive for value companies, which tend to well under such considerations. Furthermore, the dynamism of ESG themes has abated compared to the 18-20 period, leading to a lower effect on value. Another angle on this is also a look at the valuation of value as a style. It's quite cheap, so it's a good entry point. This leads to a positive outlook for value, but also for other styles. We like, particularly the combination of value and quality as it benefits from the attractive entry levels for value, as well as the defensiveness of an investment in quality shares.
Graham Secker: So to summarize from a fundamental and quantitative approach, both Stephan and I think that the extreme underperformance of value that we've seen over the prior decade has ended, value looks well-placed to return to its traditional outperformance trends going forward. Stephan, thanks for taking the time to talk today.
Stephan Kessler: Great speaking with you, Graham.
Graham Secker: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.
As the risks to international economic growth increase, global investors may find some good news in the Japanese equities market.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Morgan Stanley's Chief Asia and Emerging Markets Equity Strategist. Along with my colleagues, bringing you a variety of perspectives, today I'll be reflecting on a recent visit to Japan. It's Thursday, June the 30th, at 1 p.m. in London.
I spent two weeks in Tokyo meeting with a wide range of market participants and others. This trip came together as Japan opened up to business visitors and small groups of tourists, after a lengthy period of COVID related travel restrictions. Japan equities - currency hedged for the U.S. dollar based investor - are our top pick in global equities and have been doing well this year relative to other markets.
My first impression was how cheap prices in Japan now are at the current exchange rate of ¥135 to the U.S. dollar. For example, a simple metro journey in the inner core of Tokyo is priced at ¥140, so almost exactly $1 USD currently. It's possible to get a delicious lunchtime meal of teriyaki salmon, rice, pickles, miso soup and a soft drink in one of the numerous small cafes under the giant urban skyscrapers of the Central District of Marinucci for ¥1,000 or even lower. So that's about $6 to $7 USD currently.
We feel this competitive exchange rate bodes well for the major Japanese industrial, technology and pharmaceutical firms, which dominate the Japan equity market as they compete globally. Indeed, the currency at these levels is one of the reasons that earnings revisions estimates, by bottom up analysts covering these companies, continue to move higher. Unlike the overall situation in global equities currently.
In meetings, I was often asked whether we shared some of the concerns which have been voiced by some commentators on the Bank of Japan's monetary policy stance. The Monetary Policy Committee meeting for June was held during my trip, and the Bank of Japan kept its short term policy rate at -0.1% and also reiterated its pledge to guide the ten year government bond yield at +/- 25 basis points around a target of zero. Clearly, this monetary policy is divergent with trends elsewhere in the world currently and in particularly with the U.S. And this divergence is a key reason why the yen has been weakening this year.
We at Morgan Stanley feel strongly that this approach is the right one for Japan, for one key reason. Unlike the U.S., UK or other advanced economies, Japan's inflation rate remains in line with policy goals. Headline CPI inflation is running at just 2.5% year on year, while CPI ex food and energy is 0.8%. Japan does not have a breakout to the upside in wage inflation either. We also think BOJ Governor Kuroda-san was correct in identifying downside risks to international economic growth as a risk factor for Japan's own GDP growth going forward, which at the moment we think is likely to track at around 2% this year.
During our trip, we also spent time with investors discussing Japan Prime Minister Kishida-san's modifications to the policies of his two predecessors, in particular around a more redistributive approach to fiscal policy and digitalization of the public sector. The trend to greater corporate engagement with minority investors and activist investors was also debated. Japan is now the second largest market globally after the US for activist investor campaigns to promote corporate restructuring, thereby unlocking shareholder value.
For us. Ultimately, the proof of the pudding, and how the Japan story all comes together, is the trend in corporate return on equity for listed equities. This has risen from less than 5% on average in the 20 years prior to Abe-san's premiership to above 10% currently. And it's now converged with two key North Asian peers; China and Korea. With Japan equities trading at the low end of the valuation range for the last 10 years, below 12 x forward price to earnings multiple, we think it's a market which deserves more attention from global investors.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As legislators try to manage the U.S. and China’s economic relationship, outbound investors will want to keep tabs on potential policy coming down the pipeline.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, June 29th, at 10 a.m. in New York.
Washington, D.C., continues to focus on two areas of bipartisan concern: fighting inflation and managing the economic relationship with China. To that end, deliberations continue on legislation intended to reduce reliance on China supply chains for semiconductors and rare earth materials, as well as invest in research and development for emerging technologies. The Senate and House have both passed versions of this legislation, respectively called the USICA and the COMPETES Act. Now there's a conference committee deciding what's in the final bill. And here's where investors need to pay attention, because there continues to be news that this committee could end up including a provision that would limit U.S. companies ability to make business investments in, quote, unquote, countries of concern. If they do, it could create downside pressure for markets in China in the near term, and would underscore the secular trend we continue to focus on: "slowbalization", which creates both equity sector challenges and opportunities.
Consider that these outbound investment restrictions would mirror ones already in place for inbound investments through CFIUS. The Committee on Foreign Investment in the United States. In short, it could make it difficult for companies to, say, build a factory in China if the product or production process includes technology that the U.S. deems critical to its economic or national security. Some independent estimates suggest this could reduce foreign direct investment in China by as much as 40%.
This is classic slowbalization in motion, where policy choices are cutting against the cost benefits of globalization, driven by security concerns as we move toward a multipolar world; one with more than one political economy power base. And the level of disruption from this particular provision could create downward pressure on equity markets in China. It could also underscore current headwinds to U.S. markets, suggesting that many U.S. companies' margins will be pressured as they spend more in the future to diversify supply chains away from China. Of course, in line with our thesis of slowbalization, there's opportunity too. The CapEx needed to build these new supply chains has to go somewhere, and for example, semiconductor capital equipment companies could see a major up shift in demand.
So investors need to stay tuned to the deliberations on outbound investment restrictions. It's far from a done deal, to be clear, but a major policy development if it happens. While there's no timeline for when we will know if this provision is included, we recommend paying attention to the Biden administration's deliberations on China tariffs. If the administration decides to provide even just targeted and temporary tariff reductions, in an attempt to ease inflation pressures over the next couple of months, it might also feel compelled to, at the same time, announce new measures to demonstrate its continued seriousness about competing with China. An announcement of a legislative agreement on outbound investment restrictions could be one way to do this.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As the Fed continues with aggressive policy tightening, fixed income investors may be wondering if the bond market is accurately priced and when we might see it rally. Chief Cross-Asset Strategist Andrew Sheets and Director of Fixed Income Research Vishy Tirupattur discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Vishy Tirupattur: And I'm Vishy Tirupattur, Director of Fixed Income Research at Morgan Stanley.
Andrew Sheets: And today on the podcast, we'll be discussing the outlook for the U.S. bond markets. It's Tuesday, June 28th, at 9 a.m. in San Francisco.
Andrew Sheets: A note to our listeners, Vishy and I are recording this while we're on the road talking to clients, so if the audio quality sounds a little bit different, we hope you'll bear with us.
Andrew Sheets: So Vishy, this has been a historically volatile start to the year for U.S. fixed income. We've seen some of the largest bond market losses in 40 years. Before we get into our views going forward, maybe just give a little bit of perspective about how you see this year so far, and what's been driving the market.
Vishy Tirupattur: Andrew, what's been driving the market is the significant and substantial change in the monetary policy expectations, not only in the U.S. but also across most developed market economies. That means we started the year with the target Fed funds rate around close to 0%, and we have now ratcheted up quite significantly. And markets are already pricing in a further substantial increase in the Fed funds rate going forward. All this has meant that the duration sensitive parts of the bond market have taken it on the chin.
Andrew Sheets: So Vishy that's interesting because we might be seeing kind of a transition in the market narrative as we head in the second half. What do you think the bond market, especially the Treasury market, is currently pricing in terms of Fed expectations? And do you think the bond market is priced for a recession?
Vishy Tirupattur: I think bond market is sending some signals here. So the bond market is pricing that the Fed will continue to combat high inflation by being aggressively frontloaded in interest rate hikes. So this frontloading of the interest rate hikes means the front end of the Treasury curve perhaps has some more to go. And we expect that the end of the year, the two year Treasury will be at 4%. But on the other hand, the ten year Treasury, we expect the year at 350. That means the market is already beginning to become concerned about how growth and growth prospects for the U.S. economy will work out in the next 6 to 12 months. So by all measures we can look at the probability of a recession have significantly increased. That is what is being priced in the market at this point.
Andrew Sheets: You know, I think it's safe to say that the dominant story, right, to start the year has been these upside surprises to inflation and then central banks, including the Fed, racing to catch up to those upside inflation surprises. And yet it's really interesting the way that Chair Powell and the Fed are now describing the way they're going to react to inflation is to say that we will effectively keep tightening policy as long as inflation surprises to the upside. But isn't the Fed using a tool that works with a lag?
Vishy Tirupattur: That is absolutely correct Andrew. What the withdrawal of policy accommodation that the Fed is accomplishing through these frontloaded hikes is tightening of financial conditions. We have begun to see some effect of this tightening of financial conditions on the economic growth already. But in reality, the long experience suggest that these effects will be lagged anywhere between 6 to 18 months. So this is what our economists are thinking, given this frontloaded hiking path. We think the Fed will stop hiking towards the end of this year in December, and we will watch for how these tighter financial conditions will restrain aggregate demand and slow the growth or slow the U.S. economy over the course of the next 6, 12, 18 months.
Andrew Sheets: So Vishy, I'd like to move next into what all this means for our fixed income recommendations and to run through the major sectors of that market. So let's start with Treasuries. What do you see as our key views in the Treasury market? And where do you think we might differ the most from what's currently in market pricing?
Vishy Tirupattur: I think we are still neutral in taking duration risk at this point. I expect that in the not so distant future we would become constructive on taking interest rate risk to the Treasury market. So our expectation is that a year from now, so second quarter of next year, ten year Treasury will be at three or five.
Andrew Sheets: And Vishy, you know, we're in this environment where inflation is high and usually high inflation is bad for bonds. But growth is slowing, which is good for bonds. So, you know, given that push and pull, how do we think treasuries come out of that?
Vishy Tirupattur: I think Treasuries will come out pretty well out of this. Why I say that is that the bulk of the pain from aggressive monetary policy has already been felt and taken in the market. So going forward, our expectation is not for incrementally more aggressive policy pops to be priced, but actually something that is more or less in line with already what is priced in the market.
Andrew Sheets: Vishy, the next market I want to ask you about is the mortgage market. This is another huge part of the aggregate bond index. How do we think mortgages perform? Do we think they perform better or worse than the Treasury segment?
Vishy Tirupattur: So the mortgage market is interesting. We started the year with the the generic mortgage rate around 3%. It had gone up almost to 6%, more or less doubled over the course of the last six months or so. So embedded in the mortgage market is a mortgage spread, but around 130 basis points of nominal mortgage spread is nearly at an all time high. And we think that that means a lot of this expectation coming out of higher rates, a slowing of the housing market, is already well priced into the mortgage market. So my expectation is that going forward, the mortgage market, will outperform the treasury market over the course of the next 6 to 12 months.
Andrew Sheets: And Vishy, you know we talked about treasuries and we talked about mortgages and I probably can't ask you about those markets without also asking about quantitative tightening. The fact that the Fed has been big buyers, both Treasuries and mortgage bonds, and the Fed is going to stop doing that and is going to let its holdings of those securities roll off. So how important is that to the outlook for these markets? And is that quantitative tightening already in the price?
Vishy Tirupattur: So two things on this. There is something called a stock effect and the flow effect. We think the stock effect component of the quantitative tightening, both in the context of treasuries and in the context of NBS, is mostly priced in. The flow effect will begin to manifest itself as the quantitative tightening actually begins to happen and we see this portfolio rebalancing channel to actually materialize. All that means is that the portfolio managers that had been underweight mortgages and overweight credit. We think that will change in favor of mortgages going from underweight towards neutral and credit going from overweight towards neutral.
Andrew Sheets: So the last market I want to ask you about was the credit market, which is, I think, especially relevant given we've seen more market discussion of the risk to growth, the probability of a recession, the potential that defaults usually pick up during periods of weak economic growth. How do you see the outlook for corporate bonds fitting into this picture?
Vishy Tirupattur: So if you look at the corporate bond market, the good thing here is that compared to other points at the beginning of a rate hiking cycle, the fundamentals of corporate bond market are in really good shape. You can see that in terms of leverage, interest coverage, as well as cash and balance sheet metrics. So that's a good thing. The second thing is that the financing needs of many of these companies is not as imposing as would otherwise being the case. Take the high yield market, high yield market and the leveraged loan market together about 3 trillion outstanding market. Only 10% of this is due for refinancing over the course of this year, 2022, 2023 and 2024. That means the world of maturities being an imposing challenge for the credit markets is that much, well, manageable. But that said, there's one segment of the market that is more vulnerable to hiking to higher interest rates, and that is the leveraged loan market, which is a floating rate funding market. So we expect that this market will see its cost of financing increase as interest rates start to get ratcheted up. But the one point I want to make here is that in terms of expectations of default rates, we won't see a dramatic spike in default rates the way we have seen in the past recessions. So compared to 2008-2009 recession, the post-COVID recession, early 2000's recession, in all of those instances when we had an economic slowdown and a recession, we saw a spike in corporate default rates. Because of the starting point of fundamentally is so much better this time, our expectation is that we will not see dramatic spikes in default rates in the credit market.
Andrew Sheets: Vishy, thanks for taking the time to talk.
Vishy Tirupattur: Always a pleasure to talk to you, Andrew.
Andrew Sheets: Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
Talk of recession continues among investors and consumers alike, but last week saw a sharp rally in U.S. Equities. Is this just a blip or could U.S. equity markets rally further?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, June 27th, at 2 p.m. in New York. So let's get after it.
With talk of recession increasing sharply over the past few weeks, equity markets decided enough bad news had been priced and rallied sharply. Furthermore, the decline in both oil and interest rates helped ease some of the concerns on inflation. In our view, both the fall in oil and rates are being driven more by fears of an economic slowdown rather than a real peak in inflation and will lead to a more dovish Fed. However, with markets so oversold and bearishness pervasive, equity investors have taken the bullish view and rerated stocks higher.
Based on Friday's close, the S&P 500 is trading back at 16.3 times, or one turn higher than where it was at the prior week's lows. This seems unusual given the growing concern about earnings, however. In fact, even taking into account the fall in 10-year yields, the equity risk premium is back below 300 basis points. In our view, that makes little sense in the context of the likely negative earnings revisions coming in the second quarter reporting season and the rising risk of recession over the next 6 to 12 months.
Perhaps the best way to explain last week's rally has to do with the short-term rolling correlation between equities and real yields, which is now deeply negative again. This means the recent decline in bond yields has been perceived as positive for equities, something we think will prove to be incorrect if the falling yields are signaling slower growth or recession. For falling yields to be positive for equities at this stage, we would need to see cresting inflation pressures, a less hawkish Fed policy path, more durable economic growth than we expect, and a reacceleration in earnings revisions.
In addition to this combination of factors, which suggests a soft landing for the economy, we would also need to see limited negative revisions to earnings. Thus, we see the recent rebound in equities as another bear market rally on the path to fair value price levels of 3400-3500 in the case a soft landing is achieved with modest earnings revisions. However, as noted last week, a recession would bring tactical price lows closer to 3000 as earnings decline by at least 20% before working back to our June 2023 bear case target of 3350. In short, the bear market is likely not over, although it may feel like it over the next few weeks. Markets are likely to take the lower rates as a sign the Fed can orchestrate a soft landing and prevent a meaningful revision to earnings forecasts.
In that context, we think U.S. equity markets can rally further. In addition to lower rates and oil prices helping support the belief in a soft landing there is some equity demand from pension funds that need to rebalance at the end of the month and quarter this week. If retail investors join in like last week, that could carry equity prices higher before second quarter earnings season begins and the revisions arrive. Finally, a retracement of 38-50% of the entire decline would not be unnatural or out of line with prior bear market rallies, even ones associated with a recession at the end. In S&P 500 terms, that would translate into 4100-4200 or approximately 5-7% upside from Friday's close. Furthermore, if such a rally were to continue, it would likely be led by the longer duration or interest rate sensitive stocks like technology, or the Nasdaq.
However, we want to be clear that in no way are we suggesting the bear market is over or that earnings estimates won't have to come down. Instead, we are simply being realistic about the nature of bear markets and their ability to confound all market participants at times, even the bears. We suggest using equity market strength over the next few weeks to lighten up further on portfolios.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Original Release on June 9th, 2022: While many investors may be curious to know what other investors are thinking and feeling about markets, there’s a lot more to the calculation of investor sentiment than one might think.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, June 9th, at 6 p.m. in London.
I've found that investors are almost always interested in what other types of investors are doing. Some of this is curiosity, but a lot of it is interest in sentiment and a desire to try to quantify market emotion to give a better indicator of when to buy or sell.
One can find a variety of metrics that portend to reflect this investor mood. Many of them move in nice, big, oscillating waves between fear and greed. But as anyone trying to use them as encountered, investing based on sentiment is harder in theory than practice.
The first challenge, of course, is that there is little agreement in professional circles on exactly the best way to capture market emotion. Is it different responses to a regular investor survey? Is it the level of implied volatility in the market? Is it the flow of money in and out of different funds? The potential list goes on.
Next, once you have an indicator, what's the right threshold to establish if it's telling you something is extreme? If you poll a thousand investors every week, maybe 70% of those investors being negative tells you the mood is sufficiently sour. But maybe the magic number is 80%, or maybe it's 60%. Defining positive or negative sentiment isn't always straightforward.
Finally, there's the simple but important point that sometimes the crowd is right. Think of a long bull market like the 1990s. People were often optimistic about the stock market and correct to think so as prices kept rising. Meanwhile, people are often bearish in a bear market. We remember the dour mood that persisted throughout 2008. It certainly didn't stop stocks from going down.
With all of this in mind, our research is focused on finding some ways to use sentiment measures more effectively.
We think it makes sense to use a composite of different indicators, as true extremes are likely to show up across multiple approaches to measurement. Valuing both the level and direction of sentiment can be helpful. Rather than trying to catch an absolute extreme or market bottom, the best risk reward is often when sentiment is negative but improving. And sentiment is more useful to identify market lows than market peaks, as negativity and despair tend to be stronger, sharper emotions. Identifying peak optimism, at least in our work, is much harder. So don't beat yourself up if you can't find a signal that consistently flags market tops.
Those ideas underlie the tools that we've built to try to turn market sentiment into signals as the age old debate around the true state of fear and greed continues throughout this year.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
Inflation has continued to surprise to the upside, causing global central banks to face a difficult choice; continue to raise rates at the risk of recession, or settle in for a long spell of elevated inflation.
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist. Along with my colleagues, bringing you a variety of perspectives. Today, I'll be talking about the key challenges for central banks and particularly the European Central Bank. It's Thursday, June 23rd, at 3:30 p.m. in New York.
Just about all conversations these days involve high inflation and monetary policy tightening. It is tough all over. Central banks all have to make harder and harder choices as inflation keeps surprising to the upside. Take the Fed. They hiked 75 basis points at their last meeting. That was 25 basis points more than was priced in just a week before the meeting.
At the June European Central Bank meeting, President Lagarde also weighed in. She was clear about a 25 basis point hike in July and that the rate hike in September would be larger, presumably 50 basis points if the outlook for medium term inflation is still above target. Putting that simply, if the ECB does not lower its forecast for inflation in 2024, we should expect a 50 basis point hike in September.
A lower inflation forecast faces long odds. Headline inflation in Europe will be pushed around by commodity prices. Consider that European inflation is much more non-core, that is food and energy, than it is core inflation. And for core inflation, the ECB typically looks to economic growth as the key driver, but with about a one year lag. So their forecast for 2024 inflation is going to depend on their forecast for 2023 growth. And it's just very hard to see what data we are going to get by September that's going to meaningfully lower their forecast for 2023 growth. So now the ECB has joined the ranks of central banks that are hiking more and more with the goal of slowing inflation. But they have to face the dilemma that I wrote a few pieces about back in January.
At that point, I was discussing the Fed, but the same choice is there and it is stark— either cause a recession and bring inflation down in the near term or engineer a substantial slowdown, but one that is shy of a recession, and accept elevated inflation for years to come. You see, despite the typical lags of policy, if the ECB chose to engineer a recession right now, those effects would almost surely show through to growth by 2023, pulling down inflation in 2024.
So why are they making this choice? On the most simple level, no central banker really wants to cause a recession if they can avoid it. And remember that euro area inflation is now heavily driven by food and energy prices. Those noncore prices are only barely related to Euro area activity. It would take a severe recession in Europe to meaningfully drive down noncore prices. And finally, reports are swirling of a new tool to ward off fragmentation in European markets. If we get a hard crash of the economy, that by itself could precipitate the market fragmentation that they're trying to avoid.
So what happens next? The Governing Council is on a hiking cycle, but they want a soft landing. The problem is that we are more pessimistic than they are about Euro Area growth starting as soon as the second half of this year. With inflation currently high and their commitment to tightening to fight that inflation, we might not get the clear signals of a slowdown in the economy before it's too late.
The ECB might think it is choosing the more benign path but if our forecasts are right, the risks of them hiking into a recession, even inadvertently, are clearly rising.
Thanks for listening. If you enjoy this show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As inflation remains top of mind from Wall Street to the White House, policy makers continue to propose possible actions to fight inflation, but will these proposals ever be enacted?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, June 22nd, at 10 a.m. in New York.
Main Street and Wall Street agree that inflation is a problem. And of course, Washington, DC continues to take notice. The White House and Democratic leadership continues to press publicly that they're taking inflation seriously and pursuing a variety of options to slow rising prices in the economy. This includes today's news that the White House is endorsing a plan for a gas tax holiday, which would need congressional approval. Not surprisingly, then, investors have been asking us a lot lately about policy options that have been floated in news headlines as possible inflation fighters. In short, we think many proposals will remain simply that, proposals, keeping pressure on the Fed to be the inflation fighter.
Why won't most proposals be enacted? Simply put, most options on the table can't get enough votes in Congress to be enacted due to political concerns, effectiveness concerns, and sometimes both. Take the gas tax holiday proposal. Key Republican senators have already voiced opposition to the move, as have moderates in the Democratic caucus, on concerns that the holiday would have only a limited impact on prices at the pump, while steering money away from infrastructure maintenance.
Accordingly, you might see the administration take some actions on its own. For example, there have been many headlines about the White House considering easing tariffs on imports from China. But in our view, any tariff reduction is likely to be temporary and small in scope, focusing on a subset of consumer goods rather than blanket tariff reductions, as administration is likely reticent to do too much on tariff reduction without a reciprocal concession from China. Given that independent economists estimate that a blanket tariff removal would only reduce inflation by a few tenths of a percent, this smaller scale action would not meaningfully impact key inflation measures like CPI.
So that means the Fed remains the main inflation fighter in DC. And fight they will, in the view of our economists, who expect they will hike rates another 2% over the balance of this year in order to curb economic activity. For investors, that means a higher chance of recession, and in the view of our U.S. equity strategy team, some remaining downside for stock prices in the near term.
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As price to earnings multiples fall and inflation continues to weigh on the economy, long term earnings estimates may still be too high as the risk of a recession rises.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, June 21st at 11 a.m. in New York. So let's get after it.
Coming into the year, we had a very out of consensus view that valuations would fall at least 20% due to rising interest rates and tighter monetary policy from the Fed. We also believed earnings were at risk, given payback and demand, rising costs and inventory. With price to earnings multiples falling by 28% year to date, the de-rating process is no longer much of a call, nor is it out of consensus. Having said that, many others are still assuming much higher price to earnings multiples for year end S&P 500 price targets. In contrast, we have lowered our price to earnings targets even further as 10 year U.S. Treasury yields have exceeded our expectations to the upside. In short, the price to earnings multiple should still fall towards 14x, assuming Treasury yields and earnings estimates remain stable. Of course, these are big assumptions.
At this point, a recession is no longer just a tail risk given the Fed's predicament with inflation. Indeed, this is the essence of our fire and ice narrative - the Fed having to tighten into a slowdown or worse. Our bear case for this year always assumed a recessionary outcome, but the odds were just 20%. Now they're closer to 35%, according to our economists. We would probably err a bit higher given our more negative view on the consumer and corporate profitability. From a market standpoint, this is just another reason why we think the equity risk premium could far exceed our fair value estimate of 370 basis points. Of course, the 10 year Treasury yield will not be static in a recession either, and would likely fall considerably if growth expectations plunge. For example, the equity risk premium exceeded 600 basis points during the last two recessions. We appreciate that the next recession is unlikely to be accompanied by a crisis like the housing bust in 2008, or a pandemic in 2020. Therefore, we're willing to accept a lower upside target of 500 basis points should a recession come to pass.
Should the risk of recession increase to the point where it becomes the market's base case, it would also come alongside a much lower earnings per share forecast. In other words, a recession would imply a much lower trough for the S&P 500 of approximately 3000 rather than our base case of 3400 we've been using lately.
As of Friday's close, our negative view is not nearly as fat of a pitch, with so much of the street now in our camp on both financial conditions and growth. Having said that, the upside is quite limited as well, making the near-term a bit of a gamble. Equity markets are very oversold, but they can stay oversold until market participants feel like the risk of recession has been extinguished or at least reduced considerably. We do not see that outcome in the near term. However, we can't rule it out either and appreciate that markets can be quite fickle in the short term on both the downside and the upside. What we can say with more certainty today versus a few months ago is that earnings estimates are too high, even in the event a recession is avoided. Our base case 3400 near-term downside target accounts for the kind of earnings risk we envision in the event a soft landing is accomplished.
For us, the end game remains the same. We see a poor risk reward over the next 3 to 6 months, with recession risk rising in the face of very stubborn inflation readings. Valuations are closer to fair at this point, but hardly a bargain if earnings are likely to come down or a recession is coming. While investors have suffered quite a setback this year, we can't yet get bullish for more than just a bear market rally until recession arrives or the risk of one falls materially. At the stock level, we continue to favor late cycle defensives and companies with high operational efficiency.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
With so much going on in markets, some moves that may have been hot topics against a less chaotic backdrop, such as policy shifts towards shrinking central bank balance sheets, are hitting the back burner.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, June 17th, at 2 p.m. in London.
There is so much going on in markets that events that would usually dominate discussions find themselves relegated. You'll emerge from an investor meeting having discussed everything from Fed policy to China's COVID response, and realize there was no time for a discussion of, say, the situation in Japan where the yen has just seen one of its sharpest declines in the last 30 years.
I think that applies, in a notable way, to the conversation around central bank balance sheets. For much of the last decade, the bond buying of central banks, also known as quantitative easing, was the dominant market story. That buying is now reversing with the balance sheet of central banks in the U.S., Euro area, the UK and Japan, set to shrink by about $4 trillion between now and the end of 2023. And yet, with so much else going on, this quantitative tightening really feels like it's taking a backseat.
One reason is that while the size of this balance sheet reduction is large, it is, for the moment, looking like it will be quite predictable, with central banks stating that these reductions will happen in a regular manner, almost regardless of market conditions. That's in sharp contrast to the situation in interest rates, where central bank policy has been rapidly changing, much less predictable and very dependent on incoming data.
We were reminded of this again on Wednesday, when the Federal Reserve decided to raise interest rates by 75 basis points, on top of the 50 basis point rise they executed last month. In the press conference that followed Chair Powell emphasized how important incoming data would be in shaping further interest rate decisions. With every data point potentially shifting the near-term interest rate outlook, the steady decline of the balance sheet all of a sudden becomes less pressing.
There is also a legitimate question of how much central bank bond purchases mattered in the first place. There's a whole branch of statistics designed to test how much of the variance of one thing, like stock prices, can be explained by changes in another thing, like central bank balance sheets. When we put the data through these rigorous tests, most of the stock market moves over the last 12 years are explained by factors other than the central bank balance sheet.
And one final piece of trivia; bond prices have tended to do worse when Fed bond holdings were rising, and better when bond holdings were shrinking. That might sound counterintuitive, but consider the following. Quantitative easing usually began when the economy was weak and bond prices were already high, while quantitative tightening has occurred when the economy was strong and bond prices were already lower. It's just one more example that the balance sheet is one of many factors driving cross-asset performance.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
With home prices hitting new highs and inventory hitting new lows, the differences between now and the last housing bubble may help ease investors' worries that the market is about to burst. Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.
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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research.
Jay Bacow: And on this episode of the podcast, we'll be discussing the path for both housing prices, housing activity and agency mortgages through the end of the year. It's Thursday, June 16th, at noon in New York.
Jay Bacow: Jim, it seems like every time we come on this podcast, there's another record in the housing market. And this time it's no different.
Jim Egan: Absolutely not. Home prices just set a new record, 20.6% year over year growth. They set a new month over month growth record. Affordability, when you combine that growth in home prices with the increase we've seen in mortgage rates, we've deteriorated more in the past 12 months than any year that we have on record. And a lot of that growth can be attributed to the fact that inventory levels are at their lowest level on record. Consumer attitudes toward buying homes are worse than they've been since 1982. That's not a record, but you get my point.
Jay Bacow: All right. So we're setting records for home prices. We're setting records for change in affordability. With all these broken records, investors are understandably a little worried that we might have another housing bubble. What do you think?
Jim Egan: Look, given the run up in housing in the 2000s and the fact that we,ve reset the record for the pace of home price growth, investors can be permitted a little anxiety. We do not think there is a bubble forming in the U.S. housing market. There are a number of reasons for that, two things I would highlight. First, the pre GFC run up in home prices, that was fueled by lax lending standards that really elevated demand to what we think were unsustainable levels. And that ultimately led to an incredible increase in defaults, where borrowers with risky mortgages were not able to refinance and their only real option at that point was foreclosures. This time around, lending standards have remained at the tight end of historical ranges, while supply has languished at all time lows. And that demand supply mismatch is what's driving this increase in prices this time around. The second reason, we talked about affordability deteriorating more over the past 12 months than any year on record. That hit from affordability is just not as widely spread as it has been in prior mortgage markets, largely because most mortgages today are fixed rate. We're not talking about adjustable rate mortgages where current homeowners can see their payments reset higher. This time around a majority of borrowers have fixed rate mortgages with very affordable payments. And so they don't see that affordability pressure. What they're more likely to experience is being locked in at current rates, much less likely to list their home for sale and exacerbating that historically tight inventory environment that we just talked about.
Jay Bacow: All right. So, you don't think we're going to have another housing bubble. Things aren't going to pop. So does that mean we're going to continue to set records?
Jim Egan: I wouldn't say that we're going to continue to set records from here. I think that home prices and housing activity are going to go their separate ways. Home prices will still grow, they're just going to grow at a slower pace. Home sales is where we are really going to see decreases. Those affordability pressures that we've talked about have already made themselves manifest in existing home sales, in purchase applications, in new home sales, which have seen the biggest drops. Those kinds of decreases, we think those are going to continue. That lack of inventory, the lack of foreclosures from what we believe have been very robust underwriting standards, that keeps home prices growing, even if at a slower pace. That record level we just talked about? That was 20.6% year over year. We think that slows to 10% by December of this year, 3% by December of 2023. But we're not talking about home prices falling and we're not talking about a bubble popping.
Jim Egan: But with that backdrop, Jay, you cover the agency mortgage backed securities markets, a large liquid way to invest in mortgages, how would you invest in this?
Jay Bacow: So, buying a home is generally the single largest investment for individuals, but you can scale that up in the agency mortgage market. It's an $8.5 trillion market where the government has underwritten the credit risk and that agency paper provides a pretty attractive way to get exposure to the housing outlook that you've described. If housing activity is going to slow, there's less supply to the market. That's just good for investors. And the recent concern around the Fed running off their balance sheet, combined with high inflation, has meant that the spread that you get for owning these bonds looks really attractive. It's well over 100 basis points on the mortgages that are getting produced today versus treasuries. It hasn't been over 100 basis points for as long as it has since the financial crisis. Jim, just in the same way that you don't think we're having another housing bubble, we don't think mortgages are supposed to be priced for financial crisis levels.
Jim Egan: Jay, thanks for taking the time to talk.
Jay Bacow: Great speaking with you, Jim.
Jim Egan: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
With concern high over inflation and tightening Fed policy, investors looking for practical solutions may want to take another look at the municipal bond market.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, June 15th, at 10 a.m. in New York.
It's been a tough few days for markets. With last week's inflation data showing yet another surprisingly high reading, both stock and bond markets have been selling off. The concern is that the Fed may have to get more aggressive in hiking rates in order to bring inflation under control. That would mean slower economic growth, which is a challenge for companies and stocks, and higher interest rates, which needs to be reflected in lower bond prices and higher bond yields. Understandably, investors are looking for practical solutions.
One place we continue to favor is the muni bond market. It's been a volatile performer this year, and it's true that recently bonds haven't been a haven from broader market volatility. And that bumpy performance could go on a bit longer for munis as bond yields rise to price in a more aggressive Fed path. But that should change once the Fed's intentions are better understood. Plus, the coupons of most munis are tax exempt, something that provides extra value for investors who are keeping an eye on developments in Washington, D.C., where negotiations are gaining momentum on a package to raise taxes, to pay for investments in clean energy, health care and paying down the national debt. This means an already solid taxable equivalent yield of over 5% for investors in the top tax bracket, could improve further if D.C. acts to hike taxes.
Of course, the rising recession risk from the Fed raising rates may have you concerned about muni credit quality, but in our view muni credit should be quite durable even if there is a recession. By our calculation, muni sectors got more federal aid than they needed to deal with the impacts of COVID, and the sharp economic recovery since then had mostly returned muni business activity and revenue growth to pre-COVID or better levels. And even if inflation persists, history suggests this shouldn't be a system wide credit challenge. Sure, municipalities' costs will go higher, but so would their revenues.
So putting it together, bonds are probably a decent spot for investors to shelter during this volatility, and we think munis stand out among your bond options.
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As central bank policy across the globe shifts from tight fiscal policy to tight monetary policy, the rising cost of capital will have long-term consequences for investors.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives. I'll be talking about the rising cost of capital and its implications for European equities. It's Tuesday, June the 14th, at 2 p.m. in London.
As we have discussed previously, we believe that we have witnessed a paradigm shift in the macro and market backdrops over the past couple of years, swapping the secular stagnation of the last decade with a new cycle where nominal growth is both higher and more volatile.
An alternative way to think about this is that the policy dynamic has shifted from an environment of loose monetary and tight fiscal policy over the last two decades, to one of looser fiscal policy, but tighter monetary policy today. If this characterization proves to be true over the coming years, the longer term consequences for investors will be profound.
While this may sound somewhat grandiose, it is worth noting that global interest rates fell to a record low in this last cycle. From such an unprecedented low, even a moderate increase in borrowing costs may feel significant, and we note that we have just witnessed the largest 2 year increase in 10 year U.S. Treasury yields since the early 1980s.
The fact that we are starting a new and relatively fast rate hiking cycle, at the same time as central banks are shifting from quantitative easing to quantitative tightening, further magnifies the risk for spread products such as credit or peripheral debt, both of which have underperformed materially over the last couple of months. At this stage, we think it is this dynamic that is arguably weighing most on equity markets rather than the economic impact of higher borrowing costs.
When thinking through the investment implications for European equity markets of this rise in the cost of capital, we make three points in ascending order of impact.
First, the consequences of higher borrowing costs are likely to produce a relatively small hit to corporate profits. While we are concerned about a significant decline in corporate margins over the coming quarters, this is predominantly due to higher raw material prices and rising labor costs. In contrast, even a doubling of the effective interest rate on corporate debt should only take around 2.5% off of total European earnings.
Second, we see a more significant impact from higher capital costs on equity valuations, as price to earnings ratios have exhibited a close negative correlation to both central bank policy rates and credit spreads over time. Hence, while European equity valuations are now beginning to look reasonably attractive after their decline this year, we think risks remain skewed to the downside over the summer, given a tricky backdrop of slowing growth, high and sticky inflation and hawkish central banks.
Finally, the most significant impact from higher borrowing costs will, as ever, be felt by those entities that are most levered or require access to fresh funding. At this stage, we do not expect the ongoing increase in funding costs to generate a broader systemic shock across markets. However, we do see ample scope for idiosyncratic issues to emerge in the months ahead. Logically, identifying these issues in advance primarily requires due diligence at the stock level. However, from a top down perspective, the European sectors that are most correlated to credit spreads, and or have the weakest balance sheets, include autos, banks, consumer services, food retailing, insurance, telecoms and utilities.
Ultimately, the volatility within asset markets that will accompany the largest upward shift in the cost of capital in over 30 years will create lots of opportunities for investors. However, for now, we recommend patience and await a better entry point later in the year.
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With consumer sentiment hitting an all time low due to inflation concerns, the question investors should be asking is, are these risks to the economy properly priced into the market?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, June 13th, at 11 a.m. in New York. So let's get after it.
Over time, the lion's share of stock returns is determined by earnings growth if one assumes that valuations are relatively stable. However, valuations are not stable and often hard to predict. In our experience, most investors don't spend nearly as much time trying to predict multiples as they do earnings. This is probably because it's hard to do consistently, and there are so many methodologies it's often difficult to know if you are using the right one. For equity strategists, predicting valuations is core to the job, so we spend a lot of time on it.
Our methodology is fairly simple. There are just two components to our method; 10 year Treasury yields and the equity risk premium.
At the end of last year, we argued the P/E at 21x was too high. From our vantage point, both ten year Treasury yields and the equity risk premium appeared to be mispriced. Treasury yields are more levered to inflation expectations and Fed policy. At year end 10 year Treasuries did not properly reflect the risk of higher inflation or the Fed's reaction to it. Today, we would argue it's not the case. In fact, 10 year Treasury yields may be pricing too much Fed tightening if growth continues to erode and recession risks increase further.
In contrast to Treasury yields, the equity risk premium is largely a reflection of growth expectations. When growth is accelerating, the equity risk premium tends to be lower and vice versa. At year end, the equity risk premium is 315 basis points, well below the average of 375 basis points over the past 15 years. In short, the equity risk remaining was not reflecting the rising risks to growth that we expected coming into this year. Fast forward to today and the equity risk premium is even lower at just 300 basis points. Given the rising risk of slowing growth in earnings, this part of the price earnings ratio seems more mispriced today than 6 months ago. At the end of the day, we think 3400 represents a much better level of support for the S&P 500 and an area we would consider getting bullish.
Last Friday, consumer sentiment in the U.S. hit an all time low due largely to concerns inflation is here to stay. This has been one of our greatest concerns this year with respect to demand and one of the areas we received the most pushback. We continually hear from many clients that the consumer is in such great shape due to the excess savings still available in checking accounts. However, this view does not take into account savings in stocks, bonds, cryptocurrencies and other assets, which are down significantly this year. Furthermore, while most consumers have more cash on hand than pre-COVID, that cash just isn't going as far as it used to, and that is likely to restrain discretionary spending.
Finally, we think it's important to point out that the latest reading is the lowest on record, and 45% lower than during the last time the Fed embarked on such an aggressive tightening campaign, and was able to orchestrate a soft landing. In other words, the consumer was in much better shape back then, and that probably helped the economy to stabilize and avoid a recession. Let's also keep in mind that inflation was dormant in 1994 relative to today and allowed the Fed to pause, a luxury they clearly do not have now given Friday's red hot Consumer Price Index report.
Bottom line, the drop in sentiment not only poses a risk to the economy and market from a demand standpoint, but coupled with Friday's CPI print keeps the Fed on a hawkish path to fight inflation. In such an environment, we continue to recommend equity investors keep a defensive bias with overweighting utilities, health care and REITs until the price or earnings expectations come down further.
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As inflation continues to rise beyond expectations, the Fed is set to meet next week, leaving markets to wonder if an acceleration in rate hikes might be in store this summer.
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Welcome to Thoughts on the Market. I'm Robert Rosner, Senior U.S. Economist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about this morning's inflation data and how that may impact Fed discussions at next week's FOMC meeting. It's Friday, June 10th, at 2 p.m. in New York.
This morning, we received the Consumer Price Index data for May that showed a faster than anticipated increase in both headline and core inflation. Inflation continues to be lifted by high food and energy prices, and the combination of the two have pushed inflation up to a new high on a year over year basis, to. 8.6%. That rise in inflation reflects not just gains in food and energy prices, but extremely broad based increases under the surface, with core goods prices continuing to reaccelerate and core services prices also remaining strong, reflecting continued upside in travel related airfares and hotels. While other factors like rents and owners' equivalent rents both jumped. Rents in particular posted their fastest sequential month on month pace of increase since 1987.
That's really impo the Fed next week because this sets a tone of inflation that remains very elevated as the Fed sits down to discuss its policy. Moreover, many, including ourselves, had been expecting that the peak for inflation on a year over year basis would have been registered back in March. But today's data showed that CPI has reached a new high on a year over year basis. That raises uncertainty about the outlook for inflation. And Fed policymakers have expressed some concern about the possibility for some underlying reacceleration in inflation.
We also saw at the same time that data from the University of Michigan Survey of Consumer Sentiment showed that both short and longer term household expectations for inflation have been on the rise. So the risks around inflation remain high, and as the Fed sits down next week policymakers are likely to see inflation as remaining a top of mind topic.
We have been expecting the Fed to pursue a series of 50 basis point rate hikes as the FOMC seeks to tighten financial conditions in order to slow demand and eventually slow inflation. And markets after the inflation data moved very quickly to price in an even more hawkish path for Fed policy, with some risk that a 50 basis point rate hike might not be enough and that there might be some chance that the Fed could deliver a 75 basis point rate hike at some point over the summer.
We'll hear from policymakers next week as to whether or not an acceleration in the pace of rate hikes is something that they see as an attractive option. But the bottom line here is the Fed's work is far from done. Inflation remains high, incoming data suggests that growth has moderated, but has not slowed enough to feel confident that inflation is likely to follow. It's going to be a tricky summer for Fed policymakers, and a tricky summer for data watchers as well, because each incremental inflation data point is likely to inform how Fed policymakers are likely to react and what that path for rate hikes is likely to look like over the summer and into the fall.
Thank you for listening. If you enjoy the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or colleague today.
While many investors may be curious to know what other investors are thinking about current and future market trends, there’s a lot more to the calculation of investor sentiment than one might think.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, June 9th, at 6 p.m. in London.
I've found that investors are almost always interested in what other types of investors are doing. Some of this is curiosity, but a lot of it is interest in sentiment and a desire to try to quantify market emotion to give a better indicator of when to buy or sell.
One can find a variety of metrics that portend to reflect this investor mood. Many of them move in nice, big, oscillating waves between fear and greed. But as anyone trying to use them as encountered, investing based on sentiment is harder in theory than practice.
The first challenge, of course, is that there is little agreement in professional circles on exactly the best way to capture market emotion. Is it different responses to a regular investor survey? Is it the level of implied volatility in the market? Is it the flow of money in and out of different funds? The potential list goes on.
Next, once you have an indicator, what's the right threshold to establish if it's telling you something is extreme? If you poll a thousand investors every week, maybe 70% of those investors being negative tells you the mood is sufficiently sour. But maybe the magic number is 80%, or maybe it's 60%. Defining positive or negative sentiment isn't always straightforward.
Finally, there's the simple but important point that sometimes the crowd is right. Think of a long bull market like the 1990s. People were often optimistic about the stock market and correct to think so as prices kept rising. Meanwhile, people are often bearish in a bear market. We remember the dour mood that persisted throughout 2008. It certainly didn't stop stocks from going down.
With all of this in mind, our research is focused on finding some ways to use sentiment measures more effectively.
We think it makes sense to use a composite of different indicators, as true extremes are likely to show up across multiple approaches to measurement. Valuing both the level and direction of sentiment can be helpful. Rather than trying to catch an absolute extreme or market bottom, the best risk reward is often when sentiment is negative but improving. And sentiment is more useful to identify market lows than market peaks, as negativity and despair tend to be stronger, sharper emotions. Identifying peak optimism, at least in our work, is much harder. So don't beat yourself up if you can't find a signal that consistently flags market tops.
Those ideas underlie the tools that we've built to try to turn market sentiment into signals as the age old debate around the true state of fear and greed continues throughout this year.
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Under the combined stresses of dry weather, COVID, and the Russian invasion of Ukraine, agricultural prices are spiking, and many countries are scrambling to combat the consequences to the global economy. Morgan Stanley Chief Global Economist Seth Carpenter explains.
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Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll be talking about the surge in agricultural prices and some of the implications for the global economy. It's Wednesday, June 8th, at 1:30 p.m. in New York.
Agricultural prices have jumped this year, and that surge has become one of the key topics of the moment, both on a domestic level and a global scale. The Russian invasion of Ukraine clearly contributed significantly to the runup in prices, but even before the war, dry weather and COVID-19 had already started to threaten the global food supply. Rising food prices pose many risks, particularly for lower income people and lower income countries. Even though I'm going to be talking mostly about cold economics today, the human toll of all of this is absolutely critical to keep in mind. In fact, we see the surge in food prices as a risk to the global economic recovery. When prices for necessities like food go up, lower income households just have to spend more on food. And that increased spending on food means they've got less money to spend on discretionary items.
To put some numbers on how we got here, global food prices have surged about 66% since the start of COVID-19, and about 12% since the start of the Russian invasion of Ukraine. Dry weather had already affected crops, especially in Latin America and India. And remember, fertilizer is tightly linked to the petrochemical industry, and the Russian invasion of Ukraine has complicated that situation, leaving fertilizer prices at all time highs.
So what's been the response? Governments across developed markets and emerging markets have started enacting measures to try to contain their domestic prices. In the developed market world, these measures include attempts to boost domestic production so as to relieve some of the pressures. While in EM, some governments have opted to cut food taxes or put in place price controls. In addition, some governments have also imposed bans on exports of certain agricultural products. The side effect, though, is getting more trade disruptions in already tight commodity markets.
Against this backdrop, there are two key consequences. First, consumption spending is likely to be lower than it would have been. And second, inflation is likely to rise because of the rise in food prices. And if we look at it across the globe, emerging markets really look more vulnerable to these shocks than developed markets.
First, in terms of consumption spending, our estimates suggest that the recent rise in food prices might decrease real consumption spending throughout this year by about 1% in the U.S. and about 3% in Mexico, all else equal. Now, that said, not every component of spending gets affected uniformly. Historical data analysis suggests that the drop is heavily focused in durable goods spending, like for motor vehicles. And EMs are more exposed because they've got a higher share of food consumption in their overall consumption basket.
Now, when it comes to inflation, we think that the recent spike in food prices, if it lasts for the rest of this year, it's probably going to add about 1.2 percentage points to headline Consumer Price Index inflation in emerging markets, and about 6/10 of a percentage point increase to inflation in DM. These are really big increases. Now why should the inflationary push be higher in emerging markets? First, just arithmetically, food represents a larger share of CPI in emerging markets than it does in DM, something like 24% versus 17%. And second, in emerging markets, inflation expectations tend to be less well anchored, and so a rise in prices in a critical component like food tends to spread out to lots of other components in inflation as well.
So what's the bottom line here? Growth is slowing globally. Inflation is high. The surge in food prices is going to increase the risks for both of those.
Thanks for listening. If you enjoy this show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.
As some provisions of the Tax Cuts and Jobs Act start to kick in and others are set to expire, the future of U.S. tax rates may hinge on the results of the upcoming midterm elections. Head of U.S. Public Policy Research and Municipal Strategy Michael Zezas and Head of Global Valuation, Accounting and Tax Todd Castagno discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of U.S. Public Policy Research and Municipal Strategy for Morgan Stanley.
Todd Castagno: And I'm Todd Castagno, Head of Global Valuation, Accounting and Tax for Morgan Stanley Research.
Michael Zezas: And on this special edition of the podcast, we'll be talking about the 2022 U.S. midterm elections and the potential impact on individual and corporate taxes. It's Tuesday, June 7th, at 10:00 AM in New York.
Michael Zezas: If you're a regular listener, you may have heard my conversation with our chief U.S. Economist, Ellen Zentner, last week about the economic implications of this year's midterm elections. This week, Todd Castagno and I are going to continue the midterm election topic because individual and corporate taxes could be set to increase starting this year. But the question is how high, when and what the impact from the election could be. So, Todd, you and I have talked about this and we agree that taxes are likely headed higher for both individuals and corporations. Maybe you can tell us why that is.
Todd Castagno: Thanks, Michael. And it's really a driving function of how the Tax Cuts and Jobs Act was passed. And that's because Congress used the budget reconciliation legislation, which is primarily temporary. So, for instance, the individual provisions generally all expire at the end of 2025. And business tax increases have already started to phase in this year. So extension of the status quo for both businesses and individuals really is a function of the political landscape heading into midterms and then the next presidential election.
Michael Zezas: Okay. So let's start with the individual taxes. Maybe you can name some provisions set to expire and what the changes would be.
Todd Castagno: So Michael, let's first provide an overview of what the Tax Cuts and Jobs Act did for individuals. First, it reduced individual tax rates. Second, it almost doubled the standard deduction, meaning fewer taxpayers require itemized deductions. It provided a generous 20% deduction for small businesses, and pass-through businesses. It provided a much more generous child tax care credit, that's also refundable. And then the alternative minimum tax was reduced, so fewer taxpayers were caught in that tax. All these provisions are set to expire at the end of 2025 if Congress does not act.
Michael Zezas: Let's shift over to corporate taxes. The Tax Cuts and Jobs Act lowered the corporate tax rate to 21% in 2017. Is there a chance we could see that climb? And to what level?
Todd Castagno: That's true. One of the only permanent items of the Tax Cuts and Jobs Act was to reduce the corporate tax rate from 35% to 21%. However, starting this year, there are other tax increases within the corporate tax system. For instance, the requirement to amortize R&D costs over 5 years starts this year. That will primarily affect technology companies. And then there's elimination of favorable media expensing for capital expenditures, that starts to phase out next year, and that primarily would impact manufacturing and industrial companies. And then there's more restrictive deductibility of interest expense. So these in conjunction, will raise tax obligations. And it really depends on the political climate of how these get extended, and if that 21% corporate rate may nudge higher.
Michael Zezas: Todd. Last October, you and I talked in the podcast about a two pillar tax overhaul which would come out of global tax reform. Nine months later, how do you see that playing out?
Todd Castagno: So there's an ongoing effort to A, change the mix of which countries get to tax corporate income and B, the establishment of a global minimum corporate tax rate of 15%. The wheels are still in motion, but let's say the bus has slowed down. For instance, in the U.S., the required reforms are part of the build back better legislation, which has recently stalled. And then in Europe, nearly unanimous agreement, but they're still one or two states that are not fully on board.
Todd Castagno: Michael, I want to turn it back to you. Investors and policymakers clearly have some worries about inflation risks. How will that factor into what kinds of effective tax increases would be palatable for lawmakers?
Michael Zezas: Sure. Policymakers in Washington, D.C. have become really sensitive to inflation. And so tax increases now serve a purpose as a tool for Democrats to achieve some of their spending goals, like investing in clean energy, but doing so without contributing to inflation by increasing government deficits. So given that if Democrats manage to get a new spending bill focused on energy across the finish line, the tax increases will likely need to match that spending. So that keeps corporate tax increases and tax increases focused on high income earners on the table.
Todd Castagno: Finally, before we close, I'm curious if you've heard anything from our economist or equity strategist on what the impact will be on growth, or corporate bottom lines, if some or all of these expirations occur?
Michael Zezas: Well, tax increases mean higher costs for companies and households. So this becomes one of several factors that our equity strategists say will contribute to the crimping of the bottom line of U.S. companies. And they don't think that's in the price of the stock market quite yet. And so what that ultimately means is that the volatility we've been experiencing in markets is something they think is going to continue.
Michael Zezas: Todd, thank you so much for talking.
Todd Castagno: Great talking with you, Michael.
Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
While markets look forward to an acceleration in earnings growth and a subsequent rise in valuations over the next year, there are risks to this outlook that investors may want to consider before abandoning a defensive position.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, June 6th, at 11 a.m. in New York. So let's get after it.
Over the past several months, we've been highlighting the declining trend in earnings revision breath. However, it's been a slow moving train and we're barely below zero at this point. This is why forward 12 month earnings estimates are still grinding higher for the S&P 500, and one reason why stocks have rallied over the past few weeks. But now valuations have risen back to 17.5x earnings, despite a rising 10 year Treasury yield. In order for this to make sense, however, one must take the view that earnings growth will reaccelerate later this year. Time will tell, but we think S&P 500 earnings growth will slow further rather than reaccelerate.
Some have argued these revisions were fully priced, with the major averages down more than 20% year to date. In short, the earnings risk is now understood and the market is looking forward to better growth next year. In the absence of further revisions in the near term, that view can hold up for now. However, if earnings revisions don't reaccelerate, we think the price is too high. This is why we think it could be difficult for the equity market to make much upward progress this summer or fall from current levels. Either the price needs to come down to reflect the further earnings risk we foresee or the earnings need to fall. We think both will happen over the course of the second and third quarter earnings season as companies come to the confessional one by one. In the absence of a recession or a shock like the COVID lockdowns, negative earnings revisions typically take longer than they should, and this time is likely to be no different.
Therefore, we remain open minded to the idea of stocks hanging around current levels and even rallying further in the near term, especially if there is some kind of pause or cease fire in the Russia Ukraine war. However, even if that were to happen, we don't think this reverses the fire and ice that is now well-established but incomplete. Bottom line, the bear market rally that began a few weeks ago can continue for a few more weeks until the Fed makes it crystal clear they remain hawkish and earnings revisions fall well into negative territory. That combination should ultimately take the S&P 500 down towards our 3400 target by mid to late August.
As we've been highlighting all year, equity investors should be more focused on single stocks and relative opportunities across sectors. In that regard, real estate has seen the strongest earnings revisions over the past 4 weeks. Food, beverage and tobacco, commercial and professional services and materials have also seen a positive change in revisions. Finally, capital goods and the overall industrial sector have fared relatively well over the past 4 weeks, as their absolute revisions have remained flat.
The weakest revisions have come from consumer and tech industry groups, two areas we remain underweight. Food and staples retailing revisions have collapsed over the past 4 weeks, as concerns over cost pressures on top of already thin margins hit the space. Consumer discretionary has also continued to see weakness in revisions over the past 4 weeks, despite some modest relief more recently over the past 2 weeks.
Bottom line, U.S. stocks appear in the midst of a bear market rally that could run a few weeks longer. The Nasdaq and small cap indices will outperform under that view in the short term. However, we remain defensively positioned into the fall when a more durable low in equity markets is likely to coincide with a bottom in earnings growth.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
Original Release on May 17th, 2022: As we forecast the remainder of an already uncertain 2022, new questions have emerged around economic data, inflation and the potential for a recession. Chief Cross Asset Strategist Andrew Sheets and Chief Global Economist Seth Carpenter discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets. Morgan Stanley's Chief Cross-Asset Strategist.
Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.
Andrew Sheets: And today on the podcast, we'll be talking about our outlook for strategy and markets and the challenges they may face over the coming months. It's Tuesday, May 17th, at 4 p.m. in London.
Seth Carpenter: And it's 11 a.m. in New York.
Andrew Sheets: So Seth, the global Morgan Stanley Economic and Strategy Team have just completed our mid-year outlook process. And, you know, this is a big collaborative effort where the economists think about what the global economy will look like over the next 12 months, and the strategists think about what that could mean for markets. So as we talk about that outlook, I think the economy is the right place to start. As you're looking across the global economy and thinking about the insights from across your team, how do you think the global economy will look over the next 12 months and how is that going to be different from what we've been seeing?
Seth Carpenter: So I will say, Andrew, that we titled our piece, the economics piece, slowing or stopping with a question mark, because I think there is a great deal of uncertainty out there about where the economy is going to go over the next six months, over the next 12 months. So what are we looking at as a baseline? Sharp deceleration, but no recession. And I say that with a little bit of trepidation because we also try to put out alternative scenarios, the way things could be better, the way things could be worse. And I have to say, from where I'm sitting right now, I see more ways for the global economy to be worse than the global economy to be better than our baseline scenario.
Andrew Sheets: So Seth, I want to dig into that a little bit more because we're seeing, you know, more and more people in the market talk about the risk of a slowdown and talk about the risk of a recession. And yet, you know, it's also hard to ignore the fact that a lot of the economic data looks very good. You know, we have one of the lowest unemployment rates that we've seen in the U.S. in some time. Wage growth is high, spending activity all looks quite high and robust. So, what would drive growth to slow enough where people could really start to think that a recession is getting more likely?
Seth Carpenter: So here's how I think about it. We've been coming into this year with a fair amount of momentum, but not a perfectly pristine outlook on the economy. If you take the United States, Q1, GDP was actually negative quarter on quarter. Now, there are a lot of special exceptions there, inventories were a big drag, net exports were a big drag. Underlying domestic spending in the U.S. held up reasonably solidly. But the fact that we had a big drag in the U.S. from net exports tells you a little bit about what's going on around the rest of the world. If you think about what's going on in Europe, we feel that the economy in the eurozone is actually quite precarious. The Russian invasion of Ukraine presents a clear and critical risk to the European economy. I mean, already we've seen a huge jump in energy prices, we've seen a huge jump in food prices and all of that has got to weigh on consumer spending, especially for consumers at the bottom end of the income distribution. And what we see in China is these wave after wave of COVID against the policy of COVID zero means that we're going to have both a hit to demand from China and some disruption to supply. Now, for the moment, we think the disruption to supply is smaller than the hit to demand because there is this closed loop approach to manufacturing. But nevertheless, that shock to China is going to hurt the global economy.
Andrew Sheets: So Seth, the other major economic question that's out there is inflation, and you know where it's headed and what's driving it. So I was hoping you could talk a little bit about what our forecasts for inflation look like going forward.
Seth Carpenter: Our view right now is that inflation is peaking or will be peaking soon. I say that again with a fair amount of caution because that's been our view for quite some time, and then we get these additional surprises. It's clear that in many, many economies, a huge amount of the inflation that we are seeing is coming from energy and from food. Now energy prices and food prices are not likely to fall noticeably any time soon. But after prices peak, if they go sideways from there, the inflationary impulse ends up starting to fade away and so we think that's important. We also think, the COVID zero policy in China notwithstanding, that there will be some grudging easing of supply chain frictions globally, and that's going to help bring down goods inflation as well over time. So we think inflation is high, we think inflation will stay high, but we think that it's roughly peaked and over the balance of this year and into next year it should be coming down.
Andrew Sheets: As you think about central bank policy going forward, what do you think it will look like and do you think it can get back to, quote, normal?
Seth Carpenter: I will say, when it comes to monetary policy, that's a question we want to ask globally. Right now, central banks globally are generically either tight or tightening policy. What do I mean by that? Well, we had a lot of EM central banks in Latin America and Eastern Europe that had already started to hike policy a lot last year, got to restrictive territory. And for those central banks, we actually see them starting to ease policy perhaps sometimes next year. For the rest of EM Asia, they're on the steady grind higher because even though inflation had started out being lower in the rest of EM Asia than in the developed market world, we are starting to see those inflationary pressures now and they're starting to normalize policy. And then we get to the developed market economies. There's hiking going on, there's tightening of policy led by the Fed who's out front. What does that mean about getting back to an economy like we had before COVID? One of the charts that we put in the Outlook document has the path for the level of GDP globally. And you can clearly see the huge drop off in the COVID recession, the rapid rebound that got us most of the way, but not all the way back to where we were before COVID hit. And then the question is, how does that growth look as we get past the worst of the COVID cycle? Six months ago, when we did the same exercise, we thought growth would be able to be strong enough that we would get our way back to that pre-COVID trend. But now, because supply has clearly been constrained because of commodity prices, because of labor market frictions, monetary policy is trying to slow aggregate demand down to align itself with this restricted supply. And so what that means is, in our forecast at least, we just never get back to that pre-COVID trend line.
Seth Carpenter: All right, Andrew, but I've got a question to throw back at you. So the interplay between economics and markets is really uncertain right now. Where do you think we could be wrong? Could it be that the 3%, ten-year rate that we forecast is too low, is too high? Where do you think the risks are to our asset price forecasts?
Andrew Sheets: Yeah, let me try to answer your question directly and talk about the interest rate outlook, because we are counting on interest rates consolidating in the U.S. around current levels. And our thinking is partly based on that economic outlook. You know, I think where we could be wrong is there's a lot of uncertainty around, you know, what level of interest rate will slow the economy enough to balance demand and supply, as you just mentioned. And I think a path where U.S. interest rates for, say, ten year treasuries are 4% rather than 3% like they are today, I think that's an environment where actually the economy is a little bit stronger than we expect and the consumer is less impacted by that higher rate. And it's going to take a higher rate for people to keep more money in savings rather than spending it in the economy and potentially driving that inflation. So I think the path to higher rates and in our view does flow through a more resilient consumer. And those higher rates could mean the economy holds up for longer but markets still struggle somewhat, because those higher discount rates that you can get from safe government bonds mean people will expect, mean people will expect a higher interest rate on a lot of other asset classes. In short, we think the risk reward here for bonds is more balanced. But I think the yield move so far this year has been surprising, it's been historically extreme, and we have to watch out for scenarios where it continues.
Seth Carpenter: Okay. That's super helpful. But another channel of transmission of monetary policy comes through exchange rates. So the Fed has clearly been hiking, they've already done 75 basis points, they've lined themselves up to do 50 basis points at at least the next two meetings. Whereas the ECB hasn't even finished their QE program, they haven't started to raise interest rates yet. The Bank of Japan, for example, still at a really accommodative level, and we've seen both of those currencies against the dollar move pretty dramatically. Are we in one of those normal cycles where the dollar starts to rally as the Fed begins to hike, but eventually peaks and starts to come off? Or could we be seeing a broader divergence here?
Andrew Sheets: Yeah. So I think this is to your point about a really interesting interplay between markets and Federal Reserve policy, because what the Fed is trying to do is it's trying to slow demand to bring it back in line with what the supply of things in the economy can provide at at current prices rather than it at higher prices, which would mean more inflation. And there's certainly an important interest rate part to that slowing of demand story. There's a stock market part of the story where if somebody's stock portfolio is lower, maybe they're, again, a little bit less inclined to spend money and that could slow the economy. But the currency is also a really important element of it, because that's another way that financial markets can feed back into the real economy and slow growth. And if you know you're an American company that is an exporter and the dollar is stronger, you likely face tougher competition against overseas sellers. And that acts as another headwind to the economy. So we think the dollar strengthens a little bit, you know, over the next month or two, but ultimately does weaken as the market starts to think enough is priced into the Fed. We're not going to get more Federal Reserve interest rates than are already implied by the market, and that helps tamp down some of the dollar strength that we've been seeing.
Andrew Sheets: And Seth thanks for taking the time to talk.
Seth Carpenter: Andrew, it's been great talking to you.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
In the years since the Global Financial Crisis, central bank policy has been supportive and predictable. But as the economic backdrop changes, shifts in policy will come with risks and rewards.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, June 2nd, at 2 p.m. in London.
The period that followed the global financial crisis was filled with paradoxes. It was a period of serially disappointing economic growth, but exceptional asset class returns. Wealth exploded in relation to the economy, while capital investment withered. It was a period of such fragility that it demanded enormous policy support, yet produced remarkably consistent patterns of performance.
For example, in 9 of the last 12 years, growth outperformed value, bonds outperformed cash and stocks outperformed commodities. That consistency in performance was mirrored by consistency in the economy. Generally speaking, 2010 through 2021 saw low inflation, weak growth and central bank policy that was both supportive and predictable.
All of these trends are changing. Year to date, commodities have outperformed stocks, cash has outperformed bonds, and value has outperformed growth. The economic backdrop is also different; growth and inflation are high, capital investment is strong and global central bank policy has been more restrictive and less predictable.
These shifts have risks, but consider the alternative. Over the last decade, it was common to hear investors worry about the bogged down state of the global economy, with weak growth that required large monetary policy support as far as the eye could see. Low growth and low rates clearly were not optimal.
However, central banks are now adjusting their strategy. It's easy to argue that policy stayed too accommodative for too long. But hindsight is cheap and easy. What matters now is that policy is normalizing in a significant way.
More importantly, these shifts are accomplishing central bank goals. Markets assume that central banks in the US, the eurozone and Australia can raise interest rates further without material economic declines. Inflation expectations are now falling, the housing market is cooling and credit risk premiums are back near the long run average, all the while labor markets in the US and Europe remain strong.
In short, there is a lot of talk about whether central banks are making a mistake, especially given the recent market volatility. But looking at the results overall, we suspect central banks are reasonably happy with how things are going so far.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
Looking back on the 2016 and 2020 elections, it is clear that elections can have a significant impact on the U.S. economic outlook. The question is whether the coming midterm elections have any meaningful implications. Head of U.S. Public Policy Research and Municipal Strategy Michael Zezas and Chief U.S. Economist Ellen Zentner discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of U.S. Public Policy Research and Municipal Strategy for Morgan Stanley.
Ellen Zentner: And I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist.
Michael Zezas: And on this special edition of the podcast, we'll be talking about the 2022 U.S. midterm elections and the potential impact on markets and the economy. It's Wednesday, June 1st, at 10 a.m. in New York.
Ellen Zentner: Michael, I'm going to start us off here because 13 states have now completed their primaries ahead of the midterm elections. And as our key Beltway observer, I'd love to get your initial impressions. There's a fair amount of belief that Democrats will have a difficult time maintaining majorities in both houses of Congress and maybe some investor complacency around this sort of outcome. So what are you hearing from investors and how should they be thinking about the midterms?
Michael Zezas: Yeah. I think the word complacency is the correct word to use here. I think in some ways this election hasn't gotten as much attention as it should because in prior elections there was a big macro issue at play, whether it be tax cuts and trade policy in 2016, or in 2020 whether or not another tranche of COVID stimulus aid could get approved based on the election outcome. This election, we think the outcomes will really drive more sectoral impacts. So whether or not tech regulation becomes possible or regulation around cryptocurrency, or could there be a path toward spending more money on renewables and traditional energy exploration. And then, of course, corporate taxes. And then when you couple that with polls and other items suggesting that Republicans are very likely to take control of one or more chambers of Congress, it's easy to put this issue aside and become complacent about it. But Ellen, this focus on the micro doesn't necessarily mean that the outcome doesn't matter for the macro, i.e., the U.S. economic outlook. Can we look back a bit to some prior elections and how they changed the trajectory of your economic outlook?
Ellen Zentner: So, you know, I would start with 2016 where we had a Republican sweep and that led to the Tax Cut and Jobs Act being passed. It was a significant increase in the fiscal deficit and a good deal of stimulus to the economy. And so we really saw that bear out in 2017 where you already had a late cycle dynamic. At the time we called it ill timed policy, where you're throwing stimulus at the economy, when the economy doesn't really need it, you really want to do the majority of your fiscal stimulus when you're actually in a downturn. Trade policy then followed. And of course, late in 2018 started to really bite the global economy. And that's when we saw the Fed also move,v to the sidelines and start cutting rates because they saw a big slowdown in the global economy that was also hitting the U.S. economy. So fiscal policy there had both an uplifting effect and a depressing effect in the outlook. And then I would point to 2020 where the election outcome really opened the door for further fiscal stimulus related to COVID. So we had already done rounds of significant fiscal stimulus, but then in a Democratic sweep, you had two further rounds of fiscal stimulus related to COVID. And so that also had a very big effect on shaping the economy in terms of the excess savings that households were building up and the amount of excess money in the economy. And so I think those are the two best examples, of course, the two most recent examples.
Michael Zezas: So a common thread between 2016 and 2020 was that the outcome had one party in control of both chambers of Congress as well as the White House. And it's long been part of our framework that one party control is a prerequisite for Congress providing proactive fiscal aid to the economy. So let's say the conventional thinking about this election is correct and the Republicans pick up control of one or both chambers of Congress. Then we'd expect that Congress would be more reactive to economic conditions than proactive, basically, that the economy would have to demonstrably worsen before you'd see Congress deliver aid. Would that shift in dynamic mean anything to your US economic outlook?
Ellen Zentner: I mean, our baseline outlook fiscal policy is really not a big factor. The biggest factor coming from fiscal policy has already passed. So late last year we passed a significant infrastructure spending bill and while at the time that had a market impact, it doesn't really have an economic impact until about four quarters later when the bulk of those funds hit the economy. And so that's something that starts to lift growth in the fourth quarter of this year, we estimated by about 3/10 lift to GDP from those funds going out. Otherwise, in our baseline outlook, fiscal policy is just not a big factor. I think when we think about our bear case where we actually have a recession, that would be the first chance for fiscal policy to really kick in meaningfully. But even there, because we don't expect the downturn to be very deep, we expect nothing more than, say, the automatic stabilizers that typically go in to support the economy when jobless claims are rising, and the unemployment rate is rising and other economic factors are weakening. Finally, Michael, I want to ask you about election night and the days that follow. And I'm going to ask this because uncertainty around election outcomes also can impact the economy near term. So how likely is it we'll see the same sort of delays in vote tallies that we saw in 2020?.
Michael Zezas: Yeah. I think investors should be on guard for a very similar time frame. The problem that drove this delayed tally in 2020 was the growth in use of vote by mail, and that really hasn't changed or is unlikely to change in our view. And of course, the problem is voting by mail, those ballots get tallied separately and sometimes later, as opposed to the machine votes which get tallied much quicker on election night. And like last time, it seems that Democrats tend to use vote by mail more than Republicans. So it creates this dynamic where on election night, initial leads could be misleading and you have to wait until the final votes are tallied in order to understand what the true margin is. So investors should prepare to wait a few days to fully understand, particularly if this is a close election, who is going to control the House of Representatives and who is going to control the Senate. That could create some volatile moments in the parts of the market that are most sensitive to these outcomes. Again, that's going to be sectors that are sensitive to corporate tax changes, tech regulation, crypto regulation and energy spending.
Michael Zezas: Ellen, thanks so much for taking the time to talk with me.
Ellen Zentner: As always, great talking with you, Michael.
Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
While there continues to be turbulence in many sectors, such as energy and food, some Asia and Emerging Markets may fare better than others through the second half of an already hectic 2022.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Morgan Stanley's Chief Asia and Emerging Markets Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about our mid-year outlook for Asia and Emerging Markets. It's Tuesday, May the 31st at 8 p.m. in Hong Kong.
In our mid-year outlook, our advice was to stick with the markets and sectors which have performed well already this year. These are in the main plays on high energy, materials and food prices. In our coverage, this means commodity exporters including Australia, Indonesia and Saudi Arabia, which we have been overweight for some time. We also added another commodity exporter, Brazil, to this overweight group and reiterated our overweight on energy and materials.
Despite outperformance, we continue to encounter skepticism that these markets and sectors can continue to perform. And this is mainly due to concerns over global growth, and in particular growth in China. Certainly, it's true that energy and materials tend to perform well late on in the cycle, whereas I.T hardware, semiconductors and consumer discretionary tend to do well coming out of recession. And it's also true that the Chinese economy is weak right now, with data showing a considerable slowdown in April and May. And that is a key reason why we remain cautious on China equities themselves. But we think the combination of underinvestment in the prior cycle in supply and the Russia-Ukraine conflict keep the commodity markets tight for the foreseeable future.
The pattern of earnings revisions confirms our thesis. Analysts are upgrading numbers for stocks in Australia, Brazil, Indonesia and Saudi Arabia, in some cases at an accelerating pace. Whilst they’re downgrading for China, Korea and Taiwan, which are manufacturing exporting and commodity importing markets, Japan is slightly different, with balanced earnings revisions as corporate margins are helped by the recent trend to a weaker yen, amongst other factors.
Hence, thus far, for some key emerging markets, notably Brazil and Indonesia, their commodity producing and exporting characteristics are offsetting, both from a currency and equity market perspective, the traditionally negative impact on growth from a stronger U.S. dollar and monetary policy tightening by the U.S. Federal Reserve.
In time, this pronounced pattern of earnings dispersion may reverse and we are on the lookout for a trend reversal. This could be driven by factors like a change in COVID management approach in China or cessation of the conflict in Ukraine. For the time being though, we recommend keeping things simple in turbulent times.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
So far this year's economic story has been dominated by inflation and central bank policy, but as that landscape changes, is it time to shift focus back towards growth?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 27th at 2 p.m. in London.
2022 has given investors a lot to chew on. But out of the many developments of this year, one really stands out. It's inflation and the impact that high inflation has had on central bank policy. If you had to pick a defining economic trend in the last 40 years, it was probably the steady moderation of inflation. Then, if you had to pick a defining trend of the last decade, it was the issue of inflation being unusually low, a symptom of weak growth that warranted major central bank support.
This year, the story changed. Rising prices started to be driven by strong demand that outstripped available supply, rather than COVID related disruptions. The persistence of these rising prices caught central banks and professional forecasters by surprise. Central bank policy then shifted rapidly, a shift that drove bond yields higher, market valuations lower, and defined much of the market's performance year to date.
But now this story may be changing again, away from inflation and back towards growth. After rocketing higher over the first five months of the year, Morgan Stanley's economists do expect U.S. inflation to moderate for the rest of 2022. Some of this is that we're passing the peak rate of change, recall that on a year over year basis, prices today are being compared to May of 2021, a time when the U.S. vaccination rate was still low and activity was a long ways from being back to normal.
We're also seeing encouraging signs that some of the worst disruption to supply chains are easing. Fewer ships are sitting off of U.S. ports, unloaded. The cost of freight is declining. Many retailers are now reporting plenty of inventory. And don't just take our word for it. Market based estimates of future inflation have been declining, in both the U.S. and Europe, over the last month.
If this trend of moderating inflation can hold, there are some important implications. First, at a very simple but very important level, inflation that is high but falling, is much less frightening to the market than inflation that's high, but rising. This should help reduce the market's fear about a more extreme, 1970's style scenario.
Second, it suggests that expectations of future central bank interest rates don't need to rise much further. That, in turn, could help bond yields stabilize, especially in the U.S. And more stable bond yields could help higher quality parts of the fixed income market, like mortgages and municipal bonds, that tend to be very sensitive to that interest rate volatility.
The flip side is that as markets focus less on inflation, they will likely focus more on growth, where Morgan Stanley's economists see a sharp deceleration. While short term bounces are possible, we'd like to see more conservative estimates for earnings before assuming that the market's challenges are truly behind it.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
With growth slowing and the Fed focused on fighting inflation, investors should note that the outlook for government bonds depends on more than just central bank policy.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, May 26th, at 11 a.m. in New York.
For government bond markets, the start to 2022 will go down in the history books. Since the start of the year, central banks have delivered changes to monetary policies and associated forward guidance. And as a result, government bond markets have had their worst start to the year in decades. The repricing in markets ultimately came as a result of central banks surprising expectations among economists and market participants alike.
Heading into the year, our economists thought that the Federal Reserve would continue to buy bonds well into 2022 and that it wouldn't be ready to raise policy rates until 2023. Since then, however, the Fed has stopped its asset purchases, announced plans to shrink its balance sheet starting in June and has hiked short term rates by 75 basis points already.
Our economists now expect the Fed to deliver two more 50 basis point rate hikes this year, then downshift to a series of 25 basis point moves. At the end of the year, they see the Fed funds target range at 2.5% to 2.75%, and the Fed's balance sheet on its way to $6.5 trillion.
However, investors should note that the outlook for government bonds depends on more than just central bank policies. For example, projected government deficits and related financing needs will decline substantially this year, and more fully in 2023. In addition, risks to global growth skew to the downside already.
And as monetary policies tighten, downside risks to growth, and eventually inflation, will increase. These conditions, which traditionally support government bonds, factor into our view for how yields will evolve over the next 12 months.
We expect U.S. Treasury yields to move higher through 2023, but not materially so. A continued focus on above target inflation should keep the Fed marching towards a neutral level for policy this year.
Our economists anticipate a front loaded hiking cycle, with early increases in the Fed funds rate being more important than the potential for later ones. With this Fed forecast, we expect front end yields to trace market implied forward yields, largely consistent with two year Treasury yields reaching 3.25% by the end of the year.
In contrast, demand from investors looking to hedge risks to a weaker outcome for global growth will likely show up in the longer end of the Treasury curve. We think the ten year yield will end the year near 3%, which is a level we were at not that long ago.
As a result, we're forecasting an inverted yield curve at year end. With inflation remaining high and growth slowing, discussions of stagflation or outright recession should continue to lead investor debate this year. And ultimately, that should limit the degree to which Treasury yields rise into year end.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Stress on supply chains has driven a slowdown in globalization, but there are also investment opportunities emerging, particularly in Asia. Head of Public Policy Research and Municipal Strategy Michael Zezas and Asia and Emerging Markets Equity Strategist Daniel Blake discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.
Daniel Blake: And I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy Team.
Michael Zezas: And on this episode of Thoughts on the Market, we'll continue our discussion of a theme that's been rightfully getting a lot of attention - "slowbalization", slowing globalization within an ever more multipolar world. It's Wednesday, May 25th, at 8 a.m. in New York.
Michael Zezas: So Daniel, over the last few years, Morgan Stanley Research has published a lot of collaborative work across regions and sectors on the increasingly important themes of slowbalization and the multipolar world. But while in the past we focused more on the costs and challenges of this transition, today we want to put a greater emphasis on the opportunities from this theme, particularly in Asia. Investors are acutely aware that one of the key drivers behind this slowbalization trend is the tremendous disruption to the supply chain. You've been publishing a supply chain choke point tracker tool, so maybe let's start there with an update on the current state of supply chains in Asia and what your most recent tracker is indicating.
Daniel Blake: Thanks, Mike. In short, this is showing that the supply chain in general remains very stressed. And in aggregate, we have not seen any material improvement over the last six weeks. Now, when we look at the aggregate measure put together by our economists, the Morgan Stanley Supply Chain Conditions Index, we are seeing that conditions are still slightly better than the peak of the disruptions and backlogs that occurred in late 2021, particularly around the delta wave in South East Asia. But we haven't seen much further improvement beyond that. Our checkpoint tracker does go down to the individual component or service level, and it shows that supply of certain auto and industrial semis and advanced packaging remains a constraint on downstream production. And we are seeing that show up in corporate results in the tech sector as well as the broader impact on margins that we're seeing into the consumer space.
Michael Zezas: And one of the pressing issues that investors have been paying attention to is the new shocks to supply chains from China's COVID containment policy. Can you give us an update on the current impact of this policy?
Daniel Blake: Now, so far, this is having a more noticeable impact on the domestic Chinese economy rather than on export markets, with policymakers trying to prioritize industrial output through systems such as closed loop management, which sees workers living on site for extended periods to maintain as much production as possible. The challenge has been most acute where mobility is needed, including in the transportation of raw materials and industrial production within China. Geographically, we've seen the impact on the Pearl River Delta around Shenzhen, the Yangtze River Delta around Shanghai and neighboring provinces, and more recently the capital, Beijing, is seeing an outbreak. So progress has been made on reopening from full lockdowns in Shenzhen and Shanghai gradually, but our China economics team still estimate that about 25% of national GDP is being subject to some additional COVID restrictions. And again, we need to watch out for the progression of the outbreak closely.
Michael Zezas: When do you expect to see an easing of supply chain choke points and what factors could drive that easing?
Daniel Blake: One of the points in the blue paper from late 2021 was the role on the demand side, the generous stimulus and acute shifts in spending patterns from COVID had in driving demand well above the world's productive capacity, even before you consider the supply disruptions we're seeing. So heading into summer 2022, we get the flip side, which is what our consumer analysts call the great reversion. Stimulus rolls off, fiscal spending does taper, and we see spending returning to categories like travel and tourism and leisure, as opposed to demand for goods and electronics. That may mean we get an outright contraction in some product segments. Now, this downturn may not be the best way, but it's the probably quickest way to get to an easing of supply chain choke points. And we are getting more evidence of this in order cuts across PC and smartphone in Asia. On the more constructive side, we're also seeing CapEx coming into areas like driving edge semiconductor foundry. But we'll also need to watch commodity markets, particularly as we've got agricultural trade channels into the European summer looking highly stressed. And we're seeing policy responses in some markets that are looking to prioritize domestic demand for industrial output and for agricultural output over export markets. So we don't think we're through the worst of this just yet. So we really need to watch for conditions to improve potentially later in 2022.
Michael Zezas: Now let's zero in for a moment on some sector level observations. Semiconductors, for example, has been one of the sectors most in focus in the context of slowbalization. Can you talk about some of the particular challenges semis are facing in East Asia?
Daniel Blake: There really are two dimensions, I think to this. One is the centrality of semiconductor companies at the leading edge and the concentration of global production in several key markets, and in particular in Taiwan and Korea. Now, when we look at the challenges here we can see policymakers in major capitals, in D.C. and Beijing, looking to try to encourage more localization, more internalization of supply chains. And that's putting some pressure, but also creating incentives for companies to add new capacity into the U.S., and we're seeing capacity coming into the Japanese market as well. So the challenge and opportunity I think for these leading companies is to try to manage those pressure points and protect return on invested capital as much as possible in the face of the need to strengthen and secure additional capacity in supply chains. The other element, which is important in terms of the challenges for semis, is more cyclical and we have seen a surge in demand, we've seen a build up of margins in the industry as it has benefited from this pull forward, from the work from home spending. And on the other side of that, we are going to see a downturn which is potentially exacerbated by the inventory buildup that has happened across the board in semis. Some semiconductor components are still in acute supply, but there are many that are not so disrupted, and when we look at the outlook we have seen inventory build up across the board. The risk is in the downturn, we start to see deeper order cuts because the inventory in aggregate is actually higher than what we've seen historically.
Michael Zezas: Now shifting towards some macro level takeaways. The dynamic between the U.S. and China could be challenging, but is also creating potential opportunities for other countries such as Vietnam, India and Indonesia. Can you walk us through the tailwinds as well as the headwinds for these countries and what they're doing to take advantage of the situation?
Daniel Blake: Yes, in Asia-Pacific, we have seen Vietnam already playing an important role for corporates as a complement to Chinese supply chains. It's smaller, but it's a natural extension of existing production facilities in China. But we've also seen policy and corporate momentum, the reform story, improving most notably in India, but also improving in Indonesia. And both markets have enacted quite deep and broad reform programs to lower corporate tax rates, to liberalize foreign direct investment rules, to invest in infrastructure and generally to make their market more attractive for multinational corporates as they're reassessing their supply chain strategy and looking to diversify. In terms of our preferences we are currently overweight Indonesia right now in our Asia Pacific, ex-Japan and Emerging Markets rankings. It benefits from strong commodity export dynamics and we also see long term opportunities coming through in terms of supply chain investments in Indonesia. But India has a very attractive long run story. If we can see continued execution, this market will present both domestic and export opportunities, and the production linked incentives being offered have been taken up by corporates and are helping to drive this foreign direct investment cycle.
Michael Zezas: Daniel, thanks for taking the time to talk. It was great to have you here in person.
Daniel Blake: Great speaking with you, Michael.
Michael Zezas: And thanks for listening. For a look inside some of the human impacts of the recent supply chain disruptions, and how people are trying to resolve them, check out the latest season of Morgan Stanley's podcast "Now, What's Next?" on your podcast app of choice. If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
So far this year cryptocurrencies have been on a swift downturn, increasingly in line with equity market moves. What's behind this correlation? And what should investors watch out for next?
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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be talking about the crypto bear market. It's Tuesday, May 24th, at 2 p.m. in London.
Bitcoin is down 55% from its November 2021 high, and currently trades at around $30,000. Over that same period, crypto market capitalization has lost over $1 trillion. All the while, Bitcoin's correlation with the equity markets has risen to new highs. So what is going on? Who is selling and what should we watch out for next?
In 2018, retail investors were dominant in crypto markets, participating in 80% of trading volumes on Coinbase, the large crypto exchange. Today, the story couldn't be more different, with only 1/4 of trading volumes on Coinbase being with retail investors. Institutions, and more specifically crypto institutions, appear to have taken over, many of which are simply trading with each other. We think retail investors are more likely to buy and hold, but institutional investors are willing to both buy and sell crypto, if it means they can make a return. And because institutional investors are sensitive to the availability of capital and therefore interest rates, they trade crypto somewhat in sympathy with the way equities are traded. This shift in the type of market participant is key to understanding why crypto markets are selling off at the same time as the equity markets are experiencing a downturn.
Cryptocurrency prices rose rapidly in 2020 and 2021, attracting a new set of investors. Bitcoin rose 10x from March 2020 to its first peak in April 2021. Ether, the second largest crypto, rose even more, over 40x in a similar period. The stimulus provided by central banks and governments throughout the pandemic was the key driver of the crypto bull market. As the Federal Reserve indicated late last year that it plans to raise interest rates and reduce the size of its balance sheet, crypto markets began to weaken.
The downturn is now starting to have a broader impact on the crypto ecosystem. In mid-May a stablecoin called Terra Dollar, or UST, lost its peg to the U.S. dollar, which meant it was no longer trading at $1 USD and instead trades closer to $0 USD. UST lost its peg as it was backed by cryptocurrencies, which themselves were losing value, and because market makers no longer trusted the ability of the stablecoin to retain its dollar peg. There was a negative spillover into Bitcoin and other cryptos, with the largest stablecoin called Tether briefly losing its dollar peg intraday. Tether is the other side of half of all bitcoin traded on exchanges, so its stability is extremely important for the broader crypto market. The dollar asset reserves that backed Tether will continue to be scrutinized and questioned by market participants. Stablecoins are used to create leverage in decentralized finance crypto systems, and that leverage is now falling as crypto traders, that may have bought Bitcoin or other cryptos, have faced margin calls.
In general, the elevated prices were traded on speculation, with limited real user demand. NFT and digital land prices are next areas to watch. Of course, many are looking for signs of a market turnaround. The retail investors may have been outnumbered by institutions, but they haven't gone away. The downturn may continue if central banks persist in their policy of tightening, but the strong hands of these retail investors have historically served as a support to falling prices.
Thank you for listening. If you enjoy thoughts on the market, share this and other episodes with a friend or colleague today.
As we enter the second half of 2022, the market is signaling a continued de-rating of equities, lingering challenges for consumers, and an increased bearishness among equity investors.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, May 23rd at 9 a.m. in New York. So let's get after it.
As we’ve discussed our mid-year outlook the past few weeks, I'd like to share some key takeaways on today's podcast. First, the de-rating of equities is no longer up for debate. However, there is disagreement on how low price earnings multiple should fall. We believe the S&P 500 price earnings multiple will fall towards 14x, ahead of the oncoming downward earnings revisions, which is how we arrive at our near-term overshoot of fair value of 3400 for the S&P 500.
Second, the consumer is still a significant battleground. While COVID has been a terrible period in history, many U.S. consumers, like companies, benefited financially from the pandemic. Our view coming into 2022 was that this tailwind would end for most households, as we anniversaried the stimulus, asset prices de-rated and inflation in non discretionary items like shelter, food and energy ate into savings. Consumer confidence readings for the past six months support our view. Yet many investors have continued to argue the consumer is likely to surprise on the upside with spending, as they use excess savings to maintain a permanently higher plateau of consumption.
Third, technology bulls are getting more concerned on growth. This is new and in stark contrast to the first quarter when tech bulls argued work from home benefited only a few select companies, while most would continue to see very strong growth from positive secular trends for technology spend. Some bulls have even argued technology spending is no longer cyclical but structural and non-discretionary, especially in a world where costs are rising so much. We disagree with that view and argue technology spending would follow corporate cash flow growth and sentiment.
We have found many technology investors are now on our page and more worried about companies missing forecasts. While some may view this as bullish from a sentiment standpoint, we think it's a bearish sign as formerly dedicated tech investors will be more hesitant to buy the dip. In short, we believe technology spending is likely to go through a cyclical downturn this year, and it could extend to even the more durable areas like software.
Finally, energy is the one sector where a majority of investors are consistently bullish now. This is not necessarily a contrarian signal in our view, but we are a bit more concerned about the recent crowding as energy remains the only sector other than utilities that is up on the year. With oil and gasoline prices so high, there is a growing risk we have reached a level of demand destruction. We remain neutral on energy with a positive bias for the more defensive names that pay a solid dividend.
Bottom line, equity clients are bearish overall and not that optimistic about a quick rebound. While this is a necessary condition for a sustainable low in equity prices, we don't think it's a sufficient one. While our 12 month target for the S&P 500 is 3900, we expect an overshoot to the downside this summer that could come sooner rather than later. We think 3400 is a level that more accurately reflects the earnings risk in front of us, and expect that level to be achieved by the end of the second quarter earnings season, if not sooner. Vicious bear market rallies will continue to appear until then, and we would use them to lighten up on stocks most vulnerable to the oncoming earnings reset.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.
2022 is off to a rocky start for markets, but there is an organization to this downturn that is unlike recent episodes of market weakness, meaning investors can use tried-and-true strategies to bring order to the chaos.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 20th, at 3 p.m. in London.
There are a lot of ways to describe the market at the moment. One that I'm increasingly fond of is "organized chaos".
Chaos because, well, the year is off to a historically bad start. Year to date, the S&P 500 is down about 20%. The U.S. aggregate bond index is down about 9%. And almost every asset class that isn't commodities has posted negative returns. This weakness has been both large and relentless. For the stock market, it's been seven straight weeks of losses.
Yet all of this weakness has also been surprisingly organized. The worst performing parts of the stock market have been the most expensive, least profitable parts of it. After being unusually low for a long time, bond yields and credit spreads have risen. After outperforming to an extreme degree, growth stocks and U.S. equities are now lagging. Indeed, if you don't know how a particular asset class has done this year, "moving closer to its long run valuation average" is a pretty good guess.
So as difficult as 2022 has been, many tried and true strategies are working. Rules based approaches, also known as systematic strategies, have in some cases been performing quite well. Relative value strategies, which trade within an asset class based on relative valuation, yield, momentum or fundamentals, have been working unusually well.
That's different from four prior episodes that saw similar or greater weakness than we see today. Those episodes being the global financial crisis of 2007 to 2009, the European sovereign crisis of 2011 and 2012, the volatility shocks of 2018 and Covid's emergence in 2020. Each of these four instances were notable for being disorganized, stressed, with very unusual movements below the market surface.
Why does this matter? First, it suggests that investors should move toward relative value in this environment, which has been working, rather than taking large directional positions.
Second, it suggests that this downturn is different from those that we've known since 2008. It is still difficult, but it is more gradual, less stressed, and more about specific debates around growth and risk premiums, than existential questions such as whether the banking system or the European Union will survive. While that difference has many potential implications, one specific one is that it’s less problematic for high quality credit, which did unusually poorly during these more recent crises, but which we think will do better this time around.
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With rising prices already on the minds of investors and consumers, the outlook in Europe remains challenged across supply chains, inflation rates and energy markets. Chief European Economist Jens Eisenschmidt and Global Oil Strategist and Head of the European Energy Team Martijn Rats discuss.
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Jens Eisenschmidt: Welcome to Thoughts on the Market. I'm Jens Eisenschmidt, Morgan Stanley's Chief European Economist.
Martijn Rats: And I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist and Head of the European Energy Research Team.
Jens Eisenschmidt: And today on the podcast, we will be talking about the outlook for the European economy for the next 12 months in the very challenging context of rising energy prices and sustained inflationary pressure. It's Thursday, May 19, at 4 p.m. in London.
Jens Eisenschmidt: So, Martin, I wanted to talk with you today about some burning issues that seem to be topmost on everybody's mind these days, namely rising energy prices and inflation. These challenges are affecting literally everyone. And Europe, in particular, is acutely feeling the impact from the war in Ukraine. Let's maybe pick up with a topic you discussed on this podcast back in January. So even prior to the war in Ukraine, you talked about five enduring tailwinds boosting commodities. So far in 22, commodities are on track to outperform equities for the second consecutive year. Now that we are approaching the mid-year mark, what's your outlook for the second half of 22 in terms of commodities and which ones are likely to outperform the most in the current environment?
Martijn Rats: Some things have changed, but also a lot of things are still the same when it comes to the outlook for commodities. Commodities move in long cycles. The last decade was, on the whole, more challenging, but we think that we're still in the relatively early innings of what could be a long cycle ahead. You already mentioned the five enduring tailwinds that we've previously written about and discussed on podcasts like this. First of all, is inflation. Commodities often do well in inflationary periods, and the inflationary pressures are still there, that's one. Secondly, geopolitical risk. Thirdly, there's the energy transition. For a broad range of commodities the energy transition is a demand tailwind, but for a lot of others, it's basically a red flag not to invest in supply. Then fourthly, a lot of commodities have gone through a long period of very little investment. That sets up a tighter supply outlook. And then finally there's reopening. A lot of reopening has already played out, but there are still important pockets of reopening that have yet to fully materialize. A lot of that thesis is still the same. And I would expect that this will carry the commodity asset class for some time. Now, in terms of how things have changed at the start of the year, we were more optimistic about demand for a lot of commodities, and those expectations have come down a little bit because the economic slowdown, because of China. But we were also more optimistic about the supply for those commodities. We've seen a lot of headwinds in terms of the supply of a broad range of commodities, particularly because of the war in the Ukraine. So net net our balances are broadly still equally tight, if not slightly tighter, and that's to still set up the commodity asset class quite well. Also for the second half, the ones that we prefer the most, it's mostly the energy commodities. We think they'll do better than the metals. That is already happening as we speak, but there is more to come in that relative trade in the second half as well.
Jens Eisenschmidt: Let's talk a little bit about oil. You've said that you continue to see upside to oil prices, even though the nature of your thesis has changed since the start of the year. Could you walk us through your thinking specifically around oil?
Martijn Rats: Yes. At the start of the year, we were thinking that oil demand could grow this year by something like 3.5 to 4 million barrels a day, year over year compared to 2021. And that expectation had turned out to be too optimistic. There are basically two reasons for that. First of all, is China. The Zero-Covid policies in China and the stringent lockdowns that have come with that means that at the moment we're probably losing something like 1.5 to 2 million barrels a day of oil demand in China right now. Now, that might not last the entire year, but there is a material effect. And then also economic growth expectations have come down. And as a result, we also had to moderate our oil demand forecasts. But then on the supply side, we had to make even bigger changes. Russian production has fallen by broadly a million barrels a day already, and we think that that will continue to fall by another million barrels a day in the second half of the year. So when you add it all up, I'm sure our demand expectations have fallen, but they are already at a level that I would say is reflective of the current situation while there's still meaningful supply risks and when you put those two things combined, actually our balances are even slightly tighter than they were at the start of the year. Hence the call, as we've had it for a while, for $130 brent by the third quarter.
Jens Eisenschmidt: Turning to the European gas markets. Gas prices in Europe are roughly five times as high as in the U.S., reflecting the increased risk to Russian supply created by the war in Ukraine. What are your expectations in terms of Europe following through on its intent to phase out Russian gas? And what potential scenarios do you see playing out here?
Martijn Rats: The story about European gas is is quite a bit different from what it is to oil. There is clearly heightened risk in the European gas market right now that is reflected in price. As a result, the price is well above historical levels, is well above the levels that prevail in the United States. But that also means that a lot of the world's seaborne gas, a lot of those cargoes of LNG at the moment are ending up in Europe. At the same time. Russian flows of natural gas into Europe are low, but they by and large continue. And when you put all of that together, actually, judging by, you know, the normal fundamental metrics that we look at, the European gas market right here, right now today is actually relatively soft. But all of that is, of course, drowned out by the risk that Russian supplies may be impacted. Now, that remains very difficult to call in the short run. That's also the reason why you see European gas prices being so volatile. What does strike us to be the case is that Europe will wean itself off Russian gas over the next sort of 5, 6, 7 years towards the end of the decade. That will require a lot of LNG to come to Europe and also a fair amount of demand erosion. Neither of these things will happen with low prices. We have low conviction on what happens to European natural gas prices in the short run, admittedly, but we have high conviction that gas prices will need to stay high, if not very high by historical standards for several years to come to allow the European gas markets to move away from Russian supplies.
Jens Eisenschmidt: Maybe one last word on metals. What are your expectations for metals, especially vis a vis what you just said about energy?
Martijn Rats: If you look at metals for most of the metals, practically all of them, China is a huge factor in setting the demand outlook. So where would we be cautious at the moment is in the precise trajectory of the demand recovery in China. At the same time, we are quite concerned about the supply outlook, particularly as of Russia. So if you put all of that together, the metals suffer much more from weak Chinese demand, whilst the energy commodities are much more impacted by tight supply because of the Russian situation. So our preference over the last couple of months, for some time already, to be honest, has been to prefer the energy commodities. Whilst we think that the metals will probably stay a little weaker for some time to come because of their dominant exposure to Chinese demands factors. So there is a strong story to be told about many of the metals over the next sort of 5, 6, 7 years around energy transition. But right here, right now, we're biding our time a little bit with the metals. Jens, the 1Q GDP and inflation numbers confirms that supply shocks are hitting hard on the European economy, even after its strong post-COVID recovery in 2021. In your mid-year outlook, you refer to the set of challenges facing Europe as a perfect storm. Tell us why the situation looks so challenging from where you stand.
Jens Eisenschmidt: Yes, you're right, Martin. It's very difficult in these days to get very optimistic about the growth outlook. I mean, we started the year actually on a much brighter note with a growth outlook of 3.9% for 22 for the euro area and had to revise it consecutively down to 3 to 2.7 and now to 2.6. And this is all on the back of as you mentioned, supply side shocks. First of all, we would have, of course, a huge hit to disposable income through inflation. Also, as we don't really see the wage developments catching quite up to that number. We are facing here a shock to confidence that we have seen emanating from both the war, but also from more generally the developments surrounding us. We have recently seen news from increased chances for more supply chain issues coming our way, for instance, out of China. Plus, on the other side of the Atlantic, the Federal Reserve has started to aggressively rein into their inflation that has significant domestic demand component to it. Overall, it's very difficult to see really bright spots here. That's why we have arrived at 2.6% in our forecast, that is despite significant dynamics coming out from the reopening and fiscal stimulus being on the road. So overall, it's a very challenging environment we are in.
Jens Eisenschmidt: Martijn, thanks for taking the time to talk.
Martijn Rats: Thanks, Jens was great to speak with you.
Jens Eisenschmidt: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As we continue to track the trends of 'slowbalization' and the shift towards a multipolar world, Mexico stands out as an economy uniquely positioned to benefit from these changes. Head of Public Policy Research and Municipal Strategy Michael Zezas and Mexico Equity Strategist Nik Lippmann discuss.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.
Nik Lippmann: I'm Nik Lippmann, Mexico Equity Strategist for Morgan Stanley.
Michael Zezas: And on this episode of Thoughts on the Market, we'll be discussing the trend towards slowbalization within a multipolar world, a move that's been accelerated by recent geopolitical events, and in particular, the opportunity for Mexico and global investors. It's Wednesday, May 19th, at 1 p.m. in New York.
Michael Zezas: So we've talked a lot on this podcast about the trends of slowbalization and the shift to a multipolar world. It's basically the idea that the globe is no longer solely organizing around the same political economy principles. And that, for example, the rise of China as an economic power with a political system that's distinctly different from the West, creates some barriers to economic interconnectedness. And we've talked a lot about how that can create new costs for Western companies and inflationary pressures, as all of a sudden you need to make investments, for example if you're Europe, to build an infrastructure to import natural gas from the U.S. so you don't have to buy it from Russia anymore. But this trend isn't all about creating headwinds and costs for the economy, we think there's opportunity, too. And there's regions that we think stand to benefit from an uptick in investment as American and European companies need to recreate that labor and market access in other parts of the globe. Mexico is one country that stands out to us, and so we want to speak with Nik Lippmann. Nik, can you tell us why you think Mexico is poised to benefit here?
Nik Lippmann: So I'm sitting down in Mexico watching all this stuff play out from a number of different angles. And it's clear to me that Mexico will play a role. It's right next to the U.S., you have trade tariff protection, and multiple levels of rights are protected by the USMCA. And Mexico has advanced tremendously in terms of advancing the value chain and moving up in terms of complexity. So it's come a long way over the last sort of two decades. And today what we see in Mexico is really a strong ecosystem for electronics and cars and even some aerospace. When I look at this recovery, post-COVID in Mexico, I see kind of an average recovery, to be honest. But right below the headline number, we see something else going on. We see electronics growing 40%.
Michael Zezas: So you mentioned a lot has changed in Mexico recently that makes this possibility more likely. What is it that changed? Why couldn't this have been a greater opportunity for Mexico earlier?
Nik Lippmann: I think that after the trade tensions with China, the pandemic, we've just been getting, you know, higher freight costs. We've been getting a number of obstacles to the existing trade framework. So there are certain external policy factors that clearly play in and it's clear that the chip has kind of changed over the course of the beginning of this year and opened the eyes to some of the risks that could be emerging in other parts of the world. It's clear that Mexico's able and fairly high quantities of labor. There will be needs to educate and develop further infrastructure. But Mexico's position and its proven track record in terms of making electronics and cars. I think that can be expanded into other things. And we're seeing the early stages of that on the ground already today.
Michael Zezas: So geopolitics is an obvious catalyst for Mexico to be a beneficiary generally. Specifically, what sectors of the economy in Mexico stand out to you as an opportunity?
Nik Lippmann: So when we look at what Mexico does today, it makes cars and refrigerators and microwave ovens and stationary computers. It doesn't make laptops, tablets, and I don't think it will ever make tablets, mobile phones. I would imagine that we start seeing ecosystems and I always focus on ecosystems rather than individual companies, that you start having an emergence of some of the low tech health care, aerospace is growing tremendously, even pharma. And I think one of the things that I would expect to happen and it's difficult to have clear evidence today, but I would expect some corporates to at least diversify their existing supply chains rather than just relying on one country. I think Mexico just tends to benefit in that process.
Michael Zezas: And so as a market strategist, what do you expect to see or how do you expect to see this play out in Mexico's equity markets?
Nik Lippmann: By and large, I think this is a 3 to 5 year system or thesis or theme that will have a tremendous impact on potentially improving the narrative of Mexico. And it's going to impact a wide range of their corporates that would come on the U.S. side of the border. From the car space to electronics and machinery and what have you. And it doesn't happen from one day to another. But the country's fairly well positioned. I think in terms of the investability impact, clearly a couple of sectors stand out, such as real estate. This is a more than a near-term in theme that would cause us to change the recommendation from here till the year end 22. I think it's a key fact in terms of how we suggest investors to have allocation within Mexico focus on industrials, external sectors and real estate with exposure to the U.S.. And I think for a lot of investors in U.S. corporates, in manufacturing and out of the auto space and other sectors, this is a super important longer term theme that can affect and maybe redevelop to some degree in Mexico investment narrative.
Michael Zezas: Nik, thanks for taking the time to talk.
Nik Lippmann: Thanks, Mike, for inviting me.
Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
As we forecast the remainder of an already uncertain 2022, new questions have emerged around economic data, inflation and the potential for a recession. Chief Cross Asset Strategist Andrew Sheets and Chief Global Economist Seth Carpenter discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets. Morgan Stanley's Chief Cross-Asset Strategist.
Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.
Andrew Sheets: And today on the podcast, we'll be talking about our outlook for strategy and markets and the challenges they may face over the coming months. It's Tuesday, May 17th, at 4 p.m. in London.
Seth Carpenter: And it's 11 a.m. in New York.
Andrew Sheets: So Seth, the global Morgan Stanley Economic and Strategy Team have just completed our mid-year outlook process. And, you know, this is a big collaborative effort where the economists think about what the global economy will look like over the next 12 months, and the strategists think about what that could mean for markets. So as we talk about that outlook, I think the economy is the right place to start. As you're looking across the global economy and thinking about the insights from across your team, how do you think the global economy will look over the next 12 months and how is that going to be different from what we've been seeing?
Seth Carpenter: So I will say, Andrew, that we titled our piece, the economics piece, slowing or stopping with a question mark, because I think there is a great deal of uncertainty out there about where the economy is going to go over the next six months, over the next 12 months. So what are we looking at as a baseline? Sharp deceleration, but no recession. And I say that with a little bit of trepidation because we also try to put out alternative scenarios, the way things could be better, the way things could be worse. And I have to say, from where I'm sitting right now, I see more ways for the global economy to be worse than the global economy to be better than our baseline scenario.
Andrew Sheets: So Seth, I want to dig into that a little bit more because we're seeing, you know, more and more people in the market talk about the risk of a slowdown and talk about the risk of a recession. And yet, you know, it's also hard to ignore the fact that a lot of the economic data looks very good. You know, we have one of the lowest unemployment rates that we've seen in the U.S. in some time. Wage growth is high, spending activity all looks quite high and robust. So, what would drive growth to slow enough where people could really start to think that a recession is getting more likely?
Seth Carpenter: So here's how I think about it. We've been coming into this year with a fair amount of momentum, but not a perfectly pristine outlook on the economy. If you take the United States, Q1, GDP was actually negative quarter on quarter. Now, there are a lot of special exceptions there, inventories were a big drag, net exports were a big drag. Underlying domestic spending in the U.S. held up reasonably solidly. But the fact that we had a big drag in the U.S. from net exports tells you a little bit about what's going on around the rest of the world. If you think about what's going on in Europe, we feel that the economy in the eurozone is actually quite precarious. The Russian invasion of Ukraine presents a clear and critical risk to the European economy. I mean, already we've seen a huge jump in energy prices, we've seen a huge jump in food prices and all of that has got to weigh on consumer spending, especially for consumers at the bottom end of the income distribution. And what we see in China is these wave after wave of COVID against the policy of COVID zero means that we're going to have both a hit to demand from China and some disruption to supply. Now, for the moment, we think the disruption to supply is smaller than the hit to demand because there is this closed loop approach to manufacturing. But nevertheless, that shock to China is going to hurt the global economy.
Andrew Sheets: So Seth, the other major economic question that's out there is inflation, and you know where it's headed and what's driving it. So I was hoping you could talk a little bit about what our forecasts for inflation look like going forward.
Seth Carpenter: Our view right now is that inflation is peaking or will be peaking soon. I say that again with a fair amount of caution because that's been our view for quite some time, and then we get these additional surprises. It's clear that in many, many economies, a huge amount of the inflation that we are seeing is coming from energy and from food. Now energy prices and food prices are not likely to fall noticeably any time soon. But after prices peak, if they go sideways from there, the inflationary impulse ends up starting to fade away and so we think that's important. We also think, the COVID zero policy in China notwithstanding, that there will be some grudging easing of supply chain frictions globally, and that's going to help bring down goods inflation as well over time. So we think inflation is high, we think inflation will stay high, but we think that it's roughly peaked and over the balance of this year and into next year it should be coming down.
Andrew Sheets: As you think about central bank policy going forward, what do you think it will look like and do you think it can get back to, quote, normal?
Seth Carpenter: I will say, when it comes to monetary policy, that's a question we want to ask globally. Right now, central banks globally are generically either tight or tightening policy. What do I mean by that? Well, we had a lot of EM central banks in Latin America and Eastern Europe that had already started to hike policy a lot last year, got to restrictive territory. And for those central banks, we actually see them starting to ease policy perhaps sometimes next year. For the rest of EM Asia, they're on the steady grind higher because even though inflation had started out being lower in the rest of EM Asia than in the developed market world, we are starting to see those inflationary pressures now and they're starting to normalize policy. And then we get to the developed market economies. There's hiking going on, there's tightening of policy led by the Fed who's out front. What does that mean about getting back to an economy like we had before COVID? One of the charts that we put in the Outlook document has the path for the level of GDP globally. And you can clearly see the huge drop off in the COVID recession, the rapid rebound that got us most of the way, but not all the way back to where we were before COVID hit. And then the question is, how does that growth look as we get past the worst of the COVID cycle? Six months ago, when we did the same exercise, we thought growth would be able to be strong enough that we would get our way back to that pre-COVID trend. But now, because supply has clearly been constrained because of commodity prices, because of labor market frictions, monetary policy is trying to slow aggregate demand down to align itself with this restricted supply. And so what that means is, in our forecast at least, we just never get back to that pre-COVID trend line.
Seth Carpenter: All right, Andrew, but I've got a question to throw back at you. So the interplay between economics and markets is really uncertain right now. Where do you think we could be wrong? Could it be that the 3%, ten-year rate that we forecast is too low, is too high? Where do you think the risks are to our asset price forecasts?
Andrew Sheets: Yeah, let me try to answer your question directly and talk about the interest rate outlook, because we are counting on interest rates consolidating in the U.S. around current levels. And our thinking is partly based on that economic outlook. You know, I think where we could be wrong is there's a lot of uncertainty around, you know, what level of interest rate will slow the economy enough to balance demand and supply, as you just mentioned. And I think a path where U.S. interest rates for, say, ten year treasuries are 4% rather than 3% like they are today, I think that's an environment where actually the economy is a little bit stronger than we expect and the consumer is less impacted by that higher rate. And it's going to take a higher rate for people to keep more money in savings rather than spending it in the economy and potentially driving that inflation. So I think the path to higher rates and in our view does flow through a more resilient consumer. And those higher rates could mean the economy holds up for longer but markets still struggle somewhat, because those higher discount rates that you can get from safe government bonds mean people will expect, mean people will expect a higher interest rate on a lot of other asset classes. In short, we think the risk reward here for bonds is more balanced. But I think the yield move so far this year has been surprising, it's been historically extreme, and we have to watch out for scenarios where it continues.
Seth Carpenter: Okay. That's super helpful. But another channel of transmission of monetary policy comes through exchange rates. So the Fed has clearly been hiking, they've already done 75 basis points, they've lined themselves up to do 50 basis points at at least the next two meetings. Whereas the ECB hasn't even finished their QE program, they haven't started to raise interest rates yet. The Bank of Japan, for example, still at a really accommodative level, and we've seen both of those currencies against the dollar move pretty dramatically. Are we in one of those normal cycles where the dollar starts to rally as the Fed begins to hike, but eventually peaks and starts to come off? Or could we be seeing a broader divergence here?
Andrew Sheets: Yeah. So I think this is to your point about a really interesting interplay between markets and Federal Reserve policy, because what the Fed is trying to do is it's trying to slow demand to bring it back in line with what the supply of things in the economy can provide at at current prices rather than it at higher prices, which would mean more inflation. And there's certainly an important interest rate part to that slowing of demand story. There's a stock market part of the story where if somebody's stock portfolio is lower, maybe they're, again, a little bit less inclined to spend money and that could slow the economy. But the currency is also a really important element of it, because that's another way that financial markets can feed back into the real economy and slow growth. And if you know you're an American company that is an exporter and the dollar is stronger, you likely face tougher competition against overseas sellers. And that acts as another headwind to the economy. So we think the dollar strengthens a little bit, you know, over the next month or two, but ultimately does weaken as the market starts to think enough is priced into the Fed. We're not going to get more Federal Reserve interest rates than are already implied by the market, and that helps tamp down some of the dollar strength that we've been seeing.
Andrew Sheets: And Seth thanks for taking the time to talk.
Seth Carpenter: Andrew, it's been great talking to you.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
The mid-year outlook for European stocks sees markets encountering a variety of challenges to equity performance, but there may still be some interesting opportunities for investors.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the tricky outlook for European stocks for the second half of the year, and where we think the best opportunities lie. It's Monday, May the 16th at 2 p.m. in London.
Although the global macro backdrop feels particularly complicated just here, we think the outlook for European equities is relatively straightforward... and, unfortunately, still negative. Over the last month or so our European economists have revised their GDP forecast lower, their inflation forecast higher, and brought forward the timing of ECB interest rate hikes - an unappealing combination for risk assets, even before we consider elevated geopolitical risks. Looking into the second half of the year, we think this backdrop will persist, with European economic growth slowing considerably, but with inflation remaining sticky at around 7% and putting considerable pressure on consumer finances.
As well as the consumer, we think corporates are also going to feel the squeeze from this backdrop of slowing growth and rising prices. So far, Europe's corporate earnings trend has held up remarkably well this year. However, we think this is about to change and that a new downgrade cycle is likely to start in the coming months. This cycle is likely to reflect two drivers. First, weaker top line demand as new orders slows. And second, a squeeze on corporate margins as companies struggle to pass on their own input costs to customers. If we look at the gap between real GDP growth, which is low, and inflation, which is high, then the decline in margins could be really quite severe.
Historically, the impact on equity performance from a period of weaker earnings is often offset by a rise in the price-to-earnings ratio, as it usually coincides with more dovish central bank policy. However, this is unlikely to be the case this time, given that inflation is so high and central banks were relatively late to start their hiking cycle. Hence now the pace of rate hikes starts to accelerate as earnings starts to slow.
Of course, some of this difficult backdrop is already priced into markets, given that investor sentiment appears to be low. However, we do not believe that all of the bad news is yet discounted. European equity valuations are now down to a price-to-earnings ratio of 12.5, which is below the long run average. However, equity markets rarely trough on valuation grounds alone, and a further drop down towards 10-11x looks plausible to us over the summer. While we remain cautious on European equities at the headline level, we do see some interesting opportunities for investors to make money within the markets.
First, at the country level, we continue to like the UK equity market and specifically the FTSE 100, which is the cheapest major global stock market. And it also benefits from having high defensive characteristics, which means it tends to outperform when global stocks are falling.
Second, from a sector perspective, we prefer defensive names such as healthcare, telecoms, tobacco and utilities. We do expect to turn more positive on cyclicals later in 2022, but for now it is too early. On average, the best time to buy cyclicals is one month before economic leading indicators trough. The problem now is that these indices haven't started to fall yet.
Lastly, we continue to favor value stocks over growth stocks. While the latter have underperformed quite significantly so far this year, we think valuations and positioning still remain too high and that a broader reset of expectations is needed before they become attractive again. One value strategy we particularly like here is buying stocks with attractive dividends, as we think these stocks offer an appealing alternative to bonds and provide some protection from higher rates and inflation.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Stock-based employment compensation has gained popularity in recent years, and even investors who don’t receive employment compensation in stock should be asking, is SBC potentially dilutive to shareholders?
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Welcome to Thoughts on the Market. I'm Todd Castano, Head of Global Valuation, Accounting and Tax within Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the interesting conundrum around stock based compensation. It's Friday, May 13th at 2 p.m. in New York.
I don't need to tell listeners that 2022 has been rough on equity prices. And while it may be difficult to look at the double digit drop in the S&P or on your 41k, I'm going to share an interesting ripple effect from the market correction. And that's the impact on employee stock based compensation. And while some listeners may be saying, "this doesn't affect me because I don't receive compensation in stock", it doesn't mean it's not having an effect on your portfolio. But let me start at the beginning.
For those unfamiliar, stock based compensation, often called SBC, is a form of compensation given to employees or other parties like vendors in exchange for their services. It's a very common way for companies to incentivize employees and to align employee and shareholder interest. When a company does well, everyone does well. Stock options, restricted stock, restricted stock units are currently the most common types of stock based compensation.
Stock based compensation issuance has gained in popularity, particularly with startups and new issuances, allowing companies without much cash on hand to offer competitive total compensation rates and to attract and retain talent. In fact, 2021 marked the largest annual growth percentage in SBC cost at 27% year over year. Primarily because of new entrants to the equity market through initial public offerings and from the recovery from COVID that triggered performance based bonuses. Let's put a number on it. Stock based compensation is now approaching $250 billion annually, mostly concentrated in technology and communication service sectors.
So here's where it gets interesting. While stock based incentives encourage employees to perform, they also don't require upfront cash payments. It follows that they also dilute the ownership of existing shareholders by increasing the potential number of shares outstanding.
So now you may see where I'm going with this in terms of shareholders and your portfolio. While companies have been issuing more stock awards to employees, the double digit year to date decline in equity market has put a lot of these awards underwater. In other words, employees are essentially being paid less, meaning stock based compensation could have the opposite effect, lowering morale and sending some employees to the exits.
To put another number on it, we estimate nearly 40% of Russell 3000 companies currently are trading below their average stock grant values. Healthcare technology firms in particular appear most exposed. And considering we're in a tight labor market, companies may be forced to issue more grants to offset equity value decreases, further diluting ownership to existing shareholders.
I point all this out because SBC is generally treated as a non-cash expense and ignored from earnings. Market data vendors also often exclude outstanding awards from market capitalization calculations. So investors may underappreciate the potential dilution SBC brings to their shares. With more dilution on the way as companies attempt to right size employee pay.
For investors, we believe stock compensation is a real economic expense and should be incorporated in valuation. It may not appear so in bull markets, but this correction has eliminated that reality.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As consumers deal with rising interest rates, persistent inflation, and a desire to get outside in the ever changing COVID environment, the question is, what does this all mean for the future of eCommerce growth?
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Welcome to Thoughts on the Market. I'm Andrew Rubin, Morgan Stanley's Latin America Retail and eCommerce Analyst. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the outlook for global e-commerce in the years ahead. It's Thursday, May 12th, at 2 p.m. in New York.
Amid rising interest rates and persistent inflation, we've seen quite a lot of debate about the health of the consumer and the effect on eCommerce. If you couple those factors with consumers' desire to return to in-person experiences as COVID recedes, you can see why we've fielded a lot of questions about what this all means for eCommerce growth.
To answer this question, Morgan Stanley's Internet, eCommerce and Retail teams around the world drew on both regional and company level data to fashion what we call, the Morgan Stanley Global eCommerce Model. And what we found was that the forward looking picture may be more robust than some might think.
While stay at home trends from COVID certainly drove outsized eCommerce growth from 2019 to 2021, we found the trend should stay stronger for longer, with eCommerce set to grow from $3.3 trillion currently to $5.4 trillion in 2026, a compound annual growth rate of 10%.
And there are a few reasons for that. First, the shift toward online retail had already been in place well before the COVID acceleration. To put some numbers behind that, eCommerce volumes represented 21% of overall retail sales globally in 2021. That's excluding autos, restaurants and services. So, while the rise of eCommerce during the first year of COVID in 2020 is easily explained, the fact that growth persisted in 2021, even on a historically difficult comparison, is evidence, in our view, of real behavioral shift to shopping online.
Another factor that supports our multi year growth thesis is a trend of broad based eCommerce gains, even for the highest penetration countries and categories. As you might expect, China and the U.S. represent a sizable 64% of global eCommerce volumes, and these countries are the top drivers of our consolidated market estimates.
But we see higher growth rates for lower penetrated regions, such as Latin America, Southeast Asia and Africa, as well as categories like grocery and personal care. Interestingly, however, in our findings, no country or vertical represented a single outsized growth driver. Looking at South Korea, which is the global leader in e-commerce, we expect an increase from 37% of retail sales in 2021 to 45% in 2026. For the electronics category worldwide, which leads all other major categories with 38% penetration, we forecast penetration reaching 43% in 2026. And while there are some headwinds due to logistics in certain countries and verticals, we believe these barriers will continue to come down.
Another encouraging sign is that globally, we have yet to see a ceiling for eCommerce penetration. We identify three fundamental factors that underpin our growth forecasts and combine for what we see as a powerful set of multi-year secular drivers. First, logistics. We see a big push towards shorter delivery times and lower cost or free delivery. The convenience of delivery to the door is a top differentiating factor of eCommerce versus in-store shopping. And faster speeds can unlock new eCommerce categories and purchase occasions. Second, connectivity. Internet usage is shifting to mobile, and smartphones and apps are increasingly the gateway to consumers, particularly in emerging markets. And these consumers, on average, skew younger and over-index for time spent on the mobile internet. And third is Marketplace. We see a continued shift from first party owned inventory to third party marketplace platforms, connecting buyers and sellers.
For investors, it's important to note that global eCommerce does not appear to be a winner-take-all market. And this implies opportunity for multiple company level beneficiaries. In particular, investors should look at companies with forecast share gains, exposure to higher growth categories, and discounted trading multiples versus history.
Thanks for listening. If you enjoyed the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Original Release on April 26th, 2022: Global supply chains have been under stress from the pandemic, geopolitical tensions, and inflation, and the outlook for transportation in 2022 is a mixed bag so far. Chief U.S. Economist Ellen Zentner and Equity Analyst for North American Transportation Ravi Shanker discuss.
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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research,
Ravi Shanker: and I'm Ravi Shanker, Equity Analyst covering the North American Transportation Industry for Morgan Stanley Research.
Ellen Zentner: And today on the podcast, we'll be talking about transportation, specifically the challenges facing freight in light of still tangled supply chains and geopolitics. It's Tuesday, April 26, at 9:00 a.m. in New York.
Ellen Zentner: So, Ravi, it's really good to have you back on the show. Back in October of last year we had a great discussion about clogged supply chains and the cascading problems stemming from that. And I hoped that we would have a completely different conversation today, but let's try to pick up where we left off. Could we maybe start today by you giving us an update on where we are in terms of shipping - ocean, ground and air?
Ravi Shanker: So yes, things have materially changed since the last time we spoke, some for the better and some for the worse. The good news is that a lot of the congestion that we saw back then, whether it was ocean or air, a lot of that has eased or abated. We used to have, at a peak, about 110 ships off the Port of L.A. Long Beach, that's now down to about 30 to 40. The other thing that has changed is we just went from new peak to new all time peak on every freight transportation data point that we were tracking over the last two years. Now all of those rates are collapsing at a pace that we have not seen, probably ever. It's still unclear whether this legitimately marks the end of the freight transportation cycle or if it's just an air pocket that's related to the Russia Ukraine conflict or China lockdowns or something else. But yes, the freight transportation worlds in a very different place today, compared to the last time I was on in October. Ellen, I know you wanted to dig a little more deeply into the current challenges facing the shipping and overall transportation industry. But before we get to that, can you maybe help us catch up on how the complicated tangle created by supply chain disruptions has affected some of the key economic metrics that you've been watching over the last six months? That is between the time we last spoke in October and now.
Ellen Zentner: Sure. So, we created this global supply chain index to try to gauge globally just how clogged supply chains are. And we did that because, what we've uncovered is that it's a good leading indicator for inflation in the U.S. and on the back of creating that index, we could see that the fourth quarter of last year was really the peak tightness in global supply chains, and it has about a six month lead to CPI. Since then, we started to see some areas of goods prices come down. But unfortunately, that supply chain index stalled in February largely on the back of Russia, Ukraine and on the back of China's zero COVID policy, starting to disrupt supply chains again. So the improvement has stalled. There are some encouraging parts of inflation coming down, but it's not yet broad based enough, and we're certainly watching these geopolitical risks closely. So, Ravi, I want to come back to freight here because you talked about how it's been underperforming for a couple of months now and forward expectations have consistently declined as well. You pointed to it as possibly being just an air pocket, but you're pointing, you're watching closely a number of things and anticipate some turbulence in the second half of the year. Can you walk us through all of that?
Ravi Shanker: What I can tell you is that it's probably a little too soon to definitively tell if this is just an air pocket or if the cycles over. Again, we are not surprised, and we would not be surprised if the cycle is indeed over because in December of last year, we downgraded the freight transportation sector to cautious because we did start to see some of those data points you just cited with some of the other analysts. So we were expecting the cycle to end in the middle of 22 to begin with, but to see the pace and the slope of the decline and a lot of these data points in the month of March, and how that coincides with the Russia-Ukraine conflict and that the lockdowns in China, I think, is a little too much of a coincidence. So we think it could well be a situation where this is an air pocket and there's like one or two innings left in the cycle. But either way, we do think that the cycle does end in the back half of the year and then we'll see what happens beyond that.
Ellen Zentner: OK, so you're less inclined to say that you see it spilling over into 2023 or 2024?
Ravi Shanker: I would think so. Like if this is just a normal freight transportation cycle that typically lasts about 9 to 12 months. The interesting thing is that we have seen 9 to 12 months of decline in the last 4 weeks. So there are some investors in my space who think that the downturn is over and we're actually going to start improving from here. I think that's way too optimistic. But if we do see this continuing into 2023 and 2024 I think there's probably a broader macro consumer problem in the U.S. and it's not just a freight transportation inventory destocking type situation.
Ellen Zentner: So Ravi, I was hoping that you'd give me a more definitive answer that transportation costs have peaked and will be coming down because of course, it's adding to the broad inflationary pressures that we have in the economy. Companies have been passing on those higher input costs and we've been very focused on the low end consumer here, who have been disproportionately burdened by higher food, by higher energy, by all of these pass through inflation that we're seeing from these higher input costs.
Ravi Shanker: I do think that rates in the back half of the year are going to be lower than in the first half of the year and lower than 2021. Now it may not go down in a straight line from here, and there may be another little bit of a peak before it goes down again. But if we are right and there is a freight transportation downturn in the back of the year, rates will be lower. But, and this is a very important but, this is not being driven by supply. It's being driven by demand and its demand that is coming down, right. So if rates are lower in the back half of the year and going into 23, that means at best you are seeing inventory destocking and at worst, a broad consumer recession. So relief on inflation by itself may not be an incredible tailwind, if you are seeing demand destruction that's actually driving that inflation relief.
Ellen Zentner: That's a fair point. Another topic I wanted to bring up is the fact that while freight transportation continues to face significant headwinds, airlines seem to be returning to normal levels, with domestic and international travel picking up post-pandemic. Can you talk about this pretty stark disparity?
Ravi Shanker: Ellen it's absolutely a stark disparity. It's basically a reversal of the trends that you've seen over the last 2 years where freight transportation, I guess inadvertently, became one of the biggest winners during the pandemic with all the restocking we were seeing and the shift of consumer spend away from services into goods. Now we are seeing the reversion of that. So look, honestly, we were a little bit concerned a month ago with, you know, jet fuel going up as much as it did and with potential concerns around the consumer. But the message we've got from the airlines and what we are seeing very clearly in the data, what they're seeing in the numbers is that demand is unprecedented. Their ability to price for it is unprecedented. And because there are unprecedented constraints in their ability to grow capacity in the form of pilot shortages, obviously very high jet fuel prices and other constraints, I guess there's going to be more of an imbalance between demand and supply for the foreseeable future. As long as the U.S. consumer holds up, we think there's a lot more to come here. So Ellen, let me turn back to you and ask you with freight still facing such big challenges and pressure on both sides on the supply chain. What does that bode for the economy in terms of inflation and GDP growth for the rest of this year and going into next year?
Ellen Zentner: So I think because, as I said, you know, our global supply chain index has stalled since February. I think that does mean that even though we've raised our inflation forecasts higher, we can still see upside risk to those inflation forecasts. The Fed is watching that as well because they are singularly focused on inflation. GDP is quite healthy. We have a net neutral trade balance on energy. So it actually limits the impact on GDP, but has a much greater uplift on inflation. So you're going to have the Fed feeling very confident here to raise rates more aggressively. I think there's strong consensus on the committee that they want to frontload rate hikes because they do need to slow demands to slow the economy. They do almost need that demand destruction that you were talking about. That's actually something the Fed would like to achieve in order to take pressure off of inflation in the U.S.. But we think that the economy is strong enough, and especially the labor market is strong enough, to withstand this kind of policy tightening. It takes actually 4 to 6 quarters for the Fed to create enough slack in the economy to start to bring inflation down more meaningfully. But we're still looking for it to come in, for core inflation, around 2.5% by the fourth quarter of next year. So, Ravi, thanks so much for taking the time to talk. There's much more to cover, and I definitely look forward to having you back on the show in the future.
Ravi Shanker: Great speaking with you Ellen. Thanks so much for having me and I would love to be back.
Thanks for listening. If you're interested in learning more about the supply chain, check out the newest season of Morgan Stanley's podcast, Now, What's Next? If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
U.S. markets and the Federal Reserve have been grappling with high inflation this year, but could changes in global supply chains help make this problem easier?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, May 10th, at 9 a.m. in New York.
Inflation is perhaps the key to understanding the markets these days. Elevated inflation is what's driving the Fed to raise interest rates at the fastest pace in a generation. And at the risk of oversimplifying, when interest rates are higher, that means it costs more to get money. And when money is no longer cheap, anything that costs money is harder to buy and therefore might have to fall in value to find a buyer. This is the dynamic the Fed believes will eventually dampen price increases throughout the economy, and it's the dynamic that's likely contributed to stock market prices already declining.
But what if inflation were to start easing without the Fed raising rates? Could the Fed slow its rate hikes and, consequently, help stop the current stock market sell off? It's an intriguing possibility and investors who want to understand if such an outcome is likely need to carefully watch global supply chains. And to be clear, when we're talking about the supply chain, we're talking about whether companies can produce and deliver sufficient goods in a timely manner to meet demand. When they cannot, as became the case during the pandemic when consumers stopped going out and started buying more things than normal for their homes, prices rise as choke points emerge in key markets where demand outstrips supply. By that logic, if goods producers are able to ramp up production or if consumers shift back to normal, balancing consumption of goods and services, inflation would ease, putting less pressure on the Fed to raise rates.
So what's the state of global supply chains now? Are there any signs of supply chain easing that may make the Fed's job and investors near-term market experience easier? To answer this question my colleague, Asia and Emerging Market Equity Strategist Daniel Blake, formed a team to create a supply chain choke point tracker. What can we learn from this? In short, the picture is mixed. There's several factors that could lengthen global supply chain stress. COVID spread in China, for example, has led to lockdowns affecting about 26% of GDP, hampering their production of goods. And Russia's invasion of Ukraine, and resulting sanctions response by the U.S. and Europe, has crimped the global supply of oil, natural gas and key agricultural goods. But there's some good news too. Many companies are reporting initial investment and progress towards diversifying and, in some cases, reshoring supply chains, which over time should reduce choke points.
Still, the challenging news for markets is that a mixed supply chain picture means that monetary policymakers are unlikely to see supply chain easing as a reliable outcome, at least in the near term. Unfortunately, that likely means we'll continue to see risk markets struggle with how to price in a Fed that stays on track to fight inflation through higher interest rates.
Thanks for listening. If you're interested in learning more about the supply chain, check out the newest season of Morgan Stanley's podcast, Now, What's Next? If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
While the war in Ukraine has had an effect on the current pricing in European energy markets, there is more to the story of why high prices could persist for years to come. Chief Cross-Asset Strategist Andrew Sheets and Head of European Utilities and Clean Energy Research Rob Pulleyn discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist.
Rob Pulleyn: And I'm Rob Pulleyn, Head of the European Utilities and Clean Energy Research Team.
Andrew Sheets: And today on the podcast, we'll be talking about the outlook for European energy supply and demand, in both the near and long term. It's Monday, May 9th, at 4 p.m. in London.
Andrew Sheets: So, Rob, we talked a lot on this podcast since March about the effect of the Russia-Ukraine conflict on energy in Europe. I want to talk to you today in part because there are some interesting implications over the long term in the European energy and power markets. But just to level set a little bit what's been going on in European power prices.
Rob Pulleyn: Sure. For context, Andrew, what's been happening is that European power prices versus 12 months ago are up between 150 and over 300%, depending on which country. They're pretty much at all time highs or slightly off them from where we were earlier this year. Now, what does that flow through to customer bills in places like the UK? Year over year customer bills are going up 60% so far, other country's a little bit lower due to some market intervention. But this is the backdrop.
Andrew Sheets: Now, you've been talking to a lot of global investors around what's been going on in Europe. What's your most likely case? What's your base case? And then what are some realistic scenarios around that?
Rob Pulleyn: We outlined four scenarios in the new note. The base case is that we get close to the FIT for 55 climate plan from last year, which envisages 65% renewables penetration by the end of the decade. Now, this is a long way short of the Repower EU plan, which would envisage about twice as much again in terms of the renewable capacity and getting to about an 80% penetration by the end of the decade. And so we see significant growth in renewables. We think coal will be phased out more or less by 2030, but with more burn in the next few years, less gas until gas supplies can be diversified. In terms of market intervention, we continue to think this will be relatively benign for utility stocks because effectively governments need to find a way to help the customer, but also ensure that utilities actually invest in the new power system that governments want.
Andrew Sheets: But Rob, under your central scenario where power prices are significantly higher, isn't there a feedback mechanism there? Aren't people going to look at their sharply higher utility bills and say, I'm going to use less electricity, I'm going to put in double glazing, I'm going to improve my insulation, I'm going to do all these things that mean I use less energy. Which would hopefully mean less energy gets used and the power price impacts would be less significant. How much can energy efficiency influence the story or not?
Rob Pulleyn: Now you're quite right. Demand destruction, one way or another, is part of the equation here. There's many renovation tools or new technologies which are now significantly more attractive in economic terms, simply because gas prices and power prices are so high. And whilst previously we thought there'd be a slow burn on many of those routes under the guise of decarbonization, now under cold, hard economics, as you highlight these things should all accelerate. And if I was going to point to one area of incremental policy support, I think it's got to be green gasses like hydrogen. I think that's a genuine route to both diversify gas supplies and also decarbonize.
Andrew Sheets: So Rob, how do you think about the interplay between the economic backdrop and these power prices? Because it's been the energy shock from the conflict in Ukraine that's driven power prices up, but it's also been something that's led people to worry that European growth might slow, which would reduce the demand for power. So how does that play out as you're thinking about these various scenarios?
Rob Pulleyn: Sure, it's a great question, Andrew. And let's just start by saying that as it stands today, utility bills contribute around about one third to the inflation rate that we have at the moment. And therefore, if these power prices and gas prices will persist as they stand, then that inflation will also be reasonably persistent. Now, of course, there is still upside risk to power price and gas prices in several scenarios, particularly those where supplies are interrupted, which would then create higher inflation on top of the rates we currently have. This would therefore then flow into the bear case that our economists have for GDP growth. And so the economic impact would of course, be there. Ultimately, GDP is sensitive to the input costs and energy is one of the biggest there is.
Andrew Sheets: Rob, I also want to ask you about where technology fits into all of this. There are both some exciting advances in energy technology. On the renewable side, renewable energy is getting more efficient. We're seeing some interesting advances in battery storage. When you are trying to model European power consumption out over the next decade, how much of a technological impact are you putting in your numbers?
Rob Pulleyn: Yeah. So the easy one to talk about is renewables, which is currently about 38% of the European stack. The Repower EU would imply something around 80%, which coincidentally is actually also the German target. Fit for 55 has a plan of 65% across the EU by 2030. We're modeling 62%. So significant increase from where we are today. And of course, where we are with power prices at the moment, then investing in European renewables is actually looking very attractive. I mean, very simply put, the offtake price is increasing more than the input cost inflation. That should lead to, you know, the right incentives to build more of these things. We talked about green gasses earlier. Now, whether it be market forces, the gas price, whether it be government support, ultimately we think green gasses is going to be accelerated and that can certainly help the economy beyond the power generation sector. So within European gas demand, power generation is around about 30% of it. The other two thirds, broadly evenly split, are residential heating and industrial heating furnaces and processes. And certainly hydrogen could be, in the long term, a solution for those aspects. Battery storage is a question we get a lot, particularly from the states where actually we're seeing some quite, quite stunning improvements in battery uptake. In Europe that is relatively small scale, but something which could also dramatically increase across the decade.
Andrew Sheets: So, Rob, with all of this in mind, what should investors be looking at in European utilities and energy?
Rob Pulleyn: Our preferred beneficiaries within the narrow definition of utilities and clean energy would be to combine the defensive nature of networks with clean energy growth. Right. And I think ultimately that that will be a very powerful combination for what the market's looking for with a macro backdrop. Your benefit for green growth from all the policy support and from the high power prices, at the same time, retaining these defensive qualities that the market increasingly seems to have an appeal for. A slightly more optimistic take would be to try and get that real power price sensitivity through some of the outright power producers, whether that's nuclear, hydro or renewables. Those stocks should benefit from significant earnings upgrades over the next few years.
Andrew Sheets: Rob, thanks for taking the time to talk.
Rob Pulleyn: Well, has been great speaking to you, Andrew. Thank you very much.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
While oil prices usually rise and fall with the overall stock market, current prices have broken from this trend and oil may continue to outperform on a cross-asset basis.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 6th, at 2 p.m. in London.
Yesterday, U.S. equities fell more than 3% and U.S. 10 year Treasury bonds fell by more than 1%. This unusual pattern has only occurred 6 other days in the last 40 years. Markets are clearly continuing to struggle with major cross-currents, from a Federal Reserve that's raising interest rates, to mixed economic data, to the war in Ukraine.
But one asset that's bucking the confusion is oil prices. Oil usually rises and falls with the overall stock market because the prices of both are seen as proxies for economic activity. But that relationship has broken down recently. As stock markets have fallen, oil prices have held up. We think that oil will continue to outperform on a cross-asset basis.
Part of this story is fundamental. Demand for energy remains high, while energy supply has been slow to grow. The green transition is a big part of this. Consumers are likely to shift towards electric vehicles, but most cars currently on the road still burn fuel. Energy companies, seeing the shift in energy consumption coming, are more reluctant to invest in new production today. This has left the global oil market very tight, without much spare capacity.
There's also a fundamental difference in the way asset classes discount future risks. Equity and credit markets are very forward looking, and their prices today should reflect how investors discount risks over the next several years. But commodity prices are different; when you need to fill up a car, or a plane, you need that fuel now.
That distinction in timing doesn't always matter. But if you're in an environment where economic activity is strong right now, but it also might slow in coming years, equity and credit markets can start to weaken even as energy prices hold up. I think that's a pretty decent description of the current backdrop.
A final part of this story is geopolitical. Oil prices could rise further if the war in Ukraine escalates, a scenario that would likely push prices down in other asset classes. But if geopolitical risk declines, there could be better growth, more economic confidence, and more energy demand, meaning oil might not fall much relative to forward expectations. That positive skew of outcomes should be supportive of oil.
In the short term, high oil prices could weigh on consumer spending. In the long run, it creates a more powerful incentive to transition towards more energy efficiency and newer, cleaner energy sources. In the meantime, we forecast higher prices for oil, and for oil linked currencies like the Norwegian Krone.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
As “The Gig Economy” has evolved to become the Multi-Earner economy, an entire ecosystem reinventing how people earn a living, equity investors will want to take note of the related platforms that are making an impact on the market. European Head of Thematic Research Edward Stanley and U.S. Economist Julian Richers discuss.
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Ed Stanley: Welcome to Thoughts on the Market. I'm Edward Stanley, Head of Thematic Research in Europe.
Julian Richers: And I'm Julian Richards from Morgan Stanley's U.S. Economics Team.
Ed Stanley: And today on the podcast, we'll be talking about a paradigm shift in the future of work and the rise of the multi-earner era. It's Thursday, May the 5th at 3 p.m. in London.
Julian Richers: And 10 a.m. in New York.
Ed Stanley: So, Julian, I'd wager that most of our listeners have come across news articles or stories or even anecdotes about YouTubers, TikTok stars who've made an eye popping amount of money making videos. But you and I have been doing some research on this trend, and in fact, it appears to be much larger than just people making videos. It's an entire ecosystem that can reinvent how people earn a living. In essence, what we used to call the 'gig economy' has evolved into the multi earning economy—the side hustle. And people tend to be surprised at the sheer extent of side hustles that are out there: from blogging to live streaming, e-commerce, trading platforms, blockchain-enabled gaming. These are just a handful of some of the platforms that are out there that are facilitating this multi-earning era that we talk about. But explain for us and for our listeners why the employment market had such a catalyst moment with COVID.
Julian Richers: With COVID, really what has fundamentally changed is how we think about the nature of work. So people had new opportunities and new preferences. People really started enjoying working remotely. Lots of people embraced their entrepreneurial spirit. And everything has just gotten a lot faster and more integrated the more we've used technology. And so you add on top of this, this emergence of these new platforms, and it's dramatically lowering the hurdle to go to work for yourself. And that's really how I think about this multi-earn era, right? It's working and earning in and outside of the traditional corporate structure.
Ed Stanley: And talk to us a little bit about the demographics. Who are these multi-earners we're talking about?
Julian Richers: So right now in our survey, we basically observe that the younger the better. So really the most prolific multi-earners are really in Gen Z. But it's really not restricted to that generation alone, right? It's pretty clear that Gen Z really desires these nontraditional work environments, you know, the freedom to work for oneself. But the barriers are really lowered for everyone across the board that knows how to use a computer. So, yes, Gen Z and it's definitely going to be a Generation Alpha after this, but it's not limited to that and we see a lot of millennials dipping their toes in there as well.
Ed Stanley: And how should employers be thinking about this trend in terms of what labor's bargaining power should be and where it is, and the competition for talent, which is something that we hear quite consistently now in the press?
Julian Richers: My view on this is that we're really seeing a quite dramatic paradigm shift in the labor market when it comes to wages. So for the last two decades, you had long periods of very weak labor markets that have just led to this deterioration in labor bargaining power. Now, the opposite, of course, is true, right? Workers are the scarce resources in the economy, and employers really need to look far and wide for them. And then add on top of this, uh, this multi-earn story. If it's that easy for me to wake up and go to work for myself on my computer, doing things that I enjoy, you'll need to pay me a whole lot more to put on a suit and come back to my corporate job. So Ed, with this background in mind, why should equity investors look at this trend now?
Ed Stanley: It's a great question, and it's one that we confront a lot in thematic research. And we think about themes and when they become investable. For equity investors, themes tend to work best when we reach or surpass the 20% adoption curve. And that applies for technology and it applies for themes. And after this 20% point, typically investors needn't sacrifice profit for growth, which is a really important dichotomy in the markets, particularly at the moment where inflation is is clearly high and the markets are resetting from a valuation perspective. So this multi-earner theme and it's enabling technologies have hit or surpassed this 20% threshold I've talked about. While this structural trajectory is is incredibly compelling, the stock picking environment is obviously incredibly challenging at the moment.
Julian Richers: So Ed, at the top, you mentioned that there are actually more of these multi-earn platforms out there than people might think. What's the ecosystem like for 'X-to-earn' and how many platforms and verticals are really out there?
Ed Stanley: So the way we tried to simplify it, given that it is so broad and sprawling and increasingly so, was to try to bucket them. And we bucketed them into nine verticals with one extra one, which essentially is the facilitators—these are the big recruitment companies who are also trying to navigate this paradigm shift alongside these 'X-to-earners, these multi-earners. And we lay this out from the most mature to the least mature. And in the most mature category, we have content creators. We have the e-commerce platforms. We have delivery, as in grocery and delivery drivers, and then we start to get into the least mature verticals. This is trading as an earnings strategy which has been very volatile and continues to be so. Gig-to-earn, where people are spending time doing small tasks which don't take up large amounts of time typically and can be done on the side of corporate roles. And then right at the most emergent, or least mature, end of the spectrum, we have play-to-earn. And these tend to be based on blockchain platforms where participation is rewarded, in theory, by tokens which are native to that blockchain. So incredibly emerging technology and one that we're, we're looking to watch closely.
Julian Richers: Yeah. So among those platforms, is there one that you think is particularly worth watching?
Ed Stanley: Well, I think actually it comes down to that that latter point, I think many of the ones at the more mature end of the spectrum are pretty self-explanatory. A lot of that, I think, is second nature, particularly for younger users who are trying to make money on on these platforms. But it's at that more emerging end of the spectrum, the blockchain enabled solutions, where a lot of this is incredibly new and the innovation is happening at a really quite alarming rate. That blockchain enabled solution essentially is a new challenge to legacy institutions who don't anymore have to compete just with these traditional earning platforms, but they also have to compete with the labor monetization tools that blockchains facilitate. And they'll also have to compete with the lifestyle that these tools offer, which essentially is that freedom to work for yourself and to earn multiplicatively.
Julian Richers: So, my last question ties back to the question that you had for me about how employers should think about this. What does this trend actually mean for corporates?
Ed Stanley: So, this is something that certainly seems to be inflationary in the short term and I think we both agree appears to be structurally inflationary in the longer term. The real question both corporates and investors seem to have is, 'what happens to all of this in a recession?' And the recession point is something that is obviously gathering traction in the markets. It's gathering traction in the news. And a lot of this will become potentially untenable as a sustainable earning platform. And so these earning platforms cannot yet be assumed to be stable, sustainable revenue streams, particularly during downturns. And so, these are the kind of debates that are happening. But longer term, through a recession and out the other side, we still believe that the ability to scale, the low upfront costs, the low opportunity costs or perceived low opportunity costs of careers, are really what's driving this, and that is not going to go away just because of a recession. And so with that, Julian, thank you very much for taking the time to talk to me.
Julian Richers: Great speaking with you, Ed.
Ed Stanley: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
2022 has presented a complex set of challenges, meaning investors may want to take a step back and consult rules-based indicators and strategies for some clarity.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Wednesday, May 4th, at 2 p.m. in London.
2022 is complicated. Cross-asset returns are unusually bad and investors still face wide ranging uncertainties, from how fast the Federal Reserve tightens, to whether Europe sees an energy crisis, to how China addresses COVID.
But step back a bit, and the year is also kind of simple. Valuations were high, policy is tightening and growth is slowing, and prices have fallen. Cheaper stocks are finally outperforming more expensive ones. Bond yields were very low and are finally rising.
So what should investors do, given a complex set of challenges, but also signs of underlying rationality? This can be a good time to step back and look at what our rules-based indicators are saying.
Let's start by focusing on what these indicators say about where we are in the cycle, and what that means for an investment strategy. Our cycle indicator looks at a range of economic data and then tries to map this to historical patterns of cross-asset performance.
Our indicator currently sees the data as significantly above average. We call this 'late cycle', because historically readings that have been sharply above the average have often, but not always, occurred later in an economic expansion. This is not about predicting recession, but rather about thinking probabilistically. If the odds of a slowdown are rising, then it will affect cross-asset performance today, even if a recession ultimately doesn't materialize.
At present, the 'late cycle' readings of this indicator are consistent with underperformance of high yield credit relative to investment grade credit, the outperformance of defensive equities, a flatter yield curve and being more neutral towards bonds overall. All are also current Morgan Stanley Research Views.
A second question that comes up a lot in our meetings is whether or not there's enough worry and concern in the market to help it. After all, if most investors are already negative, it can be harder for bad news to push the market lower and easier for any good news to push the market higher. We try to quantify market sentiment and fear in our sentiment indicator. Our sentiment indicator works by trying to look at a wide variety of data, but also paying attention to not just its level but the direction of sentiment. At the moment, sentiment is not extreme and it's also not yet improving. Therefore, our indicator is still neutral.
Given the swirling mix of storylines and volatility, a third relevant question is what would a fully rules-based strategy do today? For that we turn to CAST, our cross-asset systematic trading strategy. CAST asks a simple question with a rules-based approach; what looks most attractive today, based on what has historically worked for cross-asset performance.
CAST is dialing back its market exposure, especially in commodities where it has become more negative on copper, although it still likes energy. CAST expects the Renminbi to weaken against the U.S. dollar, and Chinese interest rates to be lower relative to U.S. rates. In stocks, it is positive on Japan and healthcare, and negative on the Nasdaq and the Russell 2000. All of these align with current Morgan Stanley Research fundamental views and forecasts.
Rules based tools help in markets that are volatile, emotional, and showing more storylines than a reasonable investor can process. For the moment, we think they suggest cross-asset performance continues to follow a late cycle playbook, that sentiment is not yet extreme enough to give a conclusive tactical signal, and that following historical factor-based patterns can help in the current market environment. These tools won't solve everything, but given the challenges of 2022 so far, every little bit helps.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
As U.S. voters continue to show support for trade policy in regards to China, investors will want to track which actions could have consequences for China equities and currency markets.
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Welcome to Thoughts on the Market. I'm Michal Zezas, Head of Public Policy Research and Municipal Strategy for Morgan stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, May 3rd, at 2 p.m. in New York.
You might recall that, for much of 2018 and 2019 financial markets ebbed and flowed on the tensions between the U.S. and China over trade policy that led to escalation of tariffs, export restrictions and other policies that still hinder commerce between the countries today. We remind you of those events because they could echo through markets this year as calls in the U.S. for concrete trade policy action have recently grown louder. The main catalyst for this has been reports showing that China has fallen short of its purchase commitments within the Phase One trade deal signed in February of 2020. And polls show that voters would continue to view U.S. trade protections favorably, which, of course, translates to strong political incentives for lawmakers to pursue 'tough on China' policies. So in light of this, it's worth calling out three potential policy actions and their potential effect on equities and currency markets.
The first is a trade tool known as a '301 investigation.' I'll spare you the mechanics, but a 301 investigation allows the U.S. to impose tariff or non-tariff actions in response to unfair trade practices. Media reporting has indicated that the Biden administration is considering deployment of a 301 investigation. Should the U.S. adopt non-tariff measures under Section 301 against China, such as further restrictions on the technology supplied to Chinese firms, China may respond with non-tariff measures on specific American goods. For investors, a tariff escalation would likely be a drag on bilateral trade in affected sectors and discourage manufacturing capital expenditures. As a result, broad equity market sentiment in China would likely be dampened, and it could mean further downside to our already cautious view on China equities.
The second potential action would be passage of the 'Make It In America Act,' which would enhance domestic manufacturing in some key industries and reduce reliance on foreign sources by reinforcing the supply chain in the U.S. The House and Senate have both passed versions of this bill, and we expect a blended version will become law this year. For investors, this event may be largely in the price. Currency markets will likely see it as just a continuation of ongoing competition between the two nations, without an immediate escalation. The effect on equity markets would be similarly mixed.
Finally, the U.S. could escalate non-tariff barriers in places such as tech exports. This last policy action could be significant, since non-tariff measures negative effects tend to be bigger and more profound than direct tariff hikes. We expect China to respond in kind, perhaps by launching an 'unreliable entity' list, which would mean prohibitions on China-related trade, investment in China and travel and work permits.
Currency markets would likely react, seeing this as a meaningful escalation, resulting in fresh U.S. dollar strength due to concerns about companies foreign direct investment into China. And for China equities, once again, it would mean further downside to our already cautious view.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Credit markets are facing various headwinds, including policy tightening and slowing growth, and credit investors are looking for where they might see the best risk adjusted returns. Chief Cross-Asset Strategist Andrew Sheets and Global Director of Fixed Income Research Vishy Tirupattur discuss.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist.
Vishy Tirupattur: And I am Vishy Tirupattur, Global Director of Fixed Income Research.
Andrew Sheets: And today on the podcast, we'll be talking about the challenges facing credit markets. It's Monday, May 2nd at 1 p.m. in London.
Vishy Tirupattur: And 8 a.m. in New York.
Andrew Sheets: So Vishy, it's great to have you back on the show because I really wanted to speak to you about what's been happening in credit markets. There's been a lot of volatility across the whole financial landscape, but that's been particularly acute in fixed income and we've seen some large moves in credit. So maybe before we get into the rest of the discussion, let's just level set with what's been happening year to date across credit.
Vishy Tirupattur: It's been a really rough ride to credit investors. Investment grade returns are down 12% for the year and for high yield investors are down 6% for the year and leveraged loan markets are up slightly, 1.4% up for the year. So pretty dramatic differences across different segments of the credit markets. Higher quality has significantly underperformed lower quality.
Andrew Sheets: So Vishy where I think this is also interesting is that investors in other asset classes often really look to credit as both a warning sign potentially to other markets and as an overall indicator in the health of the economy, so when you think about what's been driving the credit weakness, you know, how much of it is a economic concern story? How much of it is an interest rate story? How much of it is other things?
Vishy Tirupattur: Andrew, we should always remember that the total returns to bond investors come from two parts. There's an interest rate component and there is a credit quality component. And what has driven the markets thus far in the year is really higher interest rates. As you know, Andrew, interest rates have dramatically increased from the beginning of the year to now, and a lot of expectations of future interest rates is already reflected in price. Those higher interest rate expectations have really contributed to the underperformance of the higher quality bonds, which tend to be a lot more interest rate sensitive than the lower quality bonds. The lower quality bonds tend to be a lot more sensitive to perceptions of the quality of the credit, as opposed to the level of interest rates. And that is really what explains the market moment thus far.
Andrew Sheets: So Vishy, after such a tough start to the year for credit, do you think those challenges persist and do you think we see the same pattern of performance, of investment grade underperforming high yield which is underperforming loans, translate over the rest of the year?
Vishy Tirupattur: Andrew I think that is a change that is afoot here. A pretty aggressive rate of interest rate hikes is already priced into the interest rate market. Even though investment grade returns have been affected negatively, predominantly by higher level of interest rates, going forward we think that is changing. I think we are going to see changes in the expectations of credit worthiness of bonds, the credit risks in the tail parts of the credit markets taking a greater significance in terms of credit market returns going forward.
Andrew Sheets: So in essence, Vishy, we've just had a period where higher quality credit has underperformed as interest rates have been the main factor driving bonds. But looking ahead, that interest rate move is, we think, largely done for the time being, whereas the market might start to focus more on the extra risk premium that needs to be applied for economic risk.
Vishy Tirupattur: Indeed, I think the focus of the credit markets will change from a concern about incrementally higher interest rates to concerns about the quality of the credit markets. So credit concerns are building, the economy is showing signs of downdraft, we saw the negative GDP print. So we think going forward, the market will think about credit quality more than interest rate effects on the total returns.
Andrew Sheets: And Vishy, if investors are looking at this large downdraft in the investment grade market, where do we see the best risk adjusted return within the investment grade credit market?
Vishy Tirupattur: So within the investment grade markets, the back up in rates has really created pockets of value in low dollar price bonds. And this is where we think the best opportunity for investors lies. In the high yield world, we think double B's or triple C's is a good trade.
Andrew Sheets: The final question I'd ask you that comes up a lot is, what is the outlook for defaults? How are you thinking about forecasting defaults, and are there aspects of the fundamental balance sheet trends of companies today that, you know, seem pretty important as we think about that cycle?
Vishy Tirupattur: I'm glad you asked me that question, Andrew. Even though the economy is weakening a bit and credit concerns are rising a bit, it by no means means we will see a spike in default rates. Default rates are at historically low levels now. Defaults are probably going to rise from here, but not dramatically spike. We expect that defaults will remain below the long term average for some time to come. In fact, if we look at the fundamentals of the credit markets, they have been strongest they have ever been going into a credit cycle. Andrew let me turn it back to you. You know, one can argue that this rise in yields that we have seen from the beginning of the year to now will mean significant changes to fixed income asset allocation. And in fact, makes fixed income asset allocation much more interesting. On your total return focused optimal portfolio, what's the better risk reward proposition in the fixed income markets?
Andrew Sheets: I think it's pretty interesting. You know, if you've been investing in the markets over the last decade you really feel like a broken record when you say that bond yields are low. I mean, bond yields have been low and then they've often kept going lower. So it's pretty notable that in a relatively short period of time, you know, in the last nine months, the yield picture has really changed. And bond prices going down is the way that yields go up, and we've seen the largest drawdown in bond prices since 1980 in the U.S. So that pain is painful to investors, that that drop in prices has hurt portfolios. If there's a silver lining, it means that the yields now on offer are a lot better. So as you mentioned, you know, U.S. investment grade credit yielding 4-4.25%, well that's a whole lot higher than it's been even recently. I think investors after a long drought of a lack of fixed income options, are going to start to come back to the bond market and say, look, this now has a better place in my portfolio. We've been underweight bonds from July of last year and through April 6th of this year. But we've closed that position and we now think the risk reward for bonds is a lot more balanced and investors who were underweight should start adding back.
Vishy Tirupattur: So given the increase in rates, income is back into a fixed income, right?
Andrew Sheets: It exactly is. And again, I think it's also interesting because, you know, investors, I think, no longer have to compromise quite so much between bonds that offer income and bonds that can offer some stability to a portfolio. You know, I think the other thing that's so interesting about the view that that you and our credit strategy team have changed, you know, moving up in quality and credit, moving from a preference of high yield over investment grade to the other way around is, you know, that's a similar signal that we're getting from a lot of our top down cross asset framework tools. When the unemployment rate is this low, when the yield curve is this flat, that tends to be a time when risks to high yield bonds are elevated relative to history. So I think that the bottom up, you know, fundamental view that you and the credit strategy team are talking about fits really well with some of the broader cross asset signals that we're seeing as we look across the global space.
Andrew Sheets: Vishy, thanks for coming back on the show. It's always great to hear your insights.
Vishy Tirupattur: Thanks for having me, Andrew.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As investors look to diversify their portfolios, there are two big stories to keep an eye on: the historic rise in bond yields and the increased adoption of ESG strategies. Chief Cross-Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.
Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be continuing our discussion on retail investing, ESG, and what’s been happening in Fixed income. It's Friday, April 29th at 4:00 p.m. in London.
Lisa Shalett And it's 11:00 a.m. in New York.
Andrew Sheets Lisa, the other enormous story in markets that's really impossible to ignore is the rise in bond yields. U.S. Treasury yields are up almost 100 basis points over the last month, which is a move that's historic. So maybe I'd just start with how are investors dealing with this fixed income move? How do you think that they were positioned going into this bond sell off? And what sort of flows and feedback have you been seeing?
Lisa Shalett I think on the one hand, we've been fortunate in that we've been telegraphing our perspective to be underweight treasuries and particular underweight duration for quite a long time. And it's only been really in the last three or four weeks that we have begun suggesting that people contemplate adding some duration back to their portfolios. So the first thing is I don't think it has been a huge shock to clients that after what has been obviously a 40 plus year bull market in bonds that some rainier days are coming. And many of our clients had moved to short duration, to cash, to ultra-short duration, with the portions of their portfolios that were oriented towards fixed income. I think what has been more perplexing is this idea of folks using the bond sell off as an opportunity to move into stocks under the rationale of, quote unquote, there is no alternative. That's one of the hypotheses or investment themes that we’re finding we have to push up against hard and ask people are they not concerned that this move in rates has relevance for stock valuations? And over the last 13 years, the moves that we have seen in rates have been sufficiently modest as to not have had profound impacts on valuations. These very high above average multiples have been able to hold. And very few investors seem to be blinking an eye when we talk about equity risk premiums collapsing. So, you know, the answer to your question is clients in the private client channel avoided the worst outcomes of exposure to long duration rates, were not shocked, and have actually used some of the selloff in bonds or their short duration positions to actually fund increasing stock exposures. So that's I think how I would describe where they're at.
Andrew Sheets And that's really interesting because there are these two camps related to what's been happening. One is, look at bonds selling off. I want to go to the equity market. But at the same time as bond yields have gone from very low levels to much higher levels, the relative value argument of bonds versus stocks, this so-called equity risk premium, this additional return that in theory you get for investing in more risky equities relative to bonds has really been narrowing as these yields have come up. Lisa, how do you think about the equity risk premium? How do you think about, kind of, the relative value proposition between an investment grade rated corporate bond that now yields 4-4.25% relative to U.S. equities?
Lisa Shalett One of the things that we're trying to remind our clients is they live in an inflation adjusted world and real yields matter. And from where we're sitting, the recent dynamic around real rates and real rates potentially turning positive in the Treasury market is a really important turning point for our clients because today if you just look at the equity risk premium adjusted for inflation, it's very unattractive. And so, that's the conversation we're starting to have with people is you got to want to get paid. Owning stocks is great, as long as you're getting paid to own them. You got to ask yourself the question, would I rather have a 2.8-3% return in a 10-year Treasury today if I think inflation is going to be 2.5% in 10 years or do I want to own a stock that's only yielding an extra premium of 200 basis points.
Andrew Sheets When you think about what would change this dynamic, you mentioned that if anything, yields have gone up and investors seem to be more reticent about buying bonds given the volatility in the market. There's a scenario where people buy bonds once the market calms down, what they're looking for is stability. There's an argument that's about a level, that it's about, you know, U.S. 10-year bond yields reaching 3%, or 3.5%, or some other number that makes people say, OK, this is enough. Or it's that stocks go down and that they no longer feel like this kind of more stable or maybe better inflation protecting asset. Which of those do you think would be the more realistic catalyst or the most powerful catalyst that you see kind of driving a change in behavior?
Lisa Shalett I think it's this idea of inflation protected resilience, right? There is this unbelievable faith that, quite frankly, has been reinforced by recent history that the U.S. stock indices are magically resilient to anything that you could possibly throw at them. And until that paradigm gets cracked a little bit and we see a little bit more damage at the headline level, I mean, we've seen, you know, some of the data that says at least half of the names in some of these indices are down 20, 40%. But until those headline indices really show a little bit more pain and a little bit more volatility, I think it's hard for people to want to take the bet that they're going to go back into bonds.
Andrew Sheets Lisa, another major trend that we've seen in investing over the last several years has been ESG - investing with an eye towards the environmental, social and governance characteristics of a company How strong is the demand for ESG in terms of the flows that you're seeing and how should we think about ESG within the context of other strategies, other secular trends in investing?
Lisa Shalett So ESG, I think, you know, has gone through a transformation really in the last 12 months where it's gone from an overlay strategy, or an option and preference for certain client segments, to something that's really mainstream. Where clients recognize and have come to recognize the relevance of ESG criteria as something that's actually correlated with other aspects of corporate performance that drive excellence. If you're paying this much attention to your carbon footprint as a company or you're paying this much attention to your community governance and your stakeholder outcomes, aren't you likely paying just as much attention to your more basic financial metrics like return on assets? And there's a very high correlation between companies that are great at ESG and companies who are just very high on the quality factor metrics. Now what's interesting is as we've gone through this last six months of inflation and surging energy prices around the Russia-Ukraine conflict and the recovery from COVID, what I think the world has recognized is the importance of investing in energy infrastructure. Now for ESG investors that has meant doubling down on ESG oriented investments in clean and green. For others it may mean investing back in traditional carbon-oriented assets. But ESG, from where we're sitting, has gone mainstream and remains as strong, if not stronger than ever.
Andrew Sheets Lisa, thanks for taking the time to talk. We hope to have you back on soon.
Lisa Shalett Thank you very much, Andrew.
Andrew Sheets And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
With questions around equity outperformance, tech overvaluation and currency headwinds in the U.S., retail investors may want to look internationally to diversify their portfolio. Chief Cross-Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.
Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be discussing the role of international stocks in a well-diversified portfolio. It's Thursday, April 28th at 4:00 p.m. in London.
Lisa Shalett And it's 11:00 a.m. in New York.
Andrew Sheets Lisa, it's so good to talk to you again. There's just an enormous amount going on in this market. But one place I wanted to start was discussing the performance of U.S. assets versus international assets, especially on the equity side. Because you've noticed some interesting trends among our wealth management clients regarding their U.S. versus international exposure.
Lisa Shalett One of the things that we have been attempting to advise clients is to begin to move towards more global diversification. Given the really unprecedented outperformance of U.S. equity assets, really over the last 12 to 13 years, and the relative valuation gaps and most recently, taking into consideration the relative shifts in central bank policies. With obviously, the U.S. central bank, moving towards a very aggressive inflation fighting pivot that, would have them moving, rates as much as, 200-225 basis points over the next 12 months. Whereas other central banks, may have taken their foot off the accelerator, acknowledging both, the complexities of geopolitics as well as, some of the lingering concerns around COVID. And so, having those conversations with clients has proven extraordinarily challenging. Obviously, what's worked for a very long time tends to convince people that it is secular and not a cyclical trend. And you know, we've had to push back against that argument. But U.S. investors also are looking at the crosscurrents in the current environment and are very reticent and quite frankly, nervous about moving into any positions outside the U.S., even if there are valuation advantages and even if there's the potential that in 2023 some of those economies might be accelerating out of their current positions while the U.S. is decelerating.
Andrew Sheets It's hard to talk about the U.S. versus the rest of world debate without talking about U.S. mega-cap tech. This is a sector that's really unique to the United States and as you've talked a lot about, is seen as kind of a defensive all-weather solution. How do you think that that tech debate factors into this overall global allocation question?
Lisa Shalett I think it's absolutely central. We have, come to equate mega-cap secular growth tech stocks with U.S. equities. And look, there's factual basis for that. Many of those names have come to dominate in terms of the share of market cap the indices. But as we've tried to articulate, this is not any average cycle. Many of the mega-cap tech companies have already benefited from extraordinary optimism baked into current valuations, have potentially experienced some pull forward in demand just from the compositional dynamics of COVID, where manufactured goods and certain work from home trends tended to dominate the consumption mix versus, historical services. And so it may be that some of these companies are over earning. And the third issue is that, investors seem to have assumed that these companies may be immune to some of the cost and inflation driven dynamics that are plaguing more cyclical sectors when it comes to margins. And we're less convinced that, pricing power for these companies is, perpetual. Our view is that these companies too still need to distribute product, still need to pay energy costs, still need to pay employees and are going to face headwinds to margins.
Andrew Sheets So what's the case for investing overseas now and how do you explain that to clients?
Lisa Shalett] I think it's really about diversification and illustrating that unlike in prior periods where we had synchronous global policy and synchronicity around the trajectory for corporate profit growth, that today we're in a really unique place. Where the events around COVID, the events around central bank policies, the events around sensitivity to commodity-based inflation are all so different and valuations are different. And so, taking each of these regions case by case and looking at what is the potential going forward, what's discounted in that market? One of the pieces of logic that we bring to our clients in having this debate really focuses on, the divergence we’ve seen with currencies. The U.S. Dollar has kind of reached multiyear extreme valuations versus, the yen, and the euro and the pound. And currencies tend to be self-correcting through the trade channels, and translation channels. And we don’t know that American investors are thinking that all through.
Andrew Sheets Well, I'm so glad you brought up the currency angle because that is a really fascinating part of the U.S. versus rest of world story for equities. If we take a market like Japan in yen, the Nikkei equity index is down about 4% for this year, which is better than the S&P 500. But in dollars, as you mentioned the yen has weakened a lot relative to the dollar, the Nikkei is down almost 14% because the yen has lost about 10% of its value year to date. So, when you're a investor investing in a market in a different currency, how do you think about that from a risk management standpoint? How do you think about some of these questions around taking the currency exposure versus hedging the currency exposure?
Lisa Shalett Well, for the vast majority of our clients who may be, owning their exposures through a managed solution, through a mutual fund, through an ETF, currency hedging is fraught. And so very often, we try to encourage people to just, play the megatrend. Don't overthink this. Don't try to think that you're going to be able to hedge your currency exposures. Just really ask yourself, do you think over the next year or two the dollar's going to be higher or lower? We think odds are pretty good that the dollar is going to be lower and other currencies are going to be stronger, which creates a tailwind for U.S. investors investing in those markets.
Andrew Sheets I guess taking a step back and thinking about the large amount of assets that we see within Morgan Stanley Wealth Management. What are you think, kind of, the most notable flows and trends that people should be aware of?
Lisa Shalett As we noted, one of the most, structurally inert parts of people's portfolio is in their devotion to US mega-cap tech stocks. I think, disrupting that point of view and convincing folks that while these may be great companies, they perhaps are no longer great stocks is one that that has really been an effort in futility that seems only to get cracked when an individual company faces an idiosyncratic problem. And it's only then when the stock actually goes down that we see investors willing to embrace a new thesis that says, OK, great company. No longer great stock.
Andrew Sheets Tomorrow I’ll be continuing my conversation with Lisa Shalett on retail investing, ESG, and what’s been happening in fixed income.
Andrew Sheets And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
The U.S. Congress has been quietly making progress on a couple of key pieces of legislation, and investors should be aware of which bills will matter to markets.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, April 27th, at 11 a.m. in New York.
Compared to the Russia Ukraine situation, which rightfully has investors focus when it comes to geopolitics, congressional deliberations in D.C. may seem less important. But this is often where things of consequence to markets happen. So we think investors should keep an eye on Congress this week, where progress is quietly being made on key pieces of legislation that will matter to markets.
Let's start with legislation directed at boosting energy infrastructure investment. Reports suggest that Democratic senators are seeking to revive the clean energy spending proposed in the build back better plan, and pair it with fresh authorization for traditional energy exploration. The deliberations have momentum for a few reasons. While environment conscious Senate Democrats may have in the past balked about supporting traditional energy investment, they could now see this effort as the last chance to boost clean energy investment for years, given the chance that Democrats lose control of Congress in the midterm elections. Russia's invasion of Ukraine and the resulting need to boost American energy production to aid Europe, may also be persuasive. And while there are several roadblocks to this deal getting done, in particular negotiations about which taxes to increase in order to fund it, investors should pay attention. Such a deal could unlock substantial government energy investments that benefit both the clean tech, and oil and gas sectors of the market. The downside could be that corporate tax increases become its funding source, and if the corporate minimum tax proposal becomes part of the package, that drives margin pressure in banks and telecoms.
Investors should also keep an eye on the competition and innovation bill that includes about $250 billion of funding for re-shoring semiconductor supply chains, and federal research into new technologies. The bill, known in the Senate as the U.S. Innovation and Competition Act and the House as the COMPETES Act, is in part motivated by policymakers view that the U.S. must invest in critical areas to maintain a competitive economic advantage over China. While this kind of industrial policy is uncommon in the mostly laissez faire U.S. economic system, these policy motives make it likely, in our view, to be enacted this year. That should help the semiconductor sector, which has been facing uncertainty about how to cope with the risks to its supply chains from export controls and tariffs enacted by the U.S. This week these two bills move into conference, which means in the coming weeks we should have a better sense as to what the final version will look like, and if our view that it will be enacted this year will be right or wrong.
So summing it up, don't sleep on Congress. There's slowly but surely working on policies that impact markets. We'll of course track it all, and keep you in the loop.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
Global supply chains have been under stress from the pandemic, geopolitical tensions, and inflation, and the outlook for transportation in 2022 is a mixed bag so far. Chief U.S. Economist Ellen Zentner and Equity Analyst for North American Transportation Ravi Shanker discuss.
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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research,
Ravi Shanker: and I'm Ravi Shanker, Equity Analyst covering the North American Transportation Industry for Morgan Stanley Research.
Ellen Zentner: And today on the podcast, we'll be talking about transportation, specifically the challenges facing freight in light of still tangled supply chains and geopolitics. It's Tuesday, April 26, at 9:00 a.m. in New York.
Ellen Zentner: So, Ravi, it's really good to have you back on the show. Back in October of last year we had a great discussion about clogged supply chains and the cascading problems stemming from that. And I hoped that we would have a completely different conversation today, but let's try to pick up where we left off. Could we maybe start today by you giving us an update on where we are in terms of shipping - ocean, ground and air?
Ravi Shanker: So yes, things have materially changed since the last time we spoke, some for the better and some for the worse. The good news is that a lot of the congestion that we saw back then, whether it was ocean or air, a lot of that has eased or abated. We used to have, at a peak, about 110 ships off the Port of L.A. Long Beach, that's now down to about 30 to 40. The other thing that has changed is we just went from new peak to new all time peak on every freight transportation data point that we were tracking over the last two years. Now all of those rates are collapsing at a pace that we have not seen, probably ever. It's still unclear whether this legitimately marks the end of the freight transportation cycle or if it's just an air pocket that's related to the Russia Ukraine conflict or China lockdowns or something else. But yes, the freight transportation worlds in a very different place today, compared to the last time I was on in October. Ellen, I know you wanted to dig a little more deeply into the current challenges facing the shipping and overall transportation industry. But before we get to that, can you maybe help us catch up on how the complicated tangle created by supply chain disruptions has affected some of the key economic metrics that you've been watching over the last six months? That is between the time we last spoke in October and now.
Ellen Zentner: Sure. So, we created this global supply chain index to try to gauge globally just how clogged supply chains are. And we did that because, what we've uncovered is that it's a good leading indicator for inflation in the U.S. and on the back of creating that index, we could see that the fourth quarter of last year was really the peak tightness in global supply chains, and it has about a six month lead to CPI. Since then, we started to see some areas of goods prices come down. But unfortunately, that supply chain index stalled in February largely on the back of Russia, Ukraine and on the back of China's zero COVID policy, starting to disrupt supply chains again. So the improvement has stalled. There are some encouraging parts of inflation coming down, but it's not yet broad based enough, and we're certainly watching these geopolitical risks closely. So, Ravi, I want to come back to freight here because you talked about how it's been underperforming for a couple of months now and forward expectations have consistently declined as well. You pointed to it as possibly being just an air pocket, but you're pointing, you're watching closely a number of things and anticipate some turbulence in the second half of the year. Can you walk us through all of that?
Ravi Shanker: What I can tell you is that it's probably a little too soon to definitively tell if this is just an air pocket or if the cycles over. Again, we are not surprised, and we would not be surprised if the cycle is indeed over because in December of last year, we downgraded the freight transportation sector to cautious because we did start to see some of those data points you just cited with some of the other analysts. So we were expecting the cycle to end in the middle of 22 to begin with, but to see the pace and the slope of the decline and a lot of these data points in the month of March, and how that coincides with the Russia-Ukraine conflict and that the lockdowns in China, I think, is a little too much of a coincidence. So we think it could well be a situation where this is an air pocket and there's like one or two innings left in the cycle. But either way, we do think that the cycle does end in the back half of the year and then we'll see what happens beyond that.
Ellen Zentner: OK, so you're less inclined to say that you see it spilling over into 2023 or 2024?
Ravi Shanker: I would think so. Like if this is just a normal freight transportation cycle that typically lasts about 9 to 12 months. The interesting thing is that we have seen 9 to 12 months of decline in the last 4 weeks. So there are some investors in my space who think that the downturn is over and we're actually going to start improving from here. I think that's way too optimistic. But if we do see this continuing into 2023 and 2024 I think there's probably a broader macro consumer problem in the U.S. and it's not just a freight transportation inventory destocking type situation.
Ellen Zentner: So Ravi, I was hoping that you'd give me a more definitive answer that transportation costs have peaked and will be coming down because of course, it's adding to the broad inflationary pressures that we have in the economy. Companies have been passing on those higher input costs and we've been very focused on the low end consumer here, who have been disproportionately burdened by higher food, by higher energy, by all of these pass through inflation that we're seeing from these higher input costs.
Ravi Shanker: I do think that rates in the back half of the year are going to be lower than in the first half of the year and lower than 2021. Now it may not go down in a straight line from here, and there may be another little bit of a peak before it goes down again. But if we are right and there is a freight transportation downturn in the back of the year, rates will be lower. But, and this is a very important but, this is not being driven by supply. It's being driven by demand and its demand that is coming down, right. So if rates are lower in the back half of the year and going into 23, that means at best you are seeing inventory destocking and at worst, a broad consumer recession. So relief on inflation by itself may not be an incredible tailwind, if you are seeing demand destruction that's actually driving that inflation relief.
Ellen Zentner: That's a fair point. Another topic I wanted to bring up is the fact that while freight transportation continues to face significant headwinds, airlines seem to be returning to normal levels, with domestic and international travel picking up post-pandemic. Can you talk about this pretty stark disparity?
Ravi Shanker: Ellen it's absolutely a stark disparity. It's basically a reversal of the trends that you've seen over the last 2 years where freight transportation, I guess inadvertently, became one of the biggest winners during the pandemic with all the restocking we were seeing and the shift of consumer spend away from services into goods. Now we are seeing the reversion of that. So look, honestly, we were a little bit concerned a month ago with, you know, jet fuel going up as much as it did and with potential concerns around the consumer. But the message we've got from the airlines and what we are seeing very clearly in the data, what they're seeing in the numbers is that demand is unprecedented. Their ability to price for it is unprecedented. And because there are unprecedented constraints in their ability to grow capacity in the form of pilot shortages, obviously very high jet fuel prices and other constraints, I guess there's going to be more of an imbalance between demand and supply for the foreseeable future. As long as the U.S. consumer holds up, we think there's a lot more to come here. So Ellen, let me turn back to you and ask you with freight still facing such big challenges and pressure on both sides on the supply chain. What does that bode for the economy in terms of inflation and GDP growth for the rest of this year and going into next year?
Ellen Zentner: So I think because, as I said, you know, our global supply chain index has stalled since February. I think that does mean that even though we've raised our inflation forecasts higher, we can still see upside risk to those inflation forecasts. The Fed is watching that as well because they are singularly focused on inflation. GDP is quite healthy. We have a net neutral trade balance on energy. So it actually limits the impact on GDP, but has a much greater uplift on inflation. So you're going to have the Fed feeling very confident here to raise rates more aggressively. I think there's strong consensus on the committee that they want to frontload rate hikes because they do need to slow demands to slow the economy. They do almost need that demand destruction that you were talking about. That's actually something the Fed would like to achieve in order to take pressure off of inflation in the U.S.. But we think that the economy is strong enough, and especially the labor market is strong enough, to withstand this kind of policy tightening. It takes actually 4 to 6 quarters for the Fed to create enough slack in the economy to start to bring inflation down more meaningfully. But we're still looking for it to come in, for core inflation, around 2.5% by the fourth quarter of next year. So, Ravi, thanks so much for taking the time to talk. There's much more to cover, and I definitely look forward to having you back on the show in the future.
Ravi Shanker: Great speaking with you Ellen. Thanks so much for having me and I would love to be back.
Ellen Zentner: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As U.S. equity markets digest higher inflation and a more hawkish Fed, the question is when this will turn into a headwind for earnings growth.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 25th and 11:00 a.m. in New York. So let's get after it.
As equity strategists our primary job is to help clients find the best areas of the market, at the right time. Over the past year our sector and style preferences have worked out very well as the market has gone nowhere. However, the market has been so picked over at this point, it's not clear where the next rotation lies. When that happens, it usually means the overall index is about to fall sharply, with almost all stocks falling in unison. In many ways, this is what we've been waiting for as our fire and ice narrative, a fast tightening Fed into the teeth of a slowdown, comes to its conclusion. While our defensive posture since November has been the right call, we can't argue for absolute upside anymore for these groups given the massive rerating that they've experienced in both absolute and relative terms. In many ways, this is a sign that investors know a slowdown is coming and are bracing for it by hiding in these kinds of stocks.
In our view, the accelerated negative price action on Thursday and Friday last week may also support the view we are now moving to this much broader sell off phase. Another important signal from the market lately is how poorly materials and energy stocks have traded, particularly the former. To us, this is just another sign the market's realization that we are now entering the ice phase, when growth becomes the primary concern for stocks rather than inflation, the Fed and interest rates.
On that note, more specifically, we believe inflation and inflation expectations have likely peaked. There's no doubt that a fall in inflation should take pressure off valuations for some stocks. The problem is that falling inflation comes with lower nominal GDP growth and therefore sales and earnings per share grow, too. For many companies, it could be particularly painful if those declines in inflation are swift and sharp. Of course, many will argue that a falling commodity prices will help the consumer. We don't disagree on the surface of that conclusion, but pricing has been a big reason why consumer oriented stocks have done so well. If pricing becomes less secure, the margin pressure we've been expecting to show up this year, may be just around the corner for such stocks, even as the consumer remains active.
We can't help but think we are at an important inflection point for inflation, the mirror image of our call in April of 2020. At the time, we suggested inflation would be a big part of the next recovery and lead to extremely positive operating leverage and earnings growth. Fast forward to today, and that's where we are. The question now is will that positive tailwind continue? Or will it turn into a headwind for earnings growth? Our view is that it will be more of the latter for many sectors and companies, and this is why we've been positioned defensively and in stocks with high operational efficiency.
The bottom line is that asset markets have been digesting higher inflation and a more hawkish fed path in reaction to that inflation. However, we are now entering a period when slowing growth will determine how stocks trade from here. Overall, the S&P 500 looks more vulnerable now than the average stock, the mirror image of the past year. We recommend waiting for the index to trade well below 4000 before committing new capital to U.S. equities.
Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Forecasts for China and other Emerging Markets have continued on a downtrend, extending last year’s underperformance, meaning investors might want to look into regions with a more favorable outlook.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Markets Equity Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the key reasons why we recently reiterated our cautious stance on overall emerging market equities and also China equities. It's Friday, April 22nd at 8:00 p.m. in Hong Kong.
Now, emerging market equities are underperforming again this year, and that's extending last year's underperformance versus developed market equities. And so indeed are China equities, the largest component of the Emerging Market Equities Index. This is confounding some of the optimism felt by some late last year that a China easing cycle could play its normal role in delivering a trend reversal.
We have retained our cautious stance for a number of reasons. Firstly, the more aggressive stance from the US Federal Reserve, signaling a rapid move higher in US rates, is leading to a stronger US dollar. This drives up the cost of capital in emerging markets and has a directly negative impact on earnings for the Emerging Markets Index, where around 80% of companies by market capitalization derive their earnings domestically. Secondly, China's own easing cycle is more gradual than prior cycles, and last week's decision not to cut interest rates underscores this point. This decision is driven by the Chinese authorities desire not to start another leverage driven property cycle. Meanwhile, China remains firmly committed to tackling COVID outbreaks through a lockdown strategy, which is also weakening the growth outlook. Our economists have cut the GDP growth forecast for China several times this year as a result.
Beyond these two factors, there are also other issues at play undermining the case for emerging market equities. Most notably, the strong recovery in services spending in the advanced economies in recent quarters is leading to a weaker environment for earnings growth in some of the other major emerging market index constituents, such as Korea and Taiwan. They have benefited from the surge in work from home spending on goods during the earlier phases of the pandemic. Meanwhile, the geopolitical risks of investing in emerging markets more generally have been highlighted by the Russia Ukraine conflict and Russia's removal from the MSCI Emerging Markets Index.
So what do we prefer? We continue to like commodity producers such as Australia and Brazil, which are benefiting from high agricultural, energy and metals prices. We also favor Japan, which, unlike emerging markets, has more than half of the index deriving its earnings overseas and therefore benefits from a weaker yen.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
U.S. Treasury bonds have seen significant losses over the last six months, but looking forward investors may be able to use bonds to help balance their cross-asset portfolio in an uncertain market.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, April 21st at 2pm in London.
Like any good team, most balanced investment portfolios are built with offense and defense. Stocks are usually tasked to play that proverbial offensive role, producing the majority of inflation adjusted returns over the long run. But because these equity returns come with high volatility, investors count on bonds for defense, asking bonds to provide stability during times of uncertainty with a little bit of income along the way.
At least that's the idea. And for most of the last 40 years, it's worked pretty well. But lately it really hasn't. The last 6 months have seen the worst total returns for U.S. 10 year Treasury bonds since 1980, with losses of more than 10%. Investors are likely looking at what they thought was the defense in their portfolio, with a mix of frustration and disbelief.
On April 9th, we closed our long held underweight in U.S. bonds in our asset allocation and moved back up to neutral. Part of our reasoning was, very simply, that significantly higher yields now improved the forward looking return profile for bonds relative to other assets.
But another part of our thinking is the belief that going forward, bonds will be more effective at providing defense for other parts of the portfolio. We think the path here is twofold.
First, even as bonds have struggled year to date, the correlation of U.S. Treasuries to the S&P 500 is still roughly zero. That means stocks and bonds are still mostly moving independent of each other on a day to day basis, and supports the idea that bonds can lower overall volatility in a balanced portfolio if yields have now seen their major adjustment.
Second, if we think about why bonds provide defense, it's that when the economy is poor, earnings and stock prices tend to go down. But a poor economy will also lead central banks to lower interest rates, which generally pushes bond prices up.
Recently, this dynamic has struggled. Interest rates were so low, with so little in future rate increases expected that it was simply very hard for these rate expectations to decline if there was any bad economic data.
But that's now changed and in a really big way. As recently as September of last year, markets were expecting just 25 basis points of interest rate increases from the Federal Reserve over the following 12 months. That number is now 275 basis points. If the U.S. economy unexpectedly slows or the recent rise in interest rates badly disrupt the housing market, two developments that the stock market might dislike, markets might start to think the Fed will do less. They will apply fewer rate increases and thus give support to bonds under this negative scenario. That would be a direct way that bonds would once again provide portfolio defense.
Bonds still face challenges. But after a historically bad run, we are no longer underweight, and think they can once again prove useful within a broader cross asset portfolio.
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Although consensus forecasts for European equities continue to trend up, there are a few key risks on the horizon that investors may want to keep an eye on during the upcoming earnings season and year ahead.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the upcoming earnings season here in Europe and why we think corporate margins look set to come under pressure in the coming months. It's Wednesday, April the 20th at 2pm in London.
This week marks the start of the first quarter earnings season for European companies, and we expect to see another "net beat", with more companies exceeding estimates than missing. However, while this may sound encouraging, we expect the size of this beat to be considerably smaller than recent quarters, which have been some of the best on record. At the same time, we think commentary around future trends is likely to turn more cautious, given triple headwinds from elevated geopolitical risks, an increasingly stagflation like economy and intensifying pressures on corporate margins. And we think this last point is probably the most underappreciated risk to European equities at this time.
Historically, European margins have been positively correlated to inflation. Which likely reflects the index's sizable exposure to commodity sectors, and also the fact that the presence of inflation itself tends to signal both a strong topline environment and a positive pricing power dynamic for companies. In this regard, we note the consensus sales revisions for European companies are currently close to a 20-year high.
So far, so good. However, the influence of inflation on the bottom line depends much more on its relative relationship with real GDP growth. Put simply, when inflation is below real GDP growth margins tend to rise, but when inflation is above real GDP growth, as it is now, margins and profitability in general tend to fall. As of today, consensus forecasts for European margins have yet to turn down. However, we have seen earnings revisions turn negative in recent weeks, such as the gap between sales revisions, which are currently positive, and earnings revisions, currently negative, has never been wider.
In addition to this warning signal on margins from higher input costs, companies are also continuing to deal with challenging supply chain issues, whether related to the conflict in Eastern Europe or to the recent COVID lockdowns in China. A recent survey from the German Chambers of Commerce suggested that 46% of companies supply chains are completely disrupted or severely impacted by the current COVID 19 situation in China. In contrast, just 7% of companies reported no negative impact at all.
For now, the market appears to be ignoring these warning signs. Consensus 2022 earnings estimates for the MSCI Europe Index are still trending up and have now risen by 5% year to date. This compares to a much smaller 2% upgrade for U.S. earnings and actual downgrades for Japan and emerging markets. While commodity sectors are the main source of this European upgrade, the absence of any offsetting downgrades across other sectors feels unsustainable to us.
Ahead of every earnings season, we survey our European analysts to gather their views on the credibility of consensus forecasts. This quarter, the survey generally supports our own top down views, with our analysts expecting a small upside beat to consensus numbers in the first quarter, but then seeing downside risks for the full year 2022 estimates. This is the first time in nearly two years that this survey has given us a cautious message. Taking it to the sector level, our analysts see the greatest downside risks to consensus estimates for banks, construction, industrials, insurance, media, retailing and consumer staples. In contrast, our analysts see upside risks to earnings forecasts for brands, chemicals, energy, mining, healthcare and utilities.
Historically, a move higher in equity valuations often tends to mitigate the impact on market performance from prior periods of earnings downgrades. However, we are skeptical that price to earnings ratios will rise much from here, as long as global central banks remain hawkish. Consequently, we continue to see an unattractive risk reward profile for European stocks just here and suggest investors wait for a better entry point, after economic and earnings expectations have reset lower.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As the U.S. Economy contends with higher inflation, supply chain stress, and rising recession risks, one indicator to keep an eye on is what’s going on at the sector level and how U.S. business conditions may help shape the economic outlook.
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Welcome to Thoughts on the Market. I'm Robert Rosener, Senior U.S. Economist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be sharing a read on how industries across the U.S. may be viewing the current economic environment. It's Tuesday, April 19th at noon in New York.
As we move through the economic recovery and expansion that has been uneven, it's increasingly important to track what's going on at the sector level. And collaboratively with our equity analysts we do exactly that with our Morgan Stanley Business Conditions Index; a monthly survey to track what's going on across industries. With the MSBCI we try to put all of those stories together into one coherent macro signal, from 0 to 100, where 50 is the even mark, above 50 is expansion and below 50 is contraction.
It incorporates a variety of data points on hiring plans, capex plans, advance bookings and how those factors are evolving. Now, amid a more challenging and uncertain economic backdrop with higher inflation, supply chain stress and concerns about rising recession risks, I'd like to dive into a few key findings from our most recent survey to give listeners a picture of how U.S. businesses might be seeing the current environment.
First, in our April survey the headline measure for the MSBCI fell to a two year low of 44. We saw that decline in the index as driven by a deterioration in sentiment, because it coincided with a sharp pullback in business conditions expectations - so how analysts are seeing the forward trajectory for activity. And that decline in sentiment was particularly concentrated in the manufacturing sector, where we had a sharp decline in the MSBCI manufacturing component, while service sector activity appeared to bounce a little bit but remained at low levels.
When we look at the underlying details, the fundamental components of the survey were more mixed this month. So downside in our survey was led by business conditions expectations, as well as advance bookings and more strikingly, credit conditions. Now some of this can be noise, and we need to look very carefully through the data to see if we can identify a clear trend. Advance bookings, the decline there may have been more noise, but we are monitoring credit conditions very closely as the Fed tries to tighten financial conditions with its monetary policy stance.
We also got a bit of insight into supply chain conditions in this report. Responses from analysts in our survey indicated some stalling in the improvement in April, and a pickup in the share of analysts who reported that conditions remained unchanged. Which is broadly consistent with what we've seen in other indicators. Nevertheless, analysts generally expect improvement in supply conditions over the next 3 months.
Finally, there was some good news in the survey on business investment plans, what we call capex, as well as hiring plans. There was some moderation, but the two factors remain bright spots in the report, with upside in capex plans, and hiring plans coming back but holding at a fairly solid level.
So what does this all tell us about how businesses see the road ahead? First, there's important momentum in hiring and capex. With respect to inflation, the deterioration we saw in supply conditions during the month does point to some upside risk for prices in the near term, and that was also reflected in strong upward pressure in the MSBCI pricing measures during the month. We can also see that businesses are facing increased uncertainty about the outlook. That's clear looking at the deterioration in sentiment, and that's clear looking at the pullback in business conditions expectations. So firms are watching the pace and trajectory of economic activity carefully. So it will continue to be important to watch these stories to judge what's going on at the sector level and how that's all coming together to shape the economic outlook.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While ongoing inflation has had some positive effects, consumers continue to feel its ill effects and we are beginning to see net negatives for earnings growth as Q1 earnings season begins.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 18th at 3 p.m. in New York. So let's get after it.
Last week, we discussed how stocks were sending different messages about growth than bonds. We laid out our case for why stocks are likely to be the most trusted on this messaging and reiterated our preference for late cycle defensives that we've held since November. This week, we lay out the case for why this earnings season may finally bring the downward revisions to forward earnings forecasts that have remained elusive thus far.
While we appreciate how inflation can be good for nominal GDP and therefore revenue growth, we think the inflation we are experiencing now is no longer a net positive for earnings growth for several reasons. First, there's a latent impact of inflation on costs that are now showing up in margins. Secondarily, the spike in energy and food costs, which serve as a tax on the consumer that is already struggling with high prices. In other words, we think the positive effects of inflation on earnings growth have reached their peak, and are now more likely to be a headwind to growth, particularly as inflation forces the Fed to be increasingly bearish, which leads to another headwind - significantly higher long term interest rates. More specifically, the average 30 year fixed mortgage rate is now above 5%, which is more than 60% higher since the start of the year, and why mortgage applications are also down more than 60% from their peak last year. This hasn't gone unnoticed by the market, by the way, which has punished housing related stocks to the tune of 40% or more. Given the long tailed effect that housing has on the economy, we think this is a major headwind to economic and earnings growth more broadly.
Perhaps this explains why the de-rating has been so severe in the economically sensitive areas of the market, while defensive areas have actually seen valuations expand. This suggests the market is worrying about higher rates and slower growth, even as the overall index remains expensive. This is also very much in line with our view for defensives to dominate in this late cycle environment. However, the overall index remains a bit of a mystery, with the price earnings multiple down only 11% in the face of much higher interest rates. We chalk this up to the incredibly strong flows into equities from asset owners, which include retail, pension funds and endowments. These investors seem to have made a decision to abandon bonds in favor of stocks, which are a much better inflation hedge. These flows are keeping the main index more expensive, thereby leaving the real message about growth at the sector level. As already suggested, we think that message is crystal clear and in line with our own view that growth is slowing and likely more than most are forecasting. Especially for 2023, when the risk of a recession is increased.
With regard to that view, signs are emerging that first quarter earnings season may disappoint, particularly from a guidance and forward earnings standpoint. More specifically, earnings revisions breadth for the S&P 500 has resumed its downward trend over the past 2 weeks, and is once again approaching negative territory. This is largely being driven by declining revisions in cyclical industries where we've been more negative. These include consumer discretionary, industrials, tech hardware and semiconductors. Negative revisions are often an indication that forward earnings estimates are going to flatten out or even fall. When forward earnings fall, it's usually not good for stocks and may even break the pattern of strong inflows to equities, as investors rethink their decision to use stocks at this point as a good hedge against inflation.
Bottom line, stick with more defensively oriented sectors and stocks as earnings visibility is challenged for the average company. Secondarily, wait for at least one or two rounds of earnings cuts at the S&P level before adding to broader equity risk.
Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
While there continues to be a lot of market chatter surrounding recession risks and the U.S. Treasury yield curve, there are several key factors that make the most recent dip into inversion different. Chief Global Economist Seth Carpenter and Head of U.S. Interest Rate Strategy Guneet Dhingra discuss.
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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist,
Guneet Dhingra: and I'm Guneet Dhingra, Head of U.S. Interest Rate Strategy.
Seth Carpenter: And on this episode of Thoughts on the Market, we're going to be discussing the sometimes inconsistent signals of economic recession and what investors should be watching. It's Thursday, April 14th at 10 a.m. in New York.
Seth Carpenter: All right, Guneet, as I think most listeners probably know by now, there's a lot of market chatter about recession risks. However, if you look just at the hard data in the United States, I think it's clear that the U.S. economy right now is actually quite strong. If you look at the last jobs report, we had almost 450,000 new jobs created in the month of March. And between that, the strength of the economy right now and the multi-decade highs in inflation, the Federal Reserve is ready to go, starting to tighten monetary policy by raising short term interest rates and running off its balance sheet. That said, every time short term interest rates start to rise, they rise more than longer term interest rates do, and we get a flattening in the yield curve. The yield curve flattened so much recently that it actually inverted briefly where 2's were higher than 10's in yield. And as we've talked about before on this very podcast, there has been historically a signal from an inverted 2s10s curve to a recession probability, rising and rising and rising. Some of the work you've been doing recently, I think you've argued very eloquently, that this time is different. Can you walk me through why this time is different?
Guneet Dhingra: Yeah, absolutely. I mean, right now you cannot have a conversation with investors without discussing yield curve inversion and the associated recession risks. So I think the way I've been framing it, this time is different because of two particular reasons that haven't been always true. The first one is the yield curve today is artificially very distorted by a multitude of factors. The number one and the most obvious one is the massive amounts of central bank bond buying from the Fed, from the ECB, from the Bank of Japan over the last few years. And so that puts a lot of flattening pressure on the curve, which makes it appear that the curve is too flat, whereas in practice it's just the residual effect of how central banks have affected the yield curve. On top of that, what's also happening is the Fed is obviously trying to address the inflation risk and they are looking to make policy restrictive in the next couple of years. So take the dot plot for instance, right, at the March meeting the Fed gave us a dot plot where the median participant expects the Fed funds rate to get to close to 3% in 2023, and the neutral rate that they see for the economy is close to 2.5%. So in essence, the Fed is telegraphing a form of inversion and ultimately the markets are mimicking what the Fed is telling them, which naturally leads to some curve inversion. So overall, I would say a combination of artificially flattening forces, a restrictive fed, just means that 2s10s curve today is not the macro signal it used to be.
Seth Carpenter: Got it, got it, so that helps and that squares things, I think, with the way we on the economics team are looking at it. Because in our baseline forecast, there is not a recession in the US. But if that's right, and if we end up avoiding a recession, you've got a bunch of clients, we've got a bunch of clients who are trying to make trades in a market. What are you telling investors that they should be doing, how do you trade in an environment with an inverted curve?
Guneet Dhingra: Right. So I think the way I talk to investors about this issue is the 2s10s curve merely inverting is not the signal used to be, which means for the yield curve to be predictive for a recession this time, the level threshold is much lower. So, for instance, you can imagine an economy where 2s10s curve inverting to minus 50 or minus 75 is the real true signal for a slowdown ahead and a recession ahead. And so what I tell investors today is do not get concerned about the yield curve getting to 0 basis points, there's a lot more room for the yield curve to keep inverting. And the target you should have for yield curve flattening trade should be more like minus 50 or minus 75.
Seth Carpenter: Got it. That that's a very big difference, very far away from where we are now. And in fact, as I mentioned earlier, the inversion that we did see was somewhat short lived and we've actually had a bit of a steepening off the back of it. I guess one question, and this is something that you've also written about is, what's driving that tightening? Is it because the Fed is going to be unwinding its balance sheet, doing so-called quantitative tightening. If the quantitative easing that they were doing flattened the curve, are you seeing the quantitative tightening is the thing that's going to be steepening the curve?
Guneet Dhingra: I think instinctively, many investors think tightening is the opposite of easing, so that must mean quantitative tightening is the opposite of quantitative easing. And that's why I think a big fallacy lies in how people are simplifying the understanding of QT. I think the reality is quantitative tightening is perhaps not the perfect term for what the Fed is going to do next. The main thing to understand here is when the Fed does QE, the Fed chooses which part of the Treasury curve are they going to target, and that ultimately decides whether the curve will steepen or flatten. However, in this case, it's the U.S. Treasury, which is going to decide once the Fed stops reinvesting, how will the U.S. Treasury respond by increasing supply in the front end or the back end? And that decides whether the yield curve should steepen or flatten, quite the opposite from QE where the Fed decides. So the way I sort of summarize this to people is QT is not the opposite of QE, asset sales are. So Seth, you spent 15 years working at the Fed. Do you think the FOMC cares about an inverted curve?
Seth Carpenter: I would not say that the core of the FOMC cares about an inverted curve the same way that the average market participant does. I think it's undeniable that the Fed is aware of all of the research, all of the history, all of the correlation between an inverted curve and a recession. But I don't think it's a dispositive signal. And by that what I mean is, if we got to the point where the 2s10s curve were pancake flat, it was a zero or even slightly inverted, but if at the same time we were still getting 400-500,000 nonfarm payrolls per month, I think then that signal from the yield curve would get dismissed against the evidence that the economy is very, very strong. So I think an inverted curve is the sort of thing that would cause the Fed to double check their math in some sense. But it's not going to be the signal by itself. And then, going back to what you had said earlier about the dot plot. I think that's very important. What the Fed is trying to do is engineer a so-called soft landing. That is, they are trying to tighten policy so that the economy slows a lot, but not too much. So that the inflationary pressures that we see start to abate. How would they do that? Well, in part, they'd be raising the short term interest rate. They'd be raising it above their own estimate of neutral. And as you pointed out, in their last dot plot they said they'll go up to maybe 3% before eventually coming back down to 2.5%. So achieving that soft landing is almost surely going to end up creating an inverted yield curve anyway.
Guneet Dhingra: Yeah, so you talk about the Fed engineering a soft landing. Have they successfully done it in the past? And what makes you think that they can do it this time?
Seth Carpenter: So two very, very important questions. The answer to the first one, have they done it in the past, is a bit in the eye of the beholder. If you listen to Chair Powell a couple of weeks ago, when he gave a speech at the National Association of Business Economists conference, he gave at least three different examples where he says historically the Fed has achieved a soft landing. If I was going to point to a soft landing, I would look at 1994 to 1995. The economy did slow pretty dramatically after the Fed had hiked rates fairly aggressively, and then the Fed paused the hiking and eventually reversed course, and the economic expansion continued. I think you could consider that to be a soft landing. The big difference this time is that this is the first rate hiking cycle since the 1970s where the Fed is actively trying to bring inflation down. Whereas the more recent cycles have been the Fed trying to keep inflation from rising above their target. So bringing it down as opposed to keeping it down are two very different things. So the way I like to think about it is the Fed's got a very difficult job. Can they do it? Yes, I absolutely think they can do it. And part of what gives me hope is the episode in late 2018 to early 2019, the last time the Fed was hiking, running off the balance sheet, raising short term interest rates. We had that period where the economy slowed, risk markets cracked. And what did the Fed do? They reversed course. Chair Powell has taken to using the word nimble a lot recently. I think if they can be that responsive to conditions, it increases the chances that they pull it off. But it's going to be difficult.
Seth Carpenter: Well Guneet, I think we would both agree that we don't think an inverted yield curve is signaling a recession, but that doesn't mean that one can't happen. The world is an uncertain place, but thanks for joining us and taking the time to talk.
Guneet Dhingra: Absolutely. Great speaking to you Seth.
Seth Carpenter: And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
As investors continue to discuss the uncertainty surrounding the U.S. Treasury market, there may be some good news for bond holders as the year progresses.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. Public Policy and financial markets. It's Wednesday, April 13th at 10 a.m. in New York.
It's been a tough year for bond investors so far. As inflation picked up, the Fed signaled its intent to hike rates rapidly. That pushed market yields for bonds higher and prices lower. And with the latest consumer price index showing prices rose 8.5% over the past year, bond investors could, understandably, be concerned that there's still more poor returns to come.
But we're a bit more optimistic and see reason to think that bonds could deliver positive returns through year-end and, accordingly, play the volatility dampening role they typically play in one's multi-asset portfolio. Accordingly, our cross-asset team is no longer underweight government bonds. And our interest rate strategy team has said that the recent increase in longer maturity bond yields have put that group in overshoot territory.
What's the fundamental basis for this thinking? In short, it has to do with something economists typically call demand destruction. Basically, it's the idea that as prices on a product increase, perhaps due to inflation, they reach a point where fewer consumers are willing or able to purchase that product. That in turn crimps economic growth and, accordingly, one would expect that longer maturity bond yields would rise less, or perhaps even decline, to reflect an expectation of lower inflation and economic growth down the road.
And we're starting to see evidence of that demand destruction. Last week we talked about how the federal government was attempting to reduce the price of oil by selling some of its strategic petroleum reserve. But it's noteworthy that the biggest declines in the price of oil from its recent highs happened before this announcement, suggesting that the price surge at the pump was already crimping demand, resulting in prices having to come back down to put supply and demand in balance. You can also see similar evidence in the market for used cars. For example, used car dealer CarMax reported this week its biggest earnings miss in four years. Management cited car affordability as a key reason that it sold less cars year over year.
So the bottom line is this: bond investors may have taken some pain this year, but that doesn't mean it's time to run from the asset class. In fact, there's good reason to believe it can deliver on its core goal for many investors, diversification in uncertain markets.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
In light of the U.S. Treasury yield curve recently inverting, many are asking if home prices will be affected and how the housing market might look going forward. Co-Heads of U.S. Securitized Product Research Jay Bacow and Jim Egan discuss.
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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research.
Jay Bacow: And on this edition of the podcast, we'll be talking about the state of the mortgage and housing market, amidst an inverted yield curve. It's Tuesday, April 12th at 11 a.m. in New York.
Jay Bacow: Now, Jim, lots of people have come on to talk about curve inversion and Thoughts on the Market. But let's talk about the impact to the mortgage and housing market. Now, the big question that everybody wants to know, whether or not they own a home or they're thinking about buying one, is what does an inverted curve mean for home prices?
Jim Egan: When we look back at the history of, let's use the Case-Shiller home price index, we look back at that into the 80’s, it's turned negative twice over that 35-year period. Both of those times were pretty much immediately preceded by an inverted yield curve. However, there's a lot of other instances where the yield curve has inverted and home prices have climbed right on through, sometimes they've accelerated right on through. So if we're using history as our guide, we can say that an inverted yield curve is necessary but not sufficient to bring home prices down. And the logical next question that follows from that is, well, what's the common denominator? And in our view, there's a very clear answer, and that clear answer is supply. The times when home prices fell, the supply of homes was abundant. The times when home prices kept rising, we really did not have a lot of homes for sale. And when we look at the environment as we stand today, the inventory of homes for sale is at historic lows.
Jay Bacow: OK, but that's the current inventory. What do you think about supply for the next year?
Jim Egan: So I think there's two ways we have to think about the 12-month outlook for supply. The first is existing inventory, the second is new inventory, so building homes that come on market. Existing inventory is really driving that total number to historic lows. And we think it's just headed lower from here. One of the big reasons for that is, let's just talk about mortgage rates away from curve inversion. The significant increase we've seen in mortgage rates because of the unique construction of the mortgage market today, we think are going to bring inventories lower. And that's because an overwhelming majority of mortgage borrowers have fixed rate mortgages today, much more than in prior cycles in the past. And what that means is as rates go higher, as affordability deteriorates, which is something we've discussed in previous episodes of this podcast, that's for first time homebuyers. The current homeowner locked into those low fixed rates is not experiencing affordability pressure as mortgage rates go higher. In fact, they're probably less likely to put their home on the market. Selling their home and buying a new home would involve taking out a mortgage that might be 150 to 200 basis points higher. That can be prohibitively expensive in some instances, and so you actually get an environment where supply gets tighter and tighter, which could be supporting home prices. Now the other side of the equation is new homes. If existing inventory is at all-time lows, if prices continue to climb like they have, that should be an environment where we'll see more building. And we do think that inventories are already primed to come on the market over the next year because of the fact that look, we look at building permits, we look at housing starts, we look at completions, those numbers get talked about all the time when they come out monthly and they've been climbing. But they haven't been climbing all that much relative to history. What is up is kind of the interim points between those events, between housing start and completion. Units under construction is back to where we were in kind of late 2004, early 2005. Further up the chain units that have been permitted or authorized but haven't been started yet, that's starting to swell too. Now what’s currently in the pipeline isn't enough to alleviate the tight supply situation we find ourselves in. But it is enough to soften home price growth a little bit. But the real common denominator for home price growth in a curve inverted environment is that existing inventory number, which is at historic lows and continuing to go lower.
Jay Bacow: All right, Jim. So mortgage rates are a lot higher, causing people to be locked in to their mortgage, and supply is low and you're saying probably going to stay that way. So what does that mean for housing activity going forward?
Jim Egan: We think sales are going to fall. Housing sales normally fall either while the curve is inverted or shortly after the curve inverts, this time is no different. When we look at the impact that the incredible decrease in affordability that we've seen over the past 6 months, over the past 12 months, that also normally leads to sales volume slowing 6 months forward and 12 months forward. We've already started to see it. Existing home sales are starting to turn negative on a year over year basis, pending home sales are negative, purchase applications have decoupled even more than those statistics. So the ingredients for that decline in sales volumes that typically follow a curve inversion, they're already in place. We think that existing home sales have already peaked for at least the next year. But Jay, if we think existing home sales are going to fall, then that would mean fewer mortgages and fewer mortgages would mean less supply for mortgage-backed securities. Now that would be a good thing, right?
Jay Bacow: Yeah, look, it's not advanced research to say that less supply is good for a market, and we think that's absolutely the case here. But the other side of the supply is demand, and the biggest source of demand, the largest holder of mortgages, is domestic banks. And domestic banks have a problem in an inverted yield curve that the incremental spread that they pick up to own mortgages versus their deposits is just going to be lower in an inverted yield curve. When we look at the data historically, we see that strong statistical correlation. That as the curve flattens, bank demand goes lower. It's also exacerbated by the fact that a lot of the mortgages that banks own are in their hold to maturity portfolios, over a trillion dollars. And those bonds yield less than where we project fed funds to be at the end of the year. So when we think about the demand for mortgages, the largest source of demand, it's going away. That's going to be a problem for mortgages.
Jim Egan: OK, so the largest source of demand? Banks, they're going away. Who else is going to buy, if not the banks?
Jay Bacow: Well, that's when we run into an even bigger problem. The second largest source of demand is the Fed, and the Fed has basically said in the minutes that were released last week, that they're going to be normalizing their mortgage holdings. Taking those two largest sources of demand it's likely to force money managers and overseas to end up buying mortgages, but probably at wider spreads than here. And that's why we're recommending still an underweight agency mortgages, which will cause spreads to go a little wider and maybe mortgage rates to go higher, further impacting the affordability problems that you were discussing earlier in the podcast, Jim.
Jim Egan: All right Jay. Thanks for taking the time to talk today.
Jay Bacow: Always great speaking with you, Jim.
Jim Egan: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Original Release on March 31st, 2022: As interest in using cryptocurrencies for transactions continues to rise for both consumers and businesses, crypto has begun a cycle of increased stability and popularity - but the question is, can this cycle continue?
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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be asking the question - are cryptocurrencies currency? It's Thursday, March 31st at 2:00 p.m. in London.
Did you really buy that house with crypto? Or did you just sell your crypto for dollars and use dollars to buy the house?
Crypto skeptics think that goods cannot be priced in cryptocurrencies like bitcoin, primarily because their price is too volatile. But at some point, if crypto begins to be used for enough purchases of everyday goods and services, prices may begin to stabilize. Increased stability will further entice consumers to use crypto, and the cycle will continue. The question has always been, will this virtuous cycle ever begin? The answer is now clear, it has already begun. Here are some examples.
Firstly, paying with cryptocurrency needs to be as easy as paying with a credit or debit card today. Over 50 crypto companies and exchanges have issued their own crypto cards, and these are attached to the Visa or MasterCard payments networks, meaning they're accepted all around the world. In the last quarter of 2021, Visa said its crypto related cards handled $2.5 billion worth of payments. Now that may sound small, at less than 1% of all Visa's transactions, but it is growing quickly. The difficulty in increasing crypto adoption is getting the merchant to accept crypto. It needs to be easy and cheap, which is something lots of new crypto companies and products are trying to achieve.
Secondly, many would argue that something can only be a currency if you can pay your taxes with it. Even that is changing today. Over the past year, local and some national governments have introduced or proposed laws that will allow its residents to use cryptocurrency to pay their taxes. El Salvador famously made bitcoin legal tender in its country in 2021. In the past week, Rio de Janeiro announced it will become the first city in Brazil to allow cryptocurrency payments for taxes starting next year.
It isn't just emerging economies, though, that are trying to attract global crypto investors. The city of Lugano in Switzerland has teamed up with Tether, the creator of the largest stablecoin - a type of cryptocurrency that's kept stable versus the U.S. dollar, to make bitcoin and two other cryptocurrencies de facto legal tender. In the U.S., Colorado is hoping to become the first state to accept crypto for taxes later in the year, and Florida's governor is investigating the logistics of doing the same. Both these proposals may be difficult to put into law in the end, as the U.S. constitution doesn't allow individual states to create their own legal tender, but it hasn't stopped these proposals and more from coming in.
In both these examples, the receiver of the crypto typically immediately converts to fiat currency, like U.S. dollars, through an intermediary service provider. So let's come back to our original question - did you really buy that house with crypto? In February, a house in Florida was sold for 210 Ether, the second largest crypto, or the equivalent of over $650,000 dollars. Interestingly, the seller received the ether but didn't liquidate into U.S. dollars soon afterwards due to market volatility, because the value of ether in U.S. dollars fell by around 10%.
Consumers and businesses are increasingly wanting to transact in cryptocurrency. Maybe most are simply wanting to trade the value of the asset, but as it becomes easier to transact in crypto and legal structures are defined, cryptocurrencies could start to become currency. The question is, will the virtuous cycle continue or be broken? Cryptocurrencies are beginning the long journey of challenging U.S. dollar primacy, and the president's recent executive order on digital assets shows little sign of regulators getting in their way for now.
Thanks for listening. If you enjoy Thoughts on the Market, share this and other episodes with a friend or colleague today.
Since the Fed’s first rate hike and the inversion of the U.S. Treasury yield curve, the outlook on U.S. government bonds has changed, leading to a new take on U.S. Bonds.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, April 8th at 2:00 p.m. in London.
We've made a key change in our strategic cross-asset allocations, closing our underweight to government bonds and are overweight in cash. We did this via U.S. Treasuries. This is a big debate among investors, many of whom are underweight bonds and questioning when to buy them back. There are a couple of reasons why we made this change.
First, U.S. 10 year Treasury yields are now above the 2.6% year-end yield target of Morgan Stanley's U.S. interest rate strategists, meaning our forecast for U.S. bond returns are looking better on a cross asset basis. These forecasts should reflect the impact and the uncertainty of higher inflation, quantitative tightening and the growth outlook.
Second, another part of our asset allocation framework is asking what economic indicators say about future cross asset performance. On these measures the outlook for U.S. bonds is also improving. For example, bonds tend to do better on a cross asset basis after the yield curve inverts, which recently happened.
Another reason we were underweight bonds is that they often underperform other asset classes during the expansion phase of our cycle indicator, a tool we've developed within Morgan Stanley research to measure the ebb and flow of the economic cycle. But this underperformance starts to shift and stop when this indicator gets very extended, and on its current measures, well, it's very extended.
Third, while this change was made with a 12 month horizon in mind, we could see some reasons to take action now rather than wait. Recently, cyclical stocks have been sharply underperforming defensive stocks, and that usually coincides with unusually good bond market performance as investors worry about growth. But recently, bonds have been underperforming, even as defensive stocks have worked. That divergence is unusual, but could normalize.
We also have an important release of U.S. Consumer Price Inflation next week. While a peak in inflation has so far been elusive, Morgan Stanley's economists believe it may arrive with next week's number.
Of course, there are many risks to adding back to bonds at the current juncture. One of those risks is that the U.S. Federal Reserve remains hawkish, and committed to a large number of rate hikes over the next 12 months. While that is certainly possible, the market is now expecting a faster rate hiking path, reducing the chance of a Federal Reserve surprise.
To raise our weight of U.S. bonds back to neutral, we are closing or overweight to cash. Cash has performed well year to date, as many other asset classes have seen price declines. But this outperformance is unusual and warrants a more balanced approach for the time being.
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As the European Central Bank prepares to meet, the war in Ukraine continues to add to uncertainty, forcing investors in Europe to adjust their expectations for the remainder of the year. Chief Cross Asset Strategist Andrew Sheets and Chief Europe Economist Jens Eisenschmidt discuss.
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----- Transcript -----
Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset Strategist.
Jens Eisenschmidt And I'm Jens Eisenschmidt. Morgan Stanley's Chief Europe Economist.
Andrew Sheets And today on the podcast we'll be talking about the outlook for Europe's economy amid possible rate hikes, business reopenings and the war in Ukraine. It's Thursday, April 7th at 3 p.m. in London.
Andrew Sheets Jens, clearly we're dealing with a lot in Europe right now amid the Ukraine conflict and I want to get into that situation and the impacts on the economy. But given that the European Central Bank is meeting in just a few days and there is speculation about possible rate hikes, let's start there. Maybe you could give a bit of a background on what we expect the ECB is going to do.
Jens Eisenschmidt Thanks a lot, Andrew. First of all, let me say that we don't expect any change at next week's meeting relative to what the ECB has been saying in March at their last meeting. They're essentially keeping all options open. They have started on a gradual exit from their very accommodative monetary policy. They have increased the pace of policy normalization at their last meeting, and we do not expect the ECB to change that roadmap now. Just as a reminder, the roadmap is asset purchases could end in Q3 and any interest rate hike would come sometime thereafter. And any decision on ending asset purchases and rate hikes is highly data dependent. And that really it takes us to the current situation. Inflation continues to surprise to the upside. We just had a 7.5 percentage point print in March, and this undoubtedly does increase the pressure on the ECB to act. At the same time, there are significant downside risks to the outlook for growth in the Euro area stemming essentially from the Ukraine-Russia conflict, and this puts a premium on treading very carefully with any changes to the monetary policy configuration, hence the emphasis on optionality, flexibility and gradualism by the ECB.
Andrew Sheets Jens, when you talk about gradualism, that implies that the inflation that we're seeing in Europe is more temporary, is more transitory, isn't going to get out of hand. Can you talk a little bit about what is different at the moment between inflation in Europe and inflation in the U.S.?
Jens Eisenschmidt I think there are a lot of technical aspects that indeed you could be looking at on that question, but I think it's sufficient for our purposes here really to focus on the key difference. In the U.S. there's a huge internal demand component to inflation. While the same is not true for the euro area, where most of the inflation, you could argue, largest part is imported through energy. Another difference is that the outlook for the economy is slightly different. While you would say that in the U.S., if you're talking about an overheated economy, you have a very tight labor market, it's very difficult to see, you know, some sort of self-correcting forces bringing down inflation, which is why the Fed is embarking on a relatively aggressive tightening cycle. Here in the euro area, there is, of course, growth we see in '22 in our base case but at the same time, we are far away from such an overheating situation and even we are here now relying increasingly on fiscal stimulus to keep the growth momentum going given the high energy prices that are coming, dampening growth. So I think the situation is fundamentally a different one.
Andrew Sheets And so Jens, maybe digging more into that growth outlook. You mentioned this rise in energy prices. There is uncertainty over the war in Ukraine. And yet in your team's base case, we see GDP growth in Europe growing about 3% this year, which would be pretty good by the standards of the last decade. What's behind that overall outlook?
Jens Eisenschmidt You're right. our base case has the euro area economy growing by 3% in '22 on the back of the ongoing recovery from the pandemic, 'reopening' in one word, which has lagged here relative to, say, the U.S., as well as due to the fiscal stimulus. But we see increasing headwinds emerging as you were just also referencing. We had this series of consumer confidence prints clearly affected by high inflation and the ongoing conflict, and we are watching attentively how this develops. Energy prices have skyrocketed. So, while we stick to our base call for now, we think that the balance of risks is slowly migrating to the downside. As for the ECB, the projections presented at their last meeting in March are more optimistic in terms of growth than ours. Now, clearly, if the ECB's view of the world prevails, so growth comes in better than we expect, we think the ECB will start to raise rates as early as September this year. Contrary to that, we think that incoming data will disappoint the ECB and this is why we have the first rate hike only in December. In any case, you can see the ECB is clearly on the path of policy normalization, the need for which is driven by the high inflation regime we are in and even the less favorable growth outlook won't change that fundamentally.
Andrew Sheets Jens, given that we were discussing the ECB, I'd also like to talk about what higher interest rates mean in Europe. How do you think about that debate and do you see a scenario where the ECB might be quicker to take rates from negative to zero, but then pause at zero for a more extended period of time?
Jens Eisenschmidt I think this is a fair question, given that the negative rate experiment, if you want to call it, is really unique in its scope in the Euro area. And there has been a lot of debate about the effect of negative rates on banks, and you can probably argue that revising or returning from negative to zero is a little bit of a different journey than just raising rates in positive territory like what the what the Fed is going to do or is about to do now. So I'd say while there are some merits in the argument that probably, you know, getting rid of negative rates in the front end will help banks and may be good for lending in some sense, I think overall, our assessment would be increasing rates is something that detracts from economic activity.
Andrew Sheets So Jens, you know, you mentioned some of the risks around energy supply, and I think it's safe to say this is the single biggest area of questions for investors who are in Europe or are looking at Europe is, how would the region respond to either cutting off its imports of gas and oil from Russia voluntarily or this disruption happening involuntarily? What would a complete cut off of Russian oil and gas mean for Europe's economy? And how does somebody in your position even go about trying to model that sort of outcome?
Jens Eisenschmidt So we have, of course, tried to get our head around this question and we we have published last week a note on exactly that issue. The typical approaches or the approaches that we have as economists here is really you look at the sectoral dependencies on on these flows of gas and oil, say. You make some assumptions and of course, it gives rise to ranges which are relatively wide. What we can say with certainty is that in a scenario of a complete cut off of Russian supplies in terms of oil and gas, we we are very, very likely in a recession in 22 in the euro area. And we are really talking about a significant recession risk. While only through higher energy prices, so oil going the direction of 150, but you know, other than that supply still flowing, we also see huge dampening impact on the economy with a shallow recession emerging not as bad as we would see in a total cutoff scenario. But I have to admit there's huge uncertainty.
Jens Eisenschmidt But Andrew, I was going to ask you a similar question as a strategist looking at different asset classes around the world. What's your team's view on Europe?
Andrew Sheets Well thanks, Jens. So I think, unfortunately, the outlook for Europe, as you mentioned, has deteriorated since the start of the year. This terrible conflict in Ukraine has introduced additional uncertainty and binary risks to Europe around energy security that are difficult for investors to price and to discount. So, we've lowered our price target for European equities, which now leaves very limited upside versus current prices. And I think the region is now less attractive than something like Japan, for example, where I think you still have some of the same positive arguments that apply to Europe. The valuations are low. The currency is weak. Investors, I do not think are overly positioned in the region, but with less risk around aggressive central bank policy and with less risk around energy security. So for those reasons, we now think Japan is going to be outperforming market on a on a global basis.
Andrew Sheets So Jens, all that said, the war in Ukraine is a wild card for our forecasts. What are the developments or indicators that you and your team are going to be watching?
Jens Eisenschmidt We are really dependent on what's happening in the political sphere, given that the cut off of energy supplies will be either a decision by Russia or by the EU to no longer accept delivery of any gas or oil or coal. And obviously, this is a political process for which you have many ingredients, so you would want to watch these ingredients and some of which are essentially in the conflict itself. So I think we are attentively watching the developments that the conflict is taking. And there for instance, the news flow coming out of potential war crimes that certainly has not helped the case of energy supplies flowing freely. So there is a discussion right now in the European Union to restrict import of coal. And I think it's exactly these sort of developments that you have to be watching. Another space that we attentively watch is energy markets because high energy prices are so detrimental for the growth outlook. And might remind you, we have one scenario, our so-called bear scenario, which sees energy prices almost as high as we have seen them or higher a little bit maybe as we have seen them in early March. That is a scenario which would get us very, very close to recessionary territory. So, in some sense, it's a situation where we have to watch the energy markets as much as we have to watch the political scene and see how this conflict evolves.
Andrew Sheets Well, clearly a lot that we'll need to follow. Jens, thanks for taking the time to talk.
Jens Eisenschmidt Great speaking with you, Andrew.
Andrew Sheets And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As the U.S. government attempts to combat high gas prices by drawing on its oil reserves, investors should pay attention to the impacts on the U.S. economy and consumer behavior.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, April 6th at 10 a.m. in New York.
Last week President Biden announced the largest release of oil reserves in history, about 1 million barrels per day for the next 6 months from the government's Strategic Petroleum Reserve. The move is intended to put downward pressure on the price of gasoline by increasing the supply of oil, thereby relieving pressure on the American consumer from higher costs at the pump. Will it work? That remains to be seen, but investors should pay close attention, not just because it impacts their cost of driving, but also because it impacts the outlook for the U.S. economy by affecting how consumers behave.
Our U.S. economics team, led by Ellen Zentner, has done some work worth highlighting here. The big takeaway is this; oil price shocks do dampen consumer activity, but not right away. The jump in oil prices seems to have to sustain itself before having a big impact. For example, consumption in real dollar terms seems to weaken after initial oil price increases, but it's not until 2 to 3 months after that shock that consumers start to buy less of other things in order to have enough money to pay the higher costs of filling up their cars. Looking at this effect on a specific product, for instance automobiles, you can see a similar pattern. Spending on cars doesn't seem to change in the first month after a price shock but drops almost 10% thereafter for 8 months.
So the bottom line is this; the White House's move on releasing oil reserves has some time to play out. But if it doesn't reduce gas prices in the next couple months, then it becomes one cost pressure among several, including labor costs, that could start slowing the U.S. economy from its currently healthy pace. It's one reason our equity strategy team continues to see higher costs creating some pressure in key sectors of the stock market, notably consumer services, apparel and staples.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Original Release on March 30th, 2022: As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.
-----Transcript-----
Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.
Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley.
Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York.
Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now?
Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s.
Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle?
Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this...
Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists.
Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home.
Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today?
Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy.
Michael Zezas: Well, Matt, thank you for taking the time to talk with me today.
Matthew Hornbach: It was great talking with you, Michael,
Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
With the end of the first financial quarter of 2022 the market has begun to price in some of the continuing risks to economic growth, forcing investors to reconsider the trajectory for the rest of the year.
-----Transcript-----
Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 4th, at 11:00 a.m. in New York. So let's get after it.
Given how bad first quarter returns were for both stocks and bonds, most investors were probably happy to see it end. Furthermore, the rally in the second half of March made it considerably better for stocks than it was looking just a few weeks ago. In the end, though, bond returns ranked worse than stocks from a historical perspective, with Treasuries posting the worst quarter in 50 years.
The tough first quarter was very much in line with our view coming into 2022. To recall, we didn't see many fat pitches given the Fed's resolve to fight the surge in inflation in the face of slowing growth. Whether it was for technical or fundamental reasons, bond and stock markets ignored this risk into year-end. Apparently, they required a more obvious signal, which appeared on January 5th with the minutes of the Fed's December meeting. From that moment, both stocks and bonds made a sharp U-turn and never really looked back for the entire first month of the year.
In short, headline indices for both stocks and bonds finally adjusted to the fire part of our narrative, a risk that started to price under the surface back in November. With inflation and the Fed the number one concern during the first quarter, it makes sense that bonds would be worse than equities. It also makes sense that stocks more vulnerable to higher interest rates underperformed. As an example, the Nasdaq performance was considerably worse than both the S&P 500 and the small cap Russell 2000, a very rare occurrence over the past few years. And this is after a major rally in the past two weeks that was led by the Nasdaq. Our conclusion is that markets were preoccupied in the first quarter with the Fed's sharp pivot, more than anything else, and it played out in asset prices appropriately.
Of course, the other major driver for markets in the first quarter was the war in Ukraine. While tensions had been building since late last year, it's fair to say markets had ignored that risk, too. The only difference is that the Fed's pivot was well telegraphed, while Russia's invasion was far from a sure thing and more of an unknown known to most, including us. Obviously, such an event did materially factor into the risk for the first quarter by accentuating the fire and ice by making inflation worse whilst simultaneously dampening growth prospects. It also has rattled confidence for both businesses and consumers, especially in Europe. This was not in our calculus when we made our forecast for 2022. As such, we find ourselves incrementally more negative on growth trends than we were at the end of last year.
Last fall, we pushed out the timing of the ice part of our narrative to the first half of this year, when we realized that the economy still had plenty of strength left for companies to deliver on earnings growth. But now investors face multiple headwinds to growth that will be harder to ignore. These include the payback in demand from last year's fiscal stimulus, demand destruction from higher prices, food and energy price spikes from the war that serves as a tax and inventory bills that have now caught up to demand.
While the employment report for March last Monday was strong once again, the Purchasing Managers Survey for Manufacturing showed a sharp deterioration in the orders component. Relative to inventories it looks even worse, with the inventory component of the index now below orders for the first time since the recovery began. Think of this ratio as the book to bill for the broader manufacturing economy. Perhaps this survey is the moment of recognition for the slowdown, much like the Fed's minutes were for inflation and Fed policy.
The bottom line is that the fundamental outlook for stocks has deteriorated in our view since the end of last year. While markets have reflected some of this deterioration, we think it remains vulnerable to disappointing growth and increased risk of a recession next year. As such, we continue to recommend investors position for this late cycle setup. More specifically, that means favor defensively oriented sectors like Utilities, REITs and Healthcare, while avoiding stocks more vulnerable to a payback in consumer demand.
Thanks for listening. If you enjoyed Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Investors are looking to the U.S. Treasury bond market as concerns rise around what the flattening, and potential inversion, of the yield curve might mean.
-----Transcript-----
Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, April 1st at 2:00 p.m. in London.
The so-called flattening and inversion of the U.S. yield curve is a dominant story in financial markets. As rates have risen, short term interest rates have risen more, meaning investors receive about the same yield on a 2 year U.S. Treasury as its 10 year version. This is unusual, and raises big questions for both bond investors and the economic outlook overall.
Unsurprisingly, investors are usually paid more for investing in longer term bonds because these are generally more volatile. When that's not the case, it often means the market thinks the economy is going to be good in the near term, keeping short term central bank rates high, but possibly weaker in the longer term, which would imply lower future central bank rates and more supportive policy further out.
And that feels like a pretty decent encapsulation of the current market debate. The U.S. economy is very strong at the moment, with the US unemployment rate recently falling to just 3.6%. But that strength is driving inflation and leading the Federal Reserve to raise interest rates more aggressively, rate increases that investors fear could weaken growth further out in the future.
With implications like this it's no wonder that a lot of other asset classes, from credit markets, to equity markets, to commodities, really care about what the bond market is doing. And for these investors, we think there are a number of interesting implications.
Let me start by saying that similar yields on 2 year and 10 year government bonds is not, in itself, a sell signal. Indeed, the last five times these rates were the same, global stocks rose by an average of about 10% over the following year.
What we do see, however, is that a flat yield curve starts to support the outperformance of higher quality, more defensive assets. I try to explain this by the idea that investors do try to retain some growth in income exposure, given the strong current economic conditions, but try to move away from assets that could be much more vulnerable if growth deteriorates in the future.
Specifically, when the U.S. 2 year and 10 year yields become similar, investment grade bonds start to outperform high yield bonds. Developed market stocks start to outperform emerging market stocks. And defensive sectors like health care and utilities outperform the broader market over the ensuing 12 months.
Today, we think all of those strategies make sense. That's not because we necessarily think a recession is likely. Rather, we think it's a prudent reading of history in response to current bond market signals.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.
As interest in using cryptocurrencies for transactions continues to rise for both consumers and businesses, crypto has begun a cycle of increased stability and popularity - but the question is, can this cycle continue?
-----Transcript-----
Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be asking the question - are cryptocurrencies currency? It's Thursday, March 31st at 2:00 p.m. in London.
Did you really buy that house with crypto? Or did you just sell your crypto for dollars and use dollars to buy the house?
Crypto skeptics think that goods cannot be priced in cryptocurrencies like bitcoin, primarily because their price is too volatile. But at some point, if crypto begins to be used for enough purchases of everyday goods and services, prices may begin to stabilize. Increased stability will further entice consumers to use crypto, and the cycle will continue. The question has always been, will this virtuous cycle ever begin? The answer is now clear, it has already begun. Here are some examples.
Firstly, paying with cryptocurrency needs to be as easy as paying with a credit or debit card today. Over 50 crypto companies and exchanges have issued their own crypto cards, and these are attached to the Visa or MasterCard payments networks, meaning they're accepted all around the world. In the last quarter of 2021, Visa said its crypto related cards handled $2.5 billion worth of payments. Now that may sound small, at less than 1% of all Visa's transactions, but it is growing quickly. The difficulty in increasing crypto adoption is getting the merchant to accept crypto. It needs to be easy and cheap, which is something lots of new crypto companies and products are trying to achieve.
Secondly, many would argue that something can only be a currency if you can pay your taxes with it. Even that is changing today. Over the past year, local and some national governments have introduced or proposed laws that will allow its residents to use cryptocurrency to pay their taxes. El Salvador famously made bitcoin legal tender in its country in 2021. In the past week, Rio de Janeiro announced it will become the first city in Brazil to allow cryptocurrency payments for taxes starting next year.
It isn't just emerging economies, though, that are trying to attract global crypto investors. The city of Lugano in Switzerland has teamed up with Tether, the creator of the largest stablecoin - a type of cryptocurrency that's kept stable versus the U.S. dollar, to make bitcoin and two other cryptocurrencies de facto legal tender. In the U.S., Colorado is hoping to become the first state to accept crypto for taxes later in the year, and Florida's governor is investigating the logistics of doing the same. Both these proposals may be difficult to put into law in the end, as the U.S. constitution doesn't allow individual states to create their own legal tender, but it hasn't stopped these proposals and more from coming in.
In both these examples, the receiver of the crypto typically immediately converts to fiat currency, like U.S. dollars, through an intermediary service provider. So let's come back to our original question - did you really buy that house with crypto? In February, a house in Florida was sold for 210 Ether, the second largest crypto, or the equivalent of over $650,000 dollars. Interestingly, the seller received the ether but didn't liquidate into U.S. dollars soon afterwards due to market volatility, because the value of ether in U.S. dollars fell by around 10%.
Consumers and businesses are increasingly wanting to transact in cryptocurrency. Maybe most are simply wanting to trade the value of the asset, but as it becomes easier to transact in crypto and legal structures are defined, cryptocurrencies could start to become currency. The question is, will the virtuous cycle continue or be broken? Cryptocurrencies are beginning the long journey of challenging U.S. dollar primacy, and the president's recent executive order on digital assets shows little sign of regulators getting in their way for now.
Thanks for listening. If you enjoy Thoughts on the Market, share this and other episodes with a friend or colleague today.
As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.
-----Transcript-----
Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.
Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley.
Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York.
Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now?
Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s.
Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle?
Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this...
Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists.
Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home.
Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today?
Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy.
Michael Zezas: Well, Matt, thank you for taking the time to talk with me today.
Matthew Hornbach: It was great talking with you, Michael,
Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As oil and gas prices rise, governments and investors must weigh investment in clean energy initiatives and new capacity in traditional energy commodities. Head of North American Power & Utilities and Clean Energy Research Stephen Byrd and Head of North American Oil and Gas Research Devin McDermott discuss.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Stephen Byrd: Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Head of North American Power and Utilities, and Clean Energy Research.
Devin McDermott: And I'm Devin McDermott, Head of Morgan Stanley's North American Oil and Gas Research.
Stephen Byrd: And today on the podcast, we'll be discussing the key debate around energy security and energy transition amid the Ukraine Russia conflict. It's Tuesday, March 29th, at 9 a.m. in New York.
Stephen Byrd: So, Devin, the Russia-Ukraine conflict has, among other concerns, really put a spotlight on energy supply and demand. I want to get into this perceived tension between energy security, that is making sure there's enough supply to meet demand, and the transition to clean energy. But first, maybe let's start with the backdrop. There's been a lot of discussion around higher energy prices. This is a world you live in every day, and I wondered if you could paint us a picture of both oil and natural gas supply and demand globally.
Devin McDermott: Yeah, certainly, Stephen, and it's definitely been a dynamic market here over the last several years, coming out of COVID and the price declines that we saw then and the sharp recovery that we've been in now for about a year and a half across the energy commodity complex. If we start with oil first, we had record demand destruction in the second quarter of 2020 around global lockdowns, industrial activity slowing and along with that, oil prices broke negative for the first time in history. And then coming out of that, we've had the combination of a few factors that drove prices higher. The first has been demand has been on a very strong recovery path since that bottom in the second quarter of 2020, growing alongside people getting out again, aviation starting to pick up, the economy growing on the back of the stimulus that was injected over the past few years around the world, not just in the US. And then constrained supply, and that constrained supply comes from a mix of different factors, but the biggest of which is a reduction in investment around the world. The other factor is decarbonization goals, in particular with the global oil majors, which are big investors in global oil and gas capacity, and they've put their marginal dollar increasingly into low carbon initiatives, New Energy's platforms, renewables, driving decarbonization goals across their global footprint. Now, shifting over to the gas side, gas is a fascinating market. Globally, it's fairly regionally disconnected historically, but we've had this big investment over the past decade in liquefied natural gas or LNG that's really brought these regional markets together into one global picture. And we've been on, up until COVID, a declining path on prices. LNG projects take many years to build, they're expensive, they have long paybacks, and they were first to get chopped when companies cut capital budgets to preserve liquidity back in 2020, but demand was still growing through that timeframe. So it pushed us into this period of supply shortfall and higher prices. And actually, last year, on three separate occasions, we set new all time highs for global non-U.S. natural gas prices, and that recovery path and period of stronger for longer prices has persisted here into 2022. And even prior to Russia Ukraine, it was something that we thought would persist for at least the next several years.
Stephen Byrd: You know, it's fascinating before the Russia-Ukraine conflict we already had, you know, tight markets, rising pricing. Now we really need to dig into the Russia-Ukraine conflict and all the impacts. Maybe let's just start Devin with, sort of, how big of a player Russia is in terms of oil and gas, and what the impact is of any current or future sanctions against Russia.
Devin McDermott: Russia is one of the world's largest producers of oil and also one of the world's largest producers of natural gas. And to put some numbers around that, Russia represents about 10% of the world's oil supply, about half of that gets exported to the rest of the world. And they represent about 17% of the world's natural gas supply, about 7 of that gets exported to the rest of the world. These are big numbers. And if you look at Europe specifically, about 30% of their gas needs are coming from Russia on pipeline gas right now. So any disruptions to those flows have significant impacts to the global oil and gas market on top of this already tight backdrop.
Stephen Byrd: And Devin I guess as we think about Europe, there's tremendous focus, as you point out Russia is a major player in energy and a major exporter. And I wonder if you could just talk to the current situation and what do you think would be feasible in terms of satisfying energy demand as Europe thinks about looking for other sources of energy?
Devin McDermott: Yeah, it's a good question, Stephen and our European energy team has done a lot of work around this and they think that because of the events that have happened so far, not including any potential incremental sanctions or disruption of supply, that we'll lose about a million barrels a day of Russian oil here over the next several months, starting in April through the balance of this year. And again, just to put that in the context, that's about 10% of Russian supply, about 1% of the world's supply on a normalized pre-COVID basis. Now, some of the disruption in flows to Europe will be bought by other countries. You've seen India and China step in and pick up some of this Russian crude that's no longer going to Europe, but it's not going to fill the entire gap. So it leaves us tighter in the oil market than we were just a few weeks ago. On the natural gas side, it'll be a gradual pivot away from Russian pipeline gas within the European market toward a range of different things, one of which is LNG liquefied natural gas. But, as I mentioned before, that market was already in a shortfall, meaning there was not enough supply to meet demand prior to this. So this transition away from Russian gas is going to require substantial investment and take a long time, 5 to 10 years plus, to carry out. It means that these high prices that we're seeing likely have some sustainability to them.
Devin McDermott: Stephen, that brings me to a question that I wanted to ask you on the clean energy side. Do you think that we might see a greater policy, and even energy consumer push, to clean energy both in the US and globally on the back of these elevated commodity prices and what's going on in Russia and Ukraine at the moment?
Stephen Byrd: Yeah, Devin, we've been seeing a lot of interest among investors in exactly what is going to be the policy response both in Europe and the United States and elsewhere. And I'd say the EU has taken action already. The European Commission laid out a repower EU plan that is very aggressive in terms of additional renewables growth, additional growth in green hydrogen. We see quite a few European utilities and clean energy developers benefiting from the EU's increased emphasis and push towards more and more clean energy. And Rob Pulleyn, my colleague who covers European utilities and clean energy developers and is also a commodities strategist with respect to carbon, has been spending a lot of time on this, has laid out a suite of companies that would benefit quite significantly. There does seem to be a really big policy push in Europe. The United States is not clear. The real question is whether some version of build back better legislation will pass. We just don't know. Now, there is a reason to believe that there could be a compromise position in which some elements of a support for fossil fuel production are included, along with the whole suite of clean energy support that we already know is there. That said, it's possible that compromise simply won't be met. And in that case, we won't get any kind of additional support at the federal level. What's fascinating in the United States, though, is frankly, we don't necessarily need to see that support in order to see tremendous growth in clean energy, we are already seeing a big shift. And as we stand today, we think that clean energy in the United States will more than triple between now and 2030. It's one of the fastest growth rates globally. That is driven mostly by economics, in some cases by state policy, but mostly by economics.
Devin McDermott: So, Stephen, I wanted to go back to this question on the tension between energy security and the energy transition. Is it an either or?
Stephen Byrd: You know, Devin, we get asked that question a great deal, and I strongly believe the answer is no, those two ideas are not mutually exclusive. And in fact, what we're seeing is both the policy push as well as a business push in both directions. And a good example of that would be the U.S. Utilities that I cover. They are certainly very focused on deploying more renewable energy. And as a group, for example, we see that utilities will decarbonize in the United States by about 75% by 2030 off of 2005 baseline. So very aggressive decarbonization. At the same time, those utilities are very focused on ensuring grid reliability. Now, as we deploy more renewable energy, we're learning quite a few lessons. One lesson is the importance of more energy storage, so demand has been picking up a great deal for that. Another lesson we're learning is the importance of nuclear generation, we're learning that they're critical. They provide both reliability and also zero carbon energy. And in the U.S., we've had a very strong operational track record for our nuclear fleet. So we're learning lessons along the way, but what we're seeing is a push in both directions. Now, as you know, clean energy relative to the world that you live in, oil and gas, is still fairly small. It's going to take many years before clean energy really makes a meaningful impact in terms of global energy consumption. That said, for example, coal generation in places like the United States will decline over time and be replaced with mostly renewable energy, but also with some degree of natural gas generation to ensure reliability. So we're seeing really both ideas play out, and both investment theses are very rational, and we see really good opportunities on both of those ideas.
Devin McDermott: And let's take it one step further and talk investment opportunities and themes on the back of this. As you think about the different subsets of clean energy and clean tech, where would you be focused for opportunities here?
Stephen Byrd: You know, it's interesting. One group of stocks that we generally like are clean energy developers. And the reason we like those stocks is essentially this spread between what we're thinking of as inflationary traditional energy like oil and gas, and this deflationary dynamic of clean energy. One example is in places like California, the traditional utility costs to customers are rising very rapidly above 10% a year. If you look in the long term, the cost of our clean energy solutions are dropping anywhere from 5% a year, to 10, 15% per year. That's a tremendous economic wedge, and we think the developers will be able to essentially capture a lot of that spread. On the manufacturers side there are still some supply chain dynamics, which can cause some near-term margin compression that concerns us, in some cases. I would say another area of really interesting growth is green hydrogen, especially in Europe. A number of our companies are focused on that market as well. So those would be a couple of the buckets of opportunity that we see.
Devin McDermott: Great. Stephen, thanks so much for the time today. It's really a fascinating topic and one that's unfolding right before our eyes today.
Stephen Byrd: Well, it was great speaking with you, Devin.
Devin McDermott: And thanks for listening. If you enjoy Thoughts on the Market, please give us a review on Apple Podcasts and share the podcast with a friend or colleague today.
As the Fed continues down a hawkish road for 2022, investors must consider the impact of policy tightening on economic growth and equity risk premiums.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 28th at 11:00 a.m. in New York. So let's get after it.
2022 has been a year of extraordinary hawkishness from the Fed, and it continues to surprise on the upside with both its formal guidance and informal communications. This has led to almost weekly revisions for more Fed rate hikes from just about everyone, including our economists who now expect 50 basis point interest rate hikes in both May and June, and then 25 basis points in every meeting thereafter. The bond market has definitely gotten the message, too, with one of the sharpest rises in short term interest rates ever witnessed. Longer term rates have also adjusted as the expected terminal rate for this cycle has risen to 2.9%. The questions for equity investors now is whether they believe the Fed will actually tighten this much and what will be the impact on the economy from a growth standpoint.
We have several takeaways from these recent moves. First, the Fed appears to be very committed to reducing inflation. Friday's University of Michigan Consumer Confidence Report for March confirmed that high prices are still the key reason this metric has plummeted to levels usually reserved for recessions.
Second, 10 year yields are now at a level that takes the equity risk premium to its lowest level since the Great Financial Crisis. As a reminder, equity risk premium is the return and investor receives above and beyond the yield on a Treasury bond. The higher the risk, the greater the equity risk premium. In our view, it makes little sense for the equity risk premium to be so low right now, given the heightened risks to earnings growth from a rise in cost pressures, payback in demand, and a war that has structurally increased the price of food and energy. While stocks are a good hedge from higher inflation, keep in mind that inflation from food and energy is bad for most companies as it acts as a tax on consumers. Only energy and materials companies really benefit from this kind of inflation but they make up a very small slice of the index. Some may argue technology companies are less affected, but we're skeptical as they will feel it too in lower revenues if the consumer spending fades.
Third, the risk from further exogenous shocks to growth are also elevated given the war in Ukraine, China's real estate stress, and ongoing battle with COVID, to name a few. This is one reason why market volatility remains so high. Importantly for investors, our work suggests the equity risk premium is also understated relative to this high market volatility. In short, equity investors are not being properly compensated for taking equity like risk at current prices.
Finally, these high valuations are not isolated to just a few sectors. The lower equity risk premium is present across all sectors except energy and materials, and these are the two biggest beneficiaries of high commodity inflation. In some ways, the low equity risk premium for these sectors is simply saying the market does not believe the recent boost to earnings and cash flow is sustainable, due to either demand destruction or the eventual supply response.
The bottom line is that we remain bearish on the S&P 500 index from a risk reward standpoint, particularly after the recent rally. Our year end base case target of 4400 is 4% below current levels. At the stock level, we continue to recommend investors look for stable cash flow generating companies in defensive sectors like utilities, health care, REITs and consumer staples.
Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
The new Fed hiking cycle has begun and with it comes expectations for faster rate hikes and quantitative tightening to address inflation, as well as questions around how and when the U.S. economy will be affected. Chief U.S. Economist Ellen Zentner and Senior U.S. Economist Robert Rosener discuss.
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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research.
Robert Rosener: And I'm Robert Rosner, Morgan Stanley's Senior U.S. Economist.
Ellen Zentner: On this episode of the podcast, we'll be talking about the outlook for the U.S. economy as the Fed begins a new rate hike cycle. It's Friday, March 25th at 9:00 a.m. in New York.
Ellen Zentner: So Robert, last week the U.S. Federal Reserve raised the federal funds rate a quarter of a percentage point, which is notable because it's the first interest rate hike in more than two years, and it's likely to be the first of many. Chair Powell has told us that it's unlikely to be like any prior hiking cycle, so maybe you could share our view on the pace of hikes and where and when it might peak for the cycle.
Robert Rosener: Well, it certainly is starting off unlike any recent policy tightening cycle, and recent remarks from Fed policymakers have really doubled down on the message that policy tightening is likely to be front loaded. And we're now forecasting that we're likely to see an even steeper path for Fed policy tightening this year, and we think that as soon as the May meeting, we could see the Fed pick up the pace and hike interest rates by 50 basis points and follow that in June with yet another 50 basis point increase. We're expecting they'll revert back to a 25 basis point per meeting pace after that, but still that marks 225 basis points of policy tightening that we're expecting this year in our baseline outlook.
Ellen Zentner: So how does Jay Powell, the chair of the FOMC, fit into this? Do you think he's about in line with this view as well?
Robert Rosener: He does seem to be generally in line with this view, but he is negotiating the outlook among a committee that has a diversity of views, and we've been hearing from policy makers, a wide range of policy makers, over the last week. What's been notable is that more and more policymakers are starting to get on board the train that a faster pace of policy tightening is likely to be warranted. And that may very well include rate hikes that come in larger increments, such as 50 basis point increments, over the course of the year as policymakers seek to get monetary policy into more of a neutral setting.
Ellen Zentner: So this is all because of inflation. Inflation's broad based, it's rising. I think it felt like there was a very big shift on the FOMC January/February, when the inflation data was really rocketing to new heights. So in order to bring inflation down when the Fed is hiking, how long does it take for those hikes to flow through into the economy to bring inflation down?
Robert Rosener: Well, that's a really good question, and certainly that broadening that you mentioned is key. We saw a run up in inflation in the later part of last year that was driven by a few segments, particularly on the goods side. But as we moved into the end of 2021 and early 2022, what we really started to see was a broadening out of inflationary pressures and particularly a broadening into the service sectors of the economy where price pressures began to pick up more notably and began to lead the inflation data higher. Now, as we think about how monetary policy interacts with that, tighter monetary policy needs to slow growth in order to slow inflation. And typically, you would look at monetary policy and not expect it to be really materially affecting the economy for, say, a year out. Something that Chair Powell has stressed is that monetary policy transmits through financial conditions, and financial markets moved to price in a more hawkish Fed outlook as soon as the latter part of last year. Now, as those rate hikes got priced into the market, that acted to tighten financial conditions. So as Chair Powell noted in his press conference, the clock for when rate hikes start to impact the economy doesn't necessarily start on the delivery of those rate hikes. It starts when they affect financial conditions. And so we may start to see that a backdrop of tighter financial conditions begins to reduce some of the steam in the economy and reduce some of the steam in inflation as we move through the course of the year. But with headline CPI currently at around 8%, likely to march higher in the upcoming data, there's a lot of room to bring that down. So we might have to wait some time before we see material relief on inflation.
Ellen Zentner: So let's talk about the balance sheet because they're not just hiking rates, right? They're going to reduce the size of their balance sheet, what we call quantitative tightening or Q.T. And so run us through our view and how the Fed's thinking about that quantitative tightening process when they're unwinding much of that four and a half trillion in asset purchases that they made during the pandemic.
Robert Rosener: So the Fed has made it clear they're on track to begin winding down the size of their balance sheet, and that's a decision that we're expecting will come at the May meeting, that in very short order the Fed would begin to reduce the size of its balance sheet with caps on reinvestment and total at about $80 billion per month. And that would set roughly the monthly pace by which the balance sheet would decline, and Chair Powell has indicated that that process may take around three years to bring the balance sheet down to a size that would be consistent with a neutral balance sheet. It's going to act to tighten financial conditions in the same way or similar ways that rate hikes do, but it's a little bit less clear how those effects happen, over what time horizons they happen. So there's some uncertainty there, but it's something that the Fed wants to have running in the background, while they pursue rate hikes.
Ellen Zentner: So in terms of, you know, if the balance sheet is going to be doing additional tightening, what do we think the Fed funds equivalent of that is, has Chair Powell discussed that?
Robert Rosener: So when we looked at this, we looked at the effects through financial conditions. And in our estimates, the tightening of financial conditions that we would see on the back of the balance sheet reduction that we're expecting, was about the equivalent this year of one additional 25 basis point hike. Now, perhaps coincidentally, Chair Powell in his most recent remarks, also noted that the tightening of the balance sheet or the shrinking of the balance sheet this year would be about the equivalent of one rate hike. So there's some consolidation of views there that it does act to tighten. Again, there's uncertainty bands around that, but it's about the equivalent of one additional hike this year.
Robert Rosener: So Ellen, we can't really talk about the Fed raising rates without thinking about the broader implications for the yield curve, and more recently the applications for yield curve inversion. For listeners who might not be familiar, that's when shorter term investments in U.S. treasuries, such as the 2-year yield, pay more than longer term treasuries, such as the 10-year yield. Historically, when we've seen that spread inverting, it's been a signal that a recession might be coming. What are you thinking about the risks that the yield curve is telling us now? And does that tell us anything about the risk of a future recession?
Ellen Zentner: Well, Robert, I think it is clear that the yield curve, if we're talking about just the spread between 2-year treasuries and 10-year treasuries, is going to continue to flatten and invert. And policymakers have made it clear that because of special factors, they shouldn't be concerned this time. And when I look at factors in the economy that are typically what you would look at for signals of recession, you know, jobs, we are still creating jobs, it’s been a very steady run of about 500,000 jobs a month. We are expecting another strong print in the upcoming payroll report, that does not speak to approaching recession. When I look at retail and wholesale sales still growing, industrial production still growing, real disposable income of households still growing. Even though we're dealing with the fading of fiscal stimulus, that labor income has been very strong. So all of those traditional measures would tell you that an inverted yield curve today is not providing you a signal of approaching recession, and I think overall inversion of the yield curve has become less of a recession indicator since we have been trapped so near the zero lower bound over the last cycle and this cycle.
Robert Rosener: So we talked about the Fed, we talked about the yield curve and financial conditions, but of course, there's a lot of things that the Fed has to take into account as it thinks about the outlook. And of course, we're all watching the terrible events unfolding in Ukraine. And as we think about the ripple effects on the world economy, particularly in Europe, as well as more broadly on energy security and supply and so much more. Clearly, this is an impact that's going to be affecting regions differently. But how should we think about how that's going to be felt here in the U.S. economy? And what does that mean for the Fed?
Ellen Zentner: So I think first and foremost, it plays back into the inflation story. I think what we've heard from the chair is that typically they do look through food and energy price fluctuations. But in this case, where inflation is already broad based and high, they do have to act and it just puts more fuel behind the need to have a more aggressive tightening cycle. When we look at our own analysis and impact analysis that you've done for us on the team, the impact on inflation from increases in energy prices is four times that of the impact on GDP growth. In the U.S. we're just about energy independent. And so it's become more ambiguous as whether higher energy prices are really a negative for the U.S. economy. But the way I would look at this is, it will slow activity in parts of the economy, we've taken our own growth forecasts down to reflect that forecast for GDP, and it will disproportionately affect lower income households. Where food prices, energy prices and just general inflation impacts them to a much greater degree than upper income households. So overall, aggregate spending will look quite strong in the U.S. economy, but for the lower income groups, I think it's going to be lagging behind. But certainly you mentioned Europe, you know, Europe is facing possible recession if gas supplies are cut off, which is a very real risk. But it's just not going to be as big of an impact to the U.S. economy, where we'll feel it is if other parts of the globe are deteriorating it can hamper financial conditions here, and that's something that the Fed will be watching closely. And so, Robert, you and I will be watching these developments closely as well. We've made it clear and the Fed has made it clear that it's on the path higher for interest rates, but the outlook always comes with risks and we'll be reporting back on those risks in future podcasts. So, thanks for taking the time to talk, Robert.
Robert Rosener: Great talking with you, Ellen.
Ellen Zentner: And thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
While the possibility of a yield curve inversion in the U.S. has news outlets and investors wondering if a recession is on the way, there’s more to the story that should put minds at ease.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, March 24th at noon in New York.
For most investors, most of the time, the general level of U.S. Treasury yields is more important than the differences between yields on shorter maturity bonds and those on longer maturity bonds. The most widely quoted Treasury yield is usually the one investors earn by lending their money to the government for 10 years.
But there are times when the difference between yields on, say, treasuries that mature in 2 years and those that mature in 10 years make the news. And this is one of those times. These yields are tracked over time on a visual representation we call the yield curve. And at some point soon, we expect the yields on 2 year treasuries to be higher than those on 10 year treasuries. This is what we call a 2s10s yield curve inversion.
The reason why yield curve inversion makes the news is because, in the past, yield curve inversion has preceded recessions in the U.S. economy.
Still, there are two points to make about the relationship between the yield curve and recessions, both of which should put investors' minds at ease. First, using history as a guide, inverted 2s10s yield curves preceded recessions by almost two years on average. While time flies, two years is plenty of time for people to prepare for harder times ahead.
Second, despite popular belief, yield curve inversions don't necessarily cause recessions, and neither does significantly tighter fed monetary policy - which also can cause yield curves to invert. In his recent speech, Fed Chair Powell highlighted 1965, 1984, and 1994 as times when the Fed raised the federal funds rate significantly without causing a recession.
Another important point is that the yield curve can flatten for reasons unrelated to tighter Fed policy. For example, between 2004 and 2006, the yield curve flattened by much more than Fed policy alone would have suggested. The curve flattening during this period baffled the Fed and investors alike. Former Fed Chair Greenspan labeled the episode "a conundrum" at the time.
So what caused the yield curve to flatten so much during that period? Former Fed Chair Bernanke suggested it was a global savings glut. Overseas investors purchased an increasingly larger share of the Treasury market than they had ever bought before.
Fast forward to today and the demand from overseas investors has been replaced by demand from the Fed. In fact, the Fed owns almost 30% of outstanding Treasury notes and bonds, which goes some way to explaining how flat the yield curve is today. And, to be clear, fed ownership of those bonds also isn't a reason to think recession is right around the corner.
Another common concern about a flat yield curve is that it will cause banks to stop lending. And without banks lending into the real economy, recession might loom large. But our U.S. Bank Equity Research Team is less concerned.
Their work shows that bank loans grew during the prior 11 periods of yield curve inversion since 1969. While they found some moderation in loan growth, it was modest. And this year, despite our forecast for an inverted yield curve. The project loans to grow 7% over the year, after loans shrank last year, when the yield curve was actually much steeper.
So in the end, while we think the yield curve will invert this year, we don't think investors should worry too much about a looming recession - even if the news does.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
While the demand for Environmental, Social, and Governance investing has been growing primarily in Europe, a potential new regulatory policy may drive new interest and opportunity for U.S. investors.
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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 23rd at 10 a.m. in New York.
Taking a break from specific market impacts for the moment, we want to focus on the growth of a new market for investors - the market for ESG investing, which a new regulatory policy may help nudge into the mainstream in the U.S.
As you may already know, ESG stands for Environmental, Social and Governance, three factors that represent a measurement of how socially conscious the investment is. The demand for this style of investing has grown substantially in recent years. For example, per our sustainability research team, there are about 2 trillion dollars of dedicated ESG assets under management globally. But about 85% of that is in Europe, showing how U.S. investors have been relatively slower to adopt such strategies.
Yet earlier this week, the SEC proposed a new rule that could create new incentives for U.S. investors to adopt ESG strategies. This rule would require companies to provide disclosures about their emissions, as well as governance and strategy for dealing with climate related risks. As our sustainability research team noted in a report this week, having a standard for disclosure can help build the ESG market by giving investors a common template for understanding ESG impacts. That differs from the current state of play, where many companies do disclose on climate related issues, but to different levels and by differing standards, making analytical comparisons difficult.
We should note, though, that this is just a first step toward a regulation that could boost the size of the ESG market. Regulatory rules tend to take a long time to finalize and implement. According to Government Accountability Office case studies, it can take anywhere from six months to five years, as proposed rules navigate a series of comment periods, judicial challenges and revisions. So we'll track the process here and report back when there's more to know.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
While the cost of shelter has risen quickly, the measure of housing inflation has been slow to catch up, creating challenges for renters, homeowners and the Fed.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Tuesday, March 22nd at 2:00 p.m. in London.
Our base case at Morgan Stanley is that the U.S. economy sees solid growth over the next two years, with inflation moderating but still being somewhat higher than the Federal Reserve would like. We think this means the Fed raises interest rates modestly more than the market expects, flattening the US yield curve.
But what are the risks to this view? Specifically, what could cause inflation to be much higher, for much longer, putting the Federal Reserve in a more pressing bind? I want to focus here on core inflation as central banks have more leeway to look through volatile food or energy prices. This is a story about shelter.
The cost of shelter represents about 1/3 of U.S. core consumer price inflation. That makes sense. For most Americans, where you live is your largest expense, whether you rent or pay a mortgage.
The CPI measure of inflation assumes that the cost of renting has risen 4.5% in the last year. Now, if that sounds low, you're not alone. At the publicly traded apartment companies covered by my colleague Richard Hill, a Morgan Stanley real estate analyst, rents have risen 10% or more year-over-year. There are reasons that the official CPI number is lower. For one, not everyone renews their lease at the same time. But with a strong labor market and limited supply, the case for higher rents going forward looks strong.
Owner occupied housing is even more interesting. Since 2016, U.S. home prices have risen about 56%. But the cost of a house that goes into the CPI inflation calculation, known as "owners’ equivalent rent", has risen only 21%. That's a 35% gap between actual home prices and where the inflation calculation sits.
This is a potential problem. Even if home prices stop going up, the official measure of housing inflation could keep rising at a healthy clip to simply catch up to where home prices already are. And given high demand, low supply, and still low interest rates, home prices may keep going up, meaning there's even more catching up to do from the official inflation measure.
Higher shelter costs are also a challenge because they're very hard for the Federal Reserve to address. Raising interest rates, which is the usual strategy to combat inflation, makes buying a house less attractive relative to renting. Which means even more upward pressure on rental demand and even higher rents. And higher interest rates make building homes more costly to finance, further restricting housing supply and raising home prices.
Housing has long been a very important sector for the economy and financial markets. Over the next 12 months, expect it to be central to the inflation debate as well.
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This year is validating our call for a shorter but hotter economic cycle. As the indicators begin to point to a late-cycle environment, here’s how investors can navigate the change.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 21st at 1:00 p.m. in New York. So let's get after it.
A year ago, we published a joint note with our Economics and Cross Asset Strategy teams arguing this cycle would run hotter but shorter than the prior three. Our view was based on the speed and strength of the rebound from the 2020 recession, the return of inflation after a multi-decade absence and an earlier than expected pivot to a more hawkish Fed policy. Developments over the past year support this call - US GDP and earnings have surged past prior cycle peaks and are now decelerating sharply, inflation is running at a 40-year high and the Fed has executed the sharpest pivot in policy we've ever witnessed.
Meanwhile, just 22 months after the end of the last recession, our Cross Asset team's 'U.S. Cycle' model is already approaching prior peaks. This indicator aggregates key cyclical data to help signal where we are in the economic cycle and where headwinds or tailwinds exist for different parts of the market.
With regard to factors that affect U.S. equities the most, earnings, sales and margins have also surged past prior cycle highs. In fact, earnings recovered to the prior cycle peak in just 16 months, the fastest rebound going back 40 years. The early to mid-cycle benefits of positive operating leverage have come and gone, and U.S. corporates now face decelerating sales growth coupled with higher costs. As such, our leading earnings model is pointing to a steep deceleration in earnings growth over the coming months. These negative earnings revisions are being driven by cyclicals and economically sensitive sectors - a setup that looks increasingly late cycle.
Another key input to the shorter cycle view was our analysis of the 1940s as a good historical parallel. Specifically, excess household savings unleashed on an economy constrained by supply set the stage for breakout inflation both then and now. Developments since we published our report in March of last year continue to support this historical analog. Inflation has surged, forcing the Fed to raise interest rates aggressively in a credible effort to restore price stability. Assuming the comparison holds, the next move would be a slowdown and ultimately a much shorter cycle.
Further analysis of the postwar evolution of the cycle reveals another compelling similarity to the current post-COVID phase - unintended inventory build from over ordering to meet an excessive pull forward of demand. In short, we think the risk of an inventory glut is growing this year in many consumer goods, particularly in areas of the economy that experienced well above trend demand. Consumer discretionary and technology goods stand out in our view.
Now, with the Fed raising rates this past week and communicating a very hawkish tightening path over the next year, our rate strategists are looking for an inversion of the yield curve in the second quarter. While curve inversion does not guarantee a recession, it does support our view for decelerating earnings growth and would be one more piece of evidence that says it's late cycle.
In terms of our U.S. strategy recommendations, we continue to lean defensive and focus on companies with operational efficiency with high cash flow generation. This leads us to more defensive names with more durable earnings profiles that are also attractively priced.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
The U.S. Federal Reserve recently enacted its first interest rate hike in two years, but there is still more work to be done to counteract rising inflation and markets are watching closely.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, March 18th at 2:00 p.m. in London.
On Wednesday, the U.S. Federal Reserve raised interest rates for the first time in two years. This is notable because of how much time has passed since the Fed last took action. It's notable because of how low interest rates still are, relative to inflation. And it's notable because rate increases, and decreases, by the Fed tend to lump together. Once the Fed starts raising or lowering rates, history says that it tends to keep doing so.
Now, one question looming over the Fed's action this week could be paraphrased as, "what took you so long?" Since the Fed cut rates to zero in March of 2020, the U.S. stock market is 77% higher, U.S. home prices are 35% higher, and the U.S. economy has added over 5.7 million new jobs. Core consumer price inflation, excluding volatile food and energy prices, has risen 6.4% in the last year, indicative of demand for goods outpacing the ability of the economy to supply them at current prices, exactly what a hot economy implies.
The reason the Fed waited was the genuine uncertainty around the impact of COVID on the economy, and the risk that new variants would evade vaccines or dash consumer confidence. But every decision has tradeoffs. Easy Fed policy has helped the U.S. economy recover unusually quickly, but that quick recovery now means the Fed has a lot more to do to catch up.
Specifically, we think the Fed will need to raise the upper band of its policy rate, currently at 0.5%, to about 2.75% by the end of next year. This is more than the market currently expects, and we think outcomes here are skewed to the upside, with it more likely that rates end up higher than lower.
My colleagues in U.S. interest rate strategy believe that this should cause U.S. rates to rise further, with 2 year bond yields rising most and ultimately moving higher than 10 year bond yields. It's rare for 2 year bonds to yield more than their 10 year counterpart, a so-called curve inversion. Nevertheless, this is what we expect.
Now, one counter to this Fed outlook is that the U.S. economy simply can't handle higher rates, and that will force the Fed to stop hiking earlier. But we disagree. With a large share of household debt in the U.S. in the form of 30 year fixed rate mortgages, the impact of higher rates may actually be more muted than in the past, as the cost of servicing this debt won't change even as the Fed raises rates.
Higher short-term interest rates and an inverted yield curve are one specific implication of these expectations. More broadly, inverted yield curves have historically been key signposts for increased risk of recession. While we think a recession is unlikely, the market could still worry about it, supporting U.S. defensive equities and investment grade over high yield credit.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen, and leave us a review. We'd love to hear from you.
The U.S. and its allies have frozen the Central Bank of Russia’s foreign currency reserves, leading to questions about the safety of FX assets more broadly and the centrality of the U.S. dollar to the international financial system.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm James Lord, Head of FX and EM Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for currency markets. It's Thursday, March 17th at 3:00 p.m. in London.
Ever since the U.S. and its allies announced their intention to freeze the Central Bank of Russia's foreign exchange, or FX, reserves, market practitioners have been quick to argue that this would likely accelerate a shift away from a U.S. dollar based international financial system. It is easy to understand why. Other central banks may now worry that their FX reserves are not as safe as they once thought, and start to diversify away from the dollar.
Yet, despite frequent calls for the end of the dollar based international financial system over the last couple of decades, the dollar remains overwhelmingly the world's dominant reserve currency and preeminent safe haven asset. But could sanctioning the currency reserves of a central bank the size of Russia's be a tipping point? Well, let's dig into that.
The willingness of U.S. authorities to freeze the supposedly liquid, safe and accessible deposits and securities of a foreign state certainly raises many questions for reserve managers, sovereign wealth funds and perhaps even some private investors. One is likely to be: Could my assets be frozen too?
It's an important question, but we need to remember that the U.S. is not acting alone with these actions. Europe, Canada, the UK and Japan have all joined in freezing the central bank of Russia's reserve assets. So, an equally valid question is: Could any foreign authority potentially freeze my assets?
If the answer is yes, that likely calls into question the idea of a risk free asset that underpins central bank FX reserves in general, and not just specifically for the dollar and U.S. government backed securities.
If that's the case, what could be the implications? Let me walk you through three.
First would be identifying the safest asset. Reserve managers and sovereign wealth fund investors will need to take a view on where they can find the safest assets and not just safe assets, as the concept of the latter may have been seriously impaired. And in fact, the dollar and U.S. Government backed securities may still be the safest assets since the latest sanctions against the central Bank of Russia involve a broad range of government authorities acting in concert.
A second implication is that political alliances could be key. These sanctions demonstrate that international relations between different states may play an important role in the safety of reserve assets. While the dollar might be a safe asset for strong allies of the U.S., its adversaries could see things differently. To put the dollar's dominance in the international financial system at serious risk, would-be challenges of the system would need to build strategic alliances with other large economies.
Finally, is the on shoring of foreign exchange assets. Recent sanctions have crystallized the fact that there is a big difference between an FX deposit under the jurisdiction of a foreign government and one that you own on your home ground. While both might be considered cash, they are not equivalent in terms of accessibility or safety. So another upshot might be that reserve managers bring their foreign exchange assets onshore.
One way of doing this is to buy physical gold and store it safely within the home jurisdiction. The same could be said of other FX assets, as reserve managers will certainly have access to printed U.S. dollars, Euros or Chinese Yuan banknotes if they are stored in vaults at home, though there could be practical challenges in making large transactions in that scenario. Bottom line, though, while these are all important notions to consider, in our view recent actions do not undermine the dollar as the safest global reserve asset, and it's likely to remain the dominant global currency for the foreseeable future.
Thanks for listening! As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
As oil prices rise across the globe, investors wonder if governments will continue to incentivize clean energy development or pivot to greater investment in traditional fossil fuels.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 16th, at 10:00 a.m. in New York.
With the conflict in Ukraine ongoing, many investors continue to ask questions about the U.S. and European policy response to the rising price of oil. In particular, many ask if governments will continue down the path of incentivizing clean energy development, or pivot to greater exploration of traditional fossil fuels. But as my colleague Stephen Byrd, who heads North America Power Utilities and Clean Energy Research, pointed out in a recent report, this is a false choice, and it's one that many policymakers are likely to reject in favor of embracing an "all of the above" strategy.
It's important to understand that focusing only on traditional energy sources wouldn't solve the problem in the near term. For example, switching on any dormant U.S. oil production facilities would only replace a fraction of the oil that Russia produces, so fresh explorations ramp up production would be needed, and that could take a few years. The same could be said about natural gas. The U.S. Has the spare capacity to backfill with Europe imports from Russia, but Europe mostly doesn't have the facilities to accept liquefied natural gas shipped overseas from America. Germany has announced plans to build two liquefied natural gas terminals, but that could take years to complete. The point is, focusing on traditional energy sources alone is no quick fix for high energy prices and energy independence, and therefore there's little opportunity cost in also focusing on renewable energy development. For that reason, we think western governments are likely to include both clean energy and traditional investments in their strategy going forward. You see this echoed in the statements of policymakers, such as U.S. Climate Envoy John Kerry's recent comments that the US is committed to an "all of the above" energy policy.
So what does it mean for investors? In short, expect energy companies of all types to have business to do with governments in the coming years. That includes traditional oil exploration companies, but also clean tech companies, as market beneficiaries.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As global markets face a rise in commodity prices due to geopolitical conflict, investors in Asia and EM equities will want to keep an eye on the divergence between commodity exporters and importers.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about geopolitical risk, commodity exposure, and how they affect our views on Asia and EM Equities. It's Tuesday, March the 15th at 8:00 p.m. in Hong Kong.
The Russia Ukraine conflict is having a profound impact on the investment world in multiple dimensions. In this episode we focus on just two, commodity prices and geopolitical alignment, and what they mean for investors in Asia and emerging market equities.
The major sanctions imposed by the U.S., U.K., European Union and their allies are focused not only on isolating Russia financially but depriving it, in some instances overnight and in others more gradually, of the ability to export its commodities. And Russia is a major producer of oil, natural gas, food and precious metals and rare minerals. Ukraine is also a major food exporter. In our coverage there's a sharp divergence between economies which are major commodity importers, and are therefore suffering a negative terms of trade shock as commodity prices rise, and those which are exporters and hence benefit. Major importers include Korea, Taiwan, China and India, all with more than a 5% of GDP commodity trade deficit. Meanwhile, Australia, Mexico, Brazil, Saudi Arabia, UAE and South Africa are all significant commodity exporters and stand to benefit. Australia's overall commodity trade surplus is the largest at 12% of GDP, and that is before the recent gains in price for almost everything which Australia produces and exports.
Meanwhile, on the geopolitical risk front, we've been monitoring the pattern of voting on Russia's actions at the United Nations, where there have been both UN Security Council and General Assembly votes. Although none of the countries we cover actually voted with Russia on either occasion, two major countries, China and India, did abstain twice. South Africa abstained at the General Assembly. The UAE abstained in the Security Council, but then voted with the US and Europe in the General Assembly vote. This pattern of voting, in our mind, may have an impact in raising the equity risk premium, i.e. lowering the valuation, for China and to a lesser extent India in the current environment.
All taken together, we are shifting exposure further towards commodity exporting markets and in particular those such as Australia, which are also geopolitically aligned with the major sources of global investor flows. We lowered our bear-case scenario values for China further recently and are turning incrementally more cautious on India.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
This week the market turns to the Federal Reserve as it eyes challenges to growth while remaining committed to combating high inflation with its first rate hike of the tightening cycle.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 14th at 11:00 a.m. in New York. So let's get after it.
With all eyes on the Russian invasion of Ukraine, markets are likely to turn back towards the Fed this week as it embarks upon the first tightening of the cycle and the first rate hike since 2018. This follows a period of perhaps the most accommodative monetary support ever provided by the Federal Reserve, an extraordinary statement unto itself given the Fed's actions over the past few decades.
When it comes to measuring how accommodative Fed policy is at the moment, we look at the Fed funds rate minus inflation, or the real short-term borrowing rate. Using this measure tells us that fed accommodation has been in a steady downtrend since the early 1980s. In fact, the real Fed funds rate has been in a remarkably well-defined channel for this entire period. Second, after reaching the low end of the channel in record time during the COVID recession, the real Fed funds rate has turned higher- albeit barely. That low was in November of last year, when Fed Chair Jerome Powell was renominated by President Biden, and he made it clear that the Fed was going to pivot hard on policy. It was no coincidence that this is exactly when expensive growth stocks topped and began what has been one of the largest and most persistent drawdowns in growth stocks ever witnessed. Finally, based on how low the Fed funds rate remains, the Fed has a lot of wood to chop to get this rate back to a more normal level. Furthermore, if Powell is truly committed to making monetary policy restrictive to fight inflation, expensive growth stocks remain vulnerable, in our view.
Currently, the bond market is pricing in eight 25 basis point hikes over the next 12 months. If the Fed is successful in executing this expected path, it will have achieved the soft landing it seeks. Inflation will come down as the economy remains in expansion. However, we think that's a big if at this point. First, growth is already at risk as we enter 2022 due to the payback in demand lapsing government transfers, generationally high inflation and rising inventories at the wrong time. Now, the conflict in Ukraine is leading to even higher commodity prices, while the growth outlook deteriorates further. While we are likely to avoid an economic recession in the U.S., we can't say the same for earnings. We think the Fed will keep a watchful eye on the data, but air on the side of hawkishness given the state of inflation. This likely means a collision with equity markets this spring, with valuations overshooting to the downside.
While short-term interest rates are still at zero, longer term treasury yields are now approaching a level that may offer some value for asset owners, even if they are unattractive on a standalone basis. This is especially true if one is now more concerned about growth like we are. Let's assume we're wrong about growth slowing, under such a view it's unlikely the Fed hikes faster than what is already priced into the bond market. Therefore, longer term rates are unlikely to raise much more by the time we know the answer to this growth question. Conversely, if we're right about growth slowing more than expected, longer term rates likely have room to fall and provide a cushion to equity portfolios. High quality investment grade credit may also offer some ballast given the significant correction in both rates and spreads. For equity investments, we continue to favor defensive quality stocks as well as companies with high operational efficiency. Yes, boring is still beautiful.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
With multiple countries now imposing sanctions, investors in Russian government bonds and currencies will need to consider their options as the risk of default rises.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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James Lord: Welcome to Thoughts on the Market. I'm James Lord, Head of FX and EM strategy.
Simon Waever: And I'm Simon Waever, Global Head of Sovereign Credit Strategy.
James Lord: And on this special episode of Thoughts on the Market, we'll be discussing the impact of recent sanctions on Russia for bonds and currency markets. It's Friday, March 11th at 1:00 p.m. in London.
Simon Waever: and 8:00 a.m. in New York.
James Lord: So, Simon, we've all been watching the recent events in Ukraine, which are truly tragic, and I think we've all been very saddened by everything that's happened. And it certainly feels a bit trite to be talking about the market implications of everything. But at the same time, there are huge economic and financial consequences from this invasion, and it has big implications for the whole world. So today, I think it would be great if we can provide a little bit of clarity on the impact for emerging markets. Simon, I want to start with Russia itself. The strong sanctions put in place have really had a big impact and increasing the likelihood that Russia could default on its debt. Can you walk us through where we stand on that debate and what the implications are?
Simon Waever: That's right, it's had a huge impact already. So Russia's sovereign ratings have been downgraded all the way to Triple C and below, which is only just above default, and that's them having been investment grade just two weeks ago. If you look at the dollar denominated sovereign bonds, they're trading at around 20 cents on the dollar or below. But I think it all makes sense. The economic resilience needed to support an investment grade rating goes away when you remove a large part of the effect reserves, have sanctions on 80% of the banking sector, and with the economy likely to enter into a bigger recession, higher oil prices help, but just not enough. For now, the question is whether upcoming payments on the sovereign dollar bonds will be made. And I think it really comes down to two things. One, whether Russia wants to make the payments, so what we tend to call the willingness. And two whether US sanctions allow it, so the ability. Clarifications from the US Treasury suggests that beyond May 25th, payments cannot be made. So, either a missed payment happens on the first bond repayment after this, which is May 27th or Russia may also decide not to pay as soon as the next payment, which is on March 16th. And of course, the reason for Russia potentially not paying would be that they would want to conserve their foreign exchange. And actually, we've already had some issues on the local currency government bonds, so the ones denominated in Russian ruble. James, do you want to go over what those issues have been?
James Lord: That's absolutely right. Already, foreigners do not appear to have received interest payments on their holdings of local currency government bonds. There was one due at the beginning of March, and it looks as though, although the Russian government has paid the interest on that bond, the institutions that are then supposed to transfer the interest payments onto the funds of the various bondholders haven't done so for at least the foreign holders of that bond. Does that count as default? Well, I mean, on the one hand, the government can claim to have paid, but at the same time, some bondholders clearly haven't received any money. There's also another interest payment due in the last week of March, so we'll see if anything changes with that payment. But in the end, there isn't a huge amount that bondholders can really do about it, since these are local currency bonds and they're governed under local law. There isn't really much in the way of legal recourse, and there isn't really much insurance that investors can take out to protect themselves. The situation is a bit different for Russian government bonds that are denominated in US dollars, though. So I'd like to dig a little bit more into what happens if Russia defaults on those bonds. For listeners that are unfamiliar, investors will sometimes take out insurance policies called CDSs or credit default swaps just for this type of situation, and they've been quite a lot of headlines around this. So, Simon, I'd be curious if you could walk us through the implications of default there.
Simon Waever: So it's like two different products, right? So you have the bonds there, it can take a long time to recover some of the lost value. I mean, either you actually get the economic recovery and there's no default or you then go to a debt restructuring or litigation. But then on the other hand, you have the CDS contracts, they're going to pay out within a few weeks of the missed bond payment. But it's not unusual to find disagreement on exactly what that payment will look like. And that payment is, we call it, the recovery value perhaps is a bit like the uncertainty that sometimes happens when standard insurance needs to pay out. But if we start with the facts, if there is a missed payment on any of the upcoming dollar or euro denominated bonds, then CDS will trigger. Local currency bonds do not count and the sovereign rating does not matter either. So far I think it's clear, the uncertainty has been around what bonds can actually be delivered into the contract, as that's what determines the recovery value. As it stands, sanctions do allow secondary trading of the bonds. There have been some issues around settlement, but hopefully that can be resolved by the time an auction comes around. The main question is then where that recovery rate will end up, and I would say that given the amount of selling I think is yet to come I wouldn't be surprised if it ends up being among the lower recovery rates we've seen in E.M sovereign CDS.
James Lord: Yeah, that makes sense on the recovery rates and the CDs. But I mean, clearly, if Russia defaults, there could be some big implications for the rest of emerging markets as well. And even if they don't default, I mean, there's been a lot of spill over into other asset classes and other emerging markets. How do you think about that?
Simon Waever: So I try to think of it in two ways, and I would expect both to continue if we do not see a de-escalation in Ukraine. So first, it really impacts those countries physically close to Russia and Ukraine and those then with trade linkages, which mainly comes with agriculture, energy, tourism and remittances. And that points you towards Eastern Europe, Turkey and Egypt, for instance. Secondly, if we also then see this continued weaker risk backdrop, it would then impact those countries where investor positioning is heavier. But enough on sovereign credit, I wanted to cover currencies, too. The Russian central bank was sanctioned. What do you think that means for EM currencies?
James Lord: Absolutely. The sanctions against the central Bank of Russia were really quite dramatic and have understandably had a very big impact on the Russian exchange rate. The ruble’s really depreciated in value quite significantly in the last couple of weeks. I mean, during periods of market uncertainty, the central Bank of Russia would ordinarily sell its foreign exchange assets to buy Ruble to keep the currency under control. But now that's not really possible. It's led to a whole range of countermeasures from Russia to try and protect the currency, such as lifting interest rates from just under 10% to 20%. There have also been significant restrictions on the ability of local residents to move capital abroad or buy dollars, and on the ability of foreigners that hold assets in Russia to actually sell and take their money home. All of that's designed to protect the exchange rate and keep foreign exchange reserves on home soil. I think the willingness of the US to go down that road, as well as the authorities in Europe and Canada and other jurisdictions, it does raise some important questions about whether or not investors will continue to want to hold dollars and US government bonds as part of their FX reserves. Many reserve asset holders may wonder whether or not similar action could be taken against them. This has become a big debate in the market. Some investors believe that this turn of events could ultimately lead to some long-term weakness in the dollar. But I think it's also important to remember that yes the U.S. is not the only country that has done this, and it's probably the case that actually any country could potentially freeze the foreign assets of another central bank. And if that's the case, then I don't see having a materially negative impact on the dollar over the long term, as many now seem to be suggesting. But I think that's all we have time for today. So let's leave it there. Simon, thanks very much for taking the time to talk.
Simon Waever: Great speaking with you, James.
James Lord: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
As inflation remains a focal point for the U.S. consumer, higher energy costs will dampen discretionary spending for some. But not all are impacted equally and there may be good news in this year’s tax refunds and the labor market.
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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist.
Sarah Wolfe: And I'm Sarah Wolfe, also on Morgan Stanley's U.S. Economics Team.
Ellen Zentner: And today on the podcast, we'll be discussing the outlook for the U.S. consumer during this year's tax season and after, as inflation remains in the driver's seat and new geopolitical realities raise further concerns. It's Thursday, March 10th, at 9:00 a.m. in New York.
Sarah Wolfe: So, Ellen, I know you want to get into the U.S. consumer, but before we dig in, I think it would be useful to hear your view on the overall U.S. economy, especially given the new geopolitical challenges.
Ellen Zentner: So, I think it's helpful to think about a rule of thumb for the effects of oil on overall GDP. For every 10% sustained increase in oil prices, it shaves off about one tenth on GDP growth. And so when we take into account the rise in energy prices that we've seen thus far, we took down our growth forecast for GDP this year by three tenths and shaved off an additional tenth when looking further out into 2023. Now, one thing that I think is important for the U.S. outlook versus European and U.K. colleagues is that energy prices are a much bigger factor in an economy like Europe's, and the U.K.'s where they're much more reliant on outside sources, where in the US we've become much more energy independent over the past decade. But I think where I step into your world, Sarah, as we think about higher oil prices, then translate into higher gasoline prices, which hits consumers in their pocketbook. So Sarah, that's a great segue to you on the U.S. consumer because this has been one of your focuses on the team. Consumers don't like higher prices. And, you know, we've been seeing this big divergence between sentiment and confidence. So why aren't those measures moving exactly hand in hand if inflation is the biggest concern there?
Sarah Wolfe: Definitely. There's a lot of focus on consumer confidence, which comes from the Conference Board and consumer sentiment, which comes from University of Michigan. Both have been trending down, but there's been a record divergence between the two, where Conference Board is sitting about 48 points higher than sentiment. And inflation plays a huge role in this. So just getting down to the methodology of the surveys, the reason there's been such a divergence is because Conference Board places more of a focus on labor market conditions, whereas University of Michigan sentiment focuses more on inflation expectations. And so when you're in an environment like today, where the unemployment is very low, the labor market is very tight, that's very good for income that gets reflected through the confidence surveys. But at the same time, inflation is extremely high, which erodes real income, and that's getting reflected more in the sentiment survey. So, we are seeing this large divergence between the surveys and they're telling us different things, but I think both are very important to take into account.
Ellen Zentner: So let me dig into inflation a little bit further then specifically and how it affects you when you're thinking about our consumer spending outlook. I mean, some of the changes that we've made to CPI forecast, you know, talk us through that and how you're building that into your estimates for the consumer.
Sarah Wolfe: So we recently raised our headline forecast for CPI, or Consumer Price Index, inflation for the end of this year by 40 basis points to 4.4%. And we've also lowered our forecasts for real Personal Consumption Expenditure, or PCE, but only about 10 basis points this year to around 2.8%. And the reason that it's not a one for one pass through is, first of all, we're tracking the first quarter spending so much higher than what we had expected, so overall, even though higher gasoline prices will likely hit spending a bit more in the second quarter of 2022, we are already tracking this year much stronger. So on net, the impacts a bit smaller. Also, just because gasoline prices are going up doesn't mean that people spend less. Actually, overall, it tends to mean that people just increase their spending pool. So you have income constrained households at the lower end of the income spectrum, they're gonna pull back their spending on non-gasoline, non-utility expenditures, but on the other end, middle higher income households will just increase their spending pool, you know, gasoline prices go up so they’re just going to be spending a bit more. It doesn't necessarily mean that consumption is going to be lower. If anything, it could add more upside risk to consumer spending.
Ellen Zentner: You know, this is where economists can always sound a bit dispassionate because we oftentimes look at things in the aggregate and you've been writing about, how different income levels deal with higher gas prices. Talk about some of the work that you've put out with the retail teams that might be affected by that lower income consumer pulling back.
Sarah Wolfe: Yeah. So just to start off with when we look at what this is going to cost households at higher gas prices, we estimate that on an annualized basis, it's going to cost households roughly $1600 dollars more on gasoline and utilities a year. So that's if higher prices that are where they are today last for the entire year. In terms of the hit by income group that could raise spending on energy by about 2% of disposable income for the highest income group, but by about 7% for the lowest income group, so that basically can equate to a 7% hit on non-gasoline and utility spending for lower income households. And so that feeds through mostly into discretionary spending for the lowest income group. And we did work with our retail teams describing this and talking about how very strong job growth and positive real wages are a tailwind for lower end consumers. But it's not enough to outpace the headwinds of stimulus rolling off on top of higher energy prices, which act as a tax to households.
Ellen Zentner: Yeah, so it'll be a little bit more of a struggle for them until we get some alleviation from this price burden. I want to walk you through, though something else that we're in the midst of now. Tax refund season is upon us, and I think the refund season started a few weeks ago. And so, you track this on a weekly basis once those tax refunds start getting sent out, where are we tracking?
Sarah Wolfe: Yeah, so you are right, refund season started in late January, and it's going to end in mid-April, so it's about a month earlier than last year. There's also a lot more going on with tax refunds because of all the COVID emergency programs. There's a lot more refund programs that lower middle income households could file for. You had the child tax credit, you have childcare refunds, elderly care refunds, so there was a lot of uncertainty on how refunds were going to come in this year. Through the week ending February 25th, the average refund size was roughly $3500 dollars per person, which is well above the average refund amount during the same week in previous years. So it's about $1500 higher than in 2020 and about $800 to $900 than 2019. So it's really quite significantly higher, and I think this is really important because when we talk about the low end consumer it could really provide this extra cushion that they need. We're already seeing in the auto sub-prime space and credit sub-prime space that delinquencies are starting to pick up. But I do think that this tax refund season could really help alleviate some of these pressures and bring delinquencies back down as more refunds get distributed.
Ellen Zentner: So if I tie a bow around all of this, we still have a constructive outlook on the consumer. You've written about excess savings, you're now tracking the tax refund season, at the end of the day, right, you've talked about how the fundamentals drive the consumer and the fundamentals are income and strong labor market. We've got above average job gains, we've got above average wage growth, that creates this income proxy for the consumer that looks quite strong. So I think there's a lot more room to absorb the impact of higher prices today in the U.S. and especially when you compare it to some of our other major trading partners. So, Sarah, thanks for taking the time to talk.
Sarah Wolfe: As always, it was great to speak with you, Ellen.
Ellen Zentner: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
With the rising cost of oil comes concerns around economic growth, but the distinction between the impact in Europe and the US is important, presenting both challenges and opportunities for investors.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets.
It's Wednesday, March 9th at 1:00 PM in New York.
This week, the United States closed its markets to imports of Russian oil as another measure in its response to the invasion of Ukraine. In anticipation of this announcement, the price of oil increased to as high as $129 per barrel, leading the average gas price in the United States to reach $4.25. Understandably, this has created a new burden for consumers and also has investors concerned about the macroeconomic impacts of higher fuel prices. Here’s the latest thinking from our economists.
We expect the downside to economic growth to be felt more in Europe than the United States. Unlike the US, Europe is a net importer of energy, which means when fuel prices go up they have to pay the price but don’t earn the extra income from selling fuel at a higher price. Accordingly, our European economics team has revised down their expectations for GDP growth by nearly 1% for 2022. The impact in the US should be more muted, with our colleagues dropping their growth forecast by 30 basis points to 4.3%. Again, this is because the US enjoys substantial domestic energy production. So while higher prices at the pump might interfere with some consumer purchases, the income from those fuel purchases will drive consumption elsewhere in the economy.
But these views aside, we have to acknowledge these conditions of elevated fuel and commodities prices drive uncertainty around the future economic and monetary impacts that markets will consider. Increasingly, clients want to discuss and debate the idea of stagflation, which is the combination of slowing growth and rising inflation, in both the US and Europe. And that sentiment could persist for some time, as our commodities research team thinks swings in the price of oil between $100 and $150 are possible in the near term.
We’ll have a lot more on that in future podcasts, but for now wanted to point out one tangible takeaway for investors: potential upside for equities in the energy exploration and production sector. Higher prices at the pump means potential for more revenue, yet the sector is valued at a discount to the S&P 500 when accounting for its prices relative to the cash flow of companies in that sector.
Bottom line, the global economy is changing quickly, presenting both challenges and opportunities. We’ll be keeping you in the loop on both.
Thanks for listening! If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As European markets price in slowing growth, increased inflation and geopolitical tensions, pricing power is a potential focus for European investors looking to weather the storm.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the impacts of recent geopolitical developments on European markets and why rising stagflation pressures point towards owning companies with good pricing power. It's Tuesday, March the 8th at 1:00 pm in London.
Since our last podcast on European equities, the backdrop has changed considerably, with an escalation in geopolitical tensions putting upward pressure on inflation, downward pressure on growth and generally raising European risk premia as uncertainty spikes. Last week my colleague Jens Eisenschmidt, our Chief European Economist, cut his forecasts for European GDP growth for this year and next, while also raising his projections for inflation on the back of higher energy costs. While Jens is not predicting a European recession at this time, investors are becoming incrementally more worried about this possibility as geopolitical tensions extend and oil and gas prices continue to rise.
Even if Europe does manage to avoid falling into an outright recession, the stagflationary conditions that are building in the region, namely slowing growth and rising inflation, have important implications for investors. Across the broader market it points to a more challenging backdrop for corporate profits as slowing top line momentum coincides with growing margin pressures from higher input costs. At the same time, heightened geopolitical uncertainty is putting downward pressure on equity valuations as investors rotate out of the region, thereby lowering the price to earnings ratio at the same time as profit expectations retrench.
After a near 20% decline from their January highs, it's fair to say that European stocks are pricing in quite a lot of bad news here, with equity valuations now below long run averages and close to record lows vs. U.S. stocks. While we think this provides an attractive entry point for longer term investors, European markets will likely remain tricky in the short term as investor sentiment oscillates between hope and fear. Our experience suggests that markets rarely trough on valuation grounds alone, instead requiring a backdrop of broad capitulation, coupled with a more positive turn in the news flow - conditions that have not yet fallen into place.
In many respects stagflation is the worst environment for asset allocators, as slow growth weighs on stocks at the same time as high inflation potentially undermines the case for bonds. Thankfully such an environment has been rare over the last 50 years, however we can still construct a ‘stagflation playbook’ for equity markets when it comes to picking stocks and sectors. Specifically, we identify prior periods when inflation was rising at the same time as growth indicators were falling. We then analyze performance trends over those periods. When we do this, we find that a stagflationary backdrop tends to favor commodity and defensive oriented stocks at the expense of cyclical and financial companies - a trend that has repeated itself over the last month here in Europe.
An alternative strategy is to focus on companies that have strong pricing power, as they should have more ability to raise prices to offset higher input costs than other stocks. In a European context, sectors that are currently raising prices to expand their margins, even in the face of rising input costs, include airlines, brands, hotels, metals and mining companies, telecoms and tobacco. To be clear, not every stock in these sectors will enjoy superior pricing power, but we think these areas are a good place to start the search.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The year of the stock picker is in full swing as investors look towards a future of Fed tightening and geopolitical uncertainty, where some individual stocks will fare better than others.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 7th at 11:00 a.m. in New York. So let's get after it.
Since publishing our 2022 outlook in November, we've taken a more bearish view of stocks for reasons that are now more appreciated, if not fully. First was the Fed's pivot last fall, something most suggested would be a small nuisance that stocks would easily navigate. Part of this complacency was understandable due to the fact that the Fed had never really administered tough medicine in the past 20 years. Furthermore, when things got rough in the markets, they often pivoted back - the proverbial Fed “Put”, or the safety net for markets. We argued this time was different, just like we argued back in April 2020 that this quantitative easing program was different than the one that followed the Great Financial Crisis, or GFC. In short, printing money after the GFC didn't lead to the inflation many predicted, because it was simply filling the holes created on bank and consumer balance sheets that were left over from the housing collapse. However, this time the money printing was used to massively expand the balance sheets of consumers and businesses, who would then spend it. We called it helicopter money at the time. In short, the primary difference between the post GFC Fed money printing and the one that followed the COVID lockdown, is that the money actually made it into the real economy this time and drove demand well above supply.
This imbalance is what triggered the Fed to pivot so aggressively on policy. In fact, Chair Powell has admitted that one of the Fed's miscalculations was thinking supply, including labor, would be able to adjust to the higher levels of demand making this inflation transitory. This has not been the case, and now the Fed must be resolute in its determination to reduce money supply growth. Nowhere was this resolve more clear than during Chair Powell's congressional testimony last week, when he was asked if he would be willing to take draconian steps, as Paul Volcker did in the early 1980s to fight inflation. Powell confidently answered, "Yes". To us this suggests the Fed "Put" on stocks is well below current levels, and investors should consider this when pricing risk assets.
The other reason most investors and strategists have remained more bullish than us is due to the path of earnings. So far, this positive view has been correct. Earnings have come through, and it's the primary reason why the S&P 500 has held up better than the average stock. Therefore, the key question continues to be whether earnings growth can continue to offset the valuation compression that is now in full swing. We think it can for some individual stocks, which is why the title of our outlook was the year of the stock picker. As regular listeners know, we have been focused on factors like earnings, stability and operational efficiency when looking for stocks to own. Growth stocks might be able to do a little better as earnings take center stage from interest rates, but only if the valuations have come down far enough and they can really deliver on growth that meets the still high expectations.
The bottom line is that the terribly unfortunate events in Ukraine make an already deteriorating situation worse. If we achieve some kind of cease fire or settlement that both Russia and the West can live with, equity markets are likely to rally sharply. We would use such rallies to lighten up on equity positions, however, especially those that are vulnerable to the earnings disappointment we were expecting before this conflict escalated. More specifically, that would be consumer discretionary stocks and the more cyclical parts of technology that are vulnerable to the payback in demand experienced over the past 18 months. Another area to be careful with now is energy, with crude oil now approaching levels of demand destruction. On the positive side, stick with more defensively oriented sectors like REITs, healthcare and consumer staples.
Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
While the U.S. continues to see high valuations, rising inflation, and slow policy tightening, the story is quite different for many markets outside the U.S.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, March 4th at 3 p.m. in London.
While Russia’s invasion of Ukraine has implications for financial markets, it has bigger implications for people. Hundreds of thousands have already been displaced, numbers which are likely to grow in the coming weeks. These refugees deserve our compassion, and support. To those impacted by this tragedy, you have our sympathies. And to those helping them, our admiration.
Our expertise, however, is in financial markets, and so that’s where we’ll be focusing today. For those that are most negative on the market right now, the refrain is pretty simple and pretty straightforward. Assets are still expensive relative to historical valuations. Inflation is still high and it's still rising. And central banks are still behind the curve, so to speak, with lots of interest rate increases needed to bring monetary policy back in line with the broader economy.
What I want to discuss today, however, was how different some of these concerns can look when you move beyond the United States.
Let's start with the idea that assets are expensive. Now, this clearly applies to some markets, but less to others. Stocks in Germany, for example, trade at less than 12 times next year's earnings, Korean stocks trade at 10 times next year's earnings, Brazil, it's 8 times. And many currencies trade at historically low valuations relative to the U.S. dollar.
Next up is inflation. While inflation is high in the U.S. and Europe, it's low in Asia, a region that does account for roughly 1/3 of the entire global economy. What do I mean by low? U.S. consumer prices have increased 7.5% Relative to a year ago. Consumer prices in China and Japan, in contrast, are up less than 1%.
My colleague Chetan Ahya, Morgan Stanley's Chief Asia Economist, notes that these differences aren’t just some mathematical illusion, but rather reflect real differences in Asia's economy and policy response.
Finally, there's the idea that central banks are behind the curve, so to speak. Now, the hindsight here is a little tricky, as the Federal Reserve and the ECB were dealing with enormous uncertainty around the scope of the pandemic for much of last year. But what's notable is that not all central banks took that path. Central banks in Chile, Brazil, Poland and Hungary, just to name a few, have been raising interest rates aggressively for the better part of the last 12 months.
In times of crisis, markets often try to simplify the story. But the challenges facing global markets, from valuations, to inflation, to monetary policy, really are different. As events unfold, it will be important to keep these distinctions in mind.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
As the Fed continues to signal coming rate hikes this year, the housing market will face implications across home sales, mortgage rates, and fundamentals.
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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research.
Jay Bacow: And on this edition of the podcast, we'll be talking about changes in the Fed policy and what the possible implications are for mortgages and the housing market more broadly. It's Thursday, March 3rd at 11:00 a.m. in New York.
Jim Egan: Okay, Jay, we've talked about affordability pressures as mortgage rates have moved higher a couple of other times in the past on this podcast, and we would encourage listeners to go back and listen to those prior podcasts for a deeper dive on affordability. But Jay Powell just testified this week that he'll support a 25 basis point hike in March. Furthermore, if inflation pressures are persistent, then he's gonna raise Fed funds by more than 25 basis points at later meetings. The markets priced in six hikes this year. What does that mean for mortgage rates going forward? When I think about affordability, am I gonna have to think of another 150 basis point increase in mortgage rates?
Jay Bacow: No. So you saying the market has priced in six hikes is really important, because mortgage rates are based on generally sort of the belly of the Treasury curve. And the belly of the Treasury curve is effectively a function of what the market's expecting the Fed to do, along with how much risk premium there is. And if the market's expecting the Fed to hike six times this year, then if the Fed hikes six times this year and there's no change in risk premium, then mortgage rates aren't really going to move very much from where they are right now. Now, Powell said that he's worried about inflation and so if inflation comes in higher than expected or the market changes their demand for risk premium, then mortgage rates are gonna move.
Jay Bacow: But Jim, mortgage rates have already moved a lot, they've gone up 100 basis points this year in just two months. What does this mean for affordability?
Jim Egan: From the affordability perspective, it's a problem. But that also really depends on how we define what a problem is. The housing market's been doing very, very well. But when we think about this kind of move in mortgage rates, existing home sales, transaction volumes, they're going to have to fall.
Jay Bacow: But haven't existing home sales gone up a lot already?
Jim Egan: Yes, and that's where we think it's important to really look at historical experiences during times like this. If we look back to mortgage rates to 1990 we have five other instances of this kind of increase in mortgage rates. Now, one of those was during the housing crisis, so we're going to remove the experience there, but if I look at the other four instances existing home sales climbed very sharply during that first 6 month period, while mortgage rates were climbing by 100 basis points. That's where we are right now, we're seeing that climb. The 12 months after, the subsequent year, which we're going to start to enter March of this year going forward, that's where existing home sales tend to plateau and in a lot of instances come down. And they tend to come down further if mortgage rates continue to climb during that year, which is what we just discussed. So we think it's very likely, and if historical precedent holds, then we've already seen the peak of existing home sales for at least the next 12 months.
Jay Bacow: What about home prices? Powell was asked if he thinks that home prices are going to fall and go back to pre-COVID levels, and he said he thought that raising mortgage rates would just slow down home prices, and he doesn't want to see home prices fall. What do we think?
Jim Egan: Well, I'd like to believe he's reading our research because that's very much in line with how we think about things right now. We think that home price appreciation at a 19% rate right now is going to have to slow. And as we've said on this podcast before, affordability pressures are really one of, if not the key reason that the rate of HPA has to come down. Simply put, potential homebuyers cannot continue to afford to buy homes, at prices that would allow HPA to continue to climb at almost 20% year over year levels. However, if we think about the other factors that would come into play to bring home prices from a positive level to a negative level, we just do not see those characteristics in the market right now. Supply conditions are very constrained. We think they'll be alleviated somewhat this year, but that's not enough for there to be an overhang of supply that would weigh on home prices. We think that the credit availability in the market has been very conservative. We don't think we're at a risk of increased defaults and foreclosures. What we think happens is that transaction volumes fall, as we've stated, as home buyers aren't willing to pay the prices that home sellers want to sell at. But those sellers are not forced. And so you end up with a market that kind of doesn't trade, home price growth slows and we see it bottoming out kind of in a positive 5-6% percent range from here. So, long story short, we agree with that assessment from Jay Powell.
Jim Egan: Now, the other side of the equation, mortgages. With rates backing up by that much, Jay, what do we think about the mortgage market here?
Jay Bacow: So rates backing up means that there's going to be less people refinancing. And you said that there's going to be a slowdown in existing home sales as well. But, we're still worried about the supply to the agency mortgage market. And that's because the supply that we care about the most is the new supply coming from new home sales. And the thing about new home sales is that it's about an 8-month period from the time that the homebuilder gets the permit to start building the house, to when it actually gets sold. So we're going to have about 6 more months of supply from people that started to build their house when mortgage rates were a lot lower. And that's going to weigh on the market, particularly given that Powell said during his testimony that they're going to start balance sheet normalization in the coming months. So, we've got supply coming and we've got the biggest buyer stepping away from the market. Now, mortgage rates have gone up and mortgage spreads have widened, but we think there's a little bit more room for mortgages to underperform given the supply that's coming, and the lack of demand coming from the Fed.
Jim Egan: Certainly interesting times. Jay, thanks for taking the time to talk today.
Jay Bacow: Always great speaking with you, Jim.
Jim Egan: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
The recent crisis in Ukraine has caused a great deal of uncertainty in the economy and markets. To cut through the noise, we take a look at the three key questions we are hearing from investors.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
-----Transcript-----
Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bring you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 2nd at 3pm in New York.
As an analyst focusing on the interaction between geopolitical events and financial markets, I'm accustomed to dealing with uncertainties evolving at a rapid pace. But even by those standards, nothing in my career compares to the events of the past two weeks: the Russian invasion of Ukraine and the sanctions response by the US, the UK and Europe. To help cut through the noise, here's answers to the three most frequently asked questions by our investor clients.
First, do sanctions mean higher energy costs? In the short term, the answer is likely yes. While sanctions on Russian banks currently permit payments for various energy commodities, there's still restrictions on, and disruptions to, their transportation. With Russia being a key producer of several commodities, including 10% of the world's oil, it's not surprising that global oil inventories have declined and the price of a barrel of oil is sitting above $100.
This dovetails with the second question. Should we expect the Fed will shy away from hiking rates? In short, we don't think so, at least at the Fed's March meeting, but it certainly creates substantial uncertainty in the outlook. This conflict seems to be affecting both parts of the Fed's dual mandate in opposite directions. It risks dampening economic growth, but for the reasons we just described, it can also boost inflation. Accounting for both, our economists still expect the Fed to hike 0.25% in March but the conflict adds another layer to an already unprecedented level of complexity for the Fed. This is actually the key point for fixed income markets, in our view, where investors should prepare for ongoing volatility in Treasury and credit markets as the Fed may have to regularly tinker with their own assessment of growth and inflation.
Finally, what are the long-term implications for investors? To answer this question, we refer you back to our framework for 'Slowbalization,' or the idea that companies will have to, in certain industries, spend more to adjust supply chains and exit certain businesses as governments create policies that prioritize economic and national security over short term profits. You can see how this trend may already be accelerating after the onset of the Ukraine crisis, with several multinational companies announcing they'll sell stakes in, exit joint projects with or pause sales to Russian companies. But some equity sectors may see upside. Defense and software, for example, could see bigger spending as governments reorient their budgets towards these efforts, most notably Germany announcing it will boost its defense spending to 2% of GDP.
Of course, the situation remains fluid, and we'll continue to track it and keep you in the loop on what it means for the economy and markets.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As the conflict between Russia and Ukraine continues to unfold, implications for the oil and gas sector in Europe are beginning to take shape.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Martijn Rats, Global Commodity Strategist and Head of the European Energy Research Team for Morgan Stanley. Along with my colleagues bringing you a global perspective, I'll be talking about developments in the oil and gas sector amidst geopolitical tensions. It's Tuesday, March 1st at 2:00 p.m. in London.
As the situation between Russia and the Ukraine continues to develop, implications for commodity markets are beginning to take shape. Russia is a major commodity producer, playing in an especially important role in providing energy for Europe through oil and natural gas imports. With a new round of sanctions announced over the weekend, the precise impact on prices remains to be seen, but we can begin to forecast the direction.
First, there is no sign at this stage that, at least at the aggregate level, the flow of commodities has been impacted yet. All of the pipeline and tanker tracking data that we've seen suggests that they continue to be shipped. That shouldn't be too surprising, it's still early days and the sanctions that have been announced so far have been carefully crafted to reduce the impacts on energy flows from Russia.
Second, trade patterns will nevertheless likely shift. We can already see this in the oil markets. European refiners are traditionally big buyers of Russian crudes, and even though technically they have continued to be able to buy these grades, they are increasingly reluctant to do so. There have been indications that ship owners are reluctant to send vessels to Russian ports, and that European buyers are uncertain about where sanctions will ultimately go. This is requiring increasingly large discounts. As many buyers already move away from Russian crudes, this also creates more demand for others, including North Sea crudes, which therefore drives up the price of Brent.
Third, all of this is happening against the backdrop of tightness in both global oil markets and the European gas markets. We are seeing low and falling inventories, low and falling spare capacity and low levels of investment across both. At the same time, there is a healthy demand recovery ongoing as the world emerges from COVID. Given this tightness, even a modest disruption can have large price impacts. Now, with that in mind, risks to oil and gas prices are still firmly skewed higher, at least in the short term.
Finally, I want to point at the growing tension in Europe between diversification and decarbonization. Several key politicians have said over the last several days that Europe should reduce its dependance on Russian oil and gas, and diversify its sources of supply. At the same time, Europe has set ambitious targets to decarbonize. Diversification requires investment in new supply, while decarbonization then requires that those supplies, in the end, will not be used. How that tension will be resolved is hard to know, but this is an issue that at some point will need to be addressed.
Bottom line, there is still a lot of uncertainty for commodity markets in the coming weeks and months. We will keep you posted, of course, as new developments take shape.
Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Like many markets, Corporate Credit has faced a rocky start to 2022. For investors, understanding the difference between default and duration risk will be key to positioning for the rest of the year.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about corporate credit markets against the background of policy tightening and heightened geopolitical tensions. It's Monday, February 28th at 10 a.m. in New York.
It's been a rough start for the year for the markets. Central banks' hawkish shift towards removing policy accommodation, the significant flattening of yield curves that followed, rising geopolitical tensions, fading prospects for fiscal support, and growing concerns about stretched valuations have all combined to spawn jitters in financial markets. Corporate credit has been no exception. After two years of abundant inflows, the narrative has turned outflows from credit funds in conjunction with negative total returns. These outflows conjure up painful memories of 2018, the last time the credit markets had to deal with substantial policy tightening.
Let us focus on the source - sharply higher interest rates and duration versus credit quality and default concerns. Consider leverage loans, floating rate instruments that have credit ratings comparable to high yield bonds which are fixed rate instruments.
Since the beginning of the year, high yield bond spreads have widened almost three and half times more than leverage loan spreads. If you limit the comparison just to fixed rate bonds, the longer duration investment grade bonds have significantly underperformed the lower quality high yield bonds. Clearly, it is duration and not a fear of a spike in defaults that is at the heart of credit investor angst.
My credit strategy colleagues, Srikanth Sankaran and Taylor Twamley, have analyzed the impact of rate hikes on interest coverage ratios for leveraged loan borrowers. This ratio is a measure of a company's ability to make interest payments on its debt, calculated by dividing company earnings by interest on debt expenses during a given year. The key takeaway from their work is this - What matters more for interest coverage is the point at which higher rates become a headwind for earnings growth. Loan interest coverage ratios have historically improved early in the hiking cycle as interest expenses are offset by growth in earnings.
I draw comfort from the evidence that as long as earnings growth holds up and does not turn negative, corporate credit fundamentals measured in interest coverage ratios are positioned well enough to withstand our economists base case of six 25 basis point rate hikes in this year.
While credit fundamentals look fine, valuations are not. Since the beginning of the year, we have seen spread widening, the pace of which has picked up in the last couple of weeks. So, we still prefer taking default risk over duration and spread risk. The risk to this view has increased in the last few weeks. Specifically, if central bank reaction to the heightened geopolitical risk is to control inflation at the expense of growth, lower quality credit may be more exposed.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As markets react to the conflict between Russia and Ukraine, price moves for corn, wheat, oil and metals may mean new inflationary pressures for central banks to contend with in the coming months.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
This recording references actual or potential sanctions, which may prohibit U.S. persons from buying certain securities, making certain investments and/or engaging in other activities in or pertaining to Russia.
The content of this recording is for informational purposes and does not represent Morgan Stanley’s view as to whether or not any of the Persons, instruments or investments discussed are or will become subject to sanctions. Any references in this presentation to entities, debt or equity instruments that may be covered by such sanctions should not be read as recommending or advising as to any investment activities in relation to such entities or instruments. Audience members are solely responsible for ensuring that their investment activities in relation to any sanctioned entities and/or securities are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape, and how we put those ideas together. It's Friday, February 25th at 3 p.m. in London.
Russia's invasion of Ukraine has grabbed the headlines. There are other commentators and podcasts that are far more knowledgeable and better placed to comment on that conflict. Rather than offer assessment on geopolitics, I want to try to address one small tangent of these developments- the potential impact on prices and inflation.
Russia and Ukraine are both major commodity producers. Russia produces about 10% of the world's oil, and Russia and Ukraine together account for 1/3 of the world's wheat and 1/5 of the world's corn production, according to the U.S. Department of Agriculture. So, if one is wondering why the price of wheat is up about 18% since the end of January, look no further.
These commodities are traded around the world, but specific exposure can be even more acute. Morgan Stanley analysts estimate that Russia supplies roughly 1/3 of Europe's natural gas, while analysis by the Financial Times estimates that Ukraine supplies roughly 1/3 of China's corn.
There are also second order linkages. Russia produces about 40% of the world's palladium, a key component for catalytic converters, and about 6% of the world's aluminum. But because Russia also provides the energy for a good portion of Europe's aluminum production, the impact could be even larger on aluminum prices than Russia's market share would indicate.
Central banks will need to look at these changing prices and weigh how much they should factor into their medium term inflation outlook, which ultimately determines their monetary policy. For now, we think three elements will guide central bank thinking, especially at the U.S. Federal Reserve.
First, higher policy rates are still necessary, despite international developments, given how low interest rates in the U.S. and Europe still are relative to the health of these economies. Slowing demand, which is the point of interest rate hikes, is still important to contain medium term inflationary pressures.
Second, these developments may reduce the odds of an aggressive start to central bank action. A few weeks ago, markets implied that the Fed would begin with a large .5% interest rate increase. Our economists did not think that was likely, and continue to believe that the Fed will hike by a smaller .25% at its March meeting.
Third and finally, the duration and scale of these commodity price impacts are uncertain. Indeed, I haven't even mentioned the prospect of further sanctions or other interventions that could further impact commodity prices. In the view of my colleagues who forecast interest rates, that should mean higher risk premiums, and therefore higher interest rates on government bonds in the U.S. and Europe.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.
Water scarcity brings unique challenges in the path to a more sustainable future. Solving for them will mean both risk and opportunity for governments, corporates, and investors.
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Jessica Alsford Obviously, everyone's minds today are rightly on news out of Europe. We will have an episode to cover this in the coming days, but today we are thinking more long term on sustainability.
Jessica Alsford Welcome to Thoughts on the Market. I'm Jessica Alsford, Global Head of Sustainability Research at Morgan Stanley,
Connor Lynagh And I'm Connor Lynagh, an equity analyst covering energy and industrials here at Morgan Stanley.
Jessica Alsford And on this episode of the podcast, we'll be discussing one of the leading sustainability challenges of the near future, water scarcity, as well as potential solutions that are likely to emerge. It's Thursday, February, the 24th at 3 p.m. in London,
Connor Lynagh and it's 10:00 am in New York.
Connor Lynagh So Jess, we recently collaborated on the report, 'Changing Tides, Investing for Future Water Access.' Maybe the best place to start here is the big picture. Can you walk us through the demand picture and how challenges are expected to change in the industry?
Jessica Alsford So the key issue really is that water is a critical but finite resource, and there's already huge inequality in access to water globally. So over the last century, we've seen water use rising about six fold, and yet there are still around 2 billion people without access to safely managed drinking water and around 3.6 billion without safely managed sanitation. Then add to this the fact that demand is likely to increase by around another 30% by 2050, about 70% of total demand comes from agriculture withdrawals, and clearly we need to increase the amount of food we're producing due to growing population, and there's also going to be incremental water needs from industry and municipalities. A third element to also think about is that this is all happening at the same time that climate change is going to alter the hydrological cycle. And so, this is going to increase the risk of floods in some areas and drought in others. Eight of the 10 largest economies actually have either the same or higher water risk scores than the global average. And so clearly what is already a challenge in terms of providing access to water is only going to become more complicated going forward.
Connor Lynagh So Jess, water is pretty unique when you look at the different challenges that the sustainability community is facing. What do you think is particularly unique and noteworthy about the challenge we're facing here?
Jessica Alsford So the three really big sustainability megatrends that we look at our climate, food and then water. They're all interrelated and they're all really tricky to solve for. But I think there are some unique characteristics about water that do add some complexities to it. First of all, it is finite. So, in theory, we can produce more food, but it's very difficult to make more water. In addition, it's incredibly difficult and costly to transport water around. So, if you think about energy and food, these can be moved over pretty large distances, but water is really a regionally specific commodity. And then the third element really is that water is underpriced if you compare to the actual cost of providing it. There aren't any free markets really to set prices according to supply and demand and because water is essential to life, it's really not straightforward when it comes to thinking about pricing.
Jessica Alsford So Connor, from your perspective, covering some of the stocks exposed to the water theme, what are your thoughts on how water might be priced going forward?
Connor Lynagh Yeah, I mean, I think you really hit on a lot of the big issues, which is that pricing is very heavily regulated relative to a lot of commodities out there. You know, a lot of utilities are not really able to cover their costs without subsidies from the government. And so, you know, I think as a base case, there does need to be an increase in pricing to solve for some of this shortfall that we see out there. But that has to be done delicately. We can't disadvantage members of society that are already struggling. And so, I think what we're going to need to see is some sort of market-based pricing, but in select instances. So, Australia already has a relatively well-developed water market. You're seeing some moves in that direction in California as well. But I think as a first step, I think there's going to be increased focus on larger industrial users paying more than their share and allowing consumers to have a relatively advantaged position on the cost structure.
Jessica Alsford So pricing is clearly one issue, but we also need to see huge investment in global water infrastructure. What are your thoughts on how this develops over the next few years?
Connor Lynagh It’s interesting if you look at a cross-section of countries globally, we tend to spend about 1% of GDP on our water resources. So, I think it's a fair starting point to say that water spending is going to grow in line with GDP. But, as we look at the world today and as you've covered previously, the spending is already not sufficient. It's probably hard to quantify exactly how much we, quote, 'should' spend. But I'll point out a couple of data points here. So globally, we spend about $300 billion per year on water capex. In order to get global water access to those that currently don't have it, this would cost an incremental $115 billion a year. And even in countries like the U.S., where our infrastructure is relatively well developed, we are currently facing a spending shortfall of about $40 billion per year. So, we do think this is going to need to rise significantly.
Jessica Alsford So if we look at climate, for example, we have seen a really big step up in terms of regulation and policy support to really try to drive investment into green infrastructure. And so just picking up on that, for investors who are looking at this theme, where can capital be deployed to help solve this issue?
Connor Lynagh I think that there's obviously just a major infrastructure investment need, but I think that absent major changes in policy, there's a few areas that we still think are relative areas of excess spending growth, if you will, within the sector. So, the first is emerging markets. As countries climb the wealth curve, we do think that their investment is going to increase significantly. I'd point to areas like India and China as areas of significant growth over the next few years. Wastewater management globally I really think that there is going to be increasing regulation and corporate-level focus on this. And then the final thing is applying digital technologies. So, as it stands right now, only about 70% of water globally is connected to a meter. So first and foremost, we need to get a better sense of how we're using our water, where we're using our water. But we can also use cellular technology, digital technologies to better monitor who's using this water in real time, and I think that's going to be a major area of investment, particularly in the US and Europe.
Connor Lynagh So, Jess, obviously there's opportunities for companies that can offer solutions to the water industry, but water access is also a risk for many companies around the world. How should investors think about this?
Jessica Alsford Absolutely. Energy and power generation are the most water intensive sectors. But actually, what's really critical with this theme is access to water on a local level. So actually, our analysis has shown that companies across a wide variety of sectors can really be impacted, whether that be datacenters, pharmaceuticals, apparel or beverages. One of the sectors most at risk is actually copper. So copper is a very water intensive commodity, and a lot of copper just happens to be mined in Chile, which is a country unfortunately already suffering from water scarcity. Now, desalination plants are becoming the norm in Chile as there are competing demands for water between copper mines and also the local population. If we look ahead, we actually think that demand for copper could increase by around 25% per annum. And this is due to the vital role that it's playing in the energy transition, whether it be for renewables or EVs, for example. And with this incremental demand for copper comes incremental demands for water. I'd also point to hydrogen, again, a key piece of the decarbonization puzzle. So, water is needed for hydrogen, whether for cooling, for gray or blue hydrogen, or for the electrolysis process with green hydrogen. And our analysis suggests that almost 60% of future hydrogen projects are located in countries with water stress. So again, this is going to require inventive solutions to ensure that there really is sufficient access to water for all users.
Connor Lynagh Jess, thanks for taking the time to talk.
Jessica Alsford Great speaking with you too Connor.
Jessica Alsford And as a reminder, if you enjoy Thoughts on the Market, please do take a moment to rate and review on the Apple Podcasts app. It helps more people to find the show.
While geopolitical tensions currently weigh on markets, investors should look to the fundamentals in order to anticipate the depth and duration of the ongoing correction.
Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Wednesday, February 23rd at 11 a.m. in New York. So let's get after it.
This past week tensions around Russia/Ukraine dominated the headlines. When unpredictable events like this occur, it's easy to simply throw up one's arms and blame all price action on it. However, we're not so sure that's a good idea, particularly in the current environment of Fed tightening and slowing growth.
From here, though, the depth and duration of the ongoing correction will be determined primarily by the magnitude of the slowdown in the first half of 2022. While the Russia/Ukraine situation obviously can make this slowdown even worse, ultimately, we think that preexisting fundamental risks we've been focused on for months will be the primary drivers, particularly as geopolitical concerns are now very much priced.
While most economic and earnings forecasts do reflect the slowdown from last year's torrid pace, we think there's a growing risk of greater disappointment in both. We've staked our case primarily on slowing consumer demand as confidence remains low thanks to the generationally high inflation in just about everything the consumer needs and wants. Many investors we speak with remain more convinced the consumer will hold up better than the confidence surveys suggest. After all, high frequency data like retail sales and credit card data remain robust, while many consumer facing companies continue to indicate no slowdown in demand, at least not yet. However, most of our leading indicators suggest that the risk of consumer slowdown remains higher than normal. Secondarily, but perhaps just as importantly, is the fact that supply is now rising. While this will alleviate some of the supply shortages, it could also lead to a return of price discounting for many goods where inflationary pressures have been the greatest. That's potentially a problem for margins. It's also a risk to demand, in our view, if the improved supply reveals a much greater level of double ordering than what is currently anticipated. In short, the order books - i.e. the demand picture - may not be as robust as people believe.
Overall, the technical picture is mixed also within U.S. equities. Rarely have we witnessed such weak breath and havoc under the surface when the S&P 500 is down less than 10%. In our experience, when such a divergence like this happens, it typically ends with the primary index catching down to the average stock. In short, this correction looks incomplete to us. Nevertheless, we also appreciate that equity markets are very oversold and sentiment is bearish even if positioning is not. With the Russia Ukraine situation now weighing heavily on equity markets, relief would likely lead to a tactical rally, but we acknowledge that uncertainty remains extremely high.
The bottom line for us is that we really don't have a strong view on the Russia/Ukraine situation as it relates to the equity markets. However, we think a lot of bad news is priced at this point. Therefore, we would look to sell strength into the end of the month if markets rally on the geopolitical risk failing to escalate further.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
The challenges of inflation can be felt around the world, but understanding the regional differences is key to an effective 2022 for both central banks and investors.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Seth Carpenter And I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.
Andrew Sheets And on part 2 of this special episode of Thoughts on the Market, we'll be continuing our discussion on central banks, inflation, and the outlook for markets. It's Tuesday, February 22nd at 1:00 p.m. in London.
Seth Carpenter And 8:00 a.m. in New York.
Andrew Sheets So Seth, you lay out the challenge that central banks face because they are being pulled in two directions. If they raise rates too quickly, the economy could slow too quickly. That means real people lose their jobs, real businesses have trouble getting loans. On the other hand, if they don't raise rates quickly enough, there's a risk that inflation would be higher and that has a real impact on the economy and people's lives. When it comes to, kind of, which side of caution to air on, how do you think central banks are thinking about that at the moment? And what would you be watching to indicate which side of that debate they're starting to come down on?
Seth Carpenter I think if we're looking at the developed market, central banks, the Fed, the ECB, the Bank of England right now, I think they have a high conviction that the current stance of policy is just too accommodative given the state of the real economy and where inflation is. So I think right now all of them believe they need to get going, that starting now is fine. That mindset I don't think though will last too terribly long because over time we will start to see some outright tightening. So for the Fed, where does that point change? I think once they start to run off their balance sheet, probably sometime around the middle of this year, they're going to start to get much more cautious, they're going to look at markets and say how much of this tightening is being transmitted first through financial markets and then to the economy. So they'll be looking at credit spreads, they'll be looking at risk markets to ask, are we getting some traction? We think, especially if we're right and a bunch of the inflation that we're seeing now is this frictional inflation, that comes down in the latter half of the year. We think that hiking cycle is going to slow down over time. And so much like the Bank of England's forecast based on market pricing, we think there's probably a bit too much that's baked into markets in terms of how much hiking they do. They start off reasonably swiftly, knowing that they were too far away, knowing that they were being very accommodative. But in the latter half of the year, the pace of tightening starts to slow down.
Andrew Sheets Seth, another question that I get quite a bit is at what point will market volatility cause the Fed or another central bank to change their policy? There's an idea in the market that if stocks drop or if credit spreads widen, or if there's higher volatility, then central banks would look at that and respond to that. From a central bank standpoint, how do you think central banks think about market volatility? And what are some important ways that you think investors either correctly or kind of incorrectly think about that reaction function?
Seth Carpenter I can say over the 15 years that I spent at the Fed drafting policy documents, briefing the committee on policy options, thinking about how markets are affecting the economy, I can tell you the following. The market tends to have an overdeveloped sense of how sensitive central banks are to equity market reactions in particular. Equity market changes are important, it can be a very high frequency signal that there is cause to investigate what's going on in the economy. But they give many, many, many false signals as well, and so I would say that a sharp drop in equity prices would be the sort of thing that would get the attention of central bankers but would not force their hand to make a change. Instead, there would be further investigation. In addition, the whole point of tightening monetary policy is to tighten financial conditions and thereby slow the economy. So, it is not a question of are we getting credit spread widening? Are we getting softer asset prices? The answer to that is that's part of the plan. I think the real question is how large is the move in asset prices and how quick is the move in asset prices? If we have a very orderly tightening of financial conditions that plays out over several months, I don't think that's the sort of thing that causes the central bank to reverse course. If instead, over the course of a month you get a very sharp and disruptive widening and spreads, I think that really does cause a substantial reconsideration of the plan.
Andrew Sheets So, Seth, I think it's fair to say one of the challenges of your job at Morgan Stanley is you only have the entire global economy to look after. This is an inflation story that does look similar in some ways around the world, but also looks different. Your global economics team has done some interesting research recently on Asia and how Asia, which is an enormous economy in its own right, is seeing quite different, you know, inflation dynamics and labor market dynamics. I was hoping you could touch a little bit on that and how the regional differences can actually be pretty significant.
Seth Carpenter Absolutely. And I think Asia is very much the counterpoint to what we've seen in the rest of the globe in terms of the inflationary process. So inflation in Asia has been quite subdued, and I think there's some very clear reasons for that. First, when we think about food and energy inflation in Asia, many of the countries there have much more direct government intervention in those markets, and that has been helping to keep those inflation rates low. Second, when it comes to core consumer spending, there's been a bigger lag in consumer spending recovery in a lot of Asian economies than there have been in the developed market economies, which I think reflects two issues. One, aggressive COVID response, and second, much less fiscal transfers to the household sector, that is in the United States and in some other countries really helped to support consumer spending, especially on goods. And finally, in many Asian economies, there's been a bit less in the way of supply chain disruptions for the local market. So there really has been a big difference. I'll go you one further, when we think about the central bank's response, not only do we have the large developed market economy central bank starting to hike, the PBOC is going in exactly the opposite direction. The Chinese economy slowed aggressively for reasons that we can get into on another podcast, but the PBOC has eased. So, it is very much a differential outlook for both inflation and central banking in Asia versus the rest of the world.
Seth Carpenter But I have to say, Andrew, let me turn it around to you because inflation is clearly the key story this year. The change in developed market, central banks towards hiking is huge this year. How is all of this debate affecting your views on strategy as it markets across assets across the globe?
Andrew Sheets So I think there are a couple of important elements that are driving the way we're thinking about markets. The first is one key output of higher inflation is higher interest rates, or certainly investor concern around higher interest rates, if we look at how the market has historically performed as interest rates go up, what really matters, maybe simplistically, is how good the economy is. If interest rates are going up, but the underlying economy is still ultimately solid and strong, a lot of assets end up doing OK. And so if I think about, you know, the base case that you and the Morgan Stanley Global Economic Team have laid out where we have some maybe growth softness in the first quarter of this year, but overall 2022 is a pretty solid year for growth. I think that still means that overall, markets can avoid some of the more negative scenarios that would otherwise come with higher rates. But the second issue here that I think is important, and I think this dovetails nicely with your discussion on Asia relative to say the U.S., is that the challenges around inflation and rate hikes also have a lot of global differences. The more expensive your market is, the higher your rate of inflation, the less your central bank has done to this point. Which describes the U.S. pretty accurately, it's a more expensive market, the inflation rate is higher, the Fed has not made its first rate hike yet. I think that's a market where there's more uncertainty and where my colleague Mike Wilson, our Chief U.S. Equity Strategist, is forecasting a more difficult year for returns. You know, in contrast, in Europe the valuations aren't as expensive, the inflation rate isn't as high. I actually think it's OK for investors to kind of have different views on the impact of inflation, different views for 2022, because these trends are very different globally. And I think we're going to see a market that has much more diverse performance, it's going to be less one direction, it's going to be less unified. And I think that's OK, I think that would reflect a global backdrop for inflation and monetary policy and valuations that is quite different depending on where you look.
Seth Carpenter Great. Well, you know, as the saying goes, forecasting is hard, especially about the future. But I have very high conviction in the following forecast: you and I are going to have a lot to talk about over the balance of this year. It's been great talking to you, Andrew.
Andrew Sheets It's been great talking to you, Seth. As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Inflation has reached levels not seen in years, but there is an important distinction to be made between frictional and cyclical inflation, one that has big implications for central banks this year.
----- Transcript -----
Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Seth Carpenter And I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.
Andrew Sheets And on this episode of Thoughts on the Market, we'll be discussing inflation, central banks and the outlook for rate hikes ahead. It's Friday, February 18th at 1:00 p.m. in London
Seth Carpenter and 8:00 a.m. in New York.
Andrew Sheets So, Seth, it's safe to say there's focus on inflation at the moment in markets because we're seeing some of the highest inflation rates in 30 or 40 years. When we think about inflation, though, it's really two stories. There is inflation being driven by more temporary supply chain and COVID related disruptions. And then there is a different type of inflation, the more permanent stickier type of traditional inflation you get as the economy recovers and there's more demand than supply can meet. How important is this distinction at the moment and how do you see these two sides of inflation playing out?
Seth Carpenter Andrew, I think you've laid out that framework extraordinarily well, and I think the distinction between the two types of inflation is absolutely critical for central banks and for how the global economy is likely to evolve from here. My take is that for the US, for the Euro area, for the UK, most of the excess inflation that we're seeing is in fact, COVID-related and frictional. And so, what we can see in the data is that we have an easing now in supply chain disruptions. Supply chain disruptions are still at a very high level, but they're coming down and they're getting better. Similarly, in the US and to some degree in the UK, there have been some labor market frictions because of COVID that have meant that some of the services inflation has also been higher than it might be otherwise. I don't want to diminish completely the idea that there's some good old fashioned cyclical macroeconomic inflation there, because that's also very important. But I think the majority of it is in the frictional type of COVID-related inflation. The key reason why that matters is what has to get done to bring that inflation back down to central bank targets. If the majority of this excess inflation is standard macro cyclical inflation, central banks are going to have to engage in sufficiently tight policy to slow the economy to create slack and bring down inflation. Now, the estimates are always imprecise, but estimates in the United States for, say, the Phillips curve, and when I say the Phillips curve, I mean either the relationship between the unemployment rate and inflation or more generally, the relationship between where the economy is relative to its potential to produce and how much there's currently aggregate demand in the economy. If we have three percentage points of excess inflation that has to be dealt with by creating slack, you're probably going to have to either cause a recession or wait many, many years to gradually chip away things to bring it down over time. It's just too large of an amount of excess inflation if it is truly that standard macro cyclical inflation.
Andrew Sheets So, Seth, it's been a while since we've had to deal with rate hikes in the market. And as you just laid out, there are estimates of how much the Fed would have to raise interest rates to address inflation, these so-called Phillips Curve models and other models. But there's a lot of uncertainty around these things. How much uncertainty do you think there is around how rate hikes will act with inflation? And how do you think central banks think about that uncertainty?
Seth Carpenter So I would completely agree there's uncertainty right now, and I think there are at least two important chains in that transmission mechanism, the first one that we're just talking about is how much of the inflation is cyclical and as a result, how much is going to respond to a slower economy. But the main part that I think you're getting at is also how do rate hikes - or any sort of monetary policy tightening - how does that affect the real economy? How much does that slow the economy? And I think there, it's a very open question. What we know is that over the past several decades there has been a long run downward trend in real interest rates and nominal interest rates. As a result, there's going to be a real tension for central banks trying to find just that sweet spot. How much do you need to raise interest rates to slow the economy without raising it so much that you actually tip things over into a recession? I think it's going to be difficult. And central bankers justifiably then take things very cautiously. Take the Fed as a particular example, they're tightening with two policy tools right now. They are going to both start raising interest rates and they're going to let their balance sheet runoff. We saw in 2018 that that was a tricky proposition, initially that everything went smoothly but by the time we got into late 2018, risk markets cracked, the economy slowed. Part of that was because of monetary policy tightening, and we saw the Federal Reserve in fact reverse course with those rate hikes. So it's going to be a very delicate proposition for central banks globally.
Andrew Sheets So, Seth, you talked about some of the uncertainty central banks are dealing with, how do they calibrate the level of interest rates with the effect it's going to have on the economy and maybe how that's changed relative to history. And there's another question obviously around timing. If you take a step back and kind of think about those challenges that the Fed or the ECB or the Bank of England are facing. how much into the future are they trying to aim with the monetary policy decisions they make today?
Seth Carpenter We're really talking about at least a year between monetary policy tightening and the effect it's going to have on that fundamental cyclical type of inflation. As a result, central bankers have to do forecasts, central bankers do forecasts all the time. And part of the judgment then will get back to that uncertainty that I mentioned before. How much of this inflation is temporary/frictional, how much of it is underlying, truly cyclical inflation? If all of this inflation that we're seeing is truly underlying cyclical inflation, then not only are they behind the curve, they're not going to be able to have any material effect on inflation until the beginning of next year. That's a really important distinction.
Andrew Sheets Well, and I think, you know, I think your answers there Seth raise such an interesting question and debate that's going on in markets that the market believes that the Federal Reserve won't be able to raise interest rates for very long before they'll have to stop raising rates next year. But then you also mention that the impacts of the rate increases they'll make today may not be felt for some time. These are really interesting kind of pushes and pulls. And I'm wondering if you think back through different monetary policy cycles, do you think there's a good historical precedent to help guide investors as they think about what these central banks are about to start doing?
Seth Carpenter I do, I do. And as you are comparing what central bankers may do to how the market is pricing things, I think there's a very interesting set of observations to make here. First, the last Bank of England report, where they provide their forecasts for inflation predicated on current market pricing. Under those forecasts the bank put out, the market has priced in so many rate hikes that it would cause inflation to be too low and go below their target. That's a reflection of the Bank of England's judgment that maybe the market has too much tightening baked into the outlook. But to your specific question about a previous historical precedent, I would look for the 1990s in the United States. During the 1990s hiking cycle, or should I say, just over the whole of the 1990s because it wasn't just one hiking cycle and that for me is the key historical precedent to look for. We saw hikes start in the early 90s, was not at a consistent pace. There was a time where the hikes were bigger, they were smaller, then the hiking cycle paused for a while. We got a reversal, we got a pause, we got more rate hikes and then we got a pause again and it came back down. That sort of very reactive policy is exactly what I think we're going to be seeing this time around in the United States, in the U.K., in the developed market economies where we have high inflation and central bankers are trying to sort out how much of that inflation is cyclical, how much of it is temporary.
Andrew Sheets Thanks for listening. We’ll be back in your feed soon for part two of my conversation with Seth Carpenter on central banks, inflation, and the outlook for markets.As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
The ongoing situation around Ukraine has captivated headlines and investors alike. While the resolution remains unclear, we can begin to predict how markets would react to possible outcomes.
This presentation references actual or potential sanctions, which may prohibit U.S. persons from buying certain securities, making certain investments and/or engaging in other activities in or pertaining to Russia. The content of this presentation is for informational purposes and does not represent Morgan Stanley’s view as to whether or not any of the Persons, instruments or investments discussed are or will become subject to sanctions. Any references in this presentation to entities, debt or equity instruments that may be covered by such sanctions should not be read as recommending or advising as to any investment activities in relation to such entities or instruments. Audience members are solely responsible for ensuring that their investment activities in relation to any sanctioned entities and/or securities are carried out in compliance with applicable sanctions.
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas Head of U.S. Public Policy Research and Municipal Strategy for Morgan Stanley.
Marina Zavolock And I'm Marina Zavalock, Head of Emerging Europe, Middle East, and Africa Equity Strategy at Morgan Stanley.
Michael Zezas And on this special edition of the podcast, we'll be discussing ongoing developments around Ukraine and how markets might react to various outcomes. It's Thursday, February 17th at 9:00 a.m. in New York.
Marina Zavolock And it's 2:00 p.m. in London.
Michael Zezas So, Marina, we've spent a lot of time in recent weeks tracking developments in the ongoing situation around Ukraine, on whose border Russia's amassed a substantial military presence and there are warnings of a potential invasion. This would be no small event, potentially the largest military action in Europe since World War Two, with great risk to many people. Recent news has all sides continuing to express hope for a diplomatic solution, and let's hope that can be achieved. But for this podcast, we want to focus narrowly on the market's impact because this situation has been a key driver of recent moves in many global markets. So, let's keep it simple to start, which markets are most vulnerable to a military confrontation and why?
Marina Zavolock So, of course, we see Ukrainian and Russian markets as most directly vulnerable. Ukraine is directly exposed from an economic perspective, and the Ukrainian market has more downside risks due to this direct fundamental exposure and the country's reliance on external financing as well. The risk for Russian markets are more related to sanctions, given the strong economic backdrop. There are various sanctions under discussion aimed firstly at deterring a Russian invasion of Ukraine. Should Russia invade, we would expect the U.S. and Europe to act quickly to impose new sanctions, both to impact Russia’s decision making and ability to sustain any invasion, while at the same time limiting the impact on global commodities and supply chains to the extent possible.
Marina Zavolock The situation is, of course, very fluid, as you described. Sanctions have not yet been finalized, but I'll mention three of the material sanctions that are reportedly under discussion. First, SDN list sanctions on a number of Russian banks and possibly other Russian companies. This would mean US persons would be prohibited from dealing with these companies, be it in business transactions or trading of securities. Second, Export controls restricting the export of technology products containing U.S. made components or software to Russia. Third, New sovereign debt sanctions on the secondary market – adding to the primary market sanctions already in place – this could mean exclusion from large fixed income indices in a worst case. Overall, from a Russian stock market perspective, we see the Russian banking sector as potentially most exposed, given a number of banks appear targeted by SDN list sanctions, and would also be affected meaningfully by any ban on U.S. technology.
Michael Zezas So those outcomes seem pretty substantial here in terms of their impact. So obviously the outcome of this confrontation matters quite a bit. How do you think the stock markets you're tracking are set up to react to various outcomes, whether it be de-escalation from here or some form of further escalation?
Marina Zavolock So to assess the risk reward for different Russian and Ukraine related assets and commodities, we published a framework earlier this year to outline these scenarios: de-escalation, limbo (where uncertainty persists), partial escalation, and material escalation. For Russian equities in particular, we use two key variables that investors tend to focus on: the market's implied cost of equity and dividend yield. On implied cost of equity, Russia currently trades at 19%, which is about in line with the peak seen around many prior escalation periods in geopolitics, such as during the 2018 probe into U.S. election interference. But it is below the 26% level reached following Crimea annexation in 2014. On dividend yield, Russia trades at extraordinary levels of 16% at current commodity prices. We've never seen such levels before for any major country, or Russia, historically.
Marina Zavolock So coming back to the scenarios. Using these two variables I outlined, analyzing historical geopolitical escalation periods for Russia, we see about 50% potential upside to Russian stocks in a de-escalation scenario and at least 30% downside in the event of material escalation. Russian equities are currently trading roughly in line with our 'limbo' scenario, meaning the market is assuming continued talks and uncertainty without a breakthrough agreement. It's also worth noting here that although Russian equities are down about 20% from their pre-geopolitical escalation highs in October, they have also recovered 20% from their recent lows. And at the lows, the Russian market was already pricing in a partial escalation in Ukraine.
Michael Zezas So those are some pretty substantial differences based on different outcomes. What are some of the signposts or signals that you're watching for that might tell us what direction we're headed in?
Marina Zavolock So for the de-escalation scenario to become evident, the key signpost we're watching for is a meaningful reduction in Russian troops on Ukraine's border. Earlier this week, Russia’s defense ministry announced that Russia would start a pullback of some ot its forces after completing military drills – we are watching whether troops are actually being withdrawn, and to what extent. The reason we're watching troop movements particularly closely is that when there was a related buildup of Russian troops on Ukraine's borders last spring, it was Russia's announcement of a meaningful troop removal and the subsequent move of troops that allowed the market to recover by about 40% over the following months.
Marina Zavolock As for the escalation scenarios, of course, a further buildup of troops, any movement of troops across the border, any breakdown of ongoing talks with the West, these are all key signposts we're watching. We're also watching both local and international key government official commentary and news flow, which cover the situation differently. I'd also note that for those that aren't following all of these signposts very closely, the Russian equities market is rapidly reacting to developments, we think a step ahead of global markets, which have only recently begun to react to these risks.
Michael Zezas And Marina, outside of Russian equities, are there other markets you're watching that could experience spillover effects?
Marina Zavolock From a broader perspective, Russia is a key global exporter of various commodities. It's not just the well-known oil and European gas, but Russia also produces 37% of the world's palladium, which is essential for global autos manufacturing. It's a meaningful producer of nickel, aluminum, and a dozen other commodities. Many of these commodities recently started to rally, pricing in some risk premium on the back of the rise in global focus on these geopolitical risks. Our European equity strategist, Graham Secker, also anticipates European equities may be vulnerable to mid-single digit underperformance versus global equities in the case of escalation. That said, as I mentioned before, we see a low probability of spillover to these markets from a fundamental perspective. So, the impact is likely to be short term and more market sentiment driven in the case of escalation.
Michael Zezas Alright so, even if we assume that perhaps the diplomatic solution takes hold. What are the risks that this could repeat itself again as an escalation and then de-escalation cycle? And what would that mean for your coverage universe?
Marina Zavolock Even in a de-escalation scenario, long-term geopolitical risk to Russia will remain. I don't think the market will price these risks out quickly, and we've had increases in geopolitical risk and then de-escalation many times before since the 2014 Crimea invasion, and even before that. Regular investors in Russian markets have grown accustomed to these geopolitical risks. And there have been, over recent years, windows when Russian equities can have material returns, followed by sell offs on the back of increases in geopolitical tensions and incremental sanctions. That said, from 2014 lows to the recent peak in Russian equities, the Russian Equities Index has outperformed emerging markets by about 13% per year and returned 15% total, including dividends, per year. This is on the back of many structural drivers, like a tripling in dividend payout ratios over this time. In fact, recently, the Russian stock market has seen record levels of buybacks, dividend levels, and retail inflows.
Michael Zezas Marina, thank you. This has been really insightful. Thank you for taking the time to talk.
Marina Zavolock Thank you, Michael.
Michael Zezas And thanks for listening. If you enjoy Thoughts on the Market, please be sure to rate and review us on the Apple Podcasts app. It helps more people find the show.
Original Release on February 2nd, 2022: The Federal Reserve continues to face a host of uncertainties, leading to volatility in the Treasuries market. This trend may lead some investors to reconsider the municipal bond market.
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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, February 2nd at 10 a.m. in New York.
A couple weeks back, we focused on the tough job ahead for the Federal Reserve. It's grappling with an uncertain inflation outlook driven by unprecedented circumstances, including the trajectory of the pandemic, and the still unanswered questions about whether supply chain bottlenecks and swelling demand by U.S. consumers for goods over services have become a persistent economic challenge. Against that backdrop, it's understandable that keeping open the possibility of continued revisions to monetary policy is part of the Fed's strategy. Not surprisingly, that uncertainty has translated to volatility in the Treasury market and, as expected, some fresh opportunity for bond investors.
For that, we looked in the market for municipal bonds, which are issued by state and local governments, as well as nonprofits. Credit quality is good for munis as the combination of substantial COVID aid to municipal entities and a strong economic recovery have likely locked in credit stability for 2022. But until recently, the price of munis was quite rich, in part reflecting this credit outlook, an expectation of higher taxes that would improve the benefit of munis tax exempt coupon, and a recent track record of low market volatility. But the bond market's reaction to the Fed undermined that last pillar, resulting in muni mutual fund outflows and, as a result, a move lower in relative prices for muni versus other types of bonds.
While this adjustment in valuations doesn't exactly make munis cheap, for individuals in higher tax brackets, they're now looking more reasonably priced. And, as a general rule of thumb, when the fundamentals of an investment remain good, but prices adjust for purely technical reasons, that's a good signal to pay attention.
So what does this mean for investors? Well, that fed driven volatility isn't going away, so munis could certainly still underperform some more from here. But for a certain type of investor, we wouldn't let the perfect be the enemy of the good. If you're in a higher tax bracket and need to replenish the fixed income portion of your portfolio, it could be time to curb your caution and start adding back some muni exposure.
Thanks for listening! If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
As the Fed grapples with new data from last week's Consumer Price Index report, markets are pricing a move away from the dovish policy of the past and investors should pay attention.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, February 15th at 10 a.m. in New York. So let's get after it.
While there are many moving parts in any market environment, investors often become infatuated with one in particular. In our view, going into last Thursday's consumer price index report was one of those times. For the days leading into it every conversation with investors, traders, and the media obsessed over the report and whether markets were appropriately priced. For the inflation bulls the release did not disappoint, coming in significantly stronger than expected with the components of the report just as hot.
Immediately after its release, both short- and longer-term interest rates surged. Additional policy hawkishness was quickly priced too, as markets concluded the Fed was falling even further behind the curve. Market chatter of an emergency Fed meeting made the rounds, indicating the possibility of immediate cessation of quantitative easing or even an intra-meeting rate hike. By the end of the day on Thursday markets had priced in a 90% chance of a 50 basis point hike at the March meeting, and six to seven 25 basis points worth of hikes by the end of the year. Balance sheet runoff, or quantitative tightening, is also expected to begin by the middle of this year at the rate of $80 billion a month.
When we first started talking about ‘Fire and Ice’ last September, our view that the Fed would have to go faster than expected to fight the building inflationary pressure was met with quite a bit of skepticism, and for a good part of the fall markets disagreed too. Some of this was due to the fact that most investors in markets like to see the hard data before positioning for it. The other reason is likely due to how the Fed and other central banks have behaved since the financial crisis, with their dovish policy bias. Fast forward to today and the data is irrefutable. Doves are quickly going extinct, and it's become almost a competition as who can have the most hawkish forecasts at this point.
While we don't doubt the Fed and other central banks resolve to try and get inflation back under control, the market is now all in on the idea that they will do their job to fight inflation. However, we find ourselves a bit more skeptical that they will be able to get as much policy tightening done as is now expected and priced. Furthermore, when something is this obvious and consensus, it's usually time to start focusing on something else.
As noted in the past several weeks, we think the equity markets will now begin to focus on growth or the lack thereof. In short, one should begin to worry about the ‘ice,’ now that ‘fire’ is finally appreciated. One of the reasons we are skeptical of the Fed and other central banks will be able to deliver on the policy tightening now expected, is the fact that growth is already slowing. An unusual circumstance at the beginning of any monetary policy tightening cycle, particularly one that is so ambitious. Whether it's the pay back in demand, or the sharp decline in real personal disposable income, we think the rate of consumption is likely to disappoint expectations in the first half of 2022. Furthermore, this weaker consumption is arriving just as supply chains are finally loosening up, something that is likely to be aided by the end of Omicron and the labor shortages it has created in the transportation and logistics industries. In that regard, Friday's consumer confidence survey release looks to be the more important macro data point of the week, not the CPI.
Bottom line, this correction started six months ago with the sharp rise in inflation and the Fed's pivot to address it. It will likely end when growth expectations are reset to more realistic levels sometime this spring. Until then, remain defensively biased with equity allocations.
Thanks for listening. If you enjoyed Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app, it helps more people to find the show.
As investors face the multitude of risks ahead, one may need to think like the Tiger and use the rotation towards value stocks, and away from growth, to leap over higher hurdle rates this year.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about Asia and emerging market equities in the year ahead. It's Monday, February the 14th at 8:30 p.m. in Hong Kong.
Welcome to the Year of the Tiger from the Morgan Stanley team in Asia. Ferocious, brave, and intelligent, the tiger inspires us to navigate the multitude of risks which confront investors today. For us in Asia, we're at first sight on the sidelines of the action as expectations build for a sea-change this year in monetary policy in the US and Europe.
Indeed, we have a degree of sympathy with the argument that the different phase of the monetary and fiscal cycle in China, in essence a moderate easing, is a key reason to be more constructive on Asian markets performance this year in both absolute and relative terms.
However, divergent policy cycles are only part of the story. North Asia has already benefited substantially from the major shift towards good spending and away from services, which has been such a unique feature of the COVID driven recession and recovery. Now, as that starts to reverse, given the reopening trend in the US and Europe, we may see earnings growth in markets like Korea and Taiwan slow. Moreover, significant challenges in relation to COVID management still beset the region, most notably in Hong Kong, which is experiencing its largest surge in cases since the pandemic began.
A key call that Morgan Stanley's equity strategy team made three months ago, in our year ahead outlook, was that investors on a worldwide basis should rotate away from growth stocks. That is, stocks with high expected earnings growth and high valuations towards value stocks. That is those with lower valuations, more dividend yield support, and lower anticipated earnings growth, not least due to the fact that many businesses in the value style category tend to be more established than growth stocks.
This rotation has indeed taken place, as evidenced not just by Nasdaq's underperformance in the US, but also the underperformance of growth stocks in Asia and emerging markets. This has been reflected in indices like Kosdaq in Korea or the TSE Mothers Index in Japan. In fact, in Japan banks and insurers, stocks which investors have not focused on for a long time, are leading in performance in 2022. Whilst in China, bank stocks have been outperforming internet stocks for some time now.
For those of us who worked through the 1999 to 2002 cycle in global equities, things seem very familiar. History rhymes rather than repeats, but the catalyst for growth stock underperformance then, as now, was a sudden repricing of interest rate hike expectations with a shift higher in nominal and real interest rates. That higher hurdle rate depresses valuations for equities generally, but particularly for higher multiple growth stocks, further motivation for the rotation towards value stocks.
So. investors may need to start thinking like the tiger in order to leap over that hurdle and land safely on the other side.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Headlines today are focused on US Consumer Price Inflation rising 7.5% versus 1 year ago. The question on the minds of consumers and investors alike is, where will it go from here?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, February 11th at 2 p.m. in London.
This week for the ninth month in the last 10, U.S. consumer price inflation was higher than expected, rising 7.5% Versus a year ago. Investors are currently having a very lively discussion around where inflation is headed, but also how much it matters. And I wanted to share a few of our thoughts.
One important thing about these rising prices is they aren't all rising for the same reason. COVID related disruptions are still impacting the production of everything from meat to automobiles. And say, with fewer new cars being built that means the cost of used cars has risen almost 50%. Now cars aren't a large share of the so-called inflation basket, the collection of goods and services that is used to determine how much overall prices are rising or falling. But if a small share of something rises 50%, the overall number can still rise quite a bit.
Then there are rising prices that we see today, but where the story has been building for some time. The assumed cost of shelter, for example, should be linked to the price of housing. But due to how this data is measured, there can be some pretty significant lags.
Consider the following. From the start of 2017, so about five years ago, U.S. home prices have risen 50%. But the assumed rise in the cost of shelter, that goes into the inflation calculation, suggests that the cost of shelter has risen just 16% over that same period. As this gap closes and shelter costs catch up to where home prices already are, that will get reported as a lot of additional inflation, even if home prices have stopped rising.
Another part of this story is the narrative and the timing of it. Per a quick check of the headlines this morning, Thursday’s inflation data was the top story for The Wall Street Journal and The New York Times.
Yet, based on Morgan Stanley's current forecasts, U.S. inflation is actually peaking right about now. We think the direction of data matters enormously in terms of how it's interpreted because there's a very human tendency to extrapolate whichever direction it happens to be heading. Today, the rate of inflation's been heading up, creating fears that it will continue to move higher. But if we're right that inflation peaks in the next month or two, April or May could feel very different.
Unfortunately, we're not quite there yet. The inflation rate is still rising, creating uncertainty about what central banks will do and how they'll respond. That uncertainty is driving volatility and should warrant lower prices for things that are very central bank sensitive. We think yields for government bonds in the U.S., the U.K., and the Eurozone will continue to move higher, and that spreads on mortgages, sovereign bonds, and corporates can move modestly wider.
On the other hand, we feel better about assets that are less sensitive to this inflation uncertainty, including the less expensive stock markets outside the U.S. Stocks in the United Kingdom which my colleague Graham Secker, Morgan Stanley's Chief European Equity Strategist, discussed on this program recently are one such example.
Finally, keep in mind that the inflation debate could feel very different in just a month or two. If the inflation data peaks soon, as our economists expect, it could provide some relief as we look ahead to April or May.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us to review. We'd love to hear from you.
Original Release on January 25th, 2022: With inflation on the minds of consumers and the Fed reacting with a sharp turn towards tightening, 2022 may be a year for investors to focus on incorporating tax-efficient strategies into their portfolios. Morgan Stanley Wealth Management’s Chief Investment Officer Lisa Shalett and Chief Cross-Asset Strategist Andrew Sheets discuss.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be discussing the importance of tax efficiency as a pillar of portfolio construction. It's Tuesday, January 25th at three p.m. in London.
Lisa Shalett And it's 10:00 a.m. here in New York.
Andrew Sheets Lisa, welcome back to the podcast! Now, as members of Morgan Stanley Wealth Management's Global Investment Committee, we both agree that the current portfolio construction backdrop is increasingly complicated and constrained. But tax considerations are also important, and this is something you and your team have written a lot on recently. So I'd really like to talk to you about both of these issues, both the challenges of portfolio construction and some of the unique considerations around tax that can really make a difference to the bottom line of investment returns. So Lisa, let's start with that current environment. Can you highlight why we believe that standard stock bond portfolios face a number of challenges going forward?
Lisa Shalett We've been through an extraordinary period over the last 13 years where both stocks and bonds have benefited profoundly from Federal Reserve policy, just to put it bluntly, and, you know, the direction of overall interest rates. And so, our observation has been that, you know, over the last 13 years, U.S. stocks have compounded at close to 15% per year, U.S. bonds have compounded at 9% per year. Both of those are well above long run averages. And so we're now at a point where both stocks and bonds are quite expensive. They are both correlated to each other, and they are both correlated to a large extent with Federal Reserve policy. And as we know, Federal Reserve policy by dint of what appears to be inflation that is not as transitory as the Fed originally thought is causing the Fed to have to accelerate their shift in policy. And I think, as we noted over the last three to six weeks, you know, the Fed's position has gone from, you know, we're going to taper and have three hikes to we're going to taper be done by March. We may have as many as four or five hikes and we're going to consider a balance sheet runoff. That's an awful lot for both stocks and bonds to digest at the same time, especially when they're correlated with one another.
Andrew Sheets And Lisa, you know, if I can just dive into this a little bit more, how do you think about portfolio diversification in that environment you just described, where both stocks and bonds seem increasingly linked to a single common factor, this this direction of Federal Reserve policy?
Lisa Shalett One of the things that we've been emphasizing is to take a step back and to recognize that diversification can happen beyond the simple passive betas of stocks and bonds, which we would, you know, typically represent by, you know, exposures to things like the S&P 500 or a Barclays aggregate. And so what we're saying is, within stocks, you've got to really make an effort to move away from the indexes to higher active managers who tend to take a diversified approach by sector, by style, by market cap. And within fixed income, you know, we're encouraging, clients to hire what we've described as non-core managers. These are managers who may have the ability to navigate the yield curve and navigate the credit environment by using, perhaps what are nontraditional type products. They may employ strategies that include things like preferred shares or covered call strategies, or own asset backed securities. These are all more esoteric instruments that that hiring a manager can give our clients sources of income. And last, you know, we're obviously thinking about generating income and diversification using real assets and alternatives as well.
Andrew Sheets And so, Lisa, one other thing you know, related to that portfolio construction challenge, I also just want to ask you about was how you think about inflation protection. I mean, obviously, I think a lot of investors are trying to achieve the highest return relative to the overall level of prices relative to inflation. You know, how do you think from a portfolio context, investors can try to add some inflation protection here in a smart, you know, intelligent way?
Lisa Shalett So you know what we've tried to say is let's take a step back and think about, you know, our forecast for, you know, whether inflation is going to accelerate from here or decelerate. And you know, I think our position has broadly been that that we do think we're probably at a rate of change turning point for inflation, that we're not headed for a 1970s style level of inflation and that, you know, current readings are probably, you know, closer to peak than not and that we're probably going to mean revert to something closer to the, you know, two and a half to three and a half percent range sooner rather than later. And so in the short term, you know, we've tried to take an approach that says, not only do you want to think about real assets, these are things like real estate, like commodities like gold, like energy infrastructure linked assets that have historically provided some protection to inflation but really go back to those tried and true quality oriented stocks where there is pricing power. Because, you know, 2.5-3.5% Inflation is the type of inflation environment where companies who do have very strong brands who do have very moored competitive positions tend to be able to navigate, you know, better than others and pass some of that the cost increases on to consumers.
Andrew Sheets So, Lisa, that takes me to the next thing I want to talk to you about. You know, investors also care about their return after the effects of tax, and the effects of tax can be quite complex and quite varied. So, you know, as you think about that challenge from a portfolio construction standpoint, why do you think it's critical that investors incorporate tax efficient investing strategies into their portfolios?
Lisa Shalett Well, look, you know, managing, tax and what we call tax drag is always important. And the reason is it's that invisible levy, if you will, on performance. Most of our clients are savvy enough to suss out, you know, the fees that they're paying and understand how the returns are, you know, gross returns are diluted by high fees. But what is less obvious is that some of the investment structures that clients routinely use-- things like mutual funds, things like limited partnership stakes-- very often in both public and private settings, are highly tax inefficient where, you know, taxable gain pass throughs are highly unpredictable, and clients tend to get hit with them. And so that's, you know, part of what we try to do year in, year out is be attentive to making sure that the clients are in tax efficient strategies. That having been said, what we also want to do is minimize tax drag over time. But in a year like 2022, where you know, we're potentially looking at low single digit or even negative returns for some of these asset classes, saving money in taxes can make the difference between, you know, an account that that is at a loss for the full year or at a gain. So there's work to be done. There's this unique window of opportunity right now in the beginning of 2022 to do it. And happily, we have, you know, some of these tools to speed the implementation of that type of an approach.
Andrew Sheets So Lisa, let's wrap this up with how investors can implement this advice with their investments. You know, what strategies could they consider? And I'm also just wondering, you know, if there's any way to just kind of put some numbers around, you know, what are kind of the upper limits of how much these kind of tax drags, you know, can have on performance?
Lisa Shalett Yeah. So that's a great question. So over time, through the studies that we've done, we believe that tax optimization in any given year can add, you know, somewhere between 200 and 300 full basis points to portfolio performance, literally by reducing that tax bill through intelligent tax loss harvesting, intelligent product selection, you know, choosing products that are more tax efficient, et cetera.
Andrew Sheets Well, Lisa, I think that's a great place to end it. Thanks for taking the time to talk. We hope to have you back soon.
Lisa Shalett Absolutely, Andrew. Happy New Year!
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Many investors are asking when Congress will withdraw its fiscal policy support. Our answer? It already has, and 2022 could be a year where fiscal policy becomes a non-factor in the economic outlook.
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Welcome the Thoughts on the Market. I'm Michael Zezas as Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, February 9th at 10 a.m. in New York.
As the Fed keeps signaling its intent to withdraw its extraordinary monetary support for the economy, a common question we're hearing is when will Congress do the same with fiscal policy support? Our answer is simple: it already has.
Now, we're usually getting this question from investors concerned that COVID relief aid is continuing to create inflation pressure in the economy. But the last tranche of aid was approved over a year ago, and direct aid to support households from that program have largely expired, including the child tax credit, supplemental unemployment benefits, and renter and mortgage protections.
But what about all those infrastructure and social spending plans President Biden proposed? Even here there's no sizable fiscal expansion in sight. The bipartisan infrastructure framework was mostly offset by new revenues. And on the Build Back Better plan, Senator Joe Manchin appears to have made deficit neutrality a condition for his support for it. So any legislative comeback for that plan likely won't result in more fiscal support for the economy.
For investors, this is a throwback to periods where fiscal policy was an afterthought. In many recent years, like 2018, 2020 and 2021, fiscal policy was a key variable to the U.S. economic outlook. This year, it looks like a non-factor. That syncs with our framework for forecasting U.S. fiscal policy outcomes, which currently points to the U.S. having moved from a phase of proactive fiscal expansion, to one of stability. That's because legislative decisions by Congress that expand the deficit are typically a function of motive and opportunity. The motive is strong when there's perceived political value to the short-term economic boost that comes with the deficit expansion. The opportunity is there when one party controls Congress and the White House. Both these conditions were met after the 2020 election, resulting in another round of substantial COVID aid. But with inflation on the rise and issue polls showing it's beginning to bother voters, that motive is waning. As a result, expect U.S. fiscal policy to remain neutral until an election or an economic downturn opens a path for it.
But while fiscal policy might not be a macro factor, it could still drive some sector outcomes. For example, a deficit neutral build back better plan could still feature a corporate minimum tax, creating headwinds for financials and telecom. But it could also include substantial spending on carbon reduction, potentially directing a lot of fresh capital to the clean tech sector. And of course, it's important to remember 2022 is an election year, so expect the fiscal conversation to evolve.
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Despite having been one of the worst performing stock markets over the last 5 years, the UK is seeing a dramatic turnaround reflected in the FTSE100 index. Investors may want to take a closer look.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about our positive view on U.K. equities and why we think the FTSE 100 offers a compelling opportunity here. It's Tuesday, February the 8th at 3 p.m. in London.
Having been one of the worst performing stock markets over the last five years, the UK has seen a dramatic turnaround in 2022, with the headline FTSE 100 index, which is the UK equivalent of the S&P 500, outperforming the S&P by around 8% or so, so far, and posting the second-best return of any major global stock market after the Hang Seng in Hong Kong. Looking forward, we think the reversal of fortunes for UK equities can continue for three reasons.
First, we think the Footsie 100 index offers a good blend of offense and defense. On the latter, we note the defensive sectors account for 37% of UK market capitalization, which is higher than any other major country or region. Reflecting this, the UK index has outperformed the wider European market two thirds of the time during periods when global equities are falling.
When it comes to offense, we know that the UK market is a key relative beneficiary of rising real bond yields, to the extent that a move up in US real yields to our target of minus 10 basis points by year end would imply UK stocks outperforming the rest of the European market by as much as 12% this year. The reason behind the UK's positive correlation to real yields is again down to its sector mix. As well as being quite defensive, the index also has a significant weight in value stocks, such as commodities and financials. These are sectors that tend to perform best when real yields are rising, and investors are becoming more valuation sensitive.
While the UK has always had something of a value bias, this relationship is currently even stronger than normal and this leads me to the second driver behind our positive view on the FTSE 100 here, namely that the index is cheap. So cheap, in fact, that you have to go back to the 1970s to find the last time UK equities were this undervalued versus their global peers. To provide some context to this narrative, the FTSE 100 is on a 12-month forward price to earnings ratio of 12.5 versus Europe on 15 times, and the S&P closer to 20 times. As well as a low PE, the UK also offers a healthy dividend yield of 3.6%, which is around twice that on offer from global indices.
The third and final support to our positive view on UK equities is that consensus earnings expectations are very low, thereby creating a backdrop for subsequent upgrades that should support price outperformance. For example, consensus forecasts less than 3% earnings growth over each of the next two years, which represents the lowest growth forecast in over 30 years. We think this is too pessimistic and note the consensus expectations for the equivalent Eurozone index are much closer to normal at around 8 percent. The most likely source of upgrade risk around UK earnings comes from our positive view on the oil price, given the energy stocks accounted for 25% of all UK profits last year. With our oil team expecting the Brant oil price to rise to $100 later this year, we see scope for material profit upgrades for individual oil stocks and the broader FTSE 100 index too.
One last point a positive view on the UK is primarily focused on the headline Large Cap FTSE 100 index. We are less constructive on UK mid-caps, as this part of the market is more expensive and hence gets less of a benefit from rising real yields. The more domestic nature of the mid-cap index also means it's more exposed to the growing pressure on UK households from rising energy bills, food prices, and tax increases. In contrast, the FTSE 100 is a very international index, with around 70% of revenues coming from outside the UK. This makes it less sensitive to domestic economic matters and also a beneficiary if we see any renewed weakness in the sterling currency. To conclude, we think international investors should take a closer look at the UK as we think there's a good chance it ends up being one of the best performing global stock markets in 2022.
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As we head towards the final weeks of winter, we are predicting a period of continued slow growth. As evidence we look not to our shadow but at earnings estimates and inventories.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleague bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, February 7th at 11:30 a.m. in New York. So let's get after it.
In the United States, February 2nd is known as Groundhog Day. A 135-year-old tradition of taking a groundhog out of his cage to determine if he can see his shadow. In short, a sunny February 2nd means six more weeks of winter, while a cloudy day suggests an early spring. Well, last week the most famous groundhog, who lives in Pennsylvania, saw his shadow informing us to expect more cold weather for six more weeks.
While this tradition lives on, its track record is pretty spotty with a 50% hit rate. Flipping a coin sounds a lot easier. However, it does jive with our market forecast for at least six more weeks of winter, and ice, as growth slows further into the spring. Signs of weakness are starting to appear, and we think they go beyond Omicron. While we remain optimistic that this could be the final major wave of the pandemic, we're not so sure growth will rebound and accelerate as many others are suggesting.
First, fourth quarter earnings beat rates are back to 5%, which is the long-term average. However, this is well below the beat rates of 15-20% observed over the past 18 months, a period of over earning in our view. The key question now is whether we are going to return to normal, or will we experience a period of under earning first, or payback? We've long held the view that payback was coming in the first half of 2022 as the extraordinary fiscal stimulus faded, monetary policy tightened, and supply caught up with demand in many end markets. Over the past few weeks several leading companies that weren't supposed to see this payback have disappointed with weaker than expected guidance on earnings. These stocks sold off sharply, and we think there are likely more disappointments to come as consumption falls short of expectations. Consumer confidence remains very soft due to higher prices, with our recent proprietary surveys suggesting consumers are expecting to spend more on staples categories over the next six months, versus the last six months. Spending on durables, consumer electronics and travel/leisure is expected to decline for lower income cohorts in particular.
Second, inventories are now building fast and driving strong economic growth. However, the timing of this couldn't be worse if demand is fading more than expected. As noted in prior research, we think it could also reveal the high amounts of double ordering across many different industries. If that's correct, we are likely to see order cancelations, and that will only exacerbate the already weakening demand. In short, this supports a period of under-earning by companies as a mirror image to the past 18 months when inventories were lean and pricing power was rampant.
Of course, the good news is that this likely means inflation pressures will ebb as companies lose pricing power. Eventually, this will lead to a more sustainable situation for the consumer and the economy. However, we think this could take several quarters before it's finally reflected in either earnings growth forecasts, valuations, or both. What this means for the broader market is probably six more weeks of downward bias. We continue to target sub-4000 on the S&P 500 before we would get more interested in trying to call an end to this ongoing correction. In the meantime, favor a defensive positioning. We've taken a more defensive posture in our recommendation since publishing our year ahead outlook in mid-November. Since then, it's paid off, although it hasn't been consistent. With last week's modest rally in cyclicals relative to defensives, we think it's a good time to fade the former and by the latter, since we still feel confident in our forecast for slowing growth even if the groundhog's track record isn't great.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
For only the second time in the last decade, commodities outperformed equities in 2021. Looking ahead at 2022, what challenges and opportunities are on the horizon for this asset class?
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset. Strategist.
Martijn Rats And I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist.
Andrew Sheets And today in the podcast we'll be talking about tailwinds driving commodities broadly, as well as the path ahead for global energy markets. It's Friday, February 4th at 3p.m. in London.
Andrew Sheets So, Martijn, there were a number of reasons why I wanted to talk to you today, but one of them was that, for only the second time in the last decade, commodities outperformed equities in 2021. There are a number of drivers behind this, and you and your team have done some good work recently talking about those drivers and how they might continue. But one of them has certainly been the focus on inflation, which has been a major investment topic at the end of last year and continues to be a major topic into this year. Why are commodities and the inflation debate so interlinked and why do you think they're important for commodity performance?
Martijn Rats Well, look, commodities tend to maintain their value in real terms. So when there is broad inflation, the cost of producing commodities tends to go up. And when that happens, then the price of commodities tends to follow that. So at the same time, if you have a rising inflation, then also ends up in having an impact on interest rates. Interest rates start to rise. That tends to be a headwind for a lot of financial assets. So when inflation expectations all of a sudden pick up, then then all of a sudden it weighs on the valuation of an awful lot of other things, whilst actually commodities are often somewhat insulated of that. There aren't that many sectors that that really benefit from inflation. So all of a sudden then from an investment perspective, investment demand for commodities goes up. The allocation to commodities is still small, and when you put those things together, that explains why in the past and again over the last 12, 18 months, commodities really come into their own in these periods where inflation expectations are picking up and are high, commodities tend to do well in those environments.
Andrew Sheets So another thing about commodities is that you can't ignore is that this is a really diverse set of things. You know, we're talking about everything from, you know, wheat, to coffee, to aluminum, to crude oil. So it's hard to generalize what's driving commodities as a whole, but something I think is quite interesting in your research is that one theme that actually strikes out across a lot of different commodities from aluminum to oil, is the energy transition, which is affecting both demand for certain commodities and the supply of certain commodities. Could you go into that in a little bit more detail how you see the energy transition impacting this space? You know, really over the next decade?
Martijn Rats Yeah, it broadly splits in two andthere are a range of commodities for which the energy transition is basically demand positive. So if you look at a lot of renewable projects, you know, wind power or solar power or hydrogen projects, electric vehicles, all of those types of assets require tremendous demand amounts of, basically of metals, copper, lithium, cobalt, nickel, aluminum. In those areas, it simply demands positive. But then there are other areas where the energy transition creates a lot of uncertainty about the long-term outlook for demand. This is particularly true, of course, for the fossil fuels, for oil and gas. And what is currently going on is that the energy transition is starting to become such a red flag not to invest in new productive capacity in those areas, that it's that it's already weighing on capex, and that there is an element of it constraining the supply of those fossil fuels even before demand is materially impacted. And we're seeing that at play at the moment. Oil and gas demand continues to recover quite strongly coming out of COVID, and there are actually very little signs that demand for those fossil fuels is rolling over anytime soon.But the energy transition makes the demand outlook over the long run into the 2030s very uncertain. And the way that we read the market at the moment is that the demand uncertainty is already impacting investment now. If you don't invest for the 2030s, there's a certain amount of oil and gas you also don't have over the next couple of years. So whether it's through the supply side or through the demand side, our conclusion would be that on the whole the energy transition contributes to the tightness of commodity markets in a relatively broad sense.
Andrew Sheets So Martijn, drilling down a little bit further into the oil story. You know, you and your team have identified what you call a triple deficit in oil markets that would drive a triple digit oil price estimate. You and your team think oil could hit $100 a barrel this year. Nowwhat is that triple deficit and what's driving it?
Martijn Rats The triple deficit refers to the idea or the expectation that three things will be low in the oil markets simultaneously, broadly around the middle of this year as we go into the second half. The first one is inventories, the second one is spare capacity, and a third one is investment levels. Already read last year we have seen very strong draws in global oil inventories. The oil market was under supplied by about two million barrels a day last year, which is historically very high. The way that we model supply demands, that rate of inventory draws that does slow down in 2022, but we end up with inventory draws nonetheless, and we will end 2022 on our balances with inventories that are still lower than at the end of last year. So, the first point low and falling levels of inventory. The second point relates to spare capacity. The world's spare capacity to produce oil in emergency situations when it's needed completely sits within OPEC. There is no spare capacity outside of OPEC now. OPEC is growing production this year, but they're not adding an awful lot of capacity. Our reading of the situation is that by the middle of the year OPEC's spare capacity, which at the moment stands probably somewhere around three and a half million barrels a day, will fall below two million barrels a day. And typically, when spare capacity falls to such low levels, it becomes supportive for prices. So that's the second of the triple deficit that we talk about, low and falling levels of spare capacity. And finally, there is investment. Investment has been on a sliding trend already since 2014, took an enormous nosedive in 2020, did not rebound in 2021, and is only modestly creeping higher this year. Investment levels relative to current consumption we would characterize as very low. And that is not changing anytime soon. So if you add these three things up low inventories, low spare capacity, low levels of investment, you're really looking at the oil market that is very tight. And ultimately, we think that that will support this $100 oil price forecast.
Andrew Sheets So Martijn, the last thing I want to ask you about was this question of geopolitical uncertainty. When I talked to investors, there are some who think that the only reason that the oil price has gone up a lot this year is because of increasing geopolitical tension. There are others who say, no, it's gone up mostly because of the supply and demand imbalance that you just highlightedhow do you how do you as a commodities analyst in your team try to address questions of how much of a driver is fundamental and how much of it is risk premium around event uncertainty?
Martijn Rats It depends a little bit market by market, but in most markets we have price indicators other than simply the spot price of the commodity that will tell us something about the underlying dynamics of the market. In particular, price forward curves tell us a lot, and particularly the slope of the forward curve tells us a lot. So if a market is fundamentally tight, quite often that is associated with downward sloping forward curves. Downward sloping forward curves, incentivize holders of inventory to release commodities from inventory, and the market only creates those structures when extra supply from inventory is needed. So at the moment, particularly in the oil markets, that is exactly that what we're seeing. We're seeing very steeply downward sloping forward curves. And that would be consistent with a scenario in which oil prices simply rise because of the tightness in supply demand, not because of speculative reasons. If you have purely speculative reasons, geopolitical risk building, the price can still rise, but the forward curve would not be so steeply downward sloping. And for that reason, we would be of the school of thought that actually says that particularly the rise in the price of oil recently is not related to geopolitical risk at this stage. Maybe at some point that will become more important, but that is not what's going on. So far, the price of oil is mostly supported by simply the fundamentals of supply and demand.
Martijn Rats That's typically how we go about it, but Andrew perhaps let me ask you. We look at commodities from a pure fundamentals perspective, supply and demand, inventories, those factors, but you often put it in a broader cross asset context. From a cross asset perspective, how do you look at the asset class?
Andrew Sheets So there are two factors here that I think are really important. The first is that I think commodities are really unique in that they are maybe the asset class where buying the index, kind of quote unquote, has actually potentially the most problematic. Some of the broadest, most widely recognized commodity indices have not performed particularly well over time, and some of that's due to the nature of the commodity markets you just highlighted. These markets can be inefficient, they can have structural inefficiencies. That's one thing I think investors should keep in mind is that the performance of commodities relative to some of the indices one might see can be quite different. The second element is around the inflation debate. I think that's really important. As we've discussed on this program before, I'm kind of skeptical that gold will be a particularly good inflation hedge in this environment. Whereas I'm a lot more optimistic that oil can work in that manner that energy related commodities can and I think there are some interesting dynamics there related not just to the to your team's fundamental views, your team has a much more bullish forecast for oil than it does for gold, as well as some of the more quantitative tools that we run that that oil yields a lot more to hold it than gold does, that oil has much better momentum, price momentum, than gold does. And generally speaking, in commodities, investors have been rewarded for going with the momentum. It tends to be a very cycle-based trending asset class. So, you know, I think that the case for commodities overall is strong in our cross asset allocation. We're running a modest overweight to commodities. That was a view we went out with in our 2022 outlook back in November. But you know, these nuances are really important, both between different commodities and then how one implements them going forward.
Andrew Sheets So with that, Martijn, thanks for taking the time to talk.
Martijn Rats My pleasure. Thank you, Andrew.
Andrew Sheets And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Yields on Treasury Inflation-Protected Securities, or TIPS, are set to rise but, beyond inflation, what other factors will drive moves in real yields for these bonds in the coming year?
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, February 3rd at noon in New York.
Last week, I talked about our expectation for the yields on Treasury Inflation-Protected Securities to keep rising. Those bonds are known as TIPS, and their yields are called real yields. Today, I want to tell you about what I think moves real yields up and down, and how the current macro environment influences our view on their next move.
First, let's suppose demand for TIPS increases because investors think inflation is going to rise. If nothing else changes in the market, then TIPS prices will rise and the real yields they offer will fall. But, more often than not, something else changes.
For example, the monetary policies of the Federal Reserve. An important part of the Fed's mandate is to stabilize prices. The Fed has defined this to be an average inflation rate of 2% over time.
So, when inflation is above 2% and on the rise, like today, the Fed's approach to monetary policy becomes more hawkish. That means the Fed is looking to tighten monetary conditions and, more broadly, financial conditions. This tends to put upward pressure on real yields. So, even if inflation is high and rising, the effect of a hawkish Fed tends to dominate.
But what if inflation is rising from a rate below 2%? In this case, the Fed might favor a more dovish policy stance because it wants to encourage inflation to return to its goal from below. Therefore, we would expect downward pressure on real yields.
Another important factor driving inflation is aggregate demand in the economy. When investors expect demand to strengthen, that puts upward pressure on real yields. Said differently, when economic activity accelerates and real GDP is set to grow more quickly, real yields tend to rise.
The opposite also holds true. If investors expect a deceleration in economic activity or, in the worst case, a recession, then real yields tend to fall.
But what do these relationships mean for the direction of real yields in 2022? Bottom line, our economists expect the Fed to be more hawkish this year, tightening monetary policy in light of improved economic growth. Both of these factors should push real yields higher, even as inflation eventually cools later this year.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
The Federal Reserve continues to face a host of uncertainties, leading to volatility in the Treasuries market. This trend may lead some investors to reconsider the municipal bond market.
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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, February 2nd at 10 a.m. in New York.
A couple weeks back, we focused on the tough job ahead for the Federal Reserve. It's grappling with an uncertain inflation outlook driven by unprecedented circumstances, including the trajectory of the pandemic, and the still unanswered questions about whether supply chain bottlenecks and swelling demand by U.S. consumers for goods over services have become a persistent economic challenge. Against that backdrop, it's understandable that keeping open the possibility of continued revisions to monetary policy is part of the Fed's strategy. Not surprisingly, that uncertainty has translated to volatility in the Treasury market and, as expected, some fresh opportunity for bond investors.
For that, we looked in the market for municipal bonds, which are issued by state and local governments, as well as nonprofits. Credit quality is good for munis as the combination of substantial COVID aid to municipal entities and a strong economic recovery have likely locked in credit stability for 2022. But until recently, the price of munis was quite rich, in part reflecting this credit outlook, an expectation of higher taxes that would improve the benefit of munis tax exempt coupon, and a recent track record of low market volatility. But the bond market's reaction to the Fed undermined that last pillar, resulting in muni mutual fund outflows and, as a result, a move lower in relative prices for muni versus other types of bonds.
While this adjustment in valuations doesn't exactly make munis cheap, for individuals in higher tax brackets, they're now looking more reasonably priced. And, as a general rule of thumb, when the fundamentals of an investment remain good, but prices adjust for purely technical reasons, that's a good signal to pay attention.
So what does this mean for investors? Well, that fed driven volatility isn't going away, so munis could certainly still underperform some more from here. But for a certain type of investor, we wouldn't let the perfect be the enemy of the good. If you're in a higher tax bracket and need to replenish the fixed income portion of your portfolio, it could be time to curb your caution and start adding back some muni exposure.
Thanks for listening! If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
The European Central Bank has indicated it would not raise rates this year, but markets are not fully convinced as shifts in inflation, gas prices and labor could force the ECB to reconsider.
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Welcome to Thoughts on the Market. I am Reza Moghadam, Morgan Stanley's chief economic adviser. Along with my colleagues, we bring you a variety of market perspectives. Today I'll be talking about the European Central Bank and whether it is likely to follow the Federal Reserve and the Bank of England in raising interest rates this year. It is Tuesday, February 1st at 2:00 p.m. in London.
The European Central Bank, or the ECB, has long said it would not raise interest rates until it has concluded its bond purchase program. Since the ECB only recently announced that its taper would take at least till the end of this year to complete, this in theory rules out rate increases in 2022. The ECB president, Madame Lagarde, has reiterated that rate increases this year are "highly unlikely."
However, the market is not fully convinced and is pricing some modest rate hikes. Many investors are also concerned that inflation could prove higher and more persistent than the ECB is projecting and could force it to follow the Fed and the Bank of England in tightening policy.
We should start by recognizing that euro area inflation is nowhere near as high as in the United States, and expectations of longer-term inflation are below 2% - unlike in the US. Labor market conditions are easier, with low and stable wage growth.
But even if the case for tightening is not as clear cut, this does not preclude a preemptive move by the ECB. Whether it does so will hinge on the continued viability of the ECB's inflation projections, which see inflation falling below its 2% target by the end of the year.
It is too early to conclude that this inflation path has become too optimistic. Certainly, the second-round effects of recent high inflation outcomes - on wages and long-term inflation expectations - has so far been moderate.
But this could change, and we would keep an eye on three triggers that might force a reconsideration.
First, long-term inflation expectations. If perceptions start to drift up in the face of chronic supply shortages and higher gas prices, the process risks becoming a self-fulfilling prophecy, and un-anchoring inflation expectations. The ECB will want to nip this in the bud.
Second, gas prices have jumped in the face of supply shortages and geopolitical tensions in Ukraine. Normally, the ECB looks through energy prices - not only because they are usually temporary, but also because, even when permanent, they imply a higher price level - not permanently higher inflation. But evidence of energy prices finding their way into long term inflation expectations could force action.
Third, the current benign labor market situation could tighten. In that case, the ECB would want to react before the process goes too far.
So if the ECB decides to tighten policy, what would that look like, and when could we expect it? A faster taper is the most likely vehicle for tightening monetary policy. Still, if inflation proves more resilient than currently projected, rate hikes while tapering cannot be definitively ruled out.
We see limited risk of a policy shift at the ECB meeting later this week. There could be some action in March, but we expect this to be more likely in June, when there will be a fresh forecast and some hard data to base decisions on. So stay tuned.
Thank you for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on Apple Podcasts. It helps more people find the show.
Investing strategies can be categorized into two broad categories: subjective and systematic. While some prefer one over the other, the best outcomes are realized when they are used together.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross-asset strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Monday, January 31st at 2:00 p.m. in London.
There are as many different approaches to investing as there are investors. These can generally be divided into two camps. In one, which I'll call ‘subjective,’ the investor ultimately uses their own judgment and expertise to decide what inputs to look at, and what those inputs mean.
Reasonable people often disagree, what variables matter and what they're telling us, which is why at this very moment you can find plenty of very smart, very experienced investors in complete disagreement over practically any investment debate you can think of.
A lot of the research that myself and my colleagues at Morgan Stanley do fall into this more subjective camp. We're constantly in the process of trying to decide which variables matter and what we think these mean. But there's another approach which I'll call ‘systematic.’ Systematic investing is about writing down very strict rules and then following them over and over again, no matter what, with no leeway. Think of it a bit like computer code, if A happens - I will do B.
The advantage of this systematic approach is that it isn't swayed by fear, or greed, or any other weaknesses in human psychology. The drawbacks are that very strict rules may not be flexible enough to adjust for genuine changes in the economy, in markets, or large, unforeseen shocks like a global pandemic. Think about it this way: Autopilot has been a great technological innovation in commercial aviation, but we all still feel much better knowing that there is a human at the controls that can take over if needed.
I mention all this because alongside our normal subjective research, we also run a systematic approach called our Cross Assets Systematic Trading Strategy, or CAST. CAST looks at what data has historically been most meaningful to market returns, and then makes rule-based recommendations on where that data sits today.
For example, if the key to investing in commodities historically has been favoring those with lower valuations, higher yields, and stronger recent price performance, CAST will look at current commodities and favor those with lower valuations, higher yields, and stronger recent price performance. And it will dislike commodities with the opposite characteristics. CAST then applies this thinking across lots of different asset classes and lots of different characteristics of those asset classes. It looks at equities, currencies, interest rates, credit and, of course, commodities.
At the moment there are a number of areas where our systematic approach CAST and are more subjective strategy work, are in agreement. Both approaches see US assets underperforming those in the rest of the world. Both expect European stocks to outperform European bonds to a large degree. Both see higher energy prices, and both see underperformance in mortgages and investment grade credit spreads.
When thinking about systematic versus subjective investment strategy, there's no right answer. But like our pilot analogy, we think things can work best when human and automated approaches can complement each other and work with each other.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.
Consumer prices reached an all-time high this past December, and a new year brings new challenges across inflation, wage growth and interest rates.
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Ellen Zentner Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research.
Sarah Wolfe And I'm Sarah Wolfe, also on Morgan Stanley's U.S. Economics team.
Ellen Zentner And on this episode of the podcast, we'll be talking about the outlook for consumer spending in the face of inflation, Omicron, rising interest rates and other headwinds. It's Friday, January 28th at 10:00 a.m. in New York.
Ellen Zentner So Sarah, as most listeners have observed since the Fall, inflation is on everyone's mind, with consumer prices reaching a 39-year high in December, and we're forecasting inflation to recede throughout this year from about 7% now down to 2.9% by the fourth quarter. But let's talk about right now.
Ellen Zentner So, you've got your finger on the pulse of the consumer. You're a consumer specialist on the team. And so, I want to ask, how quickly have consumers adjusted their spending over the past few months because of inflation? What evidence have we seen?
Sarah Wolfe The consumer buying power has been very resilient in the face of high inflation. This week we got the fourth quarter GDP data and we saw the real PCE expanded by 3.3%. So that is another very strong quarter for consumer spending. And that brings spending to nearly 8% year over year in 2021, so very elevated. However, we are beginning to see that consumers may be reaching the upper echelon of their price tolerance in December. We got the retail sales report a couple of weeks ago for December, and we saw a very large contraction in consumer spending declined by more than 3%, and the decline was pretty broad based across all categories that have seen very high inflation, and this is largely reflective of goods spending. So, this is a pretty clear signal to us that while Omicron may be weighing on spending, inflation is largely at play here. And we still expect inflation to be peaking in January and February, so we likely will see some deterioration in consumer spending as we enter the first quarter of 2022.
Ellen Zentner How weak could consumer spending be this quarter?
Sarah Wolfe Right now, we just started our tracking for the first quarter of 2022 at 1.5% GDP growth, but within that, we have 1-2% contraction in real PCE. I will note that inflation's high so nominal PCE is still tracking positive, but it's not looking very good as we enter the first quarter.
Ellen Zentner Yeah, it seems clear that inflation is taking a bite. And remind me, we have this great consumer pulse survey that we've been putting out, and I think it was back in November, right? That the people were actually saying, "Look, I'm more worried about inflation than Omicron or than COVID 19". And that's incredible. I mean, that's a pandemic that's been weighing on people's minds and yet inflation usurped.
Sarah Wolfe We're also seeing it in the consumer sentiment surveys. The University of Michigan surveys inflation expectations each month. Near term inflation expectations have reached all-time highs. They're at 4.9%, and we're starting to see longer term expectations also start to tick up. In January, they hit 3.1%, which is a high since 2011. So, it's definitely being felt by consumers and causing a lot of uncertainty among them as well.
Ellen Zentner But now, because we have this forecast that inflation is going to peak in February, which is data we have in hand in March, if we're right on that, can that give us a lot of confidence that at least households can see that there's light at the end of the tunnel and start to breathe a sigh of relief?
Sarah Wolfe Yeah. As you mentioned, there are few headwinds facing the consumer right now. We think most of them are going to recede by the end of the first quarter.
Ellen Zentner Another big change for the consumer versus last year, that you've been writing about is the roll off of government stimulus for a lot of Americans. That had really helped bolster consumer spending, getting us to that big growth rate in 2021 that you mentioned. But now that that's rolling off, what impact might it have on spending this year?
Sarah Wolfe So, the big impact to spending is going to be felt this quarter in the beginning of 2022. And that's for two reasons. The first is that the child tax credits have come to an end. That did not get extended because the Build Back Better plan was not passed in time. and the child tax credits were boosting income for lower, middle-income households by $15B a month. And that included $300-360 payments per child per month. A lot of that was going straight into spending, food, other essential items, school supplies. So, we're going to get a level shift down in income and spending in January alone just because of the expiration. So, the other reason that first quarter is going to be hard for consumers is because a lot of the stimulus came through one year ago in 1Q21. That's when we got the $600 checks per person, then the $1400 checks and then also the supplemental $300 unemployment insurance benefit. So, when you're looking at income and spending year over year, especially for lower middle-income households, this is going to be a tough quarter.
Ellen Zentner All right. So that's a lot of stimulus that came in, not just over 2020, but all the way into early 2021. So, does that mean that they spent all of that money that they got? Because you've been writing a lot about this idea of an excess savings. So, what do you mean by that? How do we define excess savings? Who's holding that excess savings, and can it make its way into the economy?
Sarah Wolfe So, to define what excess savings is, it's basically cumulative savings above the pre-COVID savings trend. And how does that compare to the savings rate? The savings rate is just a monthly snapshot of income and spending, but excess savings is looking at how much is building up over time. And so excess savings, as many have heard this number, was over $2T throughout 2020 and 2021. We have data that shows that some of it was held all the way across the income distribution, but 80% of that was held among the top 20%. And so, a lot of that excess savings is still sitting with the wealthiest people.
Sarah Wolfe What about the excess savings for lower income people? It's a smaller dollar amount, and for that reason, it just does not go as far. We have been dealing with, I mentioned, with six to eight months of high inflation. We've seen consumer spending throughout all of this high inflation. And part of that was likely driven by the drawdown in excess savings for lower income households. And so, when I think about spending for 2022, excess savings is not the main driver.
Ellen Zentner So in this battle that households have with inflation, right? You got excess savings. There's a lot of uncertainty around how and when that might filter into the economy. And so, it seems that in the face of higher inflation then it makes labor income all that much more important. So, when you're looking at income or prices, how do you weigh that tug of war?
Sarah Wolfe So it's OK if prices are going up as long as wages are going up by more. And so, people continue to spend. What we're seeing in the data right now is that, on net, real wages are negative. I mean, we're dealing with 7% inflation. However, and this is very important, real wages for the lowest income group are actually positive. They're the group that's seen the strongest wage growth and it actually is outpacing inflation. I say this is really important because of all we have discussed. The rolling off of fiscal stimulus - this is a group that gets hurt the most by that. Inflation - this is also the group that gets hurt the most by that. When we think about the spending bucket of lower middle-income households, most of their spending goes to essential items like food, energy and shelter. Energy prices alone have increased by over 8% in the last three months.
Sarah Wolfe So, seeing real wage growth is very important, and we expect real wages to enter a positive territory for middle- and higher-income households as well as we enter mid 2022, and inflation comes down to about 4% or so.
Ellen Zentner Yeah, so for those of you not able to see us, Sarah rolls her eyeballs when she says "come down to 4%" because that's still such a high rate of inflation. But it is quite a few percentage points lower than where we've peaked. So, it's really about the direction. Households can start to breathe a sigh of relief that indeed this is not some sort of permanently higher inflation and ultimately just that labor market improvement, remains the most important piece of the consumer spending outlook. Would you agree?
Sarah Wolfe I would agree. Fundamentally, income is what drives spending and a large chunk of income is labor compensation. So as long as we're seeing job gains and wage growth outpacing inflation, we should continue to see spending as we move through a tough first quarter.
Ellen Zentner But importantly, we've got to be right on those inflation forecasts. You know, finally, let me just say a couple of things about the Fed's meeting here. So, we do believe that the Fed has laid the groundwork to start raising rates in March, and so higher interest rates are meant to slow activity and specifically through the credit channel, right? They're going to raise the cost of access to credit this year. But in terms of, sort of what contributes most to, say, downturns when the Fed is tightening is the interest expense on the household balance sheet, right? All that debt we carry, which is a tremendous amount, that interest expense rises. So, should we be worried about household balance sheets in this environment because the Fed is going to be raising rates?
Sarah Wolfe Yeah, I mean, households are carrying over $14T in debt, but things are not as bad as they sound. 70% of household debt is in mortgages and another 10% is in auto debt. And luckily, those are largely locked in at fixed rates. 90% of mortgages are at fixed rates, so that alone is 68% of the household balance sheet.
Sarah Wolfe So, the picture looks better on net for households. Obviously, you need to be a homeowner for it to be in that fixed rate. So, there are non-homeowners that are more susceptible to changing rates. So, people that are holding more credit card debt, that's more lower income people. So that is the group that's going to be the most affected by a raising rates environment.
Ellen Zentner Right. Good point. And so, it's even more important that we keep the labor market strong and wage growth strong for those lower income cohorts.
Ellen Zentner So we've talked a lot about the consumer, Sarah, but I could do this all day long. So, thanks for taking the time today.
Sarah Wolfe It was great talking with you, Ellen. Thanks for having me on.
Ellen Zentner And thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Despite two good years for Treasury Inflation-Protected Securities, or TIPS, a dramatic rise in real yields may be cause for investors to reexamine their potential for 2022.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, January 27th at noon in New York.
Today, I want to talk about the Treasury market, and I want to get real. Yields on Treasury notes and bonds have risen dramatically to start the year, but real yields have risen more. What are "real yields"? Let me start by assuring you that yields on regular Treasury notes and bonds aren't fake. They are very real, but not in the same way as yields on Treasury inflation-protected securities.
Those inflation-protected bonds, known as TIPS, offer investors an inflation-adjusted yield. You can think about an inflation-adjusted yield as having two parts. The first part is a yield without an inflation adjustment. That's what we call the real yield. And the second part is a yield that adjusts for inflation. So, if the rate of inflation is positive, you get more than just the real yield.
Last year, a lot of investors bought TIPS because inflation was high and rising. The news media covered the topic of inflation like never before in my career. So, buying a security that offered inflation protection would have made sense last year. Consumer prices rose 7% over the year, and the TIPS index returned almost 6%. So that investment strategy worked out.
But, did you know that TIPS returned almost 11% in 2020, when consumer prices only rose 1.4%? That's right. TIPS were a much better investment in 2020, when there was less inflation than there was in 2021. How could that be?
Well, remember the real yield that TIPS offer investors? That yield can be a very important contributor to the total return of TIPS. And, at times, it can be even more important than the yield that adjusts for inflation.
Over the past couple of years, the real yields that TIPS have offered investors have been negative. So, imagine if there hadn't been any inflation over these past two years. An investment in TIPS might have been a bad one because investors would have been left with nothing but a negative yielding bond.
Of course, the yield on a bond is just one factor in driving the total return that investors receive. The other is capital gain - or loss. And the change in yields over time drive capital gains or losses. If bond yields fall, bond prices rise and that improves total returns. But if bond yields rise, well, falling prices hurt total returns.
And the same applies to the real yield on TIPS. Rising real yields hurts the total return of TIPS and can do so even during periods of high inflation, like today. The period since last Thanksgiving is a perfect example: inflation continued to surprise to the upside, but the real yield on 10-year maturity TIPS rose by over half a percentage point. As a result, TIPS delivered a negative total return of 3.5% during this period.
This should be a valuable lesson for TIPS investors. TIPS aren't just about inflation protection, although they do offer more inflation protection than most other bonds. TIPS perform best when inflation is high and rising, and real yields are stable or they're falling. We saw that environment in 2020 and through most of 2021.
But things have started to change. We expect real yields to keep rising this year and our economists expect inflation to fall. That means investors should get less yield that adjusts for inflation while having to cope with capital losses from rising real yields. It would be the worst combination for TIPS performance and stand in quite a contrast to the past two years.
So our advice is to stop thinking about TIPS as just protecting against inflation. Instead, investors should think about how TIPS performance could be impacted by higher real yields. And as the Fed raises interest rates this year, real yields should rise and hurt the performance of TIPS.
Thanks for listening. And if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
2022 is likely to bring fresh challenges for the U.S.-China dynamic. Investors can expect an increase in non-tariff barriers and continued commitment to re- and near-shoring of supply chains in the US.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, January 26th at 10:00 a.m. in New York.
While the ongoing situation between the Ukraine and Russia remains an obvious geopolitical risk to pay attention to, we shouldn't lose sight of the ongoing developments in the relationship between the U.S. and China. There's plenty of reason to expect that, in 2022, the two countries’ economic relationship - perhaps the most consequential in the world - will face fresh challenges.
From the US's perspective, there's unfinished business. For example, the 'phase one' trade deal, signed back in January of 2020, expired at the end of 2021, and the results fell short of the agreement. Per data from the Peterson Institute, China only purchased 62% of the manufactured products, 76% of the agricultural products and 47% of the energy products it had committed to. These stats likely won't change the perception of the American voter, where issue polls show a bipartisan consensus that the U.S. relationship with China continues to be a problematic one. And since 2022 is a midterm election year, don't expect U.S. policymakers to stand pat on the issue.
So what can we expect? We've covered before how the U.S. has, and likely will continue, to raise non-tariff barriers with China - things like export controls around sensitive technologies and investment restrictions. These deployments will continue to make for a more challenging environment for U.S. companies seeking easy access to China's markets, either to sell or produce goods.
But one thing you can also expect is fresh legislative action to invest in the US's capabilities in key industries and supply chains that have been declared essential for economic and national security purposes. For example, news broke this week that the U.S. House of Representatives was starting its work to advance the U.S. Innovation and Competition Act, or USICA. The bill passed the Senate last year with substantial bipartisan support and would spend over $200B on research in artificial intelligence, quantum computing and biotechnology, in addition to cultivating local supply chain sources for key tech needs, like rare earths.
This dynamic underscores a trend we've been focused on for many years. The slow but steady re and near shoring of supply chains for U.S. companies. It's a key reason our colleagues in equity research continue to see an opportunity in the capital goods sector, calling for a 'generational capex cycle over the next several years, driven by supply chain investment'.
So stay tuned. We'll keep tracking this trend and keep you informed.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
With inflation on the minds of consumers and the Fed reacting with a sharp turn towards tightening, 2022 may be a year for investors to focus on incorporating tax-efficient strategies into their portfolios. Morgan Stanley Wealth Management’s Chief Investment Officer Lisa Shalett and Chief Cross-Asset Strategist Andrew Sheets discuss.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be discussing the importance of tax efficiency as a pillar of portfolio construction. It's Tuesday, January 25th at three p.m. in London.
Lisa Shalett And it's 10:00 a.m. here in New York.
Andrew Sheets Lisa, welcome back to the podcast! Now, as members of Morgan Stanley Wealth Management's Global Investment Committee, we both agree that the current portfolio construction backdrop is increasingly complicated and constrained. But tax considerations are also important, and this is something you and your team have written a lot on recently. So I'd really like to talk to you about both of these issues, both the challenges of portfolio construction and some of the unique considerations around tax that can really make a difference to the bottom line of investment returns. So Lisa, let's start with that current environment. Can you highlight why we believe that standard stock bond portfolios face a number of challenges going forward?
Lisa Shalett We've been through an extraordinary period over the last 13 years where both stocks and bonds have benefited profoundly from Federal Reserve policy, just to put it bluntly, and, you know, the direction of overall interest rates. And so, our observation has been that, you know, over the last 13 years, U.S. stocks have compounded at close to 15% per year, U.S. bonds have compounded at 9% per year. Both of those are well above long run averages. And so we're now at a point where both stocks and bonds are quite expensive. They are both correlated to each other, and they are both correlated to a large extent with Federal Reserve policy. And as we know, Federal Reserve policy by dint of what appears to be inflation that is not as transitory as the Fed originally thought is causing the Fed to have to accelerate their shift in policy. And I think, as we noted over the last three to six weeks, you know, the Fed's position has gone from, you know, we're going to taper and have three hikes to we're going to taper be done by March. We may have as many as four or five hikes and we're going to consider a balance sheet runoff. That's an awful lot for both stocks and bonds to digest at the same time, especially when they're correlated with one another.
Andrew Sheets And Lisa, you know, if I can just dive into this a little bit more, how do you think about portfolio diversification in that environment you just described, where both stocks and bonds seem increasingly linked to a single common factor, this this direction of Federal Reserve policy?
Lisa Shalett One of the things that we've been emphasizing is to take a step back and to recognize that diversification can happen beyond the simple passive betas of stocks and bonds, which we would, you know, typically represent by, you know, exposures to things like the S&P 500 or a Barclays aggregate. And so what we're saying is, within stocks, you've got to really make an effort to move away from the indexes to higher active managers who tend to take a diversified approach by sector, by style, by market cap. And within fixed income, you know, we're encouraging, clients to hire what we've described as non-core managers. These are managers who may have the ability to navigate the yield curve and navigate the credit environment by using, perhaps what are nontraditional type products. They may employ strategies that include things like preferred shares or covered call strategies, or own asset backed securities. These are all more esoteric instruments that that hiring a manager can give our clients sources of income. And last, you know, we're obviously thinking about generating income and diversification using real assets and alternatives as well.
Andrew Sheets And so, Lisa, one other thing you know, related to that portfolio construction challenge, I also just want to ask you about was how you think about inflation protection. I mean, obviously, I think a lot of investors are trying to achieve the highest return relative to the overall level of prices relative to inflation. You know, how do you think from a portfolio context, investors can try to add some inflation protection here in a smart, you know, intelligent way?
Lisa Shalett So you know what we've tried to say is let's take a step back and think about, you know, our forecast for, you know, whether inflation is going to accelerate from here or decelerate. And you know, I think our position has broadly been that that we do think we're probably at a rate of change turning point for inflation, that we're not headed for a 1970s style level of inflation and that, you know, current readings are probably, you know, closer to peak than not and that we're probably going to mean revert to something closer to the, you know, two and a half to three and a half percent range sooner rather than later. And so in the short term, you know, we've tried to take an approach that says, not only do you want to think about real assets, these are things like real estate, like commodities like gold, like energy infrastructure linked assets that have historically provided some protection to inflation but really go back to those tried and true quality oriented stocks where there is pricing power. Because, you know, 2.5-3.5% Inflation is the type of inflation environment where companies who do have very strong brands who do have very moored competitive positions tend to be able to navigate, you know, better than others and pass some of that the cost increases on to consumers.
Andrew Sheets So, Lisa, that takes me to the next thing I want to talk to you about. You know, investors also care about their return after the effects of tax, and the effects of tax can be quite complex and quite varied. So, you know, as you think about that challenge from a portfolio construction standpoint, why do you think it's critical that investors incorporate tax efficient investing strategies into their portfolios?
Lisa Shalett Well, look, you know, managing, tax and what we call tax drag is always important. And the reason is it's that invisible levy, if you will, on performance. Most of our clients are savvy enough to suss out, you know, the fees that they're paying and understand how the returns are, you know, gross returns are diluted by high fees. But what is less obvious is that some of the investment structures that clients routinely use-- things like mutual funds, things like limited partnership stakes-- very often in both public and private settings, are highly tax inefficient where, you know, taxable gain pass throughs are highly unpredictable, and clients tend to get hit with them. And so that's, you know, part of what we try to do year in, year out is be attentive to making sure that the clients are in tax efficient strategies. That having been said, what we also want to do is minimize tax drag over time. But in a year like 2022, where you know, we're potentially looking at low single digit or even negative returns for some of these asset classes, saving money in taxes can make the difference between, you know, an account that that is at a loss for the full year or at a gain. So there's work to be done. There's this unique window of opportunity right now in the beginning of 2022 to do it. And happily, we have, you know, some of these tools to speed the implementation of that type of an approach.
Andrew Sheets So Lisa, let's wrap this up with how investors can implement this advice with their investments. You know, what strategies could they consider? And I'm also just wondering, you know, if there's any way to just kind of put some numbers around, you know, what are kind of the upper limits of how much these kind of tax drags, you know, can have on performance?
Lisa Shalett Yeah. So that's a great question. So over time, through the studies that we've done, we believe that tax optimization in any given year can add, you know, somewhere between 200 and 300 full basis points to portfolio performance, literally by reducing that tax bill through intelligent tax loss harvesting, intelligent product selection, you know, choosing products that are more tax efficient, et cetera.
Andrew Sheets Well, Lisa, I think that's a great place to end it. Thanks for taking the time to talk. We hope to have you back soon.
Lisa Shalett Absolutely, Andrew. Happy New Year!
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
All eyes are on the Fed as they implement a sharp pivot to account for higher inflation being felt by consumers and businesses alike. With these shifts we turn our attention to the ‘Ice’ portion of our ‘Fire & Ice’ narrative: slowing growth.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 24th at 11:30 a.m. in New York. So let's get after it.
Investors have recently become fixated on the Fed's every move. That makes sense, with the Fed pivoting so aggressively on policy over the past few months. It also fits nicely with the first part of our well-established "Fire and Ice" narrative and our view that equity valuations are vulnerable. The reason for the Fed's sharp pivot is obvious, as inflation has overshot its goals - leading to problems for the real economy, not to mention the White House. When the Fed first announced its inflation targeting policy in the summer of 2020, it was appropriate given the deflationary effects of the pandemic. Therefore, it's now just as appropriate for the Fed to tighten at an accelerated pace to fight the inflation overshoot. However, this is a big change for a Fed that has been fighting the risk of deflation for 20+ years, and it has market implications.
Importantly, consumers are truly starting to feel the impacts of inflation, with the University of Michigan Confidence Survey currently at levels typically observed only in recessions. Small businesses are also feeling the pain, as demonstrated by their difficulty finding employees and the prices that they are paying for supply and logistics. In short, the Fed is serious about fighting inflation, and it's unlikely they will be turning dovish anytime soon, given the seriousness of these economic threats and the political cover to take action.
The good news is that markets have been digesting this tightening for months. Despite the fact that major U.S. large cap equity indices are only down 10-15% from their highs, the damage under the surface has been much worse for many individual stocks. Expensive, unprofitable companies are down 30-50%. This is appropriate, in our view, not just because the Fed is pivoting, but because these kinds of valuations don't make sense in any kind of investment environment. In short, the froth is coming out of an equity market that simply got too extended on valuation - the key part of our 2022 outlook published in November.
But attention should now turn to the Ice part of our narrative - slowing growth. As we've been writing for months, we view the current deceleration in growth as more about the natural ebbing of the cycle than the latest variant of COVID. In fact, there are reasons to believe that we are closer to the end than the beginning of this pandemic. However, that also means the end of extraordinary stimulus, both monetary and fiscal. It also means looser supply chains as restrictions ease and people fully return back to work. Better supply is good for fighting inflation, but it may also reveal the degree to which demand has been supported and overstated by double ordering.
This would fit nicely with the 1940s analogy that we have also detailed in our 2022 outlook. In brief, the end of the Second World War freed pent up savings and unleashed demand into an economy unable to supply it. Double digit inflation ensued, which led to the first Fed rate hike in over a decade and the beginning of the end of financial repression. Sound familiar? Shortly thereafter, inflation plummeted as demand normalized, but the Fed never returned to the zero bound on interest rates. Instead, we began a new era of shorter booms and busts as the world adjusted to the higher levels of demand, as well as cost of capital and labor.
The end of secular stagnation and financial repression has arrived, in our view, but it won't be a smooth ride. In the near term, hunker down for a few more months of winter as slowing growth overtakes the Fed as the primary concern for markets. In such a world, we continue to favor value over growth, but with a defensive rather than cyclical bias.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Higher levels of inflation have made it a hot topic among investors. While inflation’s effects cannot be avoided completely, there are some strategies that can help protect against the worst of them.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, January 21st at 2:00 p.m. in London.
One question we get a lot at the moment is “how can I protect my investments against inflation?”. While Morgan Stanley's economists do expect inflation to moderate this year - actually starting this quarter - the high current readings on inflation have made it a hot topic.
One of the biggest investing challenges with inflation is that when it's truly high and persistent - the kind of inflation that we saw in, say, the 1970s - it's simply bad for everything. That decade saw stocks, bonds and real estate all perform poorly. There was simply nowhere to hide. Still, investors do look at specific strategies to try to hedge inflation. Unfortunately, some of these, we think, have challenges.
One place that investors look to protect against the effects of inflation is precious metals, like gold. But while gold has a very impressive track record of maintaining value throughout thousands of years of human history, its day to day and month to month relationship with inflation is kind of shaky. Gold can actually do worse when interest rates rise because gold, which doesn't provide any income, starts to look worse relative to bonds, which do. And note that over the last six months, when inflation has been elevated, gold hasn't performed particularly well.
Another popular strategy is owning treasury inflation protected securities, or TIPS, which have a payout linked to inflation. I mean, the inflation protection is in the name. Yet if you look at the actual performance of these securities, that inflation protection isn't always so simple. TIPS performed well in 2020, a year when inflation was low, and they performed poorly in 2018 and over the last three months, when inflation was higher. The reason for this is that TIPS are also sensitive to the overall level of interest rates - and if those are going up, they can see their performance suffer.
These two examples are part of the reason that, when we think about protecting portfolios against elevated inflation, what we're often trying to do is to avoid sensitivity to real interest rates, which, at the moment, we think will continue to rise. We think this favors keeping lighter exposure overall, favoring energy over metals and commodities, favoring stocks in Europe and Japan over those in the U.S. and emerging markets, and being underweight real interest rates directly in government bonds.
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The foundation for the housing market remains healthy in 2022, with responsible lending standards and a tight supply environment, but, as the year continues, affordability challenges and a more hawkish Fed will likely slow appreciation and dampen housing activity.
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James Egan Welcome to Thoughts on the Market. I'm James Egan, co-head of U.S. Securitized Products Research here at Morgan Stanley,
Jay Bacow And I'm Jay Bacow, the other co-head of U.S. Securitized Products Research.
James Egan And on this edition of the podcast, we'll be talking about the 2022 outlook for the U.S. housing market. It's Thursday, January 20th at 10:00 a.m. in New York.
James Egan All right, Jay. Now, since we published the outlook for 2022, the market has already priced in a much more hawkish Fed and Fed board members really haven't been pushing back. We've now priced in 100 basis points of hikes in 2022 in addition to quantitative tightening. How does this change how you're thinking about the mortgage market?
Jay Bacow When we went into the year, we thought that mortgage spreads looked pretty tight and thought they were going to go wider, and that was in a world where we just thought the Fed was going to be tapering and stop buying mortgages, but still reinvesting. Now that they're pricing in that the Fed is going to be hiking rates and normalizing their balance sheet, mortgage spreads have widened about 20 basis points this year, but we think they have further room to go. This is because a normalizing Fed is going to mean that the supply to the market in conjunction with the net issuance is going to be the highest that the private market has ever had to digest. So, we think that could push spreads about 10 or 15 basis points wider, which is going to weigh on mortgage rates, but mortgage rates have already been going up. They are about 3/8 of a point higher just over the last month. And when we forecast mortgage spreads and interest rates to go higher over the next year, we think this could end up with about a full point rise in mortgage rates this year.
Jay Bacow So, Jim, a point move higher in mortgage rates. What does that do to affordability?
James Egan The short answer is they don't help affordability. For people who've been listening to our podcast before, affordability largely has three main components: home prices, mortgage rates and incomes. And so, if we're talking about mortgage rates, a full 100 basis points higher, that's going to be bad for affordability. But look, this just reinforces what we're thinking about affordability with respect to the housing market as we look ahead to 2022. In our outlook, we described affordability as the chief headwind to home prices and housing activity this year. Looking back to the end of 2021, home prices were climbing at a record pace of growth. And one of the good things about this climb is we think it's been healthier than the prior times that HPA even approached these levels. We got to almost 20% year over year growth because of the fact that we had an historically tight supply environment, and we had a lot of demand, and that demand was not being stimulated by easing lending standards. Lending standards themselves remained very responsible.
James Egan But just because the foundation of the housing market today is healthy, and we believe it is, that doesn't mean it can't be too expensive. As home prices were climbing, mortgage rates continued to fall to record lows, and that really acted as a release valve with respect to affordability in the market. That release valve has already been turned off. Mortgage rates climbed throughout 2021. We expected them to climb in 2022. Yes, we now see them climbing faster than we anticipated, but that release Valve, as I mentioned, was already turned off. Affordability was already a substantial headwind in our call.
Jay Bacow All right, Jim. So, we've talked about affordability. Can you remind us where do home prices currently stand? Haven't they started to come down a little bit?
James Egan Yes. Home prices have been slowing for two months now. And it's becoming more pervasive geographically.
James Egan As recently as July, 100 of the top 100 metro areas in the country, were not only seeing home prices grow year over year, but that pace of growth was accelerating. Five months later, the most recent data we have there is November, it's fallen from 100 out of 100 to 38 out of 100 metro areas, still seeing acceleration. The other 62? They're still climbing. But the pace of that growth has slowed.
Jay Bacow All right, so home price growth is slowing. Does this mean that it just continues to slow and home prices actually go negative this year?
James Egan We do think that home price growth will continue to slow, but we definitively think it will remain positive. We do not see home price growth going negative on a year over year basis. One of the biggest reasons there: healthy lending standards that we mentioned earlier. That kind of responsible underwriting we think keeps distressed transactions, so delinquencies - really foreclosures. It keeps those distressed transactions limited, and you really need an increase in the concentration of distressed transactions to see home price growth turn negative, or to see home prices turn negative.
James Egan One of the other things we talked about affordability that we do think is playing a role in the housing market is supply. The supply market is at historical tights right now. That contributes to the healthy foundation that we see the housing market sitting on. We do think we are going to start to see a supply increase on the margins next year. Existing inventories continue to fall, but new inventories have been up over 30% year over year each of the past four months. While single unit starts might not be climbing at the same pace today as they were early in 2021, if we look at the number of single unit homes under construction today, that's surpassed the number of multi-unit homes under construction for the first time since 2013. We do think that will mean more supply coming on the market next year.
James Egan The overall environment will be tight. But we will no longer be able to say historically tight. We will see positive year over year changes. That also weighs on the pace of home price growth, which is why we see it slowing to 5% by 2022.
Jay Bacow OK, but Jim, you talked about supply and how that's been picking up recently, but that was based off of a period when mortgage rates are lower than they are today. What is this forecasted rise in mortgage rates mean for your expectations for housing activity going forward for the rest of 2022?
James Egan So I think there's a few ways that this rise in mortgage rates can impact housing activity. The I think most straightforward way to think about it is on the affordability spectrum that we've been talking about. It's going to make the carrying cost, the debt service of housing those mortgage payments more expensive for households. And that affordability problem is going to weigh on purchase decisions that, as I mentioned earlier, reinforces what we were already thinking about the housing market this year. It also contributes to a lock in effect - borrowers that have homes at lower mortgage rates, it now increases their opportunity costs to move. They'd have to take on a larger mortgage if they were to move their home, and so it weighs on supply as well.
James Egan We see it leading to a decrease in existing home sales. So home prices will slow, but they'll remain positive. We do think that home sales are going to fall. Throughout the totality of 2022 we see existing home sales coming in about 5% below where they'll finish 2021.
Jay Bacow All right. So basically, a more hawkish Fed has meant that mortgage spreads have widened out and mortgage rates are heading higher. This has led to reduced affordability, which is also going to cause a bit of a slowdown in home sale activity and a slowdown in home price appreciation. But home prices will still near higher than where they are now. I got that right?
James Egan Absolutely.
James Egan Jay, thanks for taking the time to chat.
Jay Bacow Always a pleasure, Jim.
James Egan As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
In 2021, many expected the US dollar to face significant challenges yet the year ended with strong levels coming off a mid-year rally. As we look out at 2022, how much more can the dollar rise and where do other currency opportunities lie?
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Welcome to Thoughts on the Market. I'm James Lord, Global Head of Foreign Exchange and Emerging Market Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for the US dollar and global currency markets. It's Wednesday, January 19th at 2:00 p.m. in London.
This time last year, many strategists on Wall Street were expecting 2021 to turn out badly for the US dollar. But as we now know, the dollar ended the year much differently. The dollar troughed on January 6th, spent the first half of the year moving sideways, then began a pretty strong rally mid-year and finished the year around the strongest levels since July of 2020. And the question we've all been asking ourselves recently is - how much more can the dollar rise in 2022?
Well, this year, most analysts and investors expect the dollar to continue to rise. But if last year's track record of prediction is anything to go by, this probably means that the dollar could instead head lower over the next 12 months. Our team at Morgan Stanley believes that the US dollar could be close to peaking. In fact, we've just changed our dollar call to neutral, which means we think it will just go sideways from here - after being bullish the dollar since June last year.
Here's why: the Federal Reserve has indicated it may be close to raising interest rates, and we think that the Fed starting an interest rate hiking cycle could be a signal that the dollar's rise is close to finished. This may seem counterintuitive, since rising interest rates tend to strengthen currencies. But the US dollar has actually already gone up on the back of rising interest rates. A year ago, the market wasn't expecting any rate hikes for the year ahead. Now, the market is expecting nearly four hikes and for lift off to potentially begin as soon as March.
If we look back at the last five cycles where the Fed has hiked interest rates, we can see the same pattern every time. The US dollar tends to rise in the months before liftoff, but fall in the months afterwards. This is a great example of buying the rumor and selling the fact.
And if the market is right and the Fed hikes rates as soon as March, the peak of the US dollar for this cycle may not be too far away.
We also need to remember that the dollar doesn't stand in isolation. Currencies are always a relative game and are valued against the currencies of other economies. Because of that, what happens in other parts of the world also affects the value of the US dollar. And what we've seen recently is that other central banks are also starting to think about tightening policy and raising interest rates, which will, to some extent, offset Fed hikes - reducing their impact on the dollar.
We think this may be a good time for investors to start to reduce their dollar long positions, not add to them.
What does the future hold for emerging market currencies? The consensus view is very negative on emerging markets, and that is the polar opposite of this time last year when everybody loved them. Like last year, though, we suspect the consensus view will probably be wrong by the time we close the year. Valuations on emerging market currencies and local currency bonds are cheap. If inflation peaks over the next few months, as Morgan Stanley economists expect, then investors may well take another look at emerging market bonds and any inflows would strengthen their currencies.
Bottom line: the dollar has probably peaked for the year, but the future for emerging market currencies is brighter than most people think. As ever, the trick is in the timing. Stay tuned.
Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
While our outlook for 2022 already called for a hawkish Fed, recent signals from the central bank of more aggressive tightening have given cause to reexamine some of our calls while remaining steadfast in key aspects of our narrative for the year.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, January 18th at 11:30 a.m. in New York. So, let's get after it.
Last week, our economics team adjusted its forecast on Fed policy, given the more hawkish tone in the most recent Fed minutes and commentary from Chair Powell and other governors. We now expect the Fed to fully exit its asset purchase program known as quantitative easing by April. We also expect the Fed to increase rates by 25 basis points 4 times this year and begin balance sheet normalization by July. That's a lot of tightening, and fits with our general outlook for 2022 that we published back in November. To recall, our Fire and Ice narrative assumed the Fed was behind the curve and would need to catch up in a hurry, given the dramatic move in inflation that we've experienced during this pandemic. Public outcry and consumer confidence measures suggest inflation is the number one concern right now - making this a political issue as much as an economic one. Expect the Fed to keep pushing until financial conditions tighten.
What that means for equity markets is that valuations should come down this year via a combination of higher long term interest rates and higher equity risk premiums. The changes to our Fed forecast simply mean it's likely to happen faster now, making the hand-off between lower valuations and higher earnings more challenging. This is the classic finishing move to the mid-cycle transition we've been anticipating for months, and it appears we've finally arrived.
Our outlook for 2022 incorporated a fairly hawkish Fed, and while that hawkishness has increased since we published in mid-November, it doesn't change our year-end targets, which are already well below the consensus. Specifically, our base case year-end target for the S&P 500 is 4400. This compares to the median forecast of approximately 4900. Our target assumes a meaningfully lower Price Earnings multiple of 18x the forward 12-month earnings. This would be a 15% drop from the current Price Earnings multiple of 21x. Our EPS forecast is largely in line with consensus. In short, our view differs with consensus mainly on valuation rather than growth.
The faster ending to QE and more aggressive rate hikes simply brings this valuation risk forward to the first half of the year. Furthermore, given the Fed's new guidance it will try to shrink its balance sheet, means valuations could even overshoot to the downside of what we think is fair value. Bottom line, the bringing forward of tapering and rate hikes is likely to lead to a 10-20% correction in the first half of this year for the S&P 500, in our view.
The good news is that markets have been adjusting for months to this new reality, with 40% of the Nasdaq having corrected by 50% or more. As we've noted many times, the breadth of the market remains poor as it goes through the classic rolling correction under the surface as the index grinds higher. This phenomenon is largely due to the relentless inflows from retail investors into equities. On one hand, this rotation from bonds to stocks by asset owners makes perfect sense in a world of rising prices. After all, stocks are a decent hedge against inflation, unlike bonds. However, certain stocks fit that billing better than others. In its simplest form, it means value over growth stocks or short duration over long - think dividend growth stocks. In addition, we would favor defensively oriented value stocks relative to cyclicals, given our view growth may slow a bit more in the near term before re-accelerating in the second half. Bottom line, don't fight the Fed and be patient with new capital deployments until later this Spring.
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After two years of support and accommodation from the Fed, 2022 is seeing a shift in tone towards the strength of the economy and risks of inflation, meaning investors may need to reassess expectations for the year.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, January 14th at 2:00 p.m. in London.
Sometimes in investing, if you're lucky, you make a forecast that holds up for a long time. Other times, the facts change, and your assumptions need to change with them. We've just made some significant shifts to our assumptions for what the Federal Reserve will do this year. I want to discuss these new expectations and how we got there.
The U.S. Federal Reserve influences interest rates through two main policy tools. First, it sets a target rate of interest for very short-term borrowing, which influences a lot of other interest rates. And second, it can buy government bonds and mortgages directly - influencing the rate that these bonds offer.
When COVID struck, the Federal Reserve pulled hard on both of these levers, cutting its target interest rate to its lowest ever level of zero and buying trillions of government bonds and mortgages to support these markets.
But now, almost two years removed from those actions, the tone from the Fed is changing, and quickly. For much of 2021, its message focused on erring on the side of caution and continuing to provide extraordinary support, even as the U.S. economy was clearly recovering.
But now, that improvement is clear. The U.S. unemployment rate has fallen all the way to 3.9%, lower than where it was in January of 2018. The number of Americans claiming unemployment benefits is the lowest since 1973. And meanwhile, inflation has been elevated - with the U.S. consumer prices up 7% over the last year.
All of this helps explain the sharp shift we've seen recently in the Fed's tone, which is now focusing much more on the strength of the economy, the risks of inflation and the need to dial back some of its policy support. It's this change of rhetoric, as well as that underlying data that's driven our economists to change their forecasts for the Federal Reserve.
We now expect the Fed to raise interest rates 4 times this year, by a total of 1%. Just as important, we think they not only stop buying bonds in March, but start reducing their bond holdings later in the year - moving from quantitative easing, or QE, to so-called quantitative tightening, or QT. The result should help push U.S. 10-year yields higher up to 2.2%, in our view, by the middle of the year.
For markets, we think this should continue to drive a bumpy first quarter for U.S. and emerging market assets. We think European stocks and financial stocks, which are both less sensitive to changes in interest rates, should outperform.
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Confirmation hearings for Fed Chair Powell’s second term highlighted the challenges for the year ahead. Inflation concerns fueled by high demand and disrupted supply chains, a tight labor market and the trajectory of the ongoing pandemic will make guessing the Fed’s next moves difficult in 2022.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Thursday, January 13th at 10:00 a.m. in New York.
A key focus in D.C. this week is the Senate confirmation hearings for Fed Chair Jay Powell, who's been nominated for another term at the helm of the Federal Reserve. Whenever the Fed chair speaks, it's must-see TV for bond investors. And this remains as true as ever this week.
See, the Fed has a really tough job ahead of them. The economy is humming, and it's nearing time to tighten monetary policy and rein in inflation. We know from their most recent meeting minutes that the Fed sees it this way. But how quickly to do it, and by what method to do it, well, that's more up for debate. That's because, in fairness to the Fed, there's no real template for the challenge that's ahead of them. The pandemic and the economic recovery from it have presented an unusual and hard to gauge set of inputs to monetary policy decision making. Take inflation, for example. There's no shortage of potential overlapping causes for the currently high inflation reads: supply chain bottlenecks; an unprecedented rapid rebound in demand for goods, both in absolute terms and relative to services; a sluggish labor force participation rate; and, influencing each of these variables, the trajectory of a global pandemic. The Fed's job, of course, is to assess to what degree these factors are temporary or enduring, and calibrate monetary policy accordingly to bring inflation to target. But to state the obvious, this is complicated.
So it's not surprising that the recent Fed minutes showed they're considering a wide range of monetary tightening options. A lot is on the table around the number of rate hikes, pace of rate hikes and pace of balance sheet normalization. We expect Chair Powell will be further underscoring this desire for optionality in monetary policy in his forthcoming statements.
Of course, another phrase for optionality might be policy uncertainty, and this is exactly the point we think bond investors should focus on. Precisely guessing the Fed's every move is likely less important than understanding the Fed has, and can continue, to change its approach to monetary tightening as it collects more data and better understands the current inflation dynamic. This is the genesis of the recent uptick in bond market volatility, which we expect will be an enduring feature of 2022.
But volatility can mean opportunity, particularly for credit investors, in our view. Corporate and municipal bond credit quality is very strong, but both markets have a history of underperforming during moments of Treasury market volatility. That's why my colleagues and I are recommending for both asset classes to start the year with portfolios positioned cautiously, allowing you to take advantage of better valuations when they present themselves. In this way, like the Fed, you too will have options to deal with uncertainty.
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As the acute bottlenecks in supply chains resolve in the long-term, some structural issues may remain, creating both opportunities and challenges for policymakers, industry leaders, and investors.
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas, head of public policy research and municipal strategy for Morgan Stanley.
Daniel Blake And I'm Daniel Blake, equity strategist covering Asia and emerging markets.
Michael Zezas And on part two of this special edition of the podcast. We'll be assessing the long term restructuring of global supply chains and how this transition may impact investors. It's Wednesday, January 12th at 9 a.m. in New York.
Daniel Blake And it's 10:00 p.m. in Hong Kong.
Michael Zezas So, Daniel, we discussed the short and medium term for supply chains, but as we broaden out our horizon, which challenges are temporary and which are more structural?
Daniel Blake We do think there are structural challenges that are emerging and have been present for some time, but have been exacerbated by the COVID pandemic and by this surge in demand that we're seeing and a panic about ordering. So we are seeing them most acute in areas of transportation where we don't expect a return to pre-COVID levels of freight rates or indeed lead times. We also see more acute pressures persisting in parts of the leading edge supply chain in semiconductors, as well as in areas of restructuring around decarbonization, for example, in EV materials and the battery supply chain. But more temporary areas are those that have been subject to short-term production shortfalls and areas where we are seeing demand that has been pulled forward in some regards and where we are also seeing the channel being restocked in areas that were not necessarily production disrupted. And so this in the tech space, for example, is more acute in some consumer electronics categories as opposed to autos, where we do have very lean inventory positions and it will take longer to rebuild.
Daniel Blake But in the short run, we do think what will be important to watch will be the development of new COVID variants and the responses from policymakers and public health officials to those and the extent to which production and distribution can be managed in the context of those challenges. So really, I think a lot comes back to the public policy decision. So what are you seeing and tracking most closely from here?
Michael Zezas Yeah, I think it's important to focus on the choices made by policymakers globally. You and I have talked about and reported on this concept of a multi-polar world. This idea that there are multiple economic power poles and that each of them might be pursuing somewhat different strategies when it comes to trade rules, tech standards, supply chain standards, et cetera. So I think the US-China dynamic is a great example of this. Obviously, over the last several years, the U.S. and China have shifted to a model where they define for themselves what they think is in their best economic and national security interest and in order to promote those interests, adopt a set of policies that are both defensive and offensive. So with the U.S., for example, there were tariff increases in 2018 and 2019. Since then, they have mostly shifted to raising non-tariff barriers like export restriction controls and increasingly over the last year have also been pivoting towards offensive tactics. So promoting legislation to invest in reshoring like the US ICA. So what this means then is that companies that had been benefiting from globalization and access to end markets and production processes in the U.S. and China now may need to recalibrate and take on new costs when they're transitioning their value chain for these conditions of kind of new barriers, new frictions in commerce between the U.S. and China.
Daniel Blake And take us through the corporate perspective. What are you seeing and how should we think about the corporate response to these supply chain challenges?
Michael Zezas A conceptual framework we laid out was to put different types of corporate sectors into categories based on how much their production processes or end markets were subject to increasing trade and transportation friction and or subject to labor shortages. And we came up with four different categories using these two axes. The first category is bottlenecks, where you have tight labor conditions and increasing trade and transportation friction, leaves these industries little choice but to pass through higher costs. Reshorers is another category where you're potentially facing further production cost hikes from trade and transportation friction but these firms are increasingly interested in domestic investment that can steady their supply chain challenges. There's also global diversifiers where trade and transportation frictions may be steady, but labor scarcity and disruption risk creates margin pressure. So that pushes sectors like these to invest in geographical supply chain diversification so they can access new labor pools and automation technology that increases their productivity. And the last category is new globalizers. So this is a relatively capital intensive industry or an industry that's able to source labor globally, given limited impact from trade and transportation frictions. It really means that these business models might be able to pursue the status quo and not have to change much at all.
Michael Zezas So, Daniel, do you have some examples of industries that might fit into these categories and how that might presents either an opportunity or a challenge for investors?
Daniel Blake We have looked at this at the sector and company level for major companies impacted by this theme of supply chain restructuring. And what I would highlight is that semiconductors are the classic bottleneck industries. They have been the acute choke points in the global economy. They have seen rising pricing power. They have seen a significant investment going in, and that has been benefiting the semiconductor capital equipment names. In terms of the reshorers, we think naturally to the US capital goods cycle. And here, our analysts has highlighted more vertical integration and really securing more of the parts supply chain, really a shortening of supply chains that is a response to these supply chain uncertainties that have emerged. And then on global diversifier, this category here, we think, is quite relevant to a lot of the tech hardware space. So semiconductors is more higher tech and more capital intensive. And in contrast, the tech hardware space tends to be more associated with assembly, distribution, marketing. And here we do think that there is potential for more diversification to broaden out exposure across supply chains and labor pools going forward. And finally, on new globalizers, overall, the key categories we have looked at in this report, we didn't see falling into this bucket. But we do think there are sectors that will continue to be new globalizers, and we see them more in the consumer and services oriented spaces of the of the global economy.
Michael Zezas So our framework represents a view of how things will settle globally over the medium to long term in a bit of a mixed picture where some sectors benefit, others have to transition through higher costs. But are there alternative cases, Daniel, where things could be better for the global economy or worse for the global economy than is envisioned in this framework we laid out?
Daniel Blake If we turn to the bull case for the global economy, what we're really looking at is a scenario where demand remains manageable and supported. But we're seeing additional supply come through and an easing of supply chain tensions. So there we would look first to the demand side of the equation, given supply takes longer to ramp up. And for us, a bull case would see a recovery of consumption skewed towards services spending that has been held back by the pandemic, and that helps keep the jobs and earnings recovery moving. But it eases some of the stress on the goods supply chain that may also be alleviated by the acute bottlenecks that we talk about in our base case, resolving and taking some more anxiety out of purchasing managers equation into 2022. In contrast, the bear case is quite clear the acute risk at this point is around new COVID variants, the impact on production and transport, as we saw just recently. So the potential for a rerun of these restrictions is very much in front of us as we're seeing selective lockdowns at time of recording starting to come through in some cities in China. At this point not impacting production materially but that is something we are watching closely. And that means we do think there is potential for demand destruction. The policy response may not be as forthcoming with the scale of stimulus that we saw through 2020 and 2021.
Michael Zezas Daniel, thanks for taking the time to talk.
Daniel Blake Great speaking with you, Michael.
Michael Zezas And thanks for listening. If you enjoy Thoughts on the Market, please be sure to rate and review us on the Apple Podcasts app. It helps more people find the show.
Supply chain delays are on the minds of not only investors, policymakers and business owners, but the average consumer as well. How will recent challenges to supply chains be resolved in the near-term and will this create opportunity for investors?
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas, head of public policy research and municipal strategy for Morgan Stanley.
Daniel Blake And I'm Daniel Blake, equity strategist covering Asia and emerging markets,
Michael Zezas And on part one of this special edition of the podcast. We'll be assessing the near-term restructuring of global supply chains and how this transition may impact investors. It's Tuesday, January 11th at 9 a.m. in New York.
Daniel Blake And it's 10:00 p.m. in Hong Kong.
Michael Zezas So, Daniel, we recently collaborated on a report, "Global Supply Chains, Repair, Restructuring and investment Implications." In it, we take a look at the story for supply chains over the short, medium and long term. Now, obviously supply chains are on the minds of not only investors and policymakers, but the average consumer as well. So I think the best place to start is, how did we get here?
Daniel Blake Thanks, Mike. What we're seeing actually is a surge in demand for goods, particularly coming out of the US economy. As we're seeing accommodation of a record stimulus program post-World War Two, combined with a share in spending that has shifted from services towards goods that has been unprecedented. For example, to put this in context, we're seeing U.S. consumer spending on goods increased by 40% in the two years between October 2019, pre-COVID, to October 2021. And that compares with 28% increase that we saw in the entire 11 years following the financial crisis. And so what we're seeing is a sharp fall in services being more than made up for with an increase in spending on goods. And that's put enormous stress on supply chains, production levels, capacity of transportation. And in conjunction with the surge in demand that was seen, we've also seen some acute difficulties emerge in parts of supply chains impacted by COVID. For example, in South Southeast Asia, we've seen semiconductor fabrication, we've seen assembly, and we're seeing components being impacted by staffing issues as a result of COVID health precautions. And this has all been made worse by the uncertainty about sourcing products and lead times. So what we're seeing is manufacturers, we're seeing suppliers, distributors and the and the end corporates that are facing the consumer, putting in additional orders, whether that component is in short supply or not. And so that's increased the stress in the system and created uncertainty about where underlying demand sits
Daniel Blake And so, Mike, amidst this uncertainty, policymakers have really taken note of the issues, not least because of the inflation that's been generated. What reactions are you seeing from the administration, from Congress and from the Fed?
Michael Zezas This is obviously unprecedented volatility in the behavior of the American consumer. And so not surprisingly, in the U.S., policymakers don't have the types of tools immediately at their disposal to deal with this. So you've actually seen the administration pull the levers that they can, but they're relatively limited. They've made certain moneys available, for example, for overtime work for port workers and transportation workers to help speed along the process of inventory accumulating at different ports of entry in the US. But there aren't really any comprehensive tools beyond that that are being used.
Michael Zezas Daniel, what about policymakers in Asia and emerging markets? How are they reacting?
Daniel Blake Yeah. In the short run, we're seeing a combination of tightening of monetary policy. For example, over 70% of emerging markets have been hiking rates by the fourth quarter of 2021. But we're also seeing competition for investment in global supply chains as they are being diversified by OEMs and as we're seeing some restructuring taking place. So we're seeing overall this competition happening across the value chain from battery materials like lithium and nickel in markets like Indonesia all the way through to leading edge 3D semiconductor manufacturing, where companies in Japan are partnering with industry leader Taiwan Semiconductor Manufacturing Corporation to try to pursue leading edge technology. So we are seeing this competition being a key feature of medium term trends.
Michael Zezas So, Daniel, clearly a challenge in the near term to supply chains in the economy. What's our view on how this resolves itself?
Daniel Blake Yeah, we have identified in conjunction with the global research team the most acute choke points, the primary choke points. And the short answer is we are seeing improvement in these in these areas. For example, in semiconductors, manufacturing capacity in in the backend foundry that was seen in Southeast Asia, we are seeing production come back in towards full capacity. And so we are seeing a real easing in the most acute bottlenecks. That should be good news for overall production levels and the most severe shortages. But at the same time, we do have some more persistent challenges, including rising costs and delays in transportation, as it will take some investment and multiple years likely to resolve the issues that we're seeing in labor shortages in areas like US trucking, in port capacity, intermodal capacity in the US. And as we see some persistent areas of demand really pushing for more investment, for example, in EV materials and the battery supply chain.
Michael Zezas OK, so the most acute stresses we see resolving in the near term, and that's one of the reason, for example, our economists expect that inflation pressures will start to ease this quarter and into next. And as a consequence, the Fed will hike rates this year, but not necessarily according to the more aggressive schedule that they previously laid out. Daniel, what do you think are some of the more micro investment implications, sectoral investment implications, that we should pay attention to here?
Daniel Blake Yeah, we are tracking very closely these key bottleneck segments in the global economy because we have seen companies producing those products have been sharp outperformers. And the challenge is obviously recognizing where these shortages will persist and where we see sustained pricing power. We do see that in some areas the semiconductors are continuing, we are still seeing investment channels in EV materials being a key source of demand. But on the flip side, we're also seeing an outlook for a reprieve in supply chains. As we mentioned some of the more acute challenges, for example, in auto production that may actually be a negative for some major semi companies, as they've benefited from these stronger margins. And so as that pricing pressure diminishes, we think investor consensus is somewhat too optimistic on this shortage and backlog persisting longer into 2022. In terms of implications, then that should be more of a positive for volume league players, for example, auto parts makers that have been held up in terms of their shipments as a result of shortages in other parts of the value chain. And the longer term, another favored investment theme coming out of the report is the likely strength of the US capex cycle in response to these challenges that we're seeing for supply chains.
Michael Zezas Thanks for listening. We'll be back in your feed soon with part two of my conversation with Daniel Blake on the restructuring of global supply chains. As a reminder, if you enjoy Thoughts on the Market, please make sure to rate and review us on. The Apple Podcasts app. It helps more people find the show.
As the year gets underway, we are seeing an aggressive rotation from growth to value stocks, triggered by Fed tapering. Will 2022 follow the patterns of the ‘taper tantrum’ of 2013?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 10th at 11:30 a.m. in New York. So let's get after it.
2022 is off to a blazing start with one of the most aggressive rotations from growth to value stocks we've ever seen. However, much of this rotation in the equity markets began back in November, with the Fed's more aggressive pivot on monetary policy. More specifically, the most expensive stocks in the market were down almost 30% in the last two months of 2021. Year to date, this cohort is down another 10%, leaving 40% of the Nasdaq stocks down more than 50% from their highs. Is the correction over in these expensive stocks yet?
What has changed since the turning of the calendar is that longer term interest rates have moved up significantly. In fact, the move in 10-year real rates is one of the sharpest on record and looks similar to the original taper tantrum in 2013. However, as already mentioned, equity markets have been discounting this inevitable move in rates for months. Perhaps the real question is, why is the rates market suddenly waking up to the reality of higher inflation and the Fed's response to it - something it has telegraphed for months? We think it has to do with several tactical supports that are now being lifted. First, the Fed itself likely increased its liquidity provisions at year-end to support the typical constraints in the banking system. Meanwhile, many macro speculators and trading desks likely shut down their books in December, despite their fundamental view to be short bonds. This combination is now reversed and simply added fuel to a fire that had been burning for months under the surface. Based on the move in 2013, it looks like real rates still have further to run, potentially much further. Our rates strategists believe real rates are headed back to negative 50 basis points, which is another 25 basis points higher. From our perspective, real rates are unreasonably negative given the very strong GDP growth. Therefore, the Fed is correct to be trying to get them higher. It's also why tapering may not be tightening for the economy, even though it's the epitome of tightening financial conditions for markets.
We have discussed this comparison to 2013 in prior research and made the following observations as it relates to equity markets. First, the taper tantrum in 2013 was the first of its kind and something for which the markets had not been prepared. Therefore, the move in real rates was much more severe and swift than what we would expect this time around. Second, valuations were much more attractive in 2013 based on both price/earnings multiples and the equity risk premiums, which adjust for absolute levels of rates, which are much lower today. Listeners may find it surprising to learn that the price/earnings multiple for the S&P 500 is actually higher today than when the Fed first announced its plan to taper asset purchases back in September. In other words, valuations have actually increased as the tapering has begun, at least for the broader S&P 500 index.
This is also similar to what happened in 2013 and makes sense. After all, Fed tightening is a good sign for growth and evidence that its policy has been successful. However, this time the starting point on valuations is much higher as already noted. More importantly, growth is decelerating, whereas in 2013 it was accelerating. This applies to both economic and earnings growth. In this kind of an environment, the most expensive parts of the market remain the most vulnerable. This argues for value to outperform growth stocks. However, given the deceleration in growth, we favor the more defensive parts of value rather than the cyclicals like we did during the first quarter of 2021. This means Healthcare, Staples, REITs and Utilities. And some financials for a little offense to offset that portfolio.
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The start of 2022 has brought a surge in COVID cases, new payroll data, increased geopolitical risks, and shifts from the Fed. Despite these new developments, we think the themes from our 2022 outlook still apply.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, January 7th at 2:00 p.m. in London.
Right out of the gates, 2022 is greeting us with a surge of COVID cases, a US unemployment rate below 4%, geopolitical risk and new hawkish Fed communication.
Amidst all these issues, the question waiting for investors is whether the thinking of late last year still holds. We think the main themes of our 2022 outlook still apply - solid growth and tighter policy within an accelerated economic cycle. But clearly, there are now a lot more moving parts.
One of those moving parts is the growth outlook. Our 2022 expectation was that global growth remains above trend, aided by a healthy consumer, robust business investment and healing supply chains. But can that still hold given a new, more contagious COVID variant?
For the moment, we think it can. Our economists note that global growth has become less sensitive to each subsequent COVID wave as vaccination rates have risen, treatment options have improved and the appetite for restrictions has declined. Modeling from Morgan Stanley's US Biotechnology team suggests that cases in Europe and the US could peak within 3-6 weeks, meaning most of this year will play out beyond that peak. Having already factored in a winter wave of some form in our original economic forecast, we don't think, for now, the main story has changed.
There are, however, some wrinkles. Because China is pursuing a different zero COVID policy from other countries, its near-term growth may be more impacted than other regions. And the emergence of this variant likely reinforces another prior expectation: that developed market growth actually exceeds emerging market growth in 2022.
A second moving part is a shift by the Federal Reserve. Last January, the market assumed that the first Fed rate hike would be in April of 2024. Last August? The market thought it would be in April of 2023. And today, pricing implies that the first rate hike will be this March.
An update from the minutes of the Federal Reserve's December meeting, released this week, only further reinforced this idea that the Fed is getting closer and closer to removing support. The Fed discussed raising rates sooner, raising them faster and reducing the amount of securities that they hold.
Indeed, it would seem for the moment that central banks in a lot of countries are increasingly comfortable pushing a more hawkish line until something pushes back. And so far, nothing has. Equity markets are steady, credit spreads are steady and yield curves have steepening over the last month. The opposite of what we would expect if the markets were afraid of a policy mistake.
As such, why should they stop now?
For markets, therefore, our strategy is based on the idea of less central bank support to start the year. Our Foreign Exchange team expects further US dollar appreciation, while our US interest rate strategists think that yields will move higher, especially relative to inflation. We think that combination should be negative for gold but supportive for financial stocks both in the US and around the world.
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Despite last year’s strong showing for European equities, will the recent spread of the Omicron variant derail our positive outlook for the region in 2022?
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the recent rise in Omicron cases and whether this could derail our constructive view on European equities for 2022. It's Thursday, January the 6th at 2:00 p.m. in London.
Before touching on Omicron and the case for European stocks in 2022, I want to start by looking back at last year, which ended up being a very good one for the region. True European equities did lag US stocks again in 2021, however, this is hard to avoid when global markets are led higher by technology shares given Europe has fewer large cap companies in this space. More impressive was Europe's performance against other regions such as Japan, Asia and emerging markets. In fact, when we measure the performance of MSCI Europe against the MSCI All Countries World Index, excluding U.S. stocks, then we find that Europe enjoyed its best year of outperformance since 1998 which, to provide some context, was the year before the euro came into existence.
As ever, past performance is not necessarily a good guide to future returns. However, in this instance, we do expect another year of positive returns for European stocks in 2022, with 7% upside to our index target in price terms, which rises to 10% once dividends are included. This is considerably better than our Chief US Equity Strategist, Mike Wilson, expects for the S&P, while Jonathan Garner, our Chief Asian Equity Strategist, also remains cautious on Asian and emerging markets at this time.
While we think the underlying assumptions behind that positive view on European stocks are actually quite conservative - we model 10% EPS growth and a modest PE de-rating - equity investors are likely to have to navigate greater volatility going forward, given scope for higher uncertainty around COVID, inflation, and the impact of tighter monetary policy on asset markets. The first of these factors was arguably the most important for markets through November and December, however, recent evidence that emerged very late in the year - that Omicron is indeed considerably less severe than prior mutations - has boosted risk appetite across the region, helping push bond yields and equity prices higher. From a more fundamental perspective, we are also encouraged that the sharp rise in COVID cases across Europe over the last couple of months does not appear to be having a significant impact on the economy. Yes, we did see quite a sharp drop in business surveys in Germany through December, however, this doesn't appear to be replicated elsewhere with the PMI services data in France and consumer confidence data in Italy staying strong for now.
Going forward, we expect the driver of volatility and uncertainty to shift from COVID to central banks and the impact of tighter monetary policy on asset markets. While this issue will be relevant across all global markets, Europe should be less negatively impacted than elsewhere given the European Central Bank is unlikely to raise interest rates through 2022. In addition, the European equity market's greater exposure to the more value-oriented sectors such as commodities and financials, should make it a relative beneficiary of rising bond yields, especially if - as our Macro Strategy team forecast - this is accompanied by rising real yields (which should weigh most on the more expensive stocks in the US) or a stronger US dollar (which is more of a headwind for emerging markets).
Consistent with this outlook, we maintain a strong bias for value over growth here in Europe, with a particular focus on banks, commodity stocks and auto manufacturers. While all three of these sectors outperformed last year, we think they are still cheap and hence offer more upside from here.
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As 2022 gets underway, investors are concerned about the Omicron variant of COVID-19, yet markets are taking developments in stride, with higher stock prices and bond yields. Is this economic confidence misplaced?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, January 5th at 10:00 a.m. in New York.
As we settle in for 2022, the early line of questioning from clients regards the impact of the Omicron variant of COVID 19. It's been shattering records for infections globally and in the US, disrupting air travel as workers stay home sick. So why then are markets so far this week taking this in stride? Higher stock prices and bond yields reflect more economic confidence than concern. Is that confidence misplaced?
Not necessarily, in our view. That's because while Omicron is clearly a serious public health risk, the data suggests it may not trigger the level of public policy response that sustainably crimps economic activity, such as indoor capacity restrictions on service establishments or stay at home orders. Since the pandemic's onset, such responses have largely been dictated by state and local governments, and as we pointed out in this podcast a month ago, in most cases where restrictions were tightened, rising COVID hospitalizations and lack of bed capacity were cited as the culprit. So far, the data suggests hospital capacity may not be a problem with Omicron.
Consider studies from the UK and South Africa, which have shown that Omicron is substantially less likely than the previously dominant Delta variant to land people in the hospital. This likelihood is lessened even more if an infected person was previously vaccinated. So even as case counts soar above those prior waves, it's not surprising to see that measures of hospital capacity stress across the US are yet to exceed those of prior waves. Further, as our colleagues in the Biotech Research team point out, the contagiousness of Omicron and subsequent protection against reinfection that the infected develop, at least for a time, has led to bigger but shorter infection waves in places like South Africa. This is why US government officials point out that Omicron could peak and fall quickly sometime this month.
In short, the wave and any attendant economic risk could be over quickly, and this may be why investors are looking through it. Hence, we expect markets will refocus on inflation and Fed policy as key drivers for 2022, continuing to push bond yields higher this year in line with our team's forecast.
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As the Omicron variant spreads across Asia, renewed lockdowns and other earnings outlook disruptions have investors on alert, reinforcing our approach of cautious patience in the region.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the impact of Omicron on China and Emerging Market Equities. It's Tuesday, January the 4th at 7:30 a.m. in Hong Kong.
As 2022 begins, our approach to Asia and EM equities remains one of cautious patience. Although these markets underperformed their peers in the U.S. and Europe last year, simple arguments of performance mean reversion in 2022 are not strong enough to warrant anything more aggressive at this juncture.
We hear a lot these days about a turn in the Chinese policy cycle as a catalyst. And it's fair to say that historically one would have been more optimistic at this juncture of the monetary and fiscal cycle for the outlook for domestic demand in China. This demand is crucial both for China's own growth outlook to stabilize, as well as to give a boost to most other markets in Asia and EM. But this is not a normal cycle.
China's ‘zero COVID’ approach must now face off against Omicron. As this episode is being recorded, Xian - a major Chinese city with a population of over 13 million - is in its 12th day of a lockdown, which is now more severe in terms of restrictions on normal daily life than any seen in China since the original lockdown of Wuhan at the start of the pandemic.
Two global companies with major semiconductor plants in the city have recently warned of production problems. And though there's no formal national policy to curtail celebration of Chinese New Year at the end of this month, domestic media is already beginning to broadcast a message of staying at home and avoiding long distance travel. In China, as in EM, we're continuing to track earnings estimates that are declining, which undermines the case for valuations - now roughly in line with long run averages - being sufficiently attractive to reengage. The situation is slightly better in Japan, where estimates are tracking sideways and individual markets - notably India and parts of Asean and Eastern Europe, Mid East and Africa - have been doing better than the EM overall.
However, disruption caused by Omicron could change individual economic and hence earnings outlooks over the short to medium term. For example, India's most recent COVID case count was up 35% day-on-day, with Omicron now present in 23 of 28 states. Maharashtra, Delhi and Tamil Nadu have reimposed restrictions on visits to public parks, beaches and other public spaces. Indeed, most of the countries we cover that had moved to a "living with COVID" approach are now having to reverse course. Take South Korea, which in mid-December, as ICU usage rose significantly, reimposed early closing restrictions on nightlife and a rule limiting public gatherings to no more than four fully vaccinated persons.
Finally, our weekly track of flows to dedicated Asia and EM equity funds is now showing steady and persistent redemptions, as some of the very large inflows from this time a year ago start to reverse course. Those flows were driven by the notion that a strong, synchronized upswing was underway globally, which it was argued would lead to outperformance by Asia and EM, whose economies generally perform strongly in a global economic upswing. We argued at the time that 2021 would not be like 2006/07 and 2016/17 when that narrative did hold true. As 2022 begins, the global and local economic outlook is clearly weakening again, and hence our mantra of continued cautious patience.
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With a new calendar year, the narrative in markets may not be shifting but there are still opportunities for investors to consider as growth rates, policy proposals, and interest rates shift in the coming year.
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Welcome to Thoughts on the Market and Happy New Year! I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 3rd at 11:30 a.m. in New York. So let's get after it.
A new year brings new investment opportunities, even if the narrative isn't changing. More specifically, tightening monetary policy and decelerating growth supports our large cap defensive quality bias - a strategy that has worked well since we first started recommending it back in mid-November. On the first score, the Fed and other central banks appear to be determined to remove monetary accommodation in the face of higher inflation. Not only is inflation turning out to be an economic issue, but it's quickly becoming a political one given this is a midterm election year. What this means is the Fed will likely turn out to be more hawkish than investors expect, and that hawkishness is likely to be front-end loaded so markets have time to recover by November.
As for the second part of the narrative, we think growth will decelerate this year as most of our leading indicators point to that outcome. Furthermore, this dynamic should be supportive of defensives outperforming cyclicals amid large cap quality leadership. This week, we expand our analysis to the industry level and illustrate that within defensives, Health Care, REITS and Consumer Staples tend to be the best performers in a decelerating but positive growth regime.
As we reflect on 2021's strong performance from large cap U.S. equity indices last year, it's hard to get too excited about any remaining upside this year. Having said that, most individual stocks have gone nowhere since March, with many in a deep bear market. In many ways, 2021 looked a lot like 2018 - a year of rolling corrections and rotations as investors continually sought out higher ground in the high-quality S&P 500 index. As we enter 2022, the key question for investors is to decide if they want to stay with the relative winners, or is it time to go bottom fishing? New calendar years tend to support the latter strategy as the pressure of keeping up with the index eases. Hence, the new opportunities for investors.
While we continue to favor the large cap defensive tilt that has been working, we recommend creating a barbell with stocks that have already corrected but still offer good prospects at a reasonable valuation. Over the past nine months, the quality bias has driven more and more money into a handful of large cap growth stocks - further highlighting the importance of favoring large over small since March. But as we already noted, this crowding has left many smaller stocks behind. A few areas we think make sense to consider include consumer services and other businesses with pent up demand. In the more growth-y segments, we think biotech and China Internet are good bottom fishing candidates. Meanwhile, we would still be careful with very expensive tech stocks that remain unprofitable.
One final development to watch closely is long term interest rates. With a significant move higher in inflation and the Fed's pivot on policy, we think long term interest rates look too low. The sharp move higher today looks like the beginning of something more meaningful, and it could lead to new 52-week highs in short order if our technical view is correct. As such, we remain positive on financials as our sole cyclical overweight. A backup in rates is the reason, and that could be happening now.
Bottom line, stick with a large cap defensive quality bias as we enter 2022, but balance it with financials and small mid-cap value stocks, particularly with the Fed and other central banks tightening policy faster than investors expect and rates likely back up.
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Original Release on August 24th, 2021: Recent developments in space travel may be setting the stage for a striking new era of tech investment. Are investors paying attention?
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Andrew Sheets This week we are bringing you 4 encores of deep dives into different kinds of investing we consider at Morgan Stanley. Thanks to all our listeners for a great year and happy holidays!
Adam Jonas Welcome to Thoughts on the Market. I'm Adam Jonas, Head of Morgan Stanley's Space and Global Auto & Shared Mobility teams. With the help of my research colleagues across asset classes and regions, I try to connect ideas and relationships across the Morgan Stanley platform to bring you insights that help you think outside the screen. Today, I'll be talking about the Apollo Effect and the arrival of a new space race. It's Tuesday, August 24th, at 10:00 a.m. in New York.
In May of 1961, President John F. Kennedy announced America's plan to send a man to the moon and bring him back safely to Earth before the end of the decade. This audacious goal set in motion one of the most explosive periods of technological innovation in history. The achievements transcended the politics and Cold War machinations of the time and represented what many still see today as a defining milestone of human achievement. In its wake, millions of second graders wanted to become astronauts, our math and science programs flourished, and almost every example of advanced technology today can trace its roots in some way back to those lunar missions. The ultimate innovation catalyst: the Apollo Effect.
60 years after JFK's famous proclamation, we once again need to draw on the spirit of Apollo to address today's formidable global challenges and to deliver the solutions that improve our world for generations to come. The first space race had clear underpinnings of the Cold War between the U.S. and the Soviet Union. Today's space race is getting increased visibility due to a confluence of profound technological change, accelerated capital formation - fueled by the SPAC phenomenon - and private space flight missions from the likes of Richard Branson and Jeff Bezos. We think space tourism is the ultimate advertisement for the realities and the possibilities of Space livestreamed to the broadest audience.
The message to our listeners is: get ready. This stuff is really happening. Talking about Space before the rollout of the SpaceX Starship mated to a Super Heavy booster is akin to talking about the Internet before Google Search, or talking about the auto industry before the Model T.
We are entering an exciting new era of space exploration, one that involves the hand of government and private enterprises - from traditional aerospace companies to audacious new startups. This race is driven by commerce and national rivalry. And the relevance for markets and investors, while seemingly nuanced at first, will become increasingly clear to a wide range of industries and enterprises.
The Morgan Stanley Space team divides the space economy into 3 principal domains: communications, transportation and earth observation. Our team forecasts the global space economy to surpass $1T by the year 2040. And at the rate things are going, it may eclipse this level far earlier.
When I first started publishing on the future of the global space economy with my Morgan Stanley research colleagues back in 2017, very few people seemed to care, and even fewer thought it was material for the stock market. I would regularly ask my clients "on a scale of 0 to 10, how important is space to your investment process?" And by far the most common answer I received was 0 out of 10. A lot of folks said 0.0 out of 10, just to make the point. Not even four years later and, oh my goodness, how things have changed. The investment community and the general public are rapidly embracing the genre and becoming aware of its importance economically and strategically.
So whatever your own area of market expertise, this next era of space exploration and the innovation and commerce that spawn from it, will matter to your work, and to your life. But beyond the national competition, the triumph, the glory, the failures and the many hundreds of billions of dollars that'll be spent on launches, missions and infrastructure - is a reminder of something far bigger that we learned over a half a century ago during the Apollo era - that Space is one of the greatest monuments of human achievement, and a unifying force for the planet.
Thanks for listening. And remember, if you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Original Release on September 30th, 2021: Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management, discusses the new shape of retail investing and the impact on markets.
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Andrew Sheets This week we are bringing you 4 encores of deep dives into different kinds of investing we consider at Morgan Stanley. Thanks to all our listeners for a great year and happy holidays!
Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be discussing the retail investing landscape and the impact on markets. It's Thursday, September 30th, at 2p.m. in London.
Lisa Shalett And it's 9:00 a.m. here in New York City.
Andrew Sheets Lisa, I wanted to have you on today because the advice from our wealth management division is geared towards individual investors, what we often call retail clients instead of institutional investors. You tend to take a longer-term perspective. As chief investment officer, you're juggling the roles of market analyst, client adviser and team manager ultimately to help clients with their asset allocation and portfolio construction.
Andrew Sheets Just to take a step back here, can you just give us some context of the level of assets that Morgan Stanley Wealth Management manages and what insight that gives you potentially into different markets?
Lisa Shalett Sure. The wealth management business, especially after the most recent acquisition of E-Trade, oversees more than four trillion dollars in assets under management, which gives us a really extraordinary view over the private wealth landscape.
Andrew Sheets That’s a pretty significant stock of the market there we have to look at. I'd love to start with what you're hearing right now. How are private investors repositioning portfolios and thinking about current market conditions?
Lisa Shalett The individual investor has been important in terms of the role that they're playing in markets over the last several years as we've come out of the pandemic. What we've seen is actually pretty enthusiastic participation in markets over the last 18 months with folks, you know, moving, towards their maximum weightings in equities. Really, I think over the last two to three months, we've begun to see some profit taking. And that motivation for some of that profit taking has kind of come in two forms. One is folks beginning to become concerned that valuations are frothy, that perhaps the Federal Reserve's level of accommodation is going to wane and, quite frankly, that markets are up a lot. The second motivation is obviously concern about potential changes in the U.S. tax code. Our clients, the vast majority of whom manage their wealth in taxable accounts, even though there is a lot of retirement savings, many of them are pretty aggressive about managing their annual tax bill. And so, with uncertainty about whether or not cap gains taxes are going to go up in in 2022, we have seen some tax management activity that has made them a little bit more defensive in their positioning, you know, reducing some equity weights over the last couple of weeks. Importantly, our clients, I think, are different and have moved in a different direction than what we might call overall retail flow where flows into ETFs and mutual funds, as you and your team have noted, has continued to be quite robust over, you know, the last three months.
Andrew Sheets So, Lisa, that's something I'd actually like to dig into in more detail, because I think one of the biggest debates we're having in the market right now is the debate over whether it's more accurate to say there's a lot of cash on the sidelines, so to speak, that investors are still overly cautious, they have money that can be put into the market. You know, kind of versus this idea that markets are up a lot, a lot of money has already flowed in and actually investors are pretty fully invested. So, you know, as you think of the backdrop, how do you think about that debate and how do you think people should be thinking about some of the statistics they might be hearing?
Lisa Shalett So our perspective is, and we do monitor this on a month-to-month basis has been that, you know, somewhere in the June/July time frame, you know, we saw, our clients kind of at maximum exposures to the equity market. We saw overall cash levels, had really come down. And it's only been in the last two to three weeks that we've begun to see, cash levels rebuilding. I do think that that's somewhat at odds with this thesis that there's so much more cash on the sidelines. I mean, one piece of data that we have been monitoring is margin debt and among retail individual investors, we've started to see margin debt, you know, start to creep up. And that's another indication to us that perhaps this idea that there's tons of cash on the sidelines may, in fact, not be the case, that people are, "all in and then some," you know, may be something worth exploring in the data because we're starting to see that.
Andrew Sheets So, Lisa, the other thing you mentioned at the onset was a focus on the tax environment, and that's the next thing I wanted to ask you about. You know, I imagine this is an issue that's at the top of minds of many investors. And your thoughts on both what sort of reactions we might get to different tax changes and also your advice to how individuals and family offices should navigate this environment.
Lisa Shalett Yeah, so that's a fantastic question, because in virtually every meeting, you know, that I'm doing right now, this question, comes up of, you know, what should we be doing? And we usually talk to clients on two levels. One is on it in terms of their personal strategies. And what we always talk about is that they should not be making changes in anticipation of changes in the law unless they're really in need of cash over the next year or two. It's really a 12-to-18-month window. In which case we would say, you know, consult with your accountant or your tax advisor. But typically, what we say is, you know, the changes in the tax law come and go. And unless you have an imminent, you know, cash flow need, you should not be making changes simply based on tax law. The second thing that we often talk about is this idea or this mythology among our client base that changes in the tax law, you know, cause market volatility. And historically that there's just no evidence for that. And so, like so many other things there's, you know, headline risk in the days around particular news announcements. But when you really look at things on a 3-month, 6-month, you know, 12- and 24-month, trailing basis on some of these things, they end up not really being the thing that drives markets.
Andrew Sheets Lisa, one of the biggest questions—well, you know, certainly I'm getting but I imagine you're getting as well—is how to think about the ratio of stocks and bonds together within a portfolio. You know, there's this old rule of thumb, kind of the 60/40, 60% stocks, 40% bonds in portfolio construction. Do you think that's an outdated concept, given where yields are, given what's happening in the stock market? And how do you think investors should think about managing risk maybe differently to how they did in the past?
Lisa Shalett That's a fantastic question. And it's one that we are confronted with, you know, virtually every day. And what we've really tried to do is take a step back and, make a couple of points. Number one, talk about, goals and objectives and really ascertain, you know, what kinds of returns are necessary over what periods of time and what portion of that return, you know, needs to be in current cash flow, you know, annualized income. And try to make the point that perhaps generating that combination of capital appreciation and income needs to be constructed, if you will, above and beyond the more traditional categories of cash, stocks and bonds given where we are in terms of overall valuations and how rich the valuations are in both stocks and bonds, where we are in terms of cash returns after inflation, and with regards to whether or not stocks and bonds at the current moment are actually behaving in a way that, you know, you're optimizing your diversification.
Lisa Shalett So with all those considerations in mind, what we have found ourselves doing is speaking to the stock portion of returns as being comprised not only of, you know, the more traditional long-only strategies that we diversify by sector and by, you know, global regions. But we're including thinking about, you know, hedged vehicles and hedge fund vehicles as part of those equity exposures and how to manage risk. When it comes to the fixed income portion of portfolios, there's a need to be a little bit more creative in hiring managers who have a mandate that can allow them to use things like preferred shares, like bank loans, like convertible shares, like some asset backs, and maybe even including some dividend paying stocks in, their income generating portion of the portfolio. And what that has really meant to your point about the 60-40 portfolio is it’s meant that we're kind of recrafting portfolio construction across new asset class lines, really. Where we're saying, OK, what portion of your portfolio and what products and vehicles can we rely on for some equity like capital appreciation and what portion of the portfolio and what strategies can generate income. So, it's a lot more mixing and matching to actually get at goals.
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people find the show.
Original Release on August 12th, 2021: Investor interest in thematic equity products such as ETFs has rapidly surged, particularly among tech themes. Why the momentum may only grow.
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Andrew Sheets This week we are bringing you 4 encores of deep dives into different kinds of investing we consider at Morgan Stanley. Thanks to all our listeners for a great year and happy holidays!
Graham Secker Welcome to Thoughts on the Market. I'm Graham Secker, Head of the European and UK Equity Strategy Team.
Ed Stanley And I'm Ed Stanley, Head of European Thematic Research.
Graham Secker And today on the podcast, we'll be talking about the continued interest in thematic investing in Europe. It's Thursday, August the 12th, at 3 p.m. in London.
Graham Secker So, Ed, I really wanted to talk to you today because investor appetite for thematic related equity products such as ETFs, mutual funds and the like has grown to the point that thematics has actually been carved out from our traditional sector research at Morgan Stanley. So as head of the European Thematic Investing team, can you walk us through what's behind the increased interest in this area and how you see the thematic landscape evolving over the next couple of years?
Ed Stanley Thanks, Graham. To understand thematics, first you have to look at the geographies. And when you do that, it's really a two-horse race. Of the $450 billion in global thematic mutual funds in June this year, 60% of that was in Europe. So the lion's share. And then there's the U.S., which is the second largest geography for thematic investing, but growing very quickly indeed. If you look in the US year to date, for example, there have been over 100 thematic ETF launches-- comfortably double the run rate of thematic starts in 2020. Once you've looked at geography, then you have to look at the landscape by theme. And this is where thematic investing gets really interesting. The breadth of and growth in thematic strategies is truly extraordinary. Fund starts are compounding over 40% over the last three years and inflows for those funds have seen high double digit, and even triple digit growth, so far this year. Most obviously, themes like genomics and eSports fall into that high growth category. We even saw a dedicated ETF launch in June this year, particularly trying to gain exposure to the metaverse, which is the first of its kind. So while we don't make explicit forecasts on where we think thematic investing is going to be in a one year view, the momentum is showing no signs of slowing down. In fact, quite the opposite.
Graham Secker So with any number of themes to choose from, the world really is your oyster, I think. So how do you whittle down or cherry pick where you spend your time?
Ed Stanley It's a great question and that's really my number one challenge. While we're never short of ideas, determining which theme is the zeitgeist of the day is absolutely critical. And to do that, our thematic research really hinges on two streams of analysis. On the one hand, demographic change and on the other, disruptive innovation. We believe that these two groupings and the subthemes therein hold the key to shifting future consumption patterns, which ultimately all investors need to be conscious of. But with that said, for most investors to be interested in a theme, it needs to be actionable within at least three to five years. Consequently, for a theme to work, investors need a relatively near-term catalyst. So when we're looking within disruptive innovation, for example, we need to think what's the catalyst to make investors care about this theme? Be that a product launch, start-up funding, falling technology costs, regulation or government policy. When you can twin up an interesting thematic idea with a catalyst, that's really where we focus our attention.
Graham Secker Another question I want to ask is, how do you test the pulse of the market to determine what is a live thematic debate and where you think investors may be too early or late to a theme?
Ed Stanley Well, I suppose this really narrows down the previous point. So we now have our theme, so to speak. We have to ask ourselves, does the market already care about this theme or will the market care in the not-too-distant future? And this is where we think we've come up with a relatively interesting and novel solution to screen for that. Through a combination of four things: patent analysis, capital spending patterns by companies, the velocity of comments made by company management teams and finally, using Google Trends momentum data, we believe that we can relatively accurately pick which themes are either gathering momentum or, on the flip side, those that may have been past their initial peak of excitement.
Graham Secker Okay. And on that point, what are some of the key themes you're watching right now?
Ed Stanley Well, I suppose one that we can't ignore, particularly given my previous comments, is hydrogen. On all of the metrics I just mentioned, it's flashing green. Whether that's pattern analysis, company transcripts, CapEx intensity. It's a hotly debated theme as investors try to grapple with this long-term potential for the fuel. But even more simply, if we take a step back, one really only needs to look at the fund startups to see where the really exciting themes are. If we look back to January 2018, for example, there are only a handful of fintech funds around the world. Today, there are nearly 200 that we're keeping track of. Part of my role is to predict what is going to be the next fintech when it comes to themes. And the themes that are most likely to tick those boxes are, in my view, the near-term ones, electric vehicles, cybersecurity, 5G; the medium term, which encompasses augmented, virtual reality as well as eSports; and then longer term, you have space, quantum computing are all beginning to show telltale signs of thematic focus areas.
Graham Secker Thanks, Ed. And finally, I want to ask you about concerns over a thematic bubble. There's been an exponential rise in the number of thematic products being set up recently. There's also been a high degree of attrition for thematic ETFs. So to what degree do you think the ongoing growth in thematic investing is here to stay? And how vulnerable do you think it could be to a prolonged technology bear market, for example?
Ed Stanley You're absolutely right. Plenty of thematic ETFs, particularly in the US, have come and gone. That will likely continue to happen, particularly in themes where hopes exceed reality. What happens in a prolonged downturn remains to be seen in all honesty. We don't have enough back history from a wide enough variety or sample of these thematic funds, to be sure. But the test case of covid highlighted the early signs of structural growth in this market. There are more thematic funds post-covid than pre-. So my view is that this is absolutely a structural rather than a cyclical phenomenon, particularly as younger marginal investors increasingly want exposure to themes rather than sectors and geographies. But while I believe that thematic investing is a structural trend, no doubt it clearly leans towards tech-heavy equities and growth as a factor, particularly. So the bigger existential threat perhaps isn't so much a bear market, but instead persistently high interest rate environments, which remains to be seen. But for now, at the very least, the future looks pretty bright for thematics in our view.
Graham Secker Very interesting. Thanks for taking the time to talk today, Ed.
Ed Stanley Great speaking with you, Graham.
Graham Secker As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Original Release on August 26th, 2021: Equity investors have applied factor-driven strategies for years, but the approach has seen slow adoption in bond markets. Here’s why that may be changing.
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Andrew Sheets This week we are bringing you 4 encores of deep dives into different kinds of investing we consider at Morgan Stanley. Thanks to all our listeners for a great year and happy holidays!
Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley,
Vishy Tirupattur And I am Vishy Tirupattur, Head of Fixed Income Research at Morgan Stanley.
Andrew Sheets And on this special edition. And on this special edition of the podcast, we'll be talking about factor investing strategies and liquidity in corporate credit markets. It's Thursday, August 26th, at 3:00 p.m. in London
Vishy Tirupattur And 10:00 a.m. in New York.
Andrew Sheets So Vishy, before we start talking about factor investing and credit, we should probably talk about what is factor investing and why are we talking about it. So, what is this concept and why is it important?
Vishy Tirupattur Factor investing whose intellectual roots are from a seminal paper from two University of Chicago professors in the early 90s, Eugene Fama and Ken French. It effectively is a way of identifying companies to invest using rules based systematic investing strategies, be it identifying quality, identifying value, identifying momentum or volatility or risk adjusted carry. A bunch of these strategies involve setting up a set of rules and systematically in following those rules to build a portfolio. And we've seen that these strategies in the context of equities have substantially outperformed more discretionary strategies.
Andrew Sheets So you can kind of think about it as the Moneyball approach to investing, that you think over time doing certain types of things in certain situations over and over again systematically is going to ultimately deliver a better long run result.
Vishy Tirupattur Exactly right.
Andrew Sheets So you mentioned that this has been a strategy that's been around a long time in equity markets. Why hasn't it been around in credit? And what's changing there?
Vishy Tirupattur The key for systematical rules-based investing strategies or factor investing is being an abundance of liquidity in the market. And the complexity of credit markets means that this has been a big challenge to implementing these types of strategies. For example, you know, S&P 500, not surprisingly, has 500 stocks. And underlying those 500 stocks are literally thousands of bonds that underlie those 500 stocks, that weigh in maturity, in coupon, in rating, in seniority, etc... Each of these introduces an element of complexity that just complicates the challenge associated with factor investing.
Andrew Sheets So Vishy, that's a great point, because if I want to buy a stock, there's one stock, but if I want to buy a bond of that same company, there might be many of them with different maturities and different coupons. They're just not interchangeable, and that does introduce complexity.
Vishy Tirupattur So one big thing that's happened is the advent of electronic trading. Electronic trading today accounts for almost a third of all trading in investment grade corporate credit and in over 20% of all trading in high yield corporate credit. This has made a significant difference and enables factor investing possible in the context of credit.
Andrew Sheets So more electronic trading, more portfolio trading is improved liquidity and made certain types of factors, systematic strategies possible in credit. Are ETFs a part of this story? Obviously, those represent a portfolio of credit. We're seeing rising volumes within the credit market of exchange traded funds. How do you see that playing into this trend? And what do you think is the outlook there?
Vishy Tirupattur Absolutely. ETFs constitute portfolio trades and portfolio trading indeed has become a very, very big part of trading here. Even five years ago, ETFs accounted for about 5% of all the traded volumes in investment grade and maybe about 20% in high yield. Today, they account for 16% of all traded volumes investment grade and 50% of all the traded volumes in high yield. So, ETF and portfolio trading in general has enabled not only greater liquidity, but smaller issue sizes and smaller issuers, and that's an important distinction.
Andrew Sheets So how would this actually work in practice? You know, I could go out and I could just buy a credit fund that owns all the bonds in a particular market. Or I could try one of these factor strategies. What would the factory strategy actually be doing? I mean, what are the characteristics that our research suggests credit investors should be trying to favor versus avoid?
Vishy Tirupattur Let me talk about two strategies. First is a risk adjusted carry strategy. So, you take the spread of the bond over Treasuries, so that gets the credit risk premium, divided by the volatility of excess returns of that particular bond over the last 12 months. Group all these bonds, sort them, and invest in the top decile that has the best risk adjusted return. And then rinse and repeat every month. And we have shown that using this strategy in investment grade, you can consistently beat the benchmark corporate bond index. So that's one strategy.
Vishy Tirupattur The other one is a momentum strategy. Momentum can be both from the bond returns as well as from the underlying stock returns. Our research has shown that by combining equity momentum signals and corporate bond momentum signals, we can also achieve substantial outperformance over the benchmark indices both in investment grade and high yield, even though in high yield the outperformance is even more significant.
Andrew Sheets So Vishy, why do you think that works? Because it would seem really obvious that, you know, investors wouldn't want to own bonds with a good return versus their volatility, that investors would want to own things that are going up and avoid things that are going down. So why would doing those things, why would following those rules, do you think, still deliver risk premium, still deliver return? Why do you think the market is kind of leaving those nickels kind of lying on the street for lack of a better word, for investors to pick up?
Vishy Tirupattur Andrew, in the past this kind of a strategy that would involve, say, a monthly rebalancing, would mean very substantial transaction costs. What we would measure through the bid offer spreads in the bond market. So, 10 years ago, in plain vanilla investment grade bonds, the bid offer spreads, the spread in the difference between the spread of buying and selling bonds, was as high as 12 basis points. And today that number is 2-3 basis points. So, this means that transaction costs, thanks to the electronification, thanks to portfolio trading and ETF volumes, has meant very substantially lower transaction costs that makes these returns possible. And since factor investing is still at the very early stages of practice in credit markets, there are still large, unharvested risk premia in the credit markets for these types of strategies.
Andrew Sheets And Vishy, my final question for you is, what are the risks here? If investors are going to look at the market from a systematic, more rules-based approach, what sort of questions should they be asking?
Vishy Tirupattur I think key question to ask is how much dependencies there are on liquidity and how long will liquidity continue to be there in the markets.I think looking at this kind of analysis over multiple credit cycles, the four cycles, lower liquidity, higher liquidity periods, which is what we have done, those are the kinds of analyzes one would need to do to start paying greater attention to systematic investing strategies in credit.
Andrew Sheets Vishy. Thanks for taking the time to talk.
Vishy Tirupattur Andrew, always fun to talk with you.
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Recent signals from the Fed are indicative of a willingness to change its mind quickly. While bond investors may be wary of the volatility this could bring, it may also create opportunities in the new year.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, December 22nd at 10:00 a.m. in New York.
While investors may be focused on the gridlock on the Build Back Better fiscal plan, we think it makes sense to shift our focus from Capitol Hill to the Federal Reserve, which just made a big move, and one that arguably matters more to markets in the near term than developments out of Congress. Last week, the Fed announced a more aggressive tapering of asset purchases. Perhaps more importantly, it signaled an expectation of hiking interest rates three times next year, rather than the two times most forecasters expected. In the press conference following the announcement, Chair Powell repeatedly signaled his intent was to demonstrate both that the Fed takes seriously the risk posed by a recent uptick in inflation, as well as the flexibility of the Fed's monetary policy, by discussing his willingness to adjust the taper and rate hike outlooks as data comes in.
This last point is an important one for bond markets. In dealing with substantial uncertainty around the inflation outlook, you have a Fed that elected a pragmatic approach - a willingness to change its mind quickly as it sees fit. That's not a novel approach, but it may be fresh to many investors today who may be more accustomed to the slower, more deliberate approach that economic conditions pressed the Fed to take under its previous two chairs. But such an approach means it's harder to predict with confidence what will happen next to monetary rates. That uncertainty means more disagreement among investors, which in turn means more sustained volatility in the Treasury market.
That's not necessarily bad news for investors, though. In our view, it actually may lead to some interesting opportunities in 2022 for credit investors. In the muni market, for example, elevated rates volatility has, more often than not, caused market weakness as investors shy away from price uncertainty in an asset class they generally want to own for reasons of capital preservation and asset allocation. But muni credit quality, in our view, is likely to remain quite strong in 2022, with continued strong economic growth allowing municipal entities to lock in their credit gains from government aid and a sharp GDP recovery in 2020 and 2021. So, if volatility leads to price weakness, we're likely to see this as an opportunity to add good credit, just at a cheaper valuation.
So, beware the Fed and volatility, but don't fear it. We'll keep you updated here for the opportunities it may create.
Happy holidays from all of us here at Thoughts on the Market. We'll be back in the new year with more episodes.
And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
With shifting focus across regulatory, monetary and fiscal policy, there is renewed confidence in the growth and recovery outlook for China in 2022.
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Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives. I'll be talking about the prospects for China's recovery amid regulatory, monetary and fiscal policy easing. It's Tuesday, December 21st at 7:00 p.m. in Hong Kong.
China's policy stance is clearly shifting from over-tightening to easing, and with it, we think the cycle is also turning from a mini downturn to an upswing. We are more bullish than the consensus and see GDP growth accelerating to 5.5% in 2022.
Over the years, China has experienced a number of mini cycles. These mini cycles in growth tend to follow the policy cycles. While tightening starts out as countercyclical, it eventually becomes pro-cyclical, and sometimes because external demand conditions deteriorate - for example, the onset of trade tensions in mid-2018. Once growth decelerates beyond policymakers' comfort zone, their priorities shift to stabilizing growth and preventing an adverse spillover impact into the labor market.
In the current cycle, with sharp pick-up in external demand, policymakers stuck to their playbook and tightened macro policies to slow infrastructure and property spending. But from the summer of this year, as Delta wave-led restrictions weighed further on consumption growth, continued policy tightening pushed growth lower than policymakers' comfort zone.
This time around, policy tightening was unusually aggressive, leading to a 10 percentage point drop in debt to GDP in 2021. Indeed, we have not seen this magnitude of debt to GDP reduction in a year since 2003-07 cycle. Moreover, the rapid succession of regulatory tightening actions related to the tech sector and decarbonization has taken markets by surprise, adding uncertainty and keeping market concerns on the boil.
Now, with GDP growth decelerating to just 3.3% on a year-on-year basis in 4Q21, which would be 4.9% adjusted for high base effect, policymakers have hit pause on deleveraging and began to ease both monetary and fiscal policy a few weeks ago. Bank reserve requirement ratio cuts were coupled with guidance to banks to allocate more credit to priority sectors. At the same time, local government bond issuance has increased significantly, which in turn will translate into stronger infrastructure spending. And several local governments have also lifted property purchase restrictions.
Two Fridays ago, policymakers convened at the Central Economic Working Conference - an annual meeting that sets the agenda for the economy in the year ahead - and the resulting statement suggested to us that there is a clear shift in policy stance, and they will continue to take action in a number of areas to stem the downturn, increasing our confidence in China's recovery.
These policy easing measures will complement the sustained strength in exports and a pickup in private capex, driving the recovery.
And in terms of market implications, our China Equity Strategy team continues to prefer A-shares rather than offshore markets, and our China Property and Asia Credit Strategy analysts are optimistic on the China property sector as well as China high yield property.
The key risk to our call in the near-term is the Omicron variant. The effectiveness of China's containment and tracing capabilities has improved over time, such that each successive wave of COVID outbreaks has had a smaller impact on mobility and growth. However, Omicron's greater transmissibility suggests to us that it will keep China's COVID zero policy in place for longer and potentially force China to impose more selective lockdowns than during the Delta wave.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.
Our narrative of tightening monetary policy and decelerating growth continues to play out amidst developments in Omicron, failed legislation and signals from the Fed.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, December 20th at 11:30 a.m. in New York. So let's get after it.
Our Fire and Ice narrative for tightening monetary policy and decelerating growth is playing out, with the central banks taking aggressive steps to deal with the higher-than-expected inflation. Meanwhile, Omicron and the failure to pass President Biden's Build Back Better bill have awakened investors to the risk of slower growth that we think is as much about the ongoing cyclical downturn as these external shocks. In short, stay defensive with your equity positioning.
First, with the Fed preparing investors over the past four months for what could be a very long process of removing monetary accommodation from markets that have become dependent on it, the most expensive and speculative stocks have already been hit exceptionally hard. Furthermore, the quality trade has taken on a more defensive posture. Both of these shifts are very much in line with our 2022 outlook - be wary of high valuations and focus on earnings stability. In other words, favor large cap defensive quality.
Second, with the market and the Fed now fully appreciating that inflation is not going to be transitory, investors must contend with the Ice part of our narrative. How much further will growth decelerate, and how much is due to Omicron versus the ongoing cyclical downturn that began in April? As noted in prior episodes of this podcast, we remain optimistic that this latest wave will prove to be the last notable one. Meanwhile, the peak rate of change in the recovery was way back in April of this year. Since then, we've seen a steady deceleration in growth that has little to do with COVID, in our view. Instead, this is the natural ebb of the business cycle and mid-cycle transition, which is not yet complete. Of course, this latest variant will be a drag on certain parts of the economy and perhaps bring forward the end of the mid-cycle transition more quickly. Finally, this past weekend Senator Manchin effectively put an end to the president's latest fiscal stimulus plan - another negative for growth in the near term.
All of these developments fit nicely with our year ahead outlook for U.S. equities. Therefore, we continue to think most stocks will see valuations come down as central banks remove monetary accommodation and growth slows more than investors expect. Favor defensively oriented stocks over cyclical ones. This includes Healthcare, REITs and Consumer Staples. Meanwhile, consumer discretionary and certain technology stocks look to be the most vulnerable as we experience a payback in demand from this year's overconsumption. While other cyclical areas like energy, materials and industrials could also underperform, ownership of these sectors is not nearly as extreme as the discretionary and tech, nor are they as expensive.
Finally, while major U.S. equity indices remain vulnerable, in our view, many individual stocks have been in a bear market for most of the year. As a reminder, almost 80% of all stocks in the Russell 2000 have seen a 20% drawdown during 2021. For the Nasdaq, it's close to 60%, while 40% of the S&P 500 has corrected by 20% or more. In our view, it makes sense to look for new investments in stocks that have already corrected, rather than the ones that have held up the best. We would recommend a barbell of these kinds of stocks with the more classic large cap defensive names that fit our current macro view.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
A quick preview of what you'll hear on the Thoughts On The Market podcast, which features short, thoughtful and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
With recent signals from the Federal Reserve and new data on the Omicron variant, there’s a lot that could impact the shape of 2022, but for now the core of our outlook remains unchanged.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bring you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, December 17th, at 2 p.m. in London.
Every year, the economists and strategists at Morgan Stanley come together and try to forecast what the next year could look like. And then, as always seems to be the case, something happens. The world, after all, is an unpredictable place.
This year, these 'somethings' have come thick and fast. As my colleague Matthew Harrison, U.S. biotechnology analyst, and I discussed on this program last week, the Omicron variant appears to be highly contagious and likely to lead to a large wave of winter infections.
At almost the same time, the US Federal Reserve, arguably the world's most important central bank, has been sounding less tolerant of inflation, leading Morgan Stanley's economists to now expect a quicker end to the central bank's bond purchases and also a larger, faster increase in Federal Reserve interest rates relative to what we thought just a month ago.
Both are major developments. But while they change some of our investment strategy around the edges, we don't think, for now, they change the main story for 2022.
To understand why, let's start with the Federal Reserve. Yes, the Fed is now likely to end bond purchases and raise interest rates sooner than we had previously assumed. But from an investment perspective, we always thought the central bank would signal an intent to be less supportive to start the new year, hoping to convince markets that they were taking inflation seriously. We had previously thought that this 'tough talk' might shift in the spring, when inflation data would come down, and the Fed wouldn't ultimately follow through on interest rate hikes. But now, it looks like they will.
But in either scenario, the strategy for investors should be to position for a central bank that is indicating it wants to be less supportive. As such, we expect interest rates to move higher, especially around five-year maturities, the dollar to appreciate and U.S. and emerging markets stocks to underperform those in Europe and Japan, where the central banks are going to be more accommodating for longer. We think financials outperform as an equity sector, seeing them as a beneficiary of less central bank accommodation.
The other development, of course, is Omicron, while the new variant appears to be highly contagious. Our economists at Morgan Stanley had always assumed some form of a 'winter wave' of COVID in their growth numbers, given the virus's seasonal characteristics. Economic data, for the moment, has actually held up quite well and global activity has been less impacted by each incremental COVID wave. And we also need to consider the entire year, not just what could be a very difficult month or two of high COVID cases. All of these together are why our base case remains for strong global growth in the next year, despite the currently worrying headlines.
Both new developments, however, require close observation. The Fed looks much more willing to shift in either direction than it has before, while the full impact of Omicron may not be seen for several more weeks. For now, however, we think a backdrop of good global growth and less central bank support remains the outlook for 2022.
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The last week brought new evidence regarding the transmissibility, immune evasion and disease severity of Omicron, and with it, more clarity on the coming weeks and months.
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Welcome to Thoughts on the Market. I'm Matthew Harrison, Biotechnology Analyst. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing our updated thoughts on the COVID 19 pandemic and the impact of Omicron. It's Thursday, December 16th at 10:00 a.m. in New York.
Since Omicron was first discovered, we've been using the framework of transmissibility, immune evasion and disease severity to think about its impact. Over the last week, the level of evidence on all three topics has increased significantly.
So first, on transmissibility. The ability of Omicron to outcompete the prior dominant variant, Delta, now appears clear. We have evidence in South Africa, the UK and Denmark, with Omicron now dominant in central London and set to be the dominant variant in the UK over the next few days. The US is a few weeks behind Europe in terms of spread, but we would expect a similar pattern. Cases are now rising globally, driven by Omicron's transmissibility. This is a combination of factors driven by one, its innate transmissibility, and second, its immune evasion properties, which have dramatically increased the percentage of the population susceptible to infection.
We now have multiple studies, which generally come to a similar conclusion. Two doses of vaccination or a single prior infection provide little to no barrier against infection. Two doses of vaccination do, however, provide protection against severe outcomes like hospitalization or death. This is around a 70% relative reduction versus those who are not vaccinated based on preliminary data. Three doses of vaccination or two doses of vaccination and a prior infection provide a greater barrier against infection. Preliminary data here suggests a 75% relative reduction to those without three doses or two doses and a prior infection. Importantly, since a limited proportion of the population has been boosted - we estimate at about mid-teens percentage of the total US population - the vast majority of the population is again susceptible to an infection with Omicron.
And finally, on disease severity. The data out of South Africa continue to suggest the percentage of patients with severe outcomes is lower relative to the prior Delta wave. This means that there are less people in the ICU and less people on a ventilator as a proportion of the total people infected compared with Delta. That said, it's important to remember that even with a lower proportion of people having severe disease, if Omicron drives a wave of infections that is much higher than Delta, the overall disease burden could still be very high.
So this leads us to what is our outlook on infections and the ultimate impact of Omicron. The variant is likely to be dominant quickly, and we would expect to be in the steeper part of the exponential rise in cases here in the US in the next two to three weeks. We believe it is possible that the Omicron wave could have a peak in terms of total number of infections that is somewhere between 2 and 3 times higher than the prior Delta wave. However importantly, vaccination should help protect against severe outcomes.
For more on Omicron, we also recently sat down for an interview with the Moderna CEO Stephane Bancel to discuss his views on that topic and more. You can see the full interview on MorganStanley.com.
Thanks for listening! We hope you have a safe and enjoyable holiday season. If you enjoy Thoughts on the Market, please be sure to rate and review us on the Apple Podcast app. It helps more people find the show.
While many are hopeful for an easing of supply chain delays in 2022, the resolution of these issues may lead to new challenges and opportunities in key stock sectors investors should be watching.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, December 15th at 10:00 a.m. in New York.
Inflation is a hot topic in Washington, D.C. The president talks about it regularly in his Twitter feed and on camera. It's also a favorite concern of Senator Manchin, who openly ponders whether inflation concerns will keep him from casting the deciding vote on the Build Back Better plan. Yet for investors, inflation has always been a necessary obsession, as its presence or lack thereof, typically drives impacts in the bond and foreign exchange markets. But today we want to focus not on the potential effects of inflation, but one of its causes - namely supply chain issues and how the resolution creates challenges and opportunities in some key stock sectors.
But let's start with the why of supply chain issues. Why are the reports of shortages, ships waiting at ports to deliver goods, and rising prices because of the scarcity it creates? In short, it has to do with the extraordinary impact of the pandemic. Social distancing initially drove sharp but short-lived declines in consumer demand and companies' consumer demand expectations. But substantial fiscal aid to the economy led to a rebound in economic activity. Yet this was mostly focused on goods over services as COVID concerns continued to crimp the demand for activities, like eating out. This led to some abnormal and astonishing data. For example, personal consumption of durable goods declined 20% in the early days of the pandemic, more than 10x the decline from the prior recession. Yet by this past October, consumption of durable goods was 40% higher than pre-COVID. It's no wonder that container shipping rates from Shanghai to Los Angeles are 5x their normal run rate.
Yet our colleagues see these pressures starting to abate in the US. Vaccines appear to have eased concerns among the population in consuming services in public spaces and service consumption is now rising sharply, whereas goods consumption growth has leveled off. Our economists expect this will help ease the pace of inflation starting in the first quarter of next year.
While this would be good news for the economy overall, the story could be more mixed across stock sectors. Our tech hardware team, for example, sees a period of weaker orders for semiconductors after customers receive their currently delayed orders. This dynamic could open the door for earnings disappointment. On the other hand, our Capital Goods team sees opportunity, as the current bottleneck may have persuaded a variety of industries that they need to invest in reinventing their supply chains and potentially engage in some re or near shoring, which would require substantial equipment and materials investment.
So as we head into the end of the year, supply chain delays are likely to continue to raise concerns around inflation, but the first half of 2022 will be telling. We'll keep you updated as the story develops.
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Cryptocurrency companies have begun to act as banks in the US, and while regulators have expressed concerns over interest rates and the primacy of the dollar, this interplay has only just begun.
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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Analyst for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the escalating financialization of cryptocurrency markets. It's Tuesday, December 14th at 2:00 p.m. in London.
BYOB - Be Your Own Bank. This has been the clarion call of Bitcoin evangelists since its very inception. But in an ironic turn of events, crypto companies Avanti, Anchorage and Kraken have all become banks in the US. Not in the sense espoused by bitcoin maximalists, but in the fiat - that is to say, government regulated sense.
And regulators have shone much of their spotlight on the conspicuously outsized interest rates on offer to depositors through crypto lending. On the 10th of December, you could deposit a cryptocurrency called USDC with a company called BlockFi and receive an interest rate of 9%.
Concern has arisen from the fact that the issuers of USDC aim to control its value, such that a single USDC should, in theory at least, always fetch a value of approximately one U.S. dollar. The disparity between a 9% rate on what is essentially a proxy for the dollar and the historically low rates on actual dollar deposits at retail banks, has regulators concerned about the emergence of a parallel banking system.
The irony here is that it was preexisting banking regulation itself that played a hand in creating this high rate. Traditional banks have turned down crypto traders due to regulatory risk, and so these traders were forced to borrow from the crypto markets and offer lenders higher rates of return.
Nevertheless, US regulators appear to be taking measures to limit competition with the dollar banking system. New Jersey regulators have ordered BlockFi to stop offering high interest crypto deposit accounts from February next year. And in September, the Securities and Exchange Commission sent Coinbase a Wells notice, following which Coinbase aborted a plan to offer 4% interest on USDC deposits.
Ultimately, regulators will have to decide how aggressively they want to safeguard the primacy of the dollar. They could stymie much of the industry to be sure or hope the dollar stands up to scrutiny in order to allow the crypto industry to grow. The longer they wait, the higher the risk. Following multi-trillion stimulus packages and over a decade of quantitative easing, the dollar has been left as open to competitors as it has been since the Bretton Woods agreement in 1944. Investors should keep an eye on the direction that regulators take in the face of this and the broad spectrum of outcomes those regulations might portend for crypto valuations, ranging anywhere from new highs to the old lows of bygone price cycles.
The meeting of crypto culture and traditional banking regulation is a seminal moment for the crypto industry. I, for one, am excited to see how this interplay evolves. Crypto companies are becoming more like banks, just as traditional banks have themselves begun to offer crypto products.
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Our 2022 outlook presented a wider than normal range of potential paths. While our base case still appears likely, shifts in supply and Fed policy could cause a change in course.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, December 13th at 11:30 a.m. in New York. So let's get after it.
In writing our year ahead outlook, we were faced with what we think is a wider than normal range of potential economic and policy outcomes. This higher "uncertainty" was one of the inputs to our key conclusion - that valuations for U.S. equity markets were likely to come down over the next 3-6 months. In our discussions with hundreds of clients since publishing our outlook, the conversations have centered on these three potential outcomes and how to handicap them.
First is Goldilocks. When we published our outlook on November 15th, this was the prevailing view by most clients. In this outcome, supply picks up in Q1 to meet the excess demand companies are having a hard time fulfilling. Inflation has a relatively fast but soft landing towards 2-3%, which allows for growth to remain strong and multiples to remain high. The S&P 500 reaches 5000 by year end 2022. And this was our bull case in our outlook with a 20% probability.
In the second outcome, inflation remains hot and the Fed responds more aggressively. Under this outcome, inflation proves to be stickier as supply chains and labor shortages remain difficult to fix in the short term. The Fed is forced to taper faster and even raise rates on a more aggressive path. This was our base case, as it essentially lined up with our hotter but shorter cycle view we first wrote about back in March. At the same time, operating leverage fades as costs increase more in line with revenues. This leaves market breadth narrow in the near-term as valuations fully normalize in line with the typical mid-cycle transition. While there is some debate around how much P/Es need to fall, we believe 18x is the right number to use for year-end 2022. When combined with 10% earnings growth, that gives us a slight downside to the index from current prices, or 4400 on the S&P 500. We put a 60% probability on this outcome.
The third outcome assumes supply ticks up, but demand fades. Under this scenario, we assume supply comes too late to meet what has been an unsustainable level of consumption for many goods. It's also too expensive for customers who have become wary of higher prices, which leads to demand destruction for many areas of the economy. While services should fare better and keep the economy growing, goods producing companies suffer. Under this scenario, the Fed may back off on their more aggressive tightening path. Rates fall, but not enough to offset the negative impact on margins and earnings, which will end up disappointing. This is essentially the "Ice" part of our Fire and Ice narrative turning out to be chillier. Equity risk premiums soar and multiples fall more than under our base case. This was our bear case with a 20% probability.
Since publishing, we feel more confident about our base case being the most likely outcome. Inflation data continues to come in hot and companies are having little problem passing it along, for now. While this will likely lead to another good quarter of earnings, we suspect there will be more casualties too, as execution risk is increasing. This will leave dispersion high and leadership inconsistent - two more conclusions in our outlook. Stock picking will be difficult, but a necessary condition to generate meaningful returns in 2022 as the market index is flat to down over the next 12 months.
This is a big week on policy outcomes, with the Fed likely to announce a more aggressive timeline for tapering its asset purchases. In short, we expect the Fed to tell us that they will end its asset purchase program by March 31st. While our base case always assumed the Fed would respond appropriately to higher inflation, this is a more aggressive pivot than what we expected a month ago. Importantly, the Fed is now suggesting stable prices are important to achieving its primary goal of full employment, which means inflation is taking center stage until it's under control. Finally, we think Jay Powell and the Fed will be under much less pressure from the White House versus the last time they were aggressively removing monetary accommodation in late 2018. Part of this is due to the fact that inflation is a much bigger problem today than it was in 2018, and part of it is due to the observation that the White House today is not as preoccupied with the stock market. Bottom line, the Fed is determined to bring down inflation, and falling stock prices are unlikely to stop them from trying.
In this kind of an environment, we continue to favor companies with earnings stability and reasonable valuations. That means large cap defensive quality stocks. In short, boring can be beautiful.
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With recent central bank action raising questions on monetary policy, Global Head of Macro Strategy Matthew Hornbach takes us through the implications for the trajectory of rates and currency markets in the year ahead.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the 2022 outlook for rates and currency markets. It's Friday, December 10th at 10:00 a.m. in New York.
Every November my colleagues within research come together to discuss the year ahead outlook. And almost every year something happens in the month after we publish our forecast that changes one or more of our views. This year, several Morgan Stanley economists have changed their calls on central bank policies given higher than expected inflation and shifting central bank reaction functions.
Our monetary policy projections have become more hawkish for central banks in emerging markets, mostly. But earlier this week, our projection for Federal Reserve policy became more hawkish as well. Our economists now see the Fed raising rates twice next year, whereas before they didn't see the Fed raising rates at all.
Does this change alter our view on how macro markets will move next year?
Well, it doesn't change our view on the direction of markets. We still think U.S. Treasury yields will rise and the U.S. dollar will strengthen in the first half of the year. But now we see a flatter U.S. yield curve and the U.S. dollar performing better than before.
What hasn't changed in our outlook? We still see macro markets dealing with variable central bank policies in 2022. Some policies will be aimed at outright tightening financial conditions, such as in the UK, Canada, New Zealand and now the U.S. Other central banks will attempt to ease financial conditions further, albeit at a slower pace than before, like the European Central Bank. And some will aim to maintain accommodative financial conditions like the Reserve Bank of Australia and the Bank of Japan.
For rates markets, we expect yields around the developed world to move higher over the forecast horizon, but only moderately so. And while we see real yields leading the charge, we don't foresee a tantrum occurring next year. We forecast 10-year Treasury yields will end 2022 just above 2%. That would represent a similar increase to what we saw in 2021.
As for the US dollar, we see two primary factors lifting it higher next year. First, we see a continued divergence between U.S. and European economic data. Recent U.S. economic strength should continue into the first half of the year. And expectations for future growth should stay elevated, assuming additional fiscal stimulus measures are approved by the U.S. Congress, in line with the Morgan Stanley base case.
At the same time, our economists have been expecting data in Europe to weaken. In addition, the worrying surge in COVID cases and the government responses across Europe pose additional downside risks. To be clear, we expect eurozone growth to be strong over the full year of 2022, yet it is likely that the economic divergence between the U.S. and Europe continues for a while longer.
This should keep the U.S. dollar appreciating against low yielding G10 currencies, such as the euro. We also expect further upside for the US dollar against the Japanese yen, driven by higher U.S. Treasury yields.
The second factor arguing for a stronger US dollar is central bank policy divergence. The Fed could strike a more upbeat and hawkish tone throughout next year, just as it has done more recently. On the other hand, the risk for the ECB is that its more hawkish members adjust their views in a more dovish direction, and then the ECB delivers more accommodation than expected, not less. If the upcoming Fed and ECB meetings this December go as we expect, they would set up the dollar for additional strength in the first half of next year.
As for higher yielding riskier currencies, we think four factors will support them. First, our economists forecast robust global growth next year. Second, they also forecast inflation will moderate from unusually high levels. Third, they see central banks maintaining abundant pools of global liquidity. And finally, we think this leads to only a moderate rise in real yields.
As a result, we have constructive views on the risk sensitive G10 currencies. In particular, we expect the Canadian dollar and the Norwegian krona to outperform the US dollar and lead the G10 pack. We see buoyant energy prices and hawkish central bank policies keeping these currencies running ahead of the U.S. dollar and far ahead of the euro and the yen.
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The US economy is in a unique moment of uncertainty but headed into 2022, shifts in inflation, the labor market and Fed policy tell a constructive story.
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Ellen Zentner Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research.
Robert Rosener And I'm Robert Rosener, Senior U.S. Economist.
Ellen Zentner And on this episode of the podcast, we'll be talking about the 2022 outlook for the U.S. economy. It's Thursday, December 9th at noon in New York.
Robert Rosener So, Ellen, we're headed into 2022. We're in a pretty unique moment for the U.S. economy. We see rising inflation, supply chain issues and uncertainty about Fed policy. Of course, we also had disappointing job growth in the month of November, but unemployment that is now not far from pre-COVID lows. So we've got a lot of different indicators sending very different messages right now. How should listeners be thinking about the U.S. economy right now and what that means for the outlook into 2022?
Ellen Zentner Yeah. So we're pretty constructive on the U.S. economy, and it may be surprising with all the uncertainties that you noted. You know, consumers are in very good shape. We've been talking about excess savings for a long time on these podcasts. Excess savings is still there as a cushion. Look, inflation is rising and continues to rise, but it's rising because demand is still strong. At the same time, we don't have enough goods of what people want to buy. So I don't think we're out of the woods yet for rising inflation. I think we're going to get some more prints here that are even higher. But we already are getting indications from our equity analysts that their companies are saying that their supply chains are easing. So I think, within just a matter of months, we should start to see inflation come down. And while households are telling us in our surveys that inflation worries them even more so than COVID, they're still spending. And we expect that as we move into next year, we're going to recoup some of that deferred demand from goods that are going to be available that weren't there before.
Ellen Zentner But the other thing that's really important for consumer spending is the jobs numbers, and you mentioned that, Robert, explained to people-- because this was the number one question we got after that jobs report: how is it that you get a headline number? That's so disappointing, but unemployment rate is that low? I mean, is it good? Is it bad?
Robert Rosener Yeah, it's a really mixed picture and a lot of different indicators pointing in a lot of different directions. So of course, we got our latest read on the labor market that showed a slower than anticipated rise in jobs. In the month of November, we created 210,000 jobs. That was less than half of what was expected, but overall, the report still had a solid tone. And one of the reasons why there are still solid indications coming from the labor market is that we're seeing continued healing from some of the biggest effects of the pandemic and that came through, most notably in November in labor force participation. One of the biggest shortfalls in the labor market has been the number of individuals who are actually actively participating in the labor force. We saw the labor force participation rate, in total, rise 20 basis points in November to 61.8%. That's still well below the 63.4% peak we saw pre-COVID, but it's notably out of the very sticky range it's been in since the summer. So we're seeing continued healing there. We're expecting that healing is going to continue, and that's going to be a very important part of this labor market recovery.
Ellen Zentner So what are you telling clients then that are worried about wage pressures and where those might go? Because participation, rising participation, does matter there. So what's our message?
Robert Rosener Well, much like the inflation backdrop, we're moving through a period of more elevated wage growth. There's been a significant amount of disruption in the labor market and alongside it, wage pressures have risen. But labor supply opening back up is a very important way that we're going to see supply and demand come back into balance in the labor market. We just got data on job openings, which showed that aggregate job openings in the economy are in excess of 11 million. There's one and a half open jobs for every unemployed individual in the labor market. If we boost the number of people who are actively participating in the labor market, it's going to bring those supply and demand metrics in better balance, and it should help to ease wage pressures alongside that.
Ellen Zentner OK, that's interesting because, you know, one conversation that we have with our equity investors quite a bit is, you know, how should companies be looking at higher wage pressures? And of course, if you talk to economists and academics, right, we love to see higher nominal wages because that means stronger backdrop for aggregate demand. But the other reason why I really like higher nominal wages, they precede capital deepening. So if companies want to offset a higher wage bill, then you've got to find efficiencies and to find efficiencies, you've got to invest. So we're seeing companies invest in IT and equipment. We are calling it 'the global COVID capex cycle.' And that's really a bright spot in the economy for next year's outlook as well. So we would expect that to continue.
Robert Rosener So, Ellen, we talked about a lot there. We've got elevated inflation now, some of which may be passing as supply chain disruptions ease. We have labor markets that, on the one hand, look tight, on the other hand, look like they have scope for further recovery. What does this mean for Fed policymakers and how do they put together the puzzle of what's going on in the economy when they're thinking about normalizing monetary policy?
Ellen Zentner Yeah, it's not an easy job, is it? But Chair Powell is going to continue that job, as we've learned, and it's not going to be an easy backdrop for him. The Fed is concerned about what looks like more persistent inflationary pressures than they had previously thought. So no doubt, you know, you and I can sit down and pick apart the data and easily point to areas of inflation that are clearly temporary. But we've just not seen evidence of it as early as expected. And markets are starting to pressure the Fed on really giving more weight to price stability. And so we have seen a shift from the Fed. Last week, we heard Chair Powell say that price stability is important and only price stability would then beget maximum employment. And so really putting a lot more pressure on the price stability side of things. So we think at this upcoming FOMC meeting next week that we're going to see quite a hawkish shift from the Fed, both in their message around how quickly they are reducing the pace of their purchases. We think that they'll end that early. And then we'll see their so-called dot plot show an indication that they're going to start rate hikes earlier than expected, probably two quarters earlier than expected. And so I think that's a really important shift. And what it means is that going forward, our forecast that inflation will eventually start slowing in the first quarter will be very important in determining when the Fed actually does start increasing rate hikes.
Ellen Zentner So that was a lot to unpack about the outlook. There's many more details, and we'll pick out interesting parts for folks as we go along. A new podcast to come. And Robert. Thanks for taking the time to talk.
Robert Rosener Great speaking with you, as always, Ellen.
Ellen Zentner As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
Headed into next year, ‘Build Back Better’ legislation remains a work in progress, but Congress may find common ground in both parties’ concerns around one issue: tech regulation.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between US public policy and financial markets. It's Thursday, December 9th at 10:00 a.m. in New York.
Congress continued to check things off its year end to do list this week, following up its funding deal to avoid a shutdown with an agreement to raise the debt ceiling. The Build Back Better plan, which features new spending on environmental and social issues backed by new taxes, remains a work in progress. So, this week we want to look ahead a little to an issue which could feature heavily in congressional debate next year: regulation of the tech industry.
Now, to be clear, we think the prospects for congressional action ahead of the midterms are quite low. But major legislation that drives sea changes in policy often is a multi-year process and you can learn a lot by paying attention to that process. Republicans spent a decade crafting the tax reform that would drive their actions in 2018. The same for Democrats with the years preceding the Affordable Care Act and the Dodd-Frank reforms of the banking industry. And this coming year could be a particularly educational one in terms of how DC wants to tackle the tech industry. That's because the industry could continue to be a popular issue for both Republicans and Democrats. Both parties share concerns about content moderation, data privacy and company size, though they differ on the approach to dealing with these issues. Crucially, they also share a political motivation, with a recent poll showing the tech industry's approval rating with the American public at 11%, one of the few institutions with a lower approval rating than Congress.
So what do we think we'll learn as Congress focuses on this issue? Policymakers are likely to update existing templates for regulating traditional broadcast media. That's because there are already institutions in place to do this, and it's easier for voters to understand the process.
A bear case for what this could look like comes from overseas. The United Kingdom's Online Safety Bill and the European Union's Digital Markets Act spell out some big and potentially costly regulatory challenges for social media companies. This includes requirements to allow users to easily move their data, disallowing product tie-ins and preferential product placement, and potentially, legal and financial liability for harmful content. If such measures were adopted in the US, our colleague and coauthor Brian Nowak estimates this could meaningfully crimp social media companies’ ad revenue, leading to underperformance of the sector.
But for now, we expect next year will reveal the U.S. is likely headed in a more moderate direction. Early legislative proposals tend to gravitate toward codifying data transparency, portability rights and content moderation. Here, our colleague Brian Nowak notes that internet companies have already begun investing heavily to develop internal infrastructure that deals with these types of regulations, potentially limiting the cost impact of new laws. That's a key reason he still sees value in this stock sector. But of course, that also means if we've read the policy direction in the US incorrectly, there's downside for the sector. So, we'll be watching carefully in 2022 to see if the U.S. continues to forge its own path or follows Europe in its approach to tech regulation.
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With early data in on the Omicron variant, biotechnology analyst Matthew Harrison takes us through where we stand on vaccine efficacy headed into the winter.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
Matthew Harrison And I'm Matthew Harrison, Biotechnology Analyst.
Andrew Sheets And on this special edition of the podcast, we'll be talking about updates on the Omicron variant and vaccine efficacy. It's Wednesday, December 8th at 4:00 p.m. in London.
Matthew Harrison And it's 11:00 a.m. in New York.
Andrew Sheets So, Matt, it's great to talk to you again. We've had a lot of small pieces of data come out recently on the Omicron variant and its ability or not to evade vaccines. What's the latest and what do we know?
Matthew Harrison So, we've had three studies published so far. I would caution that the samples are small, and we have to take them as that, but we do have some interesting trends developing. So, the first one is: most of the data has demonstrated a substantial drop in what are called 'neutralizing titers' against two doses of the vaccine. And so that unfortunately means that protection against symptomatic infection for people that have had two doses of the vaccine is quite limited. We don't know exactly what, but it's definitely below or at 50%. What we've also learned is that a third dose can help restore some of that protection. We don't know the durability of that dose and we don't know how much protection it restores, but it does restore some protection. I think importantly, though, one of the things to remember is that most of the globe has only had two doses. And as we run through this potential spread of Omicron over the next few months, most of the globe will continue to only have two doses. So that data on two doses does suggest that there can be substantial reinfection risk for those that have had the vaccine.
Andrew Sheets So Matthew, you know, when we're thinking about these numbers and we think about vaccine efficacy, maybe dropping to 50%, what does that mean in terms of the risks versus current variants and then the risks if you're not vaccinated at all?
Matthew Harrison Right. So, I think there are two important things that I would say. So, the first is, what we're talking about here is symptomatic infection. Some of the other data that's come out has been on T cells. T cells are the second component of your immune system. They help kill virus once it's already infected in cells, and the T cell data looks like there remains substantial protection driven by T cells. And so, I think what that says is even though we're seeing substantial drops in protection against symptomatic infection, my hope continues to be based on these data and other data we've looked at, that protection against severe outcomes such as hospitalization and death could remain quite high.
Andrew Sheets So that seems quite important for both the public health outcomes. And then, as would follow the impact in the economy, is that it might be more likely that somebody with two shots of a vaccination regime would get some form of COVID, would show symptoms, but it might be still much less likely that they would end up in the hospital with severe cases, as the vaccines would still help the body protect against those more extreme outcomes.
Matthew Harrison That is my hope and based on the data that we're seeing so far, I would note, as we talked about at the beginning, that all of these studies that we're seeing come out right now are preliminary. You know, my hope is over the course of the next week or so, we're going to have a lot broader data set available to answer many of the questions we're talking about. And so, we're still going to have to, take our time with this because we don't have complete information yet.
Matthew Harrison So, Andrew, one of the questions I've been thinking about here is, and you touched on it in some of the questions you were asking me, is how does the market handle a substantial increase in the number of infections, but maybe a lower proportion of those infections ending up with severe disease than we've seen in previous waves?
Andrew Sheets Yeah, thanks Matthew. So look, I think this distinction between, you know, any case of COVID that shows symptoms and a case of COVID that results in somebody being hospitalized, you know, that is a pretty big distinction. And again, it's quite possible to see headlines and get quite worried about headlines that you know this variant evades vaccines and kind of to think that, "oh, then vaccines are powerless to stop it" when you know, I think as your research has rightly highlighted, if the vaccines can still provide a powerful mitigant against the most severe cases against hospitalizations, and you can still avoid some of the most severe public health outcomes that really would force much bigger restrictions. And those are the types of things that would really slow economic activity and really disrupt the economy, in addition to obviously having a really tragic impact on human life. So I think that distinction is important.
Andrew Sheets We obviously, as you mentioned, it's early and we need to watch it in terms of just more cases, you know, evolving again, I think we have to see how public health officials react to that. How do consumers react to it? Does it impact consumer behavior around the holidays? And you know, we do think U.S. economic activity and European economic activity are pretty strong at the moment, so they have some cushion. But obviously it needs to be monitored.
Andrew Sheets I think the other economy we need to watch is China, which is operating with a zero COVID policy. So, a quite restrictive policy trying to prevent any COVID cases. You know, if the indications are that we are dealing with now two more contagious variants: the Delta variant, and the Omicron variant, you know, there's a question of, does that complicate any sort of zero COVID strategy when you are dealing with a more contagious virus? And that's another big economic story that we have to keep our eye on.
Matthew Harrison Andrew, that's great. Thanks for taking the time to chat today.
Andrew Sheets Matt, always great to talk to you.
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
With investors expected to deal with an increase in volatility in 2022, our outlook for European equities remains strong into next year.
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Welcome to Thoughts on the Market. I’m Graham Secker, Head of Morgan Stanley’s European and UK equity strategy team. Along with my colleagues, bringing you a variety of perspectives, I’ll be talking about the recent volatility in asset markets and how it impacts our 2022 outlook for European equities. It’s Tuesday, December the 7th at 4pm in London.
In recent weeks we have been arguing that equity investors would likely face an increase in volatility over the coming year. However, we hadn't envisaged this manifesting itself quite so soon, or that markets would face a double challenge from a renewed covid-driven growth scare and a tighter US monetary policy shift weighing on sentiment at the same time. To make matters worse, calendar effects are magnifying these uncertainties, with investors wary of adding risk - or alternatively encouraged to de-risk further - as we approach year-end.
In the very short-term market volatility may remain high, however absent a severe hit to growth from the new variant we think this will prove to be an attractive entry point over the medium term for two reasons. First, European equity valuations look increasingly appealing. We can find plenty of attractively valued stocks here in Europe with 28% of listed companies trading on a PE below 12.
Second, some of our tactical indicators are now quite extreme, with the number of 'bears' in the AAII investor survey now up to its 90th percentile – an occurrence that has historically proved a very strong buy signal.
Post this drop in both equity valuations and investor sentiment we think that the worst of this equity correction is now behind us - absent a material profit disappointment that we just don’t see at this time. Such a scenario would likely require a more extensive and sustained hit to activity from the Omicron virus and/or a sharp deceleration in end demand that could signal that inflation is morphing into a more stagflationary environment.
Neither do we see any growth implications from the apparent recent shift in Fed policy. Here we think the biggest implications for equity markets comes from a potential increase in real yields which traditionally occurs at the start of a new Fed tightening cycle. Such a move would fit with our bond strategists forecast for a significant rise in US real yields up to -30bps next year, an outcome that would likely cause substantial disruption within equity markets. Specifically, higher real yields should increase valuation sensitivity and push equity investors to skew portfolios away from some of the most popular and expensive stocks in the market and towards those offering better value.
At the regional level such a shift should favor European stocks over US peers as valuations here have already normalized. Looking out over the next 12 months our index target for MSCI Europe suggests 13% price upside from here, which rises to over 16% when we add in the dividend yield too. Within the market we prefer the more value-oriented sectors given the prospect of higher bond yields, attractive valuations and greater scope for earnings upgrades given that current expectations look unduly low. In particular, we like Autos, Banks and Energy – all three have outperformed the market in 2021 and we see more upside next year too.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The past few weeks have seen weak valuations across equity markets. While many look to the Omicron variant as the main culprit, the correction may have more to do with the recent Fed pivot.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bring you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, December 6th at 2:30 p.m. in New York. So let's get after it.
While there's evidence the past few weeks have been rough for equity investors, there's a lot of debate around why stocks have been so weak. To us, it seemed like too much attention had been put on the new COVID variant, Omicron, as the primary culprit. Our focus has been much more on the Fed's more aggressive pivot on tapering asset purchases. Last Tuesday, Fed Chair Jay Powell told Congress that it was time to retire the word 'transient' when talking about inflation. This was a significant change for a Fed that had been arguing inflation would likely settle back down next year as supply chains adjusted to the increased demand. As a result, the Fed is now likely to reduce its asset purchase program - known as quantitative easing, or QE - twice as fast as it had previously told us. In short, we now expect the Fed to be completely done with its QE program by the end of March. That is quite a speedy exit in our view and is likely to leave a mark on asset prices. Hence, the sharp correction in stocks last week, especially the most expensive ones.
Importantly, this move by the Fed is very much in line with our mid-cycle transition narrative that regular listeners should recognize. From an investment standpoint, the most important thing one needs to know about the mid-cycle transition is that valuations typically come down. In S&P 500 terms, it's typically 20%. So far, we've seen valuations come down by only 10%, making this normalization process only about halfway done, at least at the index level. The good news is many individual stocks have gone through a derating of much greater than 20% already. The bad news is that while some of the most expensive stocks have been hit the hardest, they still look expensive when normalizing for the period of over-earning these companies enjoyed in 2021. Sectors we think look particularly vulnerable include consumer discretionary and technology stocks. Sectors that look cheap are health care and financials.
Another consideration for investors is the fact that this White House appears to be more focused on getting inflation under control, rather than keeping the stock market propped up. This might give the Fed cover to stay the course on its plans to withdraw policy accommodation more aggressively. In other words, investors should not be so confident the Fed will reverse course quickly if stocks continue to wobble into year end.
Finally, the new variant can't be completely ignored and does pose a risk to demand. However, we always expected another big wave of COVID this winter as the cold weather set in. In fact, the recent spike in cases in the US are almost exclusively the Delta variant. In other words, we would be seeing this spike with or without Omicron's arrival. This is one of the reasons we've been expecting demand to disappoint in the first quarter and another thing that markets will have to deal with as we go into next year.
Bottom line, expect markets to remain volatile into year-end as investors are forced to chase and de-risk depending on the price action. In short, moves up and down will be accentuated by asset managers trying to keep up with their benchmarks. In such an environment, we recommend investors continue to keep their risk lower than normal with a focus on large cap quality stocks trading at a reasonable valuation. We expect that over the next three to four months, markets will give us a much fatter pitch to swing at as the Fed completes its exit from QE and growth bottoms.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
One of our most controversial calls for 2022, that the Fed won’t hike interest rates next year, faces renewed scrutiny amidst high inflation, signals on tapering, and today's employment report.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, December 3rd at 2:00 p.m. in London.
We recently published our year ahead outlook for 2022 and right there on the cover, near the top, is one of Morgan Stanley Research's most controversial calls: that the U.S. Federal Reserve will not raise interest rates next year.
Over the last week, more than one investor has pointed to this report and asked if it still applies. After all, inflation has been high, a situation that tends to call for higher interest rates to cool the economy. And Federal Reserve officials have been increasingly vocal about the merits of slowing their bond buying, accelerating the so-called tapering, even more quickly than they originally intended. Seeing the economy is strong and in less need of that additional support.
If the Fed is going to slow down and then stop its bond buying more quickly, the argument goes, surely higher interest rates must be right around the corner. But there's an interesting phenomenon here. When you talk to most investors, they view both higher interest rates and fewer bond purchases as pretty similar things. Both actions, at their core, signal less central bank support for the economy and for markets.
But maybe, just maybe, central banks view the world a little differently. For them, buying any bond, even fewer of them, still represents additional support for the economy. But in contrast, increasing interest rates... well, that's different. That's not additional support, that's actively tightening monetary policy.
At the end of the day, this question is up to the central bankers. But if they do see a genuine distinction between these two actions - a difference that isn't necessarily as apparent to many investors - a faster taper may be able to coexist with a later first interest rate hike. That, at least, is how we see it at Morgan Stanley Research where our forecast is for exactly that - the Fed to accelerate the pace of its taper but not raise interest rates next year.
But there's one more wrinkle in this story. While we think the Federal Reserve will ultimately wait longer than most people expect to raise interest rates next year, there's little reason for them to make that clear now. Inflation is still high and probably won't start to fall for several months. Economic data has been strong and today's employment report showed yet another decline in the unemployment rate. We see little reason why the Fed would want to commit not to take action right now, even if we think that's what they ultimately might do.
Why does that matter? It will mean that in the near term, the Federal Reserve will appear to be taking support away from the economy and for markets. After extraordinary intervention to support markets and the economy, the central bank training wheels are coming off, so to speak, and this impact may be uneven. We think this creates the greatest challenge for highly valued growth stocks in the U.S. and emerging market assets and suggests that investors be patient before trying to buy both.
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Chief Asia and Emerging Markets Strategist Jonathan Garner highlights the key debates around his team’s outlook on the region’s growth, policy changes and more in the coming year.
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Welcome to Thoughts on the Market. I'm Jonathan Gardner, Chief Asia and Emerging Markets Equity Strategist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the 2022 outlook for Asia equities and some of the key debates for next year. It's Thursday, December the 2nd at 7:30am in Hong Kong.
Since we published our year ahead outlook in mid-November, we've had the opportunity to debate the contents with clients in a number of formats, including presentations at our 20th Annual Asia Summit. So today I'd like to share that feedback and focus on some key debates.
Our first debate is, why aren't we more bullish on Asia equities given our economics team's constructive view on 2022 global growth? The answer is that mapping GDP growth forecasts into company earnings growth forecasts is problematic since headline revenue growth is only one driver of earnings per share growth. Margins and leverage are also crucial, and even then, the sector breakdown of earnings growth in listed equities does not always match that of the economy as a whole. That said, broadly speaking, we are more constructive on Japan earnings growth than Emerging Markets and Asia earnings growth, given stronger relative gearing to the US, Europe and developed markets GDP growth, and the broad sector mix of export earnings and global cyclicals in Japan.
We are anticipating earnings growth to continue next year and beyond consistent with continued global economic expansion. We expect 13% earnings per share growth from Tokyo's Stock Price Index “TOPIX" - in Yen - but only 8% for the MSCI Emerging Markets Index - in dollar terms. But it's fair to say that whilst we’re in line with bottom-up consensus for TOPIX, we're around 500 basis points below consensus for emerging markets. And in aggregate, this has a lot to do with the macro headwinds of our house forecast of dollar strength for Emerging Markets, but also specific sectoral headwinds which we anticipate in areas like China Internet and Asia Semis and Tech hardware in Korea and Taiwan. Another key factor to consider is clearly what's in the price, and we think emerging markets, which are trading around 13x consensus forward P/E - or around the 60th percentile of the 5-year range - still have some downside to valuations over the next year as a whole, whilst we are comfortable with Japan valuations.
Our second debate was, why we're not enthusiastic about buying back China equities. Here, we think risk/reward has not yet tilted definitively to the positive, particularly for offshore China growth stocks. We think earnings estimates still need to come down significantly further and similarly to Asia and emerging markets overall, valuations are not particularly cheap - at around 13x consensus forward price to earnings multiple for MSCI China.
For sure, China's monetary policy is gradually changing to be more accommodative, and some measures have been taken to re-stimulate property sector demand. However, the Chinese economy has developed downward momentum over the summer and autumn and still faces significant downside risk this winter as a result of prior policy tightening and factors such as COVID Zero lockdowns on the consumer and the impact of regulatory reset on private sector capital spending.
Our proprietary indicator of Global Multinational Corporations' sentiment, vis-a-vis their Chinese operations, has just reported its biggest ever quarterly decline and is now at the second lowest since we began our regular quarterly survey.
The third debate was, why are we constructive on emerging markets energy? Our answer is that the energy sector and energy sensitive markets are typically later cycle performers, and early next year will mark the second anniversary of the short but intense COVID-driven recession, which at one point marked the first time ever that oil prices went negative. We've come a long way since then in terms of demand recovery, but more is likely still to come if our commodities team is right that Brent can trade over $90 a barrel in 2022. This is the payback for underinvestment in conventional energy supply in recent years, mainly due to ESG concerns. So, it's an example of where our house view on strong global growth in 2022 and 2023 does lead directly to an investment conclusion for a particular sector. And MSCI EM Energy is trading at book value versus 1.9x price to book for the index, and with a free cash flow yield of almost 9%.
Before I close, there is a lot of discussion around the new COVID 19 variant, Omicron, and whether it changes our views. At present, we're in early days on this variant and as such, it doesn't change our already cautious view on the outlook for Asia equities.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The Omicron variant of COVID-19 has investors concerned about potential new restrictions, but the onus lies most on state and local governments who, for now, are awaiting more information on infection rates and severity.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, December 1st at 11:00 a.m. in New York.
Not surprisingly, our client conversations this week have been all about Omicron, the new COVID 19 variant that our biotech team thinks may increase infection rates and reduce vaccine effectiveness. In particular, clients want to know if the new variant will lead to fresh government restrictions and crimp the U.S. economic outlook. While the federal government gets much of the attention here, we think the key to sizing up this variable lies in understanding how state and local governments will behave. These are the jurisdictions that have generally driven mask mandates, indoor dining restrictions and other activities. And while there's much to learn about Omicron, here our initial assessment is that the bar is quite high for states and locals to take action, and that should limit downside risk to the economy.
What drives our view? In short, ever since states began lifting restrictions in late spring of 2020, their behavior has mostly been influenced by hospital capacity. Of course, some states lifted restrictions faster than others, but in most cases where restrictions were tightened, rising COVID hospitalizations and lack of bed capacity were cited as the culprits. With the availability of vaccinations in the U.S. and the high vaccination rate among vulnerable populations, risks to hospital capacity have lessened. That's because while COVID can infect the vaccinated, they are far less likely to get sick in a way that lands them in the hospital.
So that means, when it comes to sizing up if Omicron will lead to government restrictions on economic activity, it's less about whether vaccines will prevent infection, but if they can limit hospitalizations. While there's still not a lot of information, and thus outlooks could easily change as data on the new variant is collected, our biotech research team's base case is that Omicron is not more virulent than the currently dominant Delta variant. Further, the U.S. government continues to express the view that vaccines will provide protection against severe disease. Taken together, this would suggest that as long as the U.S. can sustain its vaccine campaign, including the current push for boosters, the economy may only face manageable headwinds. For fixed income investors, that means Treasury yields should still trend higher. And for credit investors, particularly in COVID sensitive municipal bond sectors like airports and hospitals, we see fundamental risks as manageable.
Yet investors should probably focus intently on what would change this view, as this ‘goldilocks outcome’ is mostly in the price of credit and equity markets already. And here again, we say focus on news about Omicron's severity, which is expected within the next few weeks. If data shows it to drive both more infection and more severe sickness, then hospital capacity could be challenged, leading state and local governments to reluctantly reimpose some restrictions. And of course, consumers could react to this signal and change their own behavior - thinking twice about that next flight, for example.
Yet perspective is important here, and even this negative outcome is more likely an economic setback than a disaster, as our biotech team notes that pharmaceutical companies may be able to turn around new boosters to address the challenge within a few months. That in turn means there's likely to be opportunities in credit and equity markets if this riskier case is the one that plays out. We'll, of course, be tracking it all here and checking in with you as we learn more.
Thanks for listening! If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
Last week’s news of the Omicron variant of COVID-19 has raised questions about transmissibility, vaccine efficacy, and virus mortality. Where does this variant leave us in the fight against COVID-19 and how are markets reacting?
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.
Matthew Harrison And I'm Matthew Harrison, Biotechnology Analyst
Andrew Sheets And on this special edition of the podcast, we'll be talking about a new COVID variant and its impact on markets. It's Tuesday, November 30th at 2p.m. in London.
Matthew Harrison And it's 9:00 a.m. in New York.
Andrew Sheets So Matt, first things first, you know, we've seen a pretty major development over the American Thanksgiving holiday. We saw a new COVID variant, the omicron variant, kind of come into the market's attention. Can you talk just a little bit about why this variant has gotten so much focus and what do we know about it?
Matthew Harrison Sure. I think there are probably three major factors that have driven the focus. The first thing is there was clear scientific concern because of the number of mutations in the variant. And specifically, there are over 50 mutations, 32 of which are in the spike protein region, which is where vaccines are targeted. And then a number in the receptor binding domain, which is where the antibodies typically tend to bind. So the antibodies that either vaccines or antibody therapies create. And what we know when we look at many of these mutations is they're present in other variants: gamma, delta, alpha, beta and we know that many of these mutations in a pair one or two have led to reduction in vaccine effectiveness. And so, when they're combined all together, from a scientific standpoint, people were very concerned about having all of those mutations together and what that would mean in terms of vaccine escape.
Andrew Sheets So Matt, this is obviously a challenging situation because this is a new variant. It's just been discovered. And yet, you know, a lot of people are trying to figure out what the longer-term implications could be. So, you know, when you look at this with the kind of a limited amount of information, you know, what are the key characteristics that you're going to be watching that that you think we should care about?
Matthew Harrison There are probably three things that I'm focused on and we can probably touch on in detail. So the first one is transmissibility, and the reason for that is if this variant overtakes Delta and becomes dominant globally, then we're going to care about the two other factors a lot more, which is vaccine escape and lethality. However, if it's not more transmissible than Delta and Delta remains the dominant variant, then this may be an issue in small pockets, but ultimately will fade and continue to be overtaken by Delta. And so that's why transmissibility is the primary focus. And so what do we know about transmissibility right now? We have a couple of pieces of information out of South Africa. The first is they have sequenced a number of recent COVID patients. And in those sequences, the vast majority or almost all of them have been Omicron. So that suggests that it is overtaking Delta. But again, sometimes sequence results can be biased because they're not a population sample and they're a selection of a certain subset of people. The second piece of information, which to me is more compelling, is I'm sure everybody's aware of the PCR tests. There's a certain kind of deletion here in this variant that that that you can pick up with a PCR test and so you can see the frequency of that deletion. And that that frequency has risen from about a background rate of about 5% in the last week and a half to about 50% of the PCR tests coming back suggestive of this variant in South Africa. And so that's a much bigger sample size than the sequencing sample size. And so that suggests at least in the small subset that you're seeing greater transmissibility compared to Delta. Now it's going to take time to confirm that. And now that we've seen cases globally in a lot of countries over the next week or two, everybody's going to be watching how quickly the Omicron cases rise compared to Delta to confirm whether or not it's more transmissible than Delta.
Andrew Sheets This question of vaccine evasion. There's there has been some increased concern about this new variant that it might be able to evade vaccines. Why do people think that? And you know, how soon might we know?
Matthew Harrison Why don't we start with the timeline, because that's the simpler part. The experiments to figure that out take about two weeks. And just so everybody has the background on this, you need to take the virus, you need to grow it up. And once you have a sample of it, then you take blood from people that have recovered from COVID and blood from people that have been vaccinated that are full of those antibodies. And you put them in the in the dish and you find out how much virus you kill. And that'll tell you how effective the serum from vaccinated or previously infected individuals are against the new variant. So that process typically takes about two weeks. So then why are people worried about vaccine evasion with this variant? Primarily because of the known mutations that it carries and the unknown mutations. And of the known mutations that it carries, it carries the same set of mutations as in beta, and the beta variant had significant vaccine evasion properties that never became dominant, but it did reduce vaccine effectiveness by about six-fold. And so, I think the concern is with those mutations, plus a range of other mutations known to have vaccine evasion properties, having them all together has really significantly increased concern about how much that may hurt the vaccine's ability to stop infection.
Andrew Sheets And, Matt, so you talked about the importance of transmissibility, you know, you talked about some of the reasons why the concerns are higher around vaccine evasion with this variant. And the last thing you talked about was the lethality of this variant. And again, you know, what are you looking for there? Is there anything that concerns you with the information that we know and when might we know more?
Matthew Harrison So this is the hardest question because as is typical, you get a lot of anecdotal reports about what's happening with recently infected patients, but it takes a while, on order of four to five weeks, to really understand if there is a significant difference in mortality or hospitalization. So we have very little information around those factors. You have seen in the capital region, in South Africa, where you've where you've seen these rising cases, a rise in hospitalizations, but we don't know if all those cases are Omicron cases or not. And we haven't seen mortality at all. But again, with recent infections, it usually takes four or five weeks to start to see the potential impact of those infections on mortality.
Matthew Harrison And Andrew, I think one other thing which is important to mention is while we're while we're talking about severity of disease and lethality, we have to remember that in addition to vaccines, we do have now other effective treatments, including antibody therapies and oral therapies. And while some antibody therapies are likely not to work against Omicron, at least two or three of them are. And so you have you will have some effective antibody therapies. And then the oral therapies, given their mechanisms of action, should not be impacted. So we will have oral therapies in terms of treatment. So hopefully, even if we do get a scenario where there is significant impact on vaccine efficacy, this will not be like going back to the beginning of the pandemic, where we didn't have other effective treatments available.
Matthew Harrison Andrew, unlike normal episodes, maybe it'll be my chance since the markets have been so volatile. How has this impacted your outlook on the markets in the near to medium term?
Matthew Harrison I know inflation and the inflation debate and the impact of central banks on inflation has been a sort of key debate that I've heard you guys reflecting on.
Andrew Sheets Yeah. So I think probably the thing I should say up front is at the moment, we don't think we have enough evidence around this variant to change our baseline economic forecast to change that optimistic view on growth. Now what it might change is some of the timing around it, and I think we saw a little bit of this with the Delta variant. Where, you know, that was a big development in 2021, you know, people didn't see that coming. And you know, if you step back and think about this year, the market was still good, yield still rose, there was a lot of market movement, very consistent with better economic growth if you take the year as a whole, even though you had this variant, but the variant did introduce some kind of twists and turns along the way. So you know, that's currently the way that we're thinking about this new omicron variant that it is not likely or we don't know enough yet to be confident that it would really change that economic outlook, especially because we think there are a lot of good reasons why growth could be solid, but it might introduce some near-term uncertainty. You know, the interesting thing about, as you mentioned, inflation is that it could affect inflation in both directions. It could cause inflation to be higher, for example, if it, you know, causes shutdowns in countries that are important for producing key goods. And you can't get the things that you want, and the price goes up. But it could also drive prices down. You know, on last Friday oil prices fell by over 10%. You know, that is a big part of inflation certainly as most people experience it. Gas prices will be lower based on what happened on Friday. So that can drive inflation down so it can cut both ways.
Matthew Harrison Andrew, it's been great talking to you. Thanks for your thoughts.
Andrew Sheets Matt, always a pleasure to talk to you.
Matthew Harrison As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
With last week’s news of the Omicron variant of COVID-19, markets sold-off sharply on Friday, but beyond the headlines, there may be other underlying factors at play.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 29th at 1:00 p.m. in New York. So let's get after it.
Last week, the big news for markets was this new COVID variant named Omicron. While we don't yet know the characteristics of this variant with respect to its transmission and mortality rates, some nations are already acting with new restrictions on travel and other activities. These new restrictions is what markets were fearing the most on Friday, in our view.
I'm also confident that markets were already expecting some seasonal increases in cases as we enter the winter months. This is why I'm not so sure Friday's sharp sell-off in equity markets was as much about Omicron as it was just a market looking for an excuse to go lower. In fact, equity markets had already been weak heading into Thanksgiving Day - a period that is almost always positive for stocks. This was before Omicron was a real concern, so why would that be the case?
As we laid out in our year-ahead outlook, the combination of tightening financial conditions and decelerating growth is usually not bullish for stocks. When combined with one of the highest valuations on record, this is why we have a very unexciting 12-month price target for the S&P 500. Finally, as discussed on this podcast for the past 6 weeks, stocks typically do well from September to year end if they are already up until that point. However, we felt like that seasonal trade would be tougher after Thanksgiving, as the Fed began to taper its asset purchases and institutional investors moved to lock in profits rather than worrying about missing out on further upside. With retail a large buyer during Friday's sharp sell-off, it appears that the institutional investors were the ones selling. In short, it looks like that switch to locking in profits may have begun.
Today's bounce back also makes sense in the context of a market that understands Omicron is probably not going to lead to a significant lockdown. In fact, we're already hearing reassuring words from the authorities making those decisions.
The bottom line is that markets were already choppy, with many higher beta indices and stocks trending lower before this latest COVID variant. Breadth has also been weak, with erratic leadership. High dispersion between stocks is another market signal that suggests the rising tide may be going out. Our view remains consistent - the investment environment is no longer rich with opportunity, which means one must be more selective. In a world of supply shortages, we favor companies with high visibility on earnings due to superior pricing power or cost management. We also think it makes sense to be very attendant to valuation and not overpay for open ended growth stories with questionable profitability. From a sector standpoint, Healthcare, REITs and Financials all fit these characteristics.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The Build Back Better Act took a key step towards becoming law last week, signaling implications for fiscal policy and taxation as the bill heads to the Senate.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, November 24th at 11:00 a.m. in New York.
Last week, the Build Back Better Act took a step toward becoming law when the House of Representatives passed the bill along party lines. While the act now still needs to win Senate approval, likely with some substantive changes, there are two lessons that we learned from the House's actions.
First, U.S. fiscal policy will continue to be expansionary in the near term. That's based on analysis from the Congressional Budget Office of the Build Back Better plan, adjusted for some key provisions that likely won't survive the Senate. When added to the analysis of the recently enacted Bipartisan Infrastructure Framework, it shows the combined plans could add around $200B to the deficit over 10 years - close to our base case of about $260B. But more importantly, the analysis suggests most of this deficit increase is front loaded, with around $800B of deficits in the first 5 years - toward the high end of the base case range we flagged earlier this year. This is the number we think matters to the economy and markets, as the durability of the policies that will reduce this deficit beyond 5 years is less certain, as elections can lead to future policy changes. And this number also helps drive some key views, namely our economists' call for above average GDP next year and our rates teams' view that bond yields will continue to move higher.
Our second lesson is that the corporate minimum tax looks like it has legs. The provision, also called the Book Profits Tax, survived the house process largely unscathed. While Senate modifications are to be expected, we expect the provision will be enacted. That means investors will have to get smart on the sectoral impacts of this new, somewhat complex, corporate tax. Our base case is that this won't be a game changer for markets. Our equity strategy team calculates a 4% hit to S&P 500 earnings before accounting for any economic growth. And while some sectors, like financials, appear most likely to have a higher tax bill, our banks analyst team expects most of this new expense can be offset by tax credits. Still, this new tax is tricky and untested, so fresh risks can emerge as the bill goes through edits in the Senate. So, we'll be tracking it carefully into year end.
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Our 500th episode! From all of us at Morgan Stanley, thanks to our listeners for all your support!
An overview of our expectations for the year ahead across inflation, policy, asset classes and more. As with 2021, we expect many twists and turns along the way.
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Welcome to the 500th episode of Thoughts on the Market. I'm Andrew Sheets, and from all of us here at Morgan Stanley, thank you for your support. Today, as always, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Tuesday, November 23rd at 2:00 p.m. in London.
At Morgan Stanley Research. We've just completed our outlook for 2022. This is a large, collaborative effort where all of the economists and strategists in Morgan Stanley Research get together and debate, discuss and forecast what we think holds for the year ahead. This is an inherently uncertain practice, and we expect a lot of twists and turns along the way, but what follows is a bit of what we think the next year might hold.
So let's start with the global economy. My colleague Seth Carpenter and our Global Economics team are pretty optimistic. We think growth is strong in the U.S., the Euro area and China next year, with all three of those regions exceeding consensus expectations. A strong consumer, a restocking of low inventories and a strong capital expenditure cycle are all part of this strong, sustainable growth. And because we think consumers saved a lot of the stimulus from 2021, we're not forecasting a big drop off in growth as that stimulus fails to appear again in 2022.
While growth remains strong, we think inflation will actually moderate. We forecast developed market inflation to peak in the coming months and then actually decline throughout next year as supply chains normalize and commodity price gains slow.
Even though inflation is moderating, monetary policy is going to start to shift. Ultimately, we think moderating inflation and some improvement in labor force participation means that the Fed thinks it can wait a little bit longer to raise interest rates and doesn't ultimately raise rates until the start of 2023.
For markets, shifting central bank policy means that the training wheels are coming off, so to speak. After 20 months of unprecedented support from both governments and central banks, this extraordinary aid is now winding down. Asset classes will need to rise and fall or, for lack of a better word, pedal under their own power.
In some places, this should be fine. From a strategy perspective, we continue to believe that this is a surprisingly normal cycle, albeit one that's moving hotter and faster given the scale of the drawdown during the recession and then the scale of a subsequent response. As part of our cross-asset strategy framework, we run a cycle indicator that tries to quantify where we are in that economic cycle. We think markets are facing many normal mid-cycle conditions, not unlike 2004/2005. Better growth colliding with higher inflation, shifting central bank policy and more expensive valuations.
Overall, we think that those valuations and this stage of the economic cycle supports stocks over corporate bonds or government bonds. We think the case for stocks is stronger in Europe and Japan than in emerging markets or the US, as these former markets enjoy more reasonable valuations, more limited central bank tightening and less risk from legislation or higher taxes. Those same issues drive a below consensus forecast here at Morgan Stanley for the S&P 500. We think that benchmark index will be at 4400 by the end of next year, lower than current levels. How do we get there? Well, we think earnings are actually pretty good, but that the market assigns a lower valuation multiple of those earnings - closer to 18x or around the average of the last 5 years as monetary policy normalizes.
For interest rates and foreign exchange, my colleagues really see a year of two parts. As I mentioned before, we think that the Fed will ultimately wait until 2023 to make its first rate hike, but it might not be in any rush to signal that action right away, especially because inflation remains relatively high. As such, we remain positive on the U.S. dollar and think that U.S. interest rates will rise into the start of the year - two factors that mean we think investors should be patient before buying emerging market assets, which tend to do worse when both the U.S. dollar and yields are rising. We forecast the U.S. 10-year Treasury yield to be at 2.1% by the end of 2022 and think the Canadian dollar will appreciate against most currencies as the Bank of Canada moves to raise interest rates.
That's a summary of just a few of the things that we think lie ahead in 2022. As with 2021, we're sure they're going to be many twists and turns along the way, and we hope you keep listening to Thoughts on the Market for updates on how we see these changes and how they impact our market views.
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With the release of our outlook for the coming year comes a cycle of feedback and debates from clients and investors. We look at those discussions around equity markets, valuations, and more in 2022.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 22nd at 11:30 a.m. in New York. So let's get after it.
Last week, we published our outlook for 2022 and spent a lot of time discussing it with investors. This week, we share feedback from those conversations where there is agreement and pushback. Our first observation is that there wasn't as much engagement as usual. Part of this may be due to the fact that our general view hasn't changed all that much, leaving us with an unexciting overall price target for the main U.S. indices. We also sense there's a bit of macro fatigue setting in, with many investors struggling to generate alpha in what appears to be a runaway bull market for the S&P 500 - the primary U.S. equity benchmark for most asset managers. This lines up with one of our key messages for the upcoming year - focus on the micro and pick stocks if you want to outperform. As the economic recovery matures, more companies are struggling with the imbalances created by the pandemic. To us, this generally means focus on earnings stability and superior execution skills as key factors when identifying winning stocks from here.
Going back to our conversations, there's a broad agreement with our more recent tactical view that U.S. equity markets are ahead of the fundamentals, but they can stay elevated in the near-term given incredibly strong flows from retail, systematic strategies and buybacks. Furthermore, pressure to keep up with the benchmarks is curtailing willingness to de-risk early. While there are signs of deterioration under the surface with many individual companies suffering from inflation pressures, supply bottlenecks and even demand destruction in some cases, the S&P 500 earnings forecasts are still moving higher, albeit at a slower pace. More specifically, we are witnessing weak breadth as the major averages make new highs.
Most clients feel that in the absence of an outright decline in earnings forecasts, seasonal strength can maintain the market's elevated levels and there's no reason to fight it. Having said that, while there is agreement valuations are currently rich, the primary push back to our outlook for next year is that we are too bearish on valuation. While many investors we speak with think 2022 will be more challenging than this year, most still expect US equity indices to deliver 5-10% returns over the next year, while we project flat to slightly down returns in our base case. The primary difference of opinion is on valuation, which appears vulnerable, in our view, to tightening financial conditions and a more uncertain range of outcomes in the economy and earnings over the next 6 months, and that should lead to higher risk premiums or lower valuations.
The other key debate with clients center on the strength of the US consumer. Recent macro data like retail sales, and micro data from strong consumer earnings in the third quarter, suggests that consumers remain ebullient into the holidays. This is very much in line with the survey that we published two weeks ago - the same survey that suggests this strength may not be sustainable into next year due to weakening personal financial conditions from higher inflation. Our analysis and comparison of the Conference Board and University of Michigan consumer confidence surveys appear to support a deterioration into next year - a key reason we are underway the consumer discretionary sector despite strength into the holidays.
Bottom line, U.S. equity markets have delivered another stellar year of returns, which is typical in the second year of an economic recovery. However, given the speed of this recovery and record returns over the prior 18 months, we thought it was prudent to reduce our equity exposure back in early September. While our timing on that risk reduction was wrong, higher prices, driven mostly by higher valuations, only make the risk/reward for 2022 worse, not better. In short, stick with larger cap, higher quality stocks at reasonable valuations.
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Andrew Sheets continues his discussion with Chief Global Economist Seth Carpenter on Morgan Stanley’s more optimistic economic outlook for 2022, what’s misunderstood and where it could be wrong.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Seth Carpenter And I'm Seth Carpenter. I'm Morgan Stanley's Chief Global Economist.
Andrew Sheets And on part two of the special episode of Thoughts on the Market, Seth and I will be continuing our discussion on the 2022 outlook for the global economy and how that outlook could impact markets in the coming year. It's Friday, November 19th at 5:00 p.m. in London.
Seth Carpenter And if it's five pm in London, it's noon in New York.
Andrew Sheets Seth, you speak to a wide variety of clients, and this topic of the supply chain, you know, keeps coming up in a variety of formats. It comes up in our financial discussions. It comes up in the popular press. Is there a part of this story that you think is poorly understood or maybe misunderstood, you know, amidst all this focus of supply chain stress?
Seth Carpenter I think I'd point to two key areas where maybe there could be a little bit more attention focused. The first one, and I was sort of talking in these terms before, is the difference between the price level and inflation. Now, if I am at the store and I'm looking at milk on the shelf, all I care about is the price level itself: is milk more expensive than it was before? Is the price high? When the central bank, when investors look at prices, they're actually measuring inflation, the rate of growth of those prices. And I think that key distinction is one of the big parts here. If supply chains stop getting worse, then it seems like in general, at some point the price level should stop going up. It'd still be a high price and it'd still be unpleasant for consumers. But the inflation on that would end up being zero. And I think that difference between growth rates and price levels is one thing that probably deserves a little bit more scrutiny.
Seth Carpenter And I think the second part is-- I'm going to use an economics type term here-- how non-linear some of these effects are. And so what do I mean there? If you think about the auto industry, which has been in the news a lot for having a shortage of microchips, for example. But suppose you had a car that had 95% of the parts already assembled, 5% were missing. That's not a car. That's spare parts. Suppose you had a hundred cars that were 95% done. In a linear version of the world, 95% of one hundred is 95 cars. But you still really just have a pile of spare parts at that point. And so it's not as though you get proportional reduction in output. You can get all of the output disrupted for one of just a few parts. I'm curious to see how it resolves on the other side. Does it turn out then that all of a sudden, we're faced with a glut of extra products because those few missing parts are now delivered and so all of a sudden that final assembly can get done and we have a lot. I don't know what the answer is. We've assumed that it's much smoother than that when things unwind, but there really is a lot of uncertainty here.
Andrew Sheets So, Seth, the last 18 months have been really hard. But you know, you could maybe argue that for the Fed, its decisions have been somewhat easy. And we've seen the Fed and other central banks take extraordinary action. But, you know, now the Fed, the European Central Bank, you know, a lot of these central banks are now coming under a lot more pressure on the one side to say, you know, inflation's now picking up, you're making a mistake to, you know, the economy still not normal. It still needs a lot of support. How do you see those debates playing out? And how do you think some of that ultimately resolves itself next year?
Seth Carpenter I mean, debate is exactly the right word, and I love to note to clients that my job used to be to argue over what should happen with policy but now my job is just to think about what's likely to happen. And there I turn to the policymakers themselves, and so when I think about Chair Powell, I think about the fact that they announced a tapering of their asset purchases, and he said he expects that to run through the middle of next year. He also said that he expects inflation to come down, but he doesn't expect it to materially come down until Q2 or Q3 of next year. In that context, that to me says he's probably waiting for a while to see how the data resolve themselves.
Seth Carpenter What I've also heard Chair Powell say is that their conditions for raising short term interest rates is both having inflation doing what they want it to do, but also full employment. And he's tried to give a few different measures of full employment means to them. It's not just the measured unemployment rate, but it's also people getting jobs. It's also people who have left the labor market coming back into the labor market. And so in the forecast that the US economics team has, inflation is coming down over the course of 2022, labor supply measured by the labor force participation rate in their forecast is going up. And so when the US economics team puts those two together and thinks about how Chair Powell has characterized the Fed's decision making process, they come to the conclusion that it seems natural to think that he's going to want them to wait at least through the end of 2022 and right at the beginning of 2023 before starting to raise short term interest rates. Now you're our cross asset strategist and so you know for a fact that markets have been pricing lots of other things.
Andrew Sheets And Seth, it's fair to say that's probably one of our more controversial assumptions for next year, this idea that the Federal Reserve doesn't end up raising interest rates in 2022, even though that is, as you mentioned, what the market's currently expecting.
Seth Carpenter Correct. It's definitely a place where we are out of consensus. And I think as we got the recent consumer price index report that showed still quite high inflation. And as markets start to look for, you know, the next couple of months where there's inflation prints go, I think the market is expecting inflation to stay high for sufficiently long that Chair Powell and the Fed change their minds. And that clearly could happen.
Andrew Sheets Seth, the thing I wanted to close with was, you know, a real central part of our research process at Morgan Stanley-- and this is true in strategy and economics down to our stock analysts-- is to not just try to think about a likely base case, but also think about a bull and a bear case around it. Kind of realistic, good and bad scenarios that could happen over the next 12 months. So let's get the bad news out of the way. If you think about a realistic bad case for the global economy next year, what does it look like and what gets us there?
Seth Carpenter Wow. So this is where I have to admit, being my first time in this outlook process, I may have tipped the apple cart over just a little bit because I threw the team a curveball and I said there are actually two key ways that I could be disappointed in the global economy. And the first one is a worse outcome for the supply side. That is our assumption that supply chains get better over time. That might not happen, right? That might stay bad for longer, we might have more frictions in the labor market than we expect. In that version of the world, we likely get both weaker economic growth than we think and higher inflation than we forecast because the supply disruptions would feed into sustained inflationary pressures that keep those price prices rising and rising and rising over time as supply chains get worse. And at the same time, we could easily see, under those circumstances, central banks globally shifting towards tighter monetary policy. If we get much higher inflationary outcomes than we currently forecast we're just going to see more tightening. And so you get that double whammy of less production, less economic activity because supply disruptions and also tighter financial conditions. And so that's an outcome that we can't rule out. And that's troubling.
Seth Carpenter On the other hand, we could be wrong about the lack of a fiscal drag in the United States. We could be wrong about how much fiscal support there is going to be in Europe, for example. We could be wrong about how the Chinese economy recovers from the recent slowdown. And so we could have a demand side bear case, a demand side worse outcome. In that case, though, the world looks a little bit more normal the way, you know, markets and economists would have thought about these things pre-pandemic, i.e. slower growth, lower inflation. In that version of the world though central banks tend to sit back, I think, and wait to see how things turn out. But that, I think, is a really good illustration of just how much uncertainty there is right now. There's a version of the world where we have worse growth and higher inflation. There's a version of the world where we have worse growth and lower inflation. And I have to admit I spent some time wringing my hands, worrying about each of them.
Andrew Sheets And finally, Seth, to end on a high note, what's the most realistic, positive case for the global economy next year and how could we get there?
Seth Carpenter Andrew, you know, I'm an economist, which means that I'm uncomfortable being cheerful, but I'll give it a shot. So those global supply disruptions, the sort of inability of consumer goods to sort of flow to market as fast as people want to buy them, the restrictions on commodity production that have led to the really high prices. I have to believe there's a version of the world where that all gets resolved much more quickly. Right? Where all of those partially produced goods that only need one or two extra spare parts, that ship arrives, those spare parts come in, and then all of a sudden, we've got a glut of supply instead of a shortage of supply. I think in that version of the world, we have a really virtuous cycle. A couple of things happen. One, inflation starts to come down much more quickly because there's much more availability of all those goods that people are looking to buy. Second, there's a lot more availability of all those goods that people are willing to buy. And so as a result, you can have that economic activity picking up. I think at the same time, in the same spirit of a better supply outlook, the labor supply could fix itself more quickly. In which case wage pressures start to ease a little bit, people feel more comfortable coming back to the labor market. Maybe that's because of the increasing vaccinations, especially among children. Maybe it's because we get past the winter and we have a milder winter when it comes to the to the pandemic. All of those sort of supply things, both physical goods and greater supply and more labor supply-- if those happened together than we should have faster growth. But as it turns out, a bit less in the way of inflationary pressures. And so that really would be sort of a fantastic outcome.
Andrew Sheets We'll have to stay tuned. Seth, thanks for taking the time to talk.
Seth Carpenter I have to say, Andrew, it's always my pleasure to get to talk to you.
Andrew Sheets Thanks for listening. If you enjoy thoughts on the market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
Andrew Sheets speaks with Chief Global Economist Seth Carpenter on Morgan Stanley’s more optimistic economic outlook for 2022 and how consumer spending, labor, and inflation contribute to that story.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Seth Carpenter And I'm Seth Carpenter. I'm Morgan Stanley's Chief Global Economist.
Andrew Sheets And on part one of this special episode of Thoughts on the market, we'll be discussing the 2022 outlook for the global economy and how that outlook could impact markets in the coming year. It's Thursday, November 18th at 5:00 p.m. in London.
Seth Carpenter And that makes it noon in New York City.
Andrew Sheets So, Seth, welcome to Thoughts on the Market. You are Morgan Stanley's new chief global economist and, while we've just sat down to work on our year ahead outlook and we're going to discuss that, I was hoping you could just give listeners a little background around yourself and what brings you to this role?
Seth Carpenter Thanks, Andrew. This has been a great experience for me working on the outlook as my introduction to Morgan Stanley. I guess I've been here just a few months now. Before coming to Morgan Stanley, I was at another big sell-side bank for a few years, spent a little time on the buy-side. But most of my career, I have to say, I spent in Washington DC. I spent 15 years of my career at the Federal Reserve working on all sorts of aspects about monetary policy. And then I spent two and a half years at the U.S. Treasury Department. So, I'm really, really a product of Washington more than I am Wall Street.
Andrew Sheets Well, that's great. And so well, let's get right into it because, you know, this is a big collaborative process that you and I and a lot of our colleagues work on. And so let's start with that global economic picture. You know, as you step back and you think about our expectations, how good is the global economy going to be next year?
Seth Carpenter Yeah, I have to say our economics team around the world is actually fairly optimistic-- call it bullish-- relative to consensus. When I think about the global economy, clearly the two biggest economies are the U.S. and China. And so starting with the U.S., Ellen Zentner, our chief U.S. economist, has an outlook that the U.S. economy is going to slow down next year, but boy, still be going kind of fast. Right around four and a half percent, which is, you know, slower than the growth rate that we're getting this year, but still a really, really solid growth for the for the year as a whole. And I think in that there's a lot of things going on. We're still getting lots of job gains and the more job gains we have, the more consumer spending we get. And of course, consumer spending, that's 70% of US GDP. I think as well, we're looking forward to there being a big restocking of inventories. I think everyone has heard about the global supply chain issue and inventories in the United States in particular are very, very lean. And so we're looking for a bit of an extra boost to the economy coming from that inventory restocking. So it's a pretty optimistic case; slower than this year, to be sure, but still a pretty optimistic outlook.
Andrew Sheets And Seth, what about that other big driver of the global economy, China? How do you think its economy looks next year?
Seth Carpenter Robin Xing is our chief China economist, and he is also similarly a bit optimistic relative to consensus. Deceleration, to be sure, from where we were before COVID. But five and a half percent growth is still going to put our forecast, you know, higher than most other people making these sorts of forecasts. And there, when I talked to Robin, what he tells me is, you know, there was a slowdown in the Chinese economy this year in Q3, but a lot of that was policy induced as the policymakers in Beijing are trying to take another step in reorienting the Chinese economy. And because the slowdown was policy induced, we're going to get a recovery that's also policy induced. And so, he's actually pretty constructive about how growth for next year is going to turn out.
Andrew Sheets So Seth, one question about the economy next year is, well, in 2021, we had all of this fiscal support, all this government support for growth and that's not going to be there in the same way. And you hear a lot about this concept of the fiscal cliff of the government support that was there falling away and even reversing and being a drag on growth. How do you square that with what seemed like pretty optimistic economic projections from our side?
Seth Carpenter So here's how the US team would talk about it. When we think about what drove the fiscal policy this year, what drove the high deficit this year, a lot of it was income replacement. Many people had lost their jobs, many people were out of work and government transfers were replacing a fair amount of that income. And so as we move into next year, we're already seeing many of those jobs coming back, to be sure, not all of them yet. But in the forecast, jobs keep coming back and with it, labor income. And so what the government support had been doing, in part, was providing income to allow spending to go on in 2021. Next year in the forecast, it's labor income that allows the same type of spending to go on. And so as a result, there's no discrete step down that's coming from that removal of fiscal policy. And moreover, I think one thing that avid readers of economic data will know is that the saving rate i.e. how much of current income is being spent versus being saved. The saving rate is actually quite elevated. And part of that is this government transfer of income, not all of it being spent in the current period. Well, the US team says we're going to take some of that excess savings and assume that a portion of it actually gets spent in 2022. So that's another factor that's going to reduce the likelihood of us having a fiscal drag the way other forecasters probably have in their numbers.
Andrew Sheets Seth, another concern that comes up a lot in these conversations is around the i-word: inflation. You know, you and I and some of our colleagues just did a large webcast for many of our investment clients. And I think without exaggeration, maybe 80% of the questions were in in some way related to inflationary risks and the inflationary backdrop. So, you know, we think growth is going to be good next year-- it might be better than expected-- but what does that imply for the inflation outlook and, how big of a risk is it that inflation is eating away at the spending power of the consumer and other parts of the economy?
Seth Carpenter No question that inflation is sort of the key question in macro these days and into next year. And I think there is a real risk that high prices end up eating into purchasing power. It's clear that people who are on fixed income, people who are at the lower end of the income distribution, when the price of gasoline is going up, when the price is food is going up, that's very, very real for those people and it can affect how much extra discretionary spending they have. So I think that that clearly matters a lot. And I think one of the challenges between being an economist, thinking in terms of the technical data side of things, versus communicating to a broader audience is that inflation is about the rate of change of those prices, as opposed to what regular people see every day, which is the level of those prices. So in our-- in the forecast the US team has there are a lot of those prices that actually stay high, but the rate at which they go up in the forecast actually peaks at the beginning of 2022 and then starts to come down. It starts to come down for a few reasons. First: oil. If we look at the futures curve, looks as if oil prices should probably peak around December and then gradually come down over the course of next year. I think in addition to that, everyone has been talking about the global supply chain sort of bottlenecks in terms of consumer goods getting to consumers being a real challenge now takes time. It's proven to be quite durable so far. The maintained assumption that the economics team around the world had was the following: that those supply chain frictions-- be it the Port of Los Angeles and shipping containers, be it semiconductor production in East Asia, the whole kit and caboodle-- goes back to something that looks like normal at the end of 2022. But what that means in the forecast is things are about at their worst now, start to get better at the beginning of the year, and then take the whole year to get better. But if that's the case, then the easier access to the consumer goods should mean that prices on those consumer goods that have been going up so dramatically should probably stop going up sometime around the beginning of the year. And in fact, maybe start to go back towards more normal levels over time. So that's what's in the forecast.
Andrew Sheets Seth, another thing I was hoping to ask you about as it relates to inflation is, you know, how much of this with your global hat on is a global phenomenon versus, you know, some more specific, idiosyncratic things related to the U.S. economy. You know, when you when you look across some different regions, some other major markets, are they having similar inflationary dynamics? Is it different? And importantly, could we see more divergence in the inflation picture going forward into next year?
Seth Carpenter Oh, absolutely. So, looking across different countries, there's unquestionably a global component to this inflationary surge. I think what can differ, though, is how that inflationary impulse is transmitted to to different economies over time. So, you know, we've talked through our views on what happens in the United States. And in countries where you tend to have more of a history of high and variable inflation, it's easier for those sort of pricing pressures to spread to other components. Add to that in countries where if it's a small, open economy with a floating exchange rate, you can easily imagine that country's currency could decline a bit in value, which means all of their imported goods are more expensive as well, which then leads to more inflation. So clearly a common shock. The net effect across economies, though, can be quite different. I'd say one component that's a bit different in the United States than others is the structure of our of our labor market. In a lot of European countries, there was a mechanism put in place, a policy put in place to essentially try to freeze people in place attached to their employer; in the U.K. they call it 'the furlough scheme.' In the United States there was no similar specific plan that was covering the entire country. That friction in the labor market is quite difficult to overcome. And we're seeing some of that show through by, in some cases, businesses needing to pay more to attract new workers. And so, like I said, a clear common global shock, but the transmission varies by country.
Andrew Sheets Thanks for listening. We'll be back in your feed soon for part two of my conversation with Seth Carpenter on the outlook for the global economy in 2022.
Andrew Sheets And as a reminder, if you enjoy thoughts on the market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.
This week’s meeting between President Biden and President Xi was not a return to an earlier phase of relations between their two countries. Instead, it suggested the normalization of a sort of ‘competitive confrontation’ that investors and markets may have mixed feelings about.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, November 17th at 11:00 a.m. in New York.
Earlier this week, U.S. President Biden and China President Xi met virtually to discuss the relationship between their two countries. A broad array of security and economic issues were discussed, and the readouts from both countries following the meeting were generally respectful. In many ways, this was a marked contrast from the rancor between the two parties for the last few years. Yet investors expressed to us disappointment with the outcome. They were looking for tariff rollbacks and other signs of a reversion to the US/China relationship that preceded the Trump administration. To those investors, our message is that there's a new normal to embrace for the US and China. And it's neither wholly positive, or negative, for markets and the economy.
In short, investors should get comfortable with the US/China relationship as one of intense competition, rather than the laissez faire economic competition that the U.S. engages in with its allies. In fact, we call the US/China dynamic a 'competitive confrontation'. That means both sides are urgently trying to enact policies that preserve their economic and national security ambitions, without creating chaos through wholesale de-linking of their intertwined economies or direct military confrontation. In short, it's complicated. But the motivation is high to follow this path. In the U.S., for example, there's still a bipartisan consensus that the U.S. should be pursuing tougher China policies, and that impulse likely only gets stronger in 2022 - a midterm election year.
So if you know this dynamic, it becomes easier to understand why the U.S. hasn't moved to reduce tariffs on China, even if that could ease inflation pressures. Even if the Biden administration would prefer those tariffs didn't exist, they may view reducing them now as short sighted, particularly when they need more time to develop more precise non-tariff tools, and since China continues to fall short on its commitments under the phase 1 trade deal. So those looking to the US/China dynamic to ease inflation pressures and perhaps reduce bond yields, we think will continue to be disappointed. As will those looking for an easing of export restrictions and other non-tariff barriers that have crimped key equity sectors, like semiconductors.
But it's not all challenges here. Over time, we think the U.S. and China can get to a dynamic we call ‘constructive competition.’ Both sides will have developed rules of engagement they think preserve their security goals, minimizing trade disruptions and allowing the reduction of blunt force tools like tariffs. At this point, of course, inflation may have already eased, but the impact could be a clearer pathway for international expansion for equity sectors which are increasingly using sensitive technologies, like automobiles. We'll be tracking the transition here and report to you as opportunities emerge.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
The housing market has seen record home price growth this year. But who does this boom benefit and who gets left behind?
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Jim Egan Welcome to Thoughts on the Market. I'm James Egan, co-head of U.S. Securitized Products Research from Morgan Stanley,
Sarah Wolfe and I'm Sarah Wolfe from the US economics team, focused on the U.S. consumer.
Jim Egan And on this edition of the podcast, we'll be talking about the impact of the housing boom on America's low-income households. It's Tuesday, November 16th, 10:00 a.m. in New York.
Jim Egan Regular listeners of the podcast have probably heard me talking with my colleague Jay Bacow about the record level of home price growth that we've seen this year. And we've talked about it from a number of different angles: how high can home price appreciation actually climb? How sustainable is this current level of growth? What's the aftermath going to be? But today, Sarah, you and I are going to be approaching this from a slightly different angle, and we're going to talk about the impact of rising home values on low-income households. So, what were some of the big questions behind your recent research, Sarah?
Sarah Wolfe So there's been a lot of discussion this year, as you mentioned, around rising home prices, rising rents and the extremely healthy housing environment. So, we wanted to look at what this meant for households all across the income distribution and, in particular, what it meant for low-income households. There's been a lot of focus on how low-income households are going to fare as we move off of fiscal stimulus - I'm talking about the unemployment insurance benefits, the economic impact payments - and so we wanted to explore real estate wealth as a potential source of equity for this group in order to make the transition away from government stimulus into a more recovery part of the economy easier or not. And so that's really the focus of this report.
Jim Egan All right. Now you've spent a lot of time talking about the low-income consumer. We've got the kind of excess savings narrative across the consumer in aggregate. I know that that is appearing in the low-income consumer a little bit, but maybe not as much as further up the spectrum. Can you dig into that for us a little bit? How is the low-income consumer performing right now?
Sarah Wolfe So overall, the low-income consumer over the last year and a half has performed very well, and that's because we've seen an unprecedent amount of fiscal stimulus. We've also seen strong job growth among low-income industries, including retail trade, leisure and hospitality. These are where the jobs are coming back. And we're also seeing pretty strong wage growth for low-income workers. And then at the same time, there was a pretty significant pullback in spending like dining out and other services. So together we got this buildup of excess savings and, low-income households had savings as well, and there was excess savings held all across the income distribution. While this is really significant, it's important to know that the dollar amount of excess savings held among lower income households is not that significant. And they also have a higher marginal propensity to consume out of their savings. So, while the savings is there, it likely will not last long. And so, it's not going to be a longer-term source of wealth, and that's why we decided to turn our attention to real estate wealth. Will this be a potential long-term source of wealth and significant for this group of consumers?
Jim Egan OK. So, when you looked into housing wealth and particularly for low-income consumers, what did you find?
Sarah Wolfe Well, low-income homeowners have actually seen their real estate wealth increased by roughly $18,000 per household. That's from the end of 2019 through mid-2021. Now, in dollar terms, that's less than the rise in real estate for higher income groups. But in percentage change, it's a 19% increase in real estate wealth among low-income homeowners. And that's the largest percentage increase across the entire income distribution when it comes to real estate wealth.
Sarah Wolfe So, there's clearly been a substantial amount of real estate wealth for homeowners, but it leads me to ask the question, can they actually access that wealth?
Jim Egan That is probably the question we get asked most frequently. The record rise we've seen in home prices has brought equity in the U.S. housing market to levels we haven't seen. We have data going back over 26 years. We've never had more equity in the housing market than we do right now. Part of that's because this rise in home prices just was not accompanied by the rise in mortgage debt that we saw in the early 2000s, the last time home price growth was really anywhere close to where it is right now. So, the question we get from investors pretty frequently is, well are borrowers going to access this? How can borrowers access this? Are we going to see that same sort of mortgage equity withdrawal, that sort of cash out activity that we saw during the last cycle. And look, the high-level answer is it's difficult to say, given the lack of comprehensive data that we see there. Now, we do have some form of data from the GSEs, we have it from Ginnie Mae, that can show us how cash out activity is evolving, and we are seeing cash out activity really pick up in 2021. It wasn't the case in 2020. Falling rates in 2020 meant that a larger percentage of refinancings were more just straight rate-and-term refinances. They didn't have a cash out component. But we are starting to see cash out refinance activity pick up in 2021 from where it was in 2020.
Sarah Wolfe And how does mortgage credit availability play into all of this?
Jim Egan We do think that's playing a pretty big role. Now we've talked about how mortgage credit availability is running at pretty tight levels. We actually undid six years’ worth of easing lending standards in the six months following COVID, but we have started to see lending standards plateau and they've started to ease from here. Now, how of those tight lending standards manifested themselves in terms of cash out activity? We're actually seeing the dollar amount that is being cashed out, it's lower today than it was in 2019 in terms of absolute dollar amount. If we talk about the amount of equity, the rising home prices we've seen, that means as a percentage of the property value, in 2019, we were seeing cash out refi’s remove roughly about 18% of value from the house. That's down to just 13% today. So people are able to access that equity, but tighter credit standards might be contributing to that dollar amount being lower. And it certainly means that the borrowers who are more likely to be able to access that are probably borrowers that are further up the credit quality spectrum, higher credit scores, for instance, perhaps higher income levels as well. So we do think that tight credit availability plays a role. But Sarah, turning this back to you.
Jim Egan Once we get past the borrower's ability to actually remove cash from their home or the borrower's ability to tap that equity in their home. What are you seeing households use that money for?
Sarah Wolfe Well, a bulk of the equity goes back into the home in the form of home improvement and repairs. There is a smaller amount that goes towards non-housing expenditures like education and apparel. Also, some of it goes towards paying down debt. But the large majority is back into the house in terms of home repairs and improvements.
Jim Egan OK, I want to switch gears from homeowners to renters. Rents have been racing higher in recent months. That doesn't seem great for low-income consumers who don't own their homes. But what are you seeing there?
Sarah Wolfe That's true. Home price appreciation is great for those who own a home, but only half of the bottom 20% are homeowners. This compares to 80% homeownership among the top 20%. And so while we've seen a rise in home price appreciation, it's coincided with escalating rents for non-homeowners. To put some numbers around it, CPI inflation-- this is consumer price index-- showed that rents rose 0.4% in October and 0.5% in September. And while that might not seem like a big number, that's the largest two month increase in rent inflation since 1992. We also find that low-income renters spend 63% of their income paying rent nationally, which is quite elevated. And we're forecasting that rent prices are just going to keep going up and up in the coming years, making it harder for Low-Income non-homeowners to afford having a home and leaving them at the mercy of rising rents.
Jim Egan Now we've done a lot of work on inequal access to homeownership among minorities. How does this factor into the rising burden of rent?
Sarah Wolfe Well, on top of the income disparity in homeownership, the racial disparity adds another dimension to the divide between low-income homeowners and renters. Our ESG strategies find that on average, the gap in homeownership between White and Black and Hispanic households is widest for low to moderate income families. This really limits the benefits of home price appreciation for minorities and further exacerbates racial inequalities.
Jim Egan All right, so the record level of home price growth, which has led to a record level of equity in U.S. households, does appear to have increased wealth across the income spectrum. But when we look a little bit closer, that's not necessarily the case for lower income households the same way it is for higher income households. And, across the board, the ability of these different households to tap that equity is still a question.
Sarah Wolfe That's correct. But I think that it's important to keep in mind that the picture is not all bad. The low-income household is still healthy, and we have the substantial amount of labor market income coming from lower wage jobs like retail trade, leisure and hospitality, transportation, combined with strong wage growth, all helping and supporting income growth longer term for this group.
Jim Egan Sarah, always great speaking with you.
Sarah Wolfe Great talking with you, Jim.
Jim Egan As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Coming out of a year marked by greater uncertainty and volatility, 2022 is poised to be a year which favors single stock investing over a focus on style and sector.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 15th at 11:30 a.m. in New York. So let's get after it.
2021 has been another very good year for U.S. equity indices. What's been different in 2021 is the higher volatility under the surface with greater dispersion of returns between individual stocks. This fits very nicely with our overall mid-cycle transition narrative, with one major exception - valuations. Typically, by this stage of an economic recovery from recession equity valuations would have normalized, particularly with the earnings recovery being even more dramatic than usual. In short, while our sector and style preferences in stock picking was strong in 2021, our S&P 500 price target proved to be too low - in other words, wrong. We think this is more about timing rather than an outright rejection of our fundamental framework or narrative. With financial conditions now tightening and earnings growth slowing, the 12-month risk/reward for the broad indices looks unattractive at current prices. More specifically, we expect solid earnings growth again in 2022 offset by lower valuations. However, strong nominal GDP growth should continue to provide plenty of good investment opportunities at the stock level.
In our view, the economic and political environment has been permanently altered from its pre-COVID days, although the changes are not necessarily due to the pandemic itself. What that means from an investment standpoint is higher nominal GDP growth led by higher inflation, which is the only way out from our over indebtedness in the longer term. Such an outcome should lead to greater investment and higher productivity, but it will take years for that to play out. In the meantime, we will have to deal with the excesses created by the extreme nature of this recession and recovery. That breeds higher uncertainty and dispersion, making stock picking more important than ever in the year ahead.
While our primary theme for 2022 is to focus more on stocks than sectors and styles, one can't ignore them either. We go into the year-end favoring earnings stability and stocks with undemanding valuations, given our view for a tougher operating environment and higher long term interest rates. This puts us overweight Healthcare, Real Estate, Financials and reasonably priced Software stocks. We are also more constructive on Consumer and Business Services. With our expectation for payback in demand from this year's overconsumption, we are underweight Consumer Discretionary Goods, Tech Hardware and commodity-oriented Semiconductors that are prone to double ordering and cancelations.
Small cap stocks have done better recently on the back of newly proposed tax legislation that is much less onerous to smaller domestic companies. However, that is simply the removal of a negative rather than an additional positive for earnings and cash flow. It does nothing to ease the burden of what may be one of the most difficult operating environments for small businesses in decades. In short, we favor large caps over small, especially after the nice seasonal run in a smaller cohort. Finally, the obsession over value versus growth should fade as there is no clear winner, in our view, over the next year, but rather trading opportunities like during 2021. Value and growth have each had periods during which they have done considerably better than the other over the past year. But year-to-date they are neck and neck. We do have a slight bias for value over growth for the rest of the year as interest rates move higher, but this is more of a trading position rather than an aggressive investment view we had coming out of the recession in 2020. Expect our bias to flip flop in 2022 like this year, as macro uncertainty reigns.
Although strategy is a macro endeavor, with stock dispersion remaining high due to uncertainty around inflation, supply chains and policy, we will focus even more on specific relative value ideas, rather than the index, over the next year. We wish you all good fortune in 2022.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Over the last decade, bonds have been a source of stability. But, with surprising moves this past month, they’ve now become a risk-management challenge that stands out amongst other asset classes.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bring you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, November 12th at 2:00 p.m. in London.
For much of the last decade, an important cross asset story has been how stable bond markets were relative to, well, everything else. A big part of this story was the action taken by central banks. They bought government bonds directly, but also set short-term interest rates at very low levels, which acted as a magnet, holding down other interest rates around the world.
There were some big moves, especially when the pandemic hit. But for the most part, bond markets have been a pretty stable place relative to stocks, commodities and other asset classes. This was a global trend, with interest rates unusually placid from Australia to Poland to the United States.
But recently, that's reversed. It's been the bond market that's been hit by a wide number of extreme moves, while other asset classes have been pretty calm. The overall market right now is a little like a duck: calm on the surface, but with some really furious churning below.
We track a wide variety of cross market relationships at Morgan Stanley research. These represent different ways an investor might express a different view on the market. For example, smaller versus larger capitalization stocks, the US dollar relative to the Japanese yen in currency markets, or 2-year yields relative to 30-year government bond yields in the United Kingdom. While investors are often exposed to the big picture direction of stocks, bonds and currencies in their portfolio, many also take views on these smaller, more 'micro' relationships as a key way to exploit mispricing and generate return.
In equities and commodities, these relationships are pretty well behaved. In government bonds, they're not. Excluding the depths of the pandemic, the last month has seen some of the most extreme moves in global bond markets in a decade.
There are a few things going on here, much of which ties back to those central banks. The Federal Reserve has signaled it's going to be rolling back its bond buying, reducing one support to the market. The Bank of England surprised markets by not raising interest rates as expected. While on the other hand, Poland's central bank surprised markets by increasing rates much, much more.
All of this is happening at a time when bond performance wasn't great to begin with. The U.S. Aggregate Bond Index, a good proxy for the high-quality bonds that most investors hold, is down 1.7% this year, underperforming cash. Rising bond yields in the UK and Australia have created a similar dilemma. And many investors who would normally take advantage of these large moves and potential dislocations have been caught up in them, making it harder for some of these relationships to normalize.
What does all that mean for markets? Investors focused on stocks, commodities or foreign exchange should be mindful that their friends over in the bond market are facing a very, very different risk management challenge as we move into the end of the year. And continued bond market volatility could challenge broader market liquidity. More broadly, less central bank support is consistent with our longer run expectations that interest rates are set to move higher. Stay tuned.
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Coming out of last week’s FOMC meeting, the Fed’s wants are becoming clearer but the implications into 2022 for asset prices, interest rates and exchange rates remain to be seen.
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Welcome to Thoughts on the Market. I’m Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I’ll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, November 11th at noon in New York.
"Don't fight the Fed." It's an oft-repeated investment principle that could be restated as "What the Fed wants, the Fed gets." Coming out of last week’s FOMC meeting, let’s take a moment to consider what the Fed really wants, and how markets may provide it.
So, the Fed wants one of three things from a financial conditions perspective. It either wants financial conditions to loosen with greater availability of money and credit in the marketplace or it may want financial conditions to tighten to cool down an overheated economy. Finally, it may want to keep the status quo with financial conditions in a certain range.
Currently, the Fed is easing monetary policy by purchasing bonds from the market. So, it wants to loosen financial conditions. But over the next 6 months, it will be tapering its asset purchases and, therefore, it will be easing policy by less and less. This implies that it wants financial conditions to keep easing starting this month and lasting into the middle of next year, but more gradually than they have been.
Coming into this year, we knew the Fed and European Central Bank would deliver monetary policies consistent with an aggressive easing of financial conditions. If we included only 3 prices in our financial conditions framework, a vast oversimplification to be sure, then our calls at Morgan Stanley for higher real yields and a stronger dollar would have implicitly suggested much higher prices for riskier assets.
So, what has happened thus far in 2021? Well, risky asset prices have risen tremendously, but the U.S. dollar has only strengthened somewhat, and real yields remained at low levels.
So, what about next year? We know the Fed wants financial conditions to loosen further. After all, it will still ease policy through asset purchases over the next 6 months. But it will be easing by less and less until, starting in the middle of 2022, it will no longer ease policy at all. At that point, it will maintain – for a period, short as though it may be – extremely easy financial conditions.
Does that mean U.S. real yields will struggle to rise, the U.S. dollar will struggle to rally, and risky asset prices will rise? The first two are certainly possible outcomes. But even if financial conditions loosen in aggregate for a time, and then remain loose for a time thereafter, not every market is guaranteed to move in a direction associated with looser financial conditions.
For example, take equities, which is a type of risky asset. A rise in equity prices - which would loosen financial conditions - might be offset somewhat by higher real yields and a stronger U.S. dollar – both of which would tighten them. As long as the final result is an overall set of financial conditions that are looser than before, the circle is squared for the Fed.
So, what determines which drivers of financial conditions do the heavy lifting? The answer is changing investor expectations and risk premiums for growth and inflation, both on an absolute basis for equities and real yields, and on a relative basis for the U.S. dollar.
Ultimately, we believe the easy monetary policies in place today—and policies that will be in place through most of next year—will keep expectations for real economic growth improving. This should support investor willingness to own riskier assets while placing upward pressure on real rates.
Expectations for inflation should remain buoyed by expectations for strong growth, but inflation risk premiums will be influenced by factors in the supply side of the economy, like supply chains and labor force participation. We see downside risks to inflation risk premiums next year, which would place further upward pressure on real interest rates.
Finally, in terms of the relative growth outlook, progress in the U.S. on COVID-19, as well as fiscal developments such as infrastructure spending, favor the U.S. over the rest of the world. This should place upward pressure on the U.S. dollar through the first half of next year.
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The bipartisan infrastructure bill has passed, and while investors will see some short term impacts, the bigger question is how long will it take for markets to see a return on these investments?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, November 10th at 11 a.m. in New York.
While Congress continues to negotiate the 'Build Back Better' plan, the package of expanded social programs paid for by fresh taxes on companies and wealthier households, it managed to get a key companion piece of legislation over the finish line last week: the bipartisan infrastructure framework. Many investors may have overlooked this event given the framework's smaller relative price tag and lack of tangible tax increases. But don't be fooled. This is a watershed event, and investors should pay attention.
In short, the infrastructure framework adds about $550 billion to the existing budget baseline for infrastructure spending in the U.S. That's a nearly doubling of spending over the next 10 years on infrastructure. And that means fresh market and economic impacts to consider.
For the broader economy, the story is nuanced. Increased infrastructure spending is generally a good return on investment. However, that impact usually isn't visible right away. In the short term, the money put into the economy to build a new road or train line is funded by money taken out of the economy by taxes. A few years out, that new road leads to more economic activity than there was before. But that might not be tangible enough to move markets in the near term.
Something more tangible is the obvious impact to the industries directly involved in infrastructure construction. For example, my colleague Nik Lippman sees material upside to cement companies, who will see major improvements in demand for their product.
Bottom line, the infrastructure supercycle is here. We'll track it and all the market impacts for you as they take shape.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
Third quarter earnings are heading into the home stretch in Europe and the UK, but while a solid number of companies have beat earnings estimates, market reaction has been a bit curious.
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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European and UK Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the emerging read on third quarter earnings for the region. It's Tuesday, November the 9th at 3pm in London.
Europe and the UK are now more than halfway through third quarter earnings season, and so we're far enough along to form a view on how this quarter's earnings are playing out. And while earnings have been largely solid, price movements on the day of earnings announcements, and in the days following, have been a bit curious. But I'll get into that in a moment.
As it stands, third quarter earnings appear on track to deliver a solid number of companies beating earnings per share estimates. As of yesterday, 55% of European companies have beaten earnings estimates, while 23% have missed, leaving a 'net beat' of 32%, which is twice the historic average. If this holds, it would put third quarter results on track to deliver another strong upside surprise, albeit slightly below the pace seen over the last few quarters. Taking it to the sector level, we find that the strongest breadth of earnings beats are coming from Financials and Energy. On the flip side, Communication Services, Healthcare and Industrials have delivered the smallest breadth of beats so far.
In addition to a healthy number of companies exceeding estimates, we are also seeing a beat in terms of the aggregate amount of European earnings overall, with weighted earnings per share currently beating consensus by about 10% for this quarter. This good news on earnings has driven a fresh bout of upgrades, which should reduce investor concerns around the risk to corporate profitability from ongoing supply chain issues and high input cost inflation.
All that said, earlier, I mentioned a bit of curiosity about price reaction. Typically, if a company beats earnings per share estimates, you might expect to see better stock performance that day or in the days that follow. And of course, the opposite is true for companies who miss estimates. However, a key talking point during this results season has been the surprisingly disappointing price action, even for companies who beat expectations.
Currently, the gap between the outperformance of earnings beats on the day of results relative to the underperformance from earnings misses has been very negatively skewed in a historic context. In fact, this negative skew to price action is close to a record low going back to 2007. On our data, we calculate that EPS misses have, on average, underperformed by 1.6% on the day of results, whereas companies that beat estimates have been broadly flat in relative terms. Hence, while the third quarter has been a solid earnings season overall, the hurdle rate to positively surprise the market is currently quite high.
In our opinion, this reflects investors' uncertainty about the future earnings outlook and whether company margins will face a delayed hit in the quarters ahead. While understandable, we think this caution is overdone. Rather, we expect Europe's earnings dynamic to remain positive into 2022, with companies benefiting from a strong external demand environment and a record level of pricing power.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As we head towards year end, stock and bond markets appear to be sending mixed signals for the year ahead. For investors, the truth could lie somewhere in the middle.
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Welcome to "Thoughts on the Market." I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace.
It’s Monday, November 8th at 2:00PM in New York. So, let's get after it.
As we enter the final stretch of the year, various markets appear to be sending very different signals about what to expect over the next year. Let’s start with Bonds where the longer-term yields have fallen sharply over the past few weeks. In fact, the moves have been so dramatic, several leading macro funds had their worst month on record in October. Some of this move is due to the fact that these same investors were all short bonds as central banks were expected to begin the long process of tightening monetary policy, perhaps faster than what was priced a few months ago.
The reason for this view was very simple: inflation has proven to be much higher than the central banks expected, and they would be forced to respond to that development by raising rates sooner than what they might prefer to do. Indeed, over the past few months, many central banks around the world have raised rates while others have begun to taper asset purchases and even end them altogether. In other words, these traders were correct in their fundamental assessment of what was about to happen, but long-term rates went down instead of up.
While the extreme positioning clearly played a role in the magnitude of the move in longer term rates, the fundamental question is why did they fall at all? One possible reason is the bond market may be discounting what we have been talking about on this podcast for weeks—that the first half of next year is likely to see a material slowing in both economic and earnings growth as fiscal stimulus from this year wears off. Furthermore, with the legislative process breaking down on the Build Back Better program, that risk has only increased. It also means less issuance of Treasury securities which directly helps the supply and demand imbalance many macro and bond traders were expecting as the Fed begins to taper asset purchases this month.
On the other side of the spectrum has been stocks. Here, we have seen higher prices for the major indices almost every day for the past 5 weeks, suggesting growth next year is not only going to be fine but may be understated by analysts. Stocks may also be taking the lower interest rates as good news for valuations. After all, much of the correction in September was due to lower valuations as the markets started to worry about central banks tightening and rates moving higher. On that score, price/earnings multiples in the US have risen by 7.5% over the past 5 weeks, one of the largest rises we’ve ever witnessed in such a short period of time. Such a rise in P/Es like this usually happen for one of two reasons: either the market thinks earnings estimates are about to go up a lot or interest rates are going to fall. The conflict here is that better growth is not compatible with lower rates. A valid explanation for the divergence could be that the potential failure of Build Back Better means no new corporate taxes. So, while the economy may be hurt by this legislative delay it could be friendly to earnings.
In keeping with our narrative over the past month, we think the main reason for the divergence in messaging between stock and bond markets can be explained by the fact that retail and other passive inflows to equity markets continue at a record pace. It’s also the seasonal time of the year when institutional investors are loathe to leave the party early for fear of missing out and falling behind their benchmarks, something that they have had a harder time keeping up with this year. On that score specifically, the S&P 500, the key benchmark in the US market, has once again outperformed the average stock. This is a very different outcome from 2020 when the average stock did better than the index. What this really means is that the index can diverge from its fundamental value for a while longer.
Bottom line is that major indices can grind higher into the holidays. However, it will get more difficult after that if we’re right about growth disappointing next year as rates eventually stabilize at higher levels from central banks tightening. In that environment, we continue to favor companies with reasonable expectations and valuations. We think healthcare, banks and some of the more non-cyclical technology companies in the software and services subsectors offer the best risk-reward. On the other side of the ledger, we would avoid consumer goods and cyclical technology companies that will see the biggest payback in demand next year.
Thanks for listening! If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Global moves in elections, COVID restrictions and energy prices are having ripple effects across markets. How should investors think about these dynamics for Asia and EM equities?
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Welcome to Thoughts on the Market. I'm Jonathan Garner, chief Asia and Emerging Markets Equity Strategist for Morgan Stanley Research. Along with my colleagues, bringing you their perspectives, today I'll be talking about our latest view on Asia and EM equities. It's Friday, November the 5th at 2pm in London.
Overall, in our coverage, we continue to prefer Japan to Non-Japan Asia and Emerging Markets. Japan has outperformed Emerging Markets by 500 basis points year to date but remains cheaper to its own recent valuation history than Emerging Markets and with stronger upward earnings revisions. New Liberal Democratic Party leader Kishida-san has recently fought and won a snap election in the lower house of the Japanese parliament. The governing Center-Right coalition, which he now leads, did considerably better than polling had suggested prior to the election outcome. Although there may be some changes in policy emphasis compared with the Abe and Suga premierships, the broad contours of market-friendly macro and micro policy in Japan are likely to continue.
Elsewhere within Emerging Markets, we're most constructive on Eastern Europe, Middle East and Africa and in particular Russia, Saudi Arabia and UAE, which are positively leveraged to rising energy prices. We're also warming up to ASEAN, having upgraded Indonesia to overweight alongside our existing overweight on Singapore. ASEAN economies are finally beginning to reopen post-COVID, which is stimulating domestic consumption.
However, we have recommended taking profits on Indian equities after a year of exceptionally strong performance. We remain structurally bullish on a cyclical recovery in earnings growth in India, but with forward price earnings valuations now very high to history and peers, and with rising energy prices a headwind for India, we think it's time to move to the sidelines. Within Latin America, we've also established a clear preference for Chile versus Brazil on relative economic momentum and export price dynamics.
Finally, we remain underweight Taiwan and equal weight China. For Taiwan, our contrarian negative view relates to our expectation of a semiconductor downcycle in 2022 and a slowing retail investor boom. Meanwhile, China equities continue to face numerous headwinds, including Delta variant COVID outbreaks, property developer deleveraging and the medium to long term impact on private sector growth stocks from the recent regulatory reset. Although valuations have improved in pockets, we expect further earnings downgrades for China and await a clearer pickup in growth and liquidity before turning more constructive.
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Central bank support has been a key driver of market strength since last year. So how will markets react during the months-long tapering process?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, November 4th at 2p.m. in London.
Since the start of the pandemic, the Federal Reserve, along with many other global central banks, instituted massive purchase programs of government bonds and mortgages. These purchases, known as quantitative easing, or QE, were designed to keep interest rates low and boost liquidity in financial markets during a time of stress. Since February of 2020, these purchases caused the Fed's bond holdings to rise by $4.4 Trillion dollars. On Wednesday, the Federal Reserve announced its intention to start dialing these purchases back.
To be clear, the Fed will still be buying a lot of bonds over the coming months. But after buying $120 billion of securities in October, the fed will buy $105 billion in November and $90 billion in December, a trend our economists think mean that they will cease these purchases entirely by June of next year. This ‘tapering’ of purchases and its impact for markets is a major source of debate.
One school of thought is that central bank support has been the main driver of market strength, not just recently, but going all the way back to the global financial crisis. Markets, after all, have done better when the Fed has been buying bonds.
But as much as you'll hear phrases like "the market is only up because of the Federal Reserve", this idea can suffer from some real statistical fallacies. Yes, markets have done better when the Fed has felt the need to support the economy. But the Fed has generally felt this need when conditions were bad, and bad conditions often meant lower market prices—something that was true in, say, the autumn of 2012 or March of last year. I know this is the type of hard-hitting financial insight you expect from this podcast but buying when prices are low tends to produce superior returns.
So what does ‘tapering’ mean? Well, one thing we can look at is the last time the Fed started to dial back its purchases. After a strong year for markets and the economy in 2013, the Fed started to ‘taper’ its bond purchases in January of 2014.
That turned out to be a bad month for markets. But the reasons were important. U.S. data was unusually weak, China's economy was slowing and there were troubles in emerging markets, including Argentina. The market's response, we'd argue, was very normal and fundamentally driven. The best example of this? Even though the Fed was reducing its bond purchases in January, bond prices actually rose, which is what you'd expect when concerns around growth increase.
The data ultimately improved, and 2014 turned into a reasonable year for stocks, albeit a shadow of the stellar returns of the year before. But putting it all together, we think 2014 provides an important clue for how markets could respond to tapering: as the Fed becomes less involved in the markets, fundamentals matter more, and become a larger driver of whether markets will sink or swim.
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Inflation rates, commodity prices and central bank policy are tied together through self-referential loops. With today’s FOMC meeting, it is worth a closer look at these meta dynamics.
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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Wednesday, November 3rd at noon in New York.
Is there anything more "meta" than commodity markets, headline inflation rates and inflation markets? The Google dictionary, using definitions from Oxford languages, defines the adjective ‘meta’ as "self-referential, referring to itself or to the conventions of its genre." A great example would be a website that doesn't review movies, it reviews the reviewers who review movies.
Rates markets can get pretty meta as well. Commodity prices, inflation rates reported by the government and inflation rates traded in the market often mirror each other in a self-referential loop. When investors see commodity prices going up, they think that inflation rates will go up, so they buy inflation linked bonds. That drives inflation rates in the market higher, which makes othes investors believe that inflation will be a problem, and so they buy commodities as a hedge for higher inflation, which drives commodity prices even higher. And so, the loop continues.
This self-referencing loop wouldn't be as problematic if actual inflation reported by the government, which looks at price changes in the past, didn't have a big impact over market-based measures of inflation, which look at what inflation might average in the future. But they do have an impact, especially when movements in actual inflation have been big, like they have been recently.
Another check on the self-referencing loop is supposed to be how central bankers react to movements in inflation rates in the marketplace, especially those that relate to inflation over a longer period of time, like five to 10 years in the future. Central bankers know that inflation rates in the market include both expectations and risk premiums. And because central bankers are primarily interested in inflation expectations, they use surveys of consumers and professional forecasters, as well as statistical models, to extract those expectations from market prices.
Still, when inflation rates in the market move to extremes, central bankers get nervous, just like investors. And therein form something else that's very ‘meta,’ the self-referential loop that includes investor fears, central banker fears, market pricing of central bank policy and central bank policy itself.
It's no wonder that the markets which price the most hawkish central bank policy paths are also the markets that priced the highest inflation rates in the future, and we can't blame investors for allowing this market behavior to persist. I'll give you an example. Looking back to the second half of 2014, the dramatic decline in oil prices allowed the market in Europe to price much lower inflation rates in the future, and the European Central Bank responded by announcing its quantitative easing policy in January 2015.
But what goes up – in this case, commodity prices, inflation rates in the market and the pricing of more hawkish central bank policies – can also come down. And given the meta nature of these markets, investors may want to pay close attention to what is happening to commodity prices today.
For example, some of the recent supply chain and commodity disruptions have peaked in futures markets like lumber, thermal coal, and natural gas. In addition, the cost of shipping many commodities, such as coal and iron ore, have also peaked.
This leaves us feeling that the pricing of central bank policy in markets is increasingly at risk of reversing somewhat. We flag today's FOMC meeting as possibly the last major central bank meeting that could spur even more hawkish pricing of central bank policy.
In other words, investors should realize that markets are pricing the high rates of inflation we've experienced – in part driven by higher commodity prices – to continue for some time. And markets are priced for central banks to respond aggressively. But what if commodity prices fall from here? Investors should be prepared for the "meta" nature of these markets to reprice central bank policies again, but this time in a more dovish direction.
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‘Build Back Better’ has gained support from all corners of the Democratic Party, but questions remain over how the framework is paid for. For investors, a look at short term dynamics may provide clarity.
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Welcome to Thoughts on the Market. I'm Michael Zezas, head of public policy research and municipal strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, November 2nd at noon in New York.
Over the past few days, the "Build Back Better" framework has gained increasing support from all corners of the Democratic Party. And although Senator Joe Manchin put his support for the framework in question yesterday, and there are still some questions on items such as prescription drug reform, our base case is still that "Build Back Better" and the bipartisan infrastructure bill will likely be enacted before year end.
However, still up for debate is whether "Build Back Better" is fully paid for by things like stronger IRS tax enforcement and tax increases on corporations. In its current form, the framework proposes fiscal balance, but over 10 years. In the short term, it doesn't mean zero fiscal expansion.
Rather as structured, we think the bill would add to deficits over the first five years but get to balance by having surpluses over the remaining years. This distinction is important, and we argue that investors should focus on the early-year deficit dynamic instead of the 10-year deficit language that Congress generally uses to communicate deficit impact.
One reason is that policy uncertainty usually increases with time. For example, several spending and contra-revenue programs including a child tax credit, expanded Affordable Care Act subsidies, and state and local tax cap relief, roll off well before the 10-year look-ahead period ends. And U.S. elections in 2022 and 2024 could conceivably result in changes to government that could mean the continuation or discontinuation of programs and new tax items.
Given this uncertainty and the estimated $256 billion dollar deficit for the bipartisan infrastructure bill -- the takeaway for investors is that we expect bond markets will focus on this early-year dynamic since this is the time frame that ultimately impacts GDP forecast horizons, impacts the Treasury supply forecast horizon and is reliable from a policy standpoint.
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Original Release on October 11th, 2021: As the weather chills and we head towards the end of the mid-cycle transition, the S&P 500 continues to avoid a correction. How long until equities markets cool off?
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In case you missed it, today we are bringing you a special encore release of a recent episode. We’ll be back tomorrow with a brand new episode.
Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 11th at 11:30 a.m. in New York. So, let's get after it.
With the turning of the calendar from summer to fall, we are treated with the best weather of the year - cool nights, warm days and clear skies. In contrast, the S&P 500 has become much more volatile and choppy than the steady pattern it enjoyed for most of the year. This makes sense as it's just catching up to the rotations and rolling corrections that have been going on under the surface. While the average stock has already experienced a 10-20% correction this year, the S&P 500 has avoided it, at least so far.
In our view, the S&P 500's more erratic behavior since the beginning of September coincided with the Fed's more aggressive pivot towards tapering of asset purchases. It also fits neatly with our mid-cycle transition narrative. In short, our Fire and Ice thesis is playing out. Rates are moving higher, both real and nominal, and that is weighing disproportionately on the Nasdaq and consequently the S&P 500, which is heavily weighted to these longer duration stocks. This is how the mid-cycle transition typically ends - multiples compressed for the quality stocks that lead during most of the transition. Once that de-rating is finished, we can move forward again in the bull market with improving breadth.
With the Fire outcome clearly playing out over the last month due to a more hawkish Fed and higher rates, the downside risk from here will depend on how much earnings growth cools off. Decelerating growth is normal during the mid-cycle transition. However, this time the deceleration in growth may be greater than normal, especially for earnings. First, the amplitude of this cycle has been much larger than average. The recession was the fastest and steepest on record. Meanwhile, the V-shaped recovery that followed was also a record in terms of speed and acceleration. Finally, as we argued last year, operating leverage would surprise on the upside in this recovery due to the unprecedented government support that acted like a direct subsidy to corporations.
Fast forward to today, and there is little doubt companies over earned in the first half of 2021. Furthermore, our analysis suggests those record earnings and margins have been extrapolated into forecasts, which is now a risk for stocks. The good news is that many stocks have already performed poorly over the past six months as the market recognized this risk. Valuations have come down in many cases, even though we see further valuation risk at the index level. The bad news is that earnings revisions and growth may actually decline for many companies. The primary culprits for these declines are threefold: payback in demand, rising costs, supply chain issues and taxes.
At the end of the day, forward earnings estimates will only outright decline if management teams reduce guidance, and most will resist it until they are forced to do it. We suspect many will blame costs and even sales shortfalls on supply constraints rather than demand, thereby giving investors an excuse to look through it. As for taxes, we continue to think what ultimately passes will amount to an approximate 5% hit to 2022 S&P 500 EPS forecasts. However, the delay in the infrastructure bill to later this year has likely delayed these adjustments to earnings.
The bottom line is that we are getting more confident earnings estimates will need to come down over the next several months, but we are uncertain about the timing. It could very well be right now as the third quarter earnings season brings enough margin pressure and supply chain disruption that companies decide to lower the bar. Conversely, it may take another few months to play out. Either way, we think the risk/reward still skews negatively over the next three months, even though the exact timing of cooler weather is unclear. Bottom line, one should stay more defensive in equity positioning until the winter arrives.
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Investors have had a lot to take in over the past few weeks, but corporate credit markets remain calm despite turbulence elsewhere. Vishy Tirupattur explains.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the current calm in the corporate credit markets. It's Friday, October 29th at 1:00 p.m. in New York.
Over the past few weeks, risk markets have been buffeted by volatility from a wide array of sources. It was around a month ago that the regulatory reset in China and the near-term funding pressures on select property developers roiled global markets, as investors fretted all the systemic implications for global growth.
Then, a mixed U.S. jobs report, along with sharply higher commodity prices, intensified the debate around stagflation. And the rhetoric from multiple central banks has been increasingly hawkish. So, a lot for investors to take in.
The combination of these concerns has resulted in substantial market gyrations. The S&P 500 index declined by about 4% before recovering to all-time highs. The shape of the Treasury yield curve has twisted and turned. The benchmark 10-year Treasury interest rate went from around 1.3% to around 1.7% and back down to 1.56%. The market pricing of the timing of a Fed rate hike has come in sharply.
But amidst all these substantial moves, corporate credit markets on both sides of the Atlantic have largely stayed calm. Credit spreads, which are the risk premium investors demand to hold corporate debt or U.S. treasuries, have hovered near 52-week tights in investment grade, high yield and leveraged loans across the U.S. and Europe. And with surprisingly limited volatility.
Credit market volatility relative to equity markets remains very low. Market access for companies across the credit spectrum has remained robust, as indicated by strong issuance trends, running at or ahead of the pace of a year ago. So, what explains this stark difference between credit and other markets? The answer boils down to meaningfully improved credit fundamentals and elevated company balance sheet liquidity, leading to a decidedly benign outlook for defaults over the next 12 months, if not longer.
Morgan Stanley's credit strategists Srikanth Sankaran and Vishwas Patkar have highlighted that the balance sheet damage from COVID has been reversed. At the end of the second quarter this year, gross leverage in U.S. investment grade credit has declined sharply back to pre-COVID levels. Net leverage is now below pre-COVID levels, while interest coverage has risen sharply to a seven-year high.
The trends in the high yield sector are even more impressive, driven not just by the rebound in earnings but also negative debt growth. After four consecutive quarters of declines from the second quarter 2020 peak, median leverage now sits below the pre-COVID trough. That 71% of the issuers are now reporting lower growth levels quarter over quarter, reflects the broad-based improvement we are seeing in the market.
Even in the leveraged buyout world, while 2021 has been a bumper year for acquisition activity, unprecedented equity cushions have resulted in a much better alignment of sponsor and lender interests, helping to alleviate concerns.
So, what are the implications for investors? A lot, of course, is already in the price. With credit spreads near the tight end of the spectrum, we are more likely to see them widen than tighten. Indeed, the base case expectation of our credit strategists is more modestly wider splits. However, the strength in credit fundamentals suggests that the outlook for defaults is benign, and likely below long term average default levels. Thus, we prefer taking default risk to spread risk here, leading us to favor high yield credit or investment grade credit and, within high yield, loans over bonds.
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One of the great conundrums of finance is predicting what markets will return over the long run. But with some historical research and the power of math, the future can become a bit clearer.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, October 28th at 2 p.m. in London.
The question of what markets will return over the next decade is a conundrum. It's complicated because of just how much can change in a given year, let alone a decade, but also simple because over longer horizons, valuation measures such as bond yields or stock price-to-earnings ratios tend to matter a lot more for how well a market does. A 10-year horizon really matters to investors saving for the future. But most investors, and also this podcast tend to focus on events happening in the much more immediate future.
So what do we think this return picture holds?
When estimating what a market will return over the long run, there are really two basic approaches. The first, sometimes called the demand approach, assumes that markets are efficient, and that investors will always demand that the market is priced to deliver an average historical return. In this approach, future returns for the market are simply assumed to be the long run average. We don't use this approach, but others do, and it is appealing for being relatively straightforward.
An alternative, which we favor, could be called the supply approach. This attempts to quantify just how much return a given asset can supply. So, for bonds with a fixed yield, this approach is attractively simple. On a 10-year horizon, the return for a broad bond index should be pretty similar to its yield today, regardless of the path that interest rates take between now and then. That might sound somewhat counterintuitive, but there's some pretty good math, we think, to back it up. After making a few minor adjustments, we think the U.S. Aggregate Bond Index may be able to supply a return of about 2% per year, over the next decade.
For stocks... now there are more moving parts and more assumptions that can ultimately be proven right or wrong. The long run return of a stock market can be broken down into three parts: the dividends of the stock market pace, the growth in the market's earnings, and the change in the valuation that's applied to those earnings. The dividend yield is relatively easy to estimate, but earnings and valuations create a lot more debate.
For earnings, our starting point is to assume that they grow, at least with the rate of inflation. We see a good argument for this, if prices everywhere are rising, companies should book higher sales and profits. This is one reason why equities tend to be a better asset class in higher inflation because they can grow their cash flows much more easily than, say, a bond can.
So how much do earnings grow over and above the rate of inflation? We average two trend lines: a very long run trend of historical earnings growth and one that only focuses on more recent history. There are pros and cons of each. For example, only using the recent historical trend may better reflect current conditions in the market, but it also might overstate what's been an unusually favorable environment for companies. By taking the average, we split the difference. Now, with stock market earnings are above trend. We assume that there is some convergence down. And if earnings are depressed, we assume some normalization up. We think there's some good historical arguments for this, as earnings do tend to oscillate around these trend lines over time.
Finally, what about those valuations? Well, we assume that valuations move back to long run averages, but do so only gradually, as we believe history says this gravitational pull takes time.
Putting all of this together, we think the U.S. stock market could return about 5.2% per year over the next decade. The bad news is that's roughly half the long run average. The good news? It's still two and a half times higher than the return from that broad bond index.
So where can investors find higher returns, especially relative to inflation? For equities, our framework suggests the highest so-called real returns are in Europe, where we think stocks could beat inflation by about six percent per year. In fixed income markets, we see the highest inflation adjusted returns in emerging market bonds.
Finally, where could our assumptions be wrong? The return for bonds should be pretty well anchored by their yields, but for stock markets, there are several swing factors. Higher corporate taxes, for example, or higher interest rates could mean we're too optimistic about our assumptions for earnings growth and valuations. On the other hand, a stronger economy and importantly, a more permanent shift higher in market profitability could mean that our assumptions for mean reversion back to historical averages are simply too pessimistic. Either way, time will tell.
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Autonomous trucking may sound like science fiction, but its impacts on transportation costs, the labor market and a breadth of industries may be closer than we think.
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Adam Jonas Welcome to Thoughts on the Market. I'm Adam Jonas, head of Morgan Stanley's Global Auto and shared mobility research team.
Ravi Shanker And I'm Ravi Shankar, equity analyst covering the North American freight transportation industry.
Adam Jonas And on this episode of the podcast, we'll be talking autonomous. Specifically, the road ahead for autonomous trucking. It's Wednesday, October 27th at 10 a.m. in New York.
Adam Jonas Ravi, before we get into the autonomy topic, specifically, your sector really sits at the epicenter of labor inflation and driver shortage. So, just help set the scene for us. How big of a problem is this?
Ravi Shanker It's pretty difficult right now. It has been the case for a while. We've had a demographic problem in trucking for pretty much the last two decades and counting. In fact, you can find news stories going back to 1910 talking about a driver shortage in the industry. But it's particularly acute right now. A lot of it is structural, not cyclical. So we think we need to find unconventional solutions to the problem.
Adam Jonas So remind us why autonomy progresses faster in trucking than in cars. You and I have had this debate over many years but tell us why it's faster in trucking.
Ravi Shanker It's a slightly different problem to solve with trucking. I mean, it's still a very difficult problem to solve. But the fact that 93% of miles driven of a truck are on the highway and autonomous driving is slightly easier to solve on the highway than it is in the middle of Manhattan for instance. That really helps. The fact that this is an industry that's really driven by unit economics and labor accounts for 35-40% of the cost of trucking, and if you can substitute a driver at least partially or maybe completely even, that will significantly reduce the cost of trucking. And obviously, there's a safety aspect; the fact that a truck accident can cause significant damage. And if you can have technology solve that problem and step in, that can save countless lives over time. So we think it's a slightly easier problem to solve. The economic savings may be better or easier to quantify with trucking than with passenger cars.
Adam Jonas And that's a really good point, because I find in my conversations with investors that people tend to think of autonomy as this blanket homogeneous technology. But I want to understand a bit more about the economics of autonomy, payback periods, cost benefit. What are some of the highlights from the numbers that you've been running?
Ravi Shanker So we think that autonomy can reduce the cost of trucking by 60%, six zero. If you can electrify the truck, that's probably another 10% on top of that. Obviously, if you take a truck company today and reduce their cost of operations by 60%, that's significant savings. On top of that, because you don't have to deal with hours of service regulations for a driver, you can significantly improve your productivity of the truck and hopefully you can gain some market share as well. So, we think that these new technology trucks cost roughly 50 to 70 thousand dollars more than a regular truck today, but the payback period can be measured in weeks and not years.
Ravi Shanker So Adam, again, to me, it's relatively clear what the use case is for autonomy in trucking. Where are we with pass cars, where are those passenger robotaxis that we were promised a few years ago?
Adam Jonas Well, I actually had the opportunity to ask the chair and CEO of General Motors, Mary Barra, on a Morgan Stanley video series that we published that exact question. And her response, pretty confidently was we're going to see major development in quarters, not years. Now that mission is focused on robotaxi in dense urban cities like San Francisco and other cities. Ravi, I think the definition of success there isn't that they've solved autonomy in two years because that's not something we're going to solve. We think that the definition of success there will be; are they able to fleet many tens or maybe even a couple of hundred robotaxis in a major city or a collection of major U.S. cities with driver out? Even if it's a simple mission doing a giant rectangle on a geofence or, you know, something that can resemble a streetcar without cables or a streetcar without wires. Just that proof point, even if it doesn't completely remove your driving license and substitute your commute entirely, will go a long way to convincing policymakers, investors and the general public that this is not science fiction, we're going to get there, right? Just like the barnstorming age of early aviation, these bigger and bigger feats every week, every month, we think we'll see something similar in autonomy.
Ravi Shanker And maybe some of the key benefits of autonomy can be realized even with these kind of small early use cases. But I was thinking like maybe a pretty nice commonality in both our worlds, maybe the center sliver of the Venn diagram, if you will, between autonomous trucking, autonomous pass cars, is autonomous delivery vans. We've done a lot of work on what this means the last mile. Obviously, GM, Ford other OEMs have been talking about this. Where do you think we stand there in terms of these OEMs entering that market again?
Adam Jonas Yeah, especially post-COVID. I mean, the growth of e-commerce and our obvious dependency, increasing dependency on final mile. That use case is perfect for electrification and autonomy. And I would just make the point that advancing the state of the art of connected car and connected car ecosystems and electric ecosystems accelerates the development of the autonomous economy too because electric cars make better AVs. And then autonomous cars make better electric cars because you can optimize the utilization and the use case and the inter workings with the infrastructure. So, I think that is a very hot area and I would agree with you there is middle ground that we're going to see in your neighborhood, perhaps sooner than people think, even if it's still at a slow speed or not all the time in all neighborhoods, in all weather conditions.
Adam Jonas Before I let you go, I wanted to ask you a question that's always on people's minds and that's the impact on the workforce and jobs. How are your companies talking to current drivers about this autonomy subject?
Ravi Shanker This is a really good question and obviously somewhat of a sensitive topic. I think the truck fleet operators want to be very careful and very clear that trucking is not going to displace every truck driver or like hundreds of thousands of truck jobs any time soon. In fact, we had a report that was commissioned and published by the Department of Transportation a few months ago, it was earlier this year that basically said that even with a bullish base of adoption of autonomous trucking, they did not see risk to significant job losses in the trucking space just given the extreme truck driver shortage that we already have and the limited new labor supply that's going into this industry. So, it's something to be very cognizant of, something to be very sensitive about, but at the same time, we think the technology can actually help the industry and not be a hindrance.
Ravi Shanker So Adam, taking everything we've discussed today into account, what are the investment implications of this?
Adam Jonas There's really lots of different ways you could express an investment opinion. I think Apple CEO Tim Cook once described autonomy as the mother of all AI. In the auto industry, many of our clients see it, as you know, the ultimate internet of things, internet of cars. And so, there are a variety of adjacent industries, both within auto and transportation, but also technology enablers, sensor companies, semiconductors, processors, A.I. companies, network operators, data.There's all sorts of ways to express it across industries. And interestingly, according to your work, the beneficiaries of autonomy ultimately extend across multiple industries, right? Fleet operators and frankly, ultimately, the consumer, too. So, the question might be what sector isn't exposed to this technological revolution?
Adam Jonas All right, Ravi, thanks for taking the time to chat.
Ravi Shanker Absolutely, Adam. Great speaking with you.
Adam Jonas And thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Debates in D.C. continue to make headlines, but even with lowered expectations for the Biden agenda, we find a robust set of climate-focused provisions likely to survive the process and benefit the clean tech sector.
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas, head of U.S. public policy research and municipal strategy for Morgan Stanley.
Stephen Byrd And I'm Stephen Byrd, head of Morgan Stanley's North American Research for the Power and Utilities and Clean Energy Industries.
Michael Zezas And on this edition of the podcast, we'll be talking about clean energy and the latest developments for the bipartisan infrastructure deal and President Biden's build back better agenda. It's Tuesday, October 26th at 10 a.m. in New York.
Michael Zezas So Steven, with the negotiations winding down on the legislation Congress is considering around the president's economic agenda, I wanted to speak with you because you cover a sector, clean tech, that's really at the nexus of many things Congress and the White House are trying to achieve. In particular, even as the size of the economic and climate package has been cut from $6 trillion dollars to $3.5 trillion dollars now, perhaps as low as $1.5 trillion dollars, one constant has been a potentially large amount earmarked for clean energy infrastructure. By our estimate, there could be roughly $500 billion of new money allocated towards this goal. So, last month on the podcast, you outlined eight headline proposals, maybe we could start by updating everyone on those proposals as they stand now in the scaled back version of the bill.
Stephen Byrd Yeah, thanks, Mike. There is still a lot of support for clean energy in the draft legislation. Let me walk through the eight elements that investors have been most focused on to give you a sense for just how broad that support is.
Stephen Byrd Number one, and the boldest of these proposals is a clean electricity performance program or CEPP. This would essentially push all utilities and load serving entities to adopt clean energy and phase out fossil fuels. Number two is a new tax credit for energy storage and biofuels. Number three is a major extension of tax credits for wind, solar, fuel cells and carbon capture, and the payment for many of these technologies is higher than they've been in the past. Number four is significant incentives for domestic manufacturing of clean energy equipment. Number five is what's often referred to as direct pay for tax credits. This essentially provides owners with the immediate cash benefit of tax losses; that avoids these companies needing to go monetize those tax losses via the tax equity market to the same extent that they do now. Number six is support for nuclear power. There's a production tax credit for nuclear power output. Number seven is a major clean hydrogen tax credit. And number eight is significant capital to reduce the risk of wildfires. So it is very broad, very far reaching. It has impacts across the board.
Michael Zezas So, which kinds of companies do you think stand to benefit the most from this funding?
Stephen Byrd It's really interesting, quite a few subsectors that I cover would receive significant benefit here, I'll highlight the biggest beneficiary. So first, any company involved in green hydrogen, I see quite a bit of benefit here. The tax credit for green hydrogen is $3 a kilogram. That is a very large amount. And we think will incent customers to adopt green hydrogen more quickly. It will incent developers to build out the infrastructure needed to both produce and distribute green hydrogen. So, a number of companies from fuel cell companies to those involved in the industrial gas business to clean energy developers, I think will see a significant benefit there. Another category would be renewable development companies. So, the tax credit for wind and solar and storage is increased. In the case of storage, this is the first time energy storage would get a tax credit, and this further lowers the cost of clean energy. Another category that could be quite significant is carbon capture and sequestration. This technology would receive a significant benefit in terms of the payment per ton of hydrogen. And we believe in many cases, this is going to be really the amount needed to get essentially over the finish line. That is, to provide enough support for those big carbon capture projects to actually get built, which is really quite exciting. Biofuels gets a big benefit. Anyone who wants nuclear power would receive a significant benefit. And also, companies that are working to reduce the risk of wildfires would receive significant government support. So, you can tell it's just very broad and touches on really every subsector that we cover.
Michael Zezas Now, the Clean Electricity Performance Program, or CEPP, will likely end up on the cutting room floor. Why is this program's exclusion not a bigger problem in your mind?
Stephen Byrd The CEPP, it's really interesting. It certainly is a very bold effort to reduce fossil fuel usage. What we find here, though, is that all of the other provisions are so significant that we believe the adoption of clean energy will continue at a rapid rate. To give you a sense, in 2020 renewable energy in the United States was about 11 percent of power output. By 2030, we project that that can approach around 40 percent. That is a huge increase in just a decade. That is predominantly driven by economics. The cost of wind, solar and energy storage is dropping so quickly that many customers are adopting clean energy based purely on economic grounds, and the elements of support in this draft legislation would further enhance those economics and push customers in that direction anyway. So, we do see a big shift occurring, with or without the CEPP. Fortunately, there are many other elements of support in this draft legislation that we think is going to really provide a boost to many clean tech technologies, many business models, and we're excited about the growth that that would bring.
Michael Zezas What about the other types of companies you cover, utilities? This government investment seems like a step toward developing a very different type of business model for them. What do you think the outlook for the sector is?
Stephen Byrd I'd say the government support for clean energy that's in this draft legislation does have a number of benefits for utilities. So, we see in parts of the country a virtuous cycle that's been forming. And let me walk through how this is playing out. The coal power plants in many parts of the U.S. are quite expensive compared to renewable energy. So, for example, in the Midwest, the cash cost to run a coal plant could be three times as high as it costs to build a new wind farm. And so what utilities are doing is they are in a very careful, measured way shutting down coal, replacing that coal typically with a combination of wind and solar and energy storage. And typically, customer bills are not going up as a result, because of the benefit from avoiding the cost of running those coal plants. That virtuous cycle is resulting in better earnings per share growth. Now, with the government support that we're seeing in this draft legislation, that shift will accelerate. We will see more transmission spending, for example, more energy storage spending. It will boost the economics of wind and solar, which is fantastic. Also, in terms of risk mitigation, the capital that's in the bill that would help with dealing with the physical damage from climate change, such as wildfires, is another area of benefit. The cost from climate change to our sector is rising. And so government support there will help essentially defray a cost that's becoming quite significant for some of our utilities. So, you know, I think you're right to point this out. The utility sector is quite a big beneficiary here. And, you know, many of our best-in-class utilities can achieve, we think 7%, sometimes 8% EPS growth over a very long time period. By very long, I mean, a multi-decade time period. That to us is quite exciting because risk adjusted, that growth is quite excellent. For many of our utilities, the risk to achieve that is fairly low because the economics of what they're doing is so clear and so compelling. So, we are excited about the impacts to the utility sector.
Michael Zezas Steven, thanks for taking the time to talk.
Stephen Byrd Great talking with you, Michael.
Michael Zezas As a reminder, if you enjoy Thoughts on the Market, please take a moment to review us on the Apple Podcasts app. It helps more people find the show.
The forecast for inflation still appears hot for both consumers and corporates, but when it comes earnings and economic growth, the outlook looks a bit chilly.
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Welcome to Thoughts on the Market. I'm Mike Wilson, chief investment officer and chief U.S. equity strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 25th at 11:30 a.m. in New York. So, let's get after it.
Over the past few weeks, we've discussed the increasing probability for a colder winter, but a later start than previously expected. In other words, our "fire and ice" narrative remains very much intact, but timing is a bit more uncertain for the ice portion. Having said that, with inflation running hot in both consumer and corporate channels, the Fed is expected to formally announce its tapering schedule at next week's meeting with perhaps a more hawkish tone to convince markets they are on the job. In other words, the fire portion of our narrative—higher rates driven by a less accommodative fed spurring multiple compression—is very much in gear and a focus for investors.
With so much attention on rising inflation now from both investors and the Fed, we shift our attention to the ice portion of our narrative - meaning the ongoing macro growth slowdown and when we can expect it to bottom and reverse course. As regular listeners know, we've been expecting a material slowdown in both economic and earnings growth amid a mid-cycle transition. The good news is, so does the consensus, with third quarter economic growth forecast coming down sharply. While consensus’ fourth quarter GDP forecasts have declined too, it expects growth to reaccelerate from here. This is due to the fact that most have blamed the Delta variant, China's crackdown on real estate or power outages around the world for the economic disappointment in third quarter. The assumption is that all three will get better as we move into year end and 2022.
Needless to say, we're not so sure about that assumption, mainly because we think the more important driver of the slowdown has been the mid-cycle transition to slowing growth from post-recession peak growth, an adjustment that's not finished. In our view, would be intellectually inconsistent to think that the mid-cycle transition slowdown won't be worse than normal given the greater than normal amplitude of this entire economic cycle so far. We can't help but recall our position over a year ago when we argued for much faster growth driven by greater operating leverage than normal for earnings. This was directly a result of the record fiscal stimulus that effectively served as government subsidies for corporations. Today, we simply find ourselves in the exact opposite side of the argument relative to consensus, but for the same reasons. Since we believe consensus missed that insight last year, it seems plausible it could be missing it this time on the other side.
In short, we think the gross slowdown will be worse and last longer than expected as the payback in demand arrives early next year with a sharp year over year decline in personal disposable income. While many have argued the large increase in personal savings will allow consumption to remain well above trend, it looks to us like personal savings have already been depleted to pre-COVID levels. The run up in stock, real estate and crypto asset prices do provide an additional buffer to savings, however, much of that wealth is concentrated in the upper quartile of the population. At the lower end of the income spectrum, consumer confidence has fallen sharply the past few months, and it's not just due to the Delta variant. Instead, surveys suggest many consumers are worried again about their finances, with inflation increasing at double digit percentages in necessities like food, energy, shelter and health care.
Bottom line, the fundamental picture for stocks is deteriorating as the Fed begins to tighten monetary policy and growth slows further into next year. However, asset prices remain elevated as the upper income cohort of retail investors continues to plow money into these same investments. With seasonal trends positive this time of year, institutional investors are forced to chase prices higher. If our analysis is correct, we think this can continue into Thanksgiving, but not much longer. Manage your risk accordingly.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
The market’s long term trajectory for oil suggests a decline in prices, but the 'why' matters, and the transition toward more green energy may imply a different outcome.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross-asset strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 22nd at 2:00 p.m. in London.
The price of energy has surged this year. While the S&P 500 is up an impressive 21% year to date, that pales in comparison to a broad index of energy commodities - things like oil and natural gas - which are up almost 80%. I wanted to talk today about some of the broader implications of this move and importantly, the somewhat surprising message from future price expectations.
Let's actually start with those expectations. While the price for oil is up sharply this year, future prices currently imply a pretty significant decline in the price of oil over the next one, two and three years. Buying a barrel of oil costs about $84 today. But if you want to buy a barrel for delivery in a year's time, the price is $76, a full 10% lower. And for those of you looking ahead to Christmas 2023, that same barrel of oil costs $70, 17% below current levels.
Those implied declines in the future price of oil are historically large. If current oil prices simply move sideways over the next year, buying oil 10% below current levels in a year's time will return, well, 10%. That's more than double the return for U.S. high yield bonds, and one reason commodity investors care so much about the shape of these prices over time. Indeed, it's a way for investors to make a pretty healthy return, in this case 10%, in a scenario where the day-to-day price of oil doesn't really move.
This dynamic that we see today, where future oil prices are lower than current levels, is called 'backwardation'. And while it matters for commodity investors, it can also have broader implications for how we interpret the economic outlook.
When oil prices are rising like they are today, one of the single biggest economic questions is whether this rise is mostly coming from increased demand or more limited oil supply. The price impact may be the same between these two dynamics, but the underlying drivers are very, very different. According to the work by my colleague Chetan Ahya, Morgan Stanley's chief Asia economist, higher demand suggests underlying activity is strengthening and higher oil prices are easier to afford. Limited oil supply, in contrast, works more like a tax and can be more economically disruptive.
So how do we know which one of these it is?
Well, there are a lot of things that investors can look at, but the shape of oil prices over time, what we've just been discussing, can be a really useful way to quantify this question. Short term oil prices, we'd argue, tend to be influenced more heavily by the demand for oil. If you're going to go on a long road trip, you're going to fill up at the pump today. Longer term oil prices, in contrast, tend to be more linked to supply, as the producers of that oil really do care about selling it over the next one, two, three and five years. So, if demand is strong, short-term prices should be biased higher. And if supply is more plentiful, longer-term prices tend to be biased lower. That downward shape of prices over time, that 'backwardation', is exactly what we were discussing earlier, and that's what we see today. That, in turn, suggests that the current oil price strength is being driven more by demand than supply.
I'll close, however, with the idea that the market might have this long-term trajectory of oil prices wrong. As my colleague Martijn Rats, Morgan Stanley's chief commodity strategist, has recently argued, an expectation of a green transition towards renewable energy has caused investment in new oil drilling to plummet. That should mean less supply over time, challenging the market's current assumption that oil prices will decline significantly over the next several years.
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Sustainably generated hydrogen has great promise as a fuel where electricity alone won’t suffice, but the road to its broad adoption remains complicated for investors to navigate.
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Jessica Alsford Welcome to Thoughts on the Market. I'm Jessica Alsford, Global Head of Sustainability Research at Morgan Stanley.
Ed Stanley And I'm Ed Stanley, Head of Thematic Research at Morgan Stanley.
Jessica Alsford And today on the podcast, we're going to be talking about the investment implications of hydrogen. It's Thursday, October the 21st at 3:00 p.m. in London.
Jessica Alsford So Ed, hydrogen has been something we've been looking at for some time, given its potential role in a low carbon economy. So why is it that the debates around green hydrogen seem to have intensified over the last 6 to 12 months?
Ed Stanley Great question. Massive, centralized support and road mapping in the form of the European Hydrogen Strategy and the US Infrastructure Bill simultaneously thrust hydrogen to center stage around the world.
Ed Stanley But the froth has come and gone to some extent from most of these hydrogen names. And so now it's a really interesting time to be relooking at the space from a stock picking perspective. The number of dedicated hydrogen thematic funds is really beginning to accelerate as well. We've reached 10 hydrogen funds in Europe from only 1 two years ago, and many of the pure play equities that these funds are or will be buying are pretty illiquid, which we expect will lead to further volatility in due course for single name equities. The electrolyzer stocks are up to two thirds of their highs, so the reason why now is that as the market froth subsides, we're beginning to see these thematic alpha opportunities all the way along the supply chain in hydrogen.
Jessica Alsford Now, projections by the Hydrogen Council suggest that green hydrogen could enable a global emissions reduction of around 6 gigatons by 2050 - so almost 10% of current global emissions. It also has the potential for unlocking something like 30 million jobs and $2.5T of associated revenues. And yet, despite this huge potential, it does feel that we're still at a very early stage. So why is that? What are some of the challenges around the wider adoption of green hydrogen?
Ed Stanley That's right, and I don't think you can fault the ambition. The Hydrogen Council, as you mentioned, is over 200 member companies and they have a clearly defined goal and they're pulling in the same direction. And increasingly, governments are also walking the talk. I guess, though, when you ask our analysts what the greatest hindrances are, if I had to boil them down to two factors, it would be these: first, the lack of standards, and that really means we have dual investment and thus potentially wasted investment going on as each stakeholder has their own vested interests on whether to use PEM or alkaline electrolysis, for example; or whether to retrofit existing pipe networks or to rebuild from scratch. So, a lack of agreement on these dichotomies is a risk of diluting the early stage growth and investment.
Ed Stanley And the second is much simpler, actually, it’s economics. Costs for renewable energy, predominantly wind and solar, that feed these very power hungry upstream electrolyzers have fallen substantially in cost - over 90% decline in 10 years. But it still requires cost per unit breakthroughs across the rest of the supply chain; from ammonia, for example, or redesigning jet engines to make it viable, particularly for publicly listed companies to make the necessary investments. Ultimately, we should probably expect very generous subsidies for some time if we are to hit that 6 gigatons value, you mentioned.
Jessica Alsford So there are challenges, but also clearly opportunities as well. Where do you think the most value can be created and how should investors participate in this market?
Ed Stanley Again, our analysts obviously have their own single stock preferences, of course. But if I were to take a step back and look at the supply chain holistically, it's a question of relative risk reward. For example, upstream, some electrolyzer names have over 100% upside in our view, but that has to be taken in the context of an ongoing debate, as I mentioned, into which electrolyzer technology will become the industry standard, and so at risk potentially putting all your eggs in one basket. At the other end of the spectrum, downstream, rail and aviation has potential, but with extremely long time horizons, which risk compounding forecasting errors several decades away.
Ed Stanley So in my mind, some of the best plays are midstream - the chemical names, for example, with best-in-class green ammonia platforms. And you can see that in their excellent intellectual property positioning relative to the rest of the supply chain. Other subsectors include the inspection companies, which will benefit to the tune of 0.5% to 1% of all global hydrogen capex being spent on safety testing. And that's irrespective of which technology or country is the first to roll out. And we don't believe some of those fundamentals are being priced in. So given there's a still very high degree of uncertainty as this technology rolls out, our preference is for midstream and particularly technology and country agnostic companies.
Ed Stanley On that note, hydrogen is obviously only one of a handful of decarbonization tools. So, what else do you think has promise in the decarbonization outlook?
Jessica Alsford Yes, you're right, Ed. And if we are to achieve a net zero scenario by 2050 and achieve the Paris Agreement, then we need to deploy a range of different strategies. Now one of them may be renewables from a power generation perspective. Solar wind is already economically viable, and we expect to see a huge amount of roll out of renewable power capacity over the coming decades. Elsewhere, we need to see electrification of certain types of energy. The great example being on the auto side as you see movement from the combustion engine to electric vehicles. And though again, although adoption rates are still very low, the stimulus has been set. The policy is outlined to really incentivize this drive from the combustion engine to an EV. So, we're very confident it is only a matter of time before you see that greater adoption of EVs globally.
Jessica Alsford Then we come on to some of the more innovative technologies. I think CCS - carbon capture and storage - is a great example of this. Just a few years ago, it was really viewed quite negatively as essentially CCS allows you to still use fossil fuels, whether that be in power generation or in industrial processes like steel and cement manufacturing. But I think now there is a greater acceptance that in some situations we're not going to be completely able to remove all fossil fuels, and so by using CCS technology, you can allow coal/gas to be used, but without emissions as a result of that. And so, I do think that CCS is a really interesting technology to also watch alongside hydrogen as an enabler of a low carbon economy.
Ed Stanley That's very clear. And I guess the timing is very opportune to speak to you today because COP26 is approaching. And so, I'm keen to find out from you, what do you think we will see from the world leaders or even corporates in terms of decarbonization pledges? And what impact could that have ultimately on the market for hydrogen longer term?
Jessica Alsford Absolutely. So COP26 starts on the 31st of October in Glasgow. It has been delayed since last year because of the pandemic. Two things that I'd particularly point to is, first of all, we would expect many world leaders to step up and announce more ambitious carbon reduction targets. Not everyone currently has a 2050 net zero ambition. And we also now need to see that shorter term trajectory about how are we're going to get there at the right pace of decarbonization as well. So, 2030 reduction targets is also something that we'll be looking for at COP.
Jessica Alsford The second area I'd point to is then in terms of global carbon markets. So, the EU has been leading the way for a long time in terms of establishing a very broad and effective carbon market through the Emission Trading Scheme. However, in order to really, again accelerate the transition to a low carbon economy, we need to see a broader adoption of higher carbon taxes, higher carbon prices globally. And why is this important for hydrogen? Well, one of the ways I think that you can really incentivize adoption of hydrogen is to make the higher carbon incumbent alternatives more expensive, and you can do that by pricing carbon at a much higher level.
Jessica Alsford So I think the combination of more ambitious carbon reduction targets and more acceptance of the need for higher carbon taxes could be two positive catalysts for hydrogen at COP26.
Jessica Alsford Ed, thanks for taking the time to talk today.
Ed Stanley Great speaking with you, Jess.
Jessica Alsford As a reminder, if you enjoy Thoughts on the Market, please do take a moment to rate and reviews on the Apple Podcasts app. It helps more people to find the show.
The bipartisan infrastructure and ‘Build Back Better’ plans remain in legislative limbo, but what could their passage mean for markets?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, October 20th at 11:00 a.m. in New York.
We spend a lot of time here thinking through exactly how and when Congress will manage to raise the debt ceiling, keep the government open and pass a multitrillion dollar package of spending offset by tax hikes. To be clear, we continue to think it will do all of the above. But for this week, let's deal with DC's policy choices in classic Morgan Stanley Research fashion... by focusing on tangible market impacts.
Let's start with new government spending, which can be a positive catalyst in equity sectors such as construction and clean tech: in our view, a conservative estimate is that Congress approves $2.5T over 10 years between both the bipartisan infrastructure and build back better plans. While that amount might fall short of the numbers you might have heard thrown around, it should get your attention. For example, the bipartisan infrastructure framework, which would make up about $500B of this total, would nearly double the US's current baseline infrastructure spend. Our colleagues think this would catalyze an infrastructure ‘supercycle’ where factors like a surge in cement demand could lead to a positive rerating of stocks in the construction sector. Additionally, the framework could include $500B in new spending and tax credits aimed at clean energy production. That means a substantial ramp in demand for clean tech companies, which our colleague Steven Byrd sees as a clear bullish catalyst for that sector.
As for corporate taxes - yes, DC is likely to push them higher. Yet for now, we don't see this as more than a near-term challenge that shouldn't get in the way of the positive medium-term outcomes for the equity sectors we've highlighted. As Mike Wilson and the Equity Strategy Team have argued, enacting higher taxes could bring down forward guidance, something investors may not yet be pricing in, given current valuations. In the near term, that may prompt U.S. equity indices to price in a greater chance of a sustained economic slowdown. But such weakness would likely be more of a correction than a bear market signal, as we expect the total fiscal package would ultimately be GDP supportive. Likely incorporating more spending than taxes, our economists expect it to boost net aggregate demand and support the view that the US can continue to grow at a brisk pace in 2022.
So, of course, we'll be tracking these policy paths into year end, but it's important to keep an eye on why they matter from a market perspective. We'll stay focused on what's going on, and what you can do about it in your portfolio.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
Moves toward scale and consolidation show promise for what is already a burgeoning content industry.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Ben Swinburne And I'm Ben Swinburne, Equity Analyst covering Media, Entertainment, Advertising and the cable/satellite industries.
Andrew Sheets And today on the podcast will be going a bit meta, as the kids say, as we talk about some interesting upside for podcasting and advertising. It's Tuesday, October 19th at 2pm in London.
Ben Swinburne [00:00:25] And 9am in New York.
Andrew Sheets So, Ben, you recently wrote a research report titled, a bit surprisingly, “Mic'd Up. Is Podcasting the Next Big Thing?” I say surprisingly, because podcasting has been around for quite a while now. So why do you think that it's now where it's actually going to be it's time to shine?
Ben Swinburne You're right. Podcasting has been around probably for at least 15 years, but what we're really seeing is a significant increase in engagement by consumers, investment by platforms and content creators jumping into this space. We think we're at a point now where the business model, at least from an advertiser ROI point of view, has been proven out. You know, advertisers are paying $20-$25 CPMs, or cost per thousand listeners, to access a podcast audience, particularly through host-read ads, that's as high as linear television. And that just shows you that advertising on podcasting works for advertisers. So, what the industry needs from here is significant growth in adoption, which we believe is going to come given the investment we're seeing in content. Wrapping it all up, we think the industry can grow at a 30% CAGR through 2025 and become a $6-7 billion market globally, which is meaningful for the companies that are in this space.
Andrew Sheets So to kind of put those numbers in context, if I have a podcast that has 4,000 regular listeners, you know, if I'm getting paid by an advertiser $25 per thousand, that'd be about $100 for that $4,000 advertising block. Is that a good way to kind of think about those numbers.
Ben Swinburne Per spot, yes. And then obviously, it's a question for you on your podcast, how many ads you want to run per hour.
Andrew Sheets Podcasting is now charging, was it similar advertising rates as local television? Did I hear that correctly?
Ben Swinburne You did. You did.
Andrew Sheets Would you say though, investors believe in that? Because you cover a wide range of media companies in your equity coverage here at Morgan Stanley, how is the market pricing that advertising opportunity? And do you think the market believes that podcasting can be this major advertising vehicle?
Ben Swinburne I think the market's skeptical, frankly. Part of that is because as we talked about earlier, podcasting is not new as a media. But also because even at 15-years-old with a lot of excitement around it, it's a very small market. You know, estimates range from a billion dollars to maybe $2 billion in 2020 of global ad revenue on podcasting. That is a low single digit percentage of the global ad market. it's just been a very slow rise in monetization. And I think the market is skeptical that it can really break out from here.
Andrew Sheets So I imagine another area where the market might be skeptical is a lot of people have been stuck inside as a result of the pandemic. They've been listening to more podcasts. But as things normalize, maybe that listening trend will shift. Can you just kind of give us some numbers around, what percentage of the U.S. population listens to podcasts and do you think that that engagement will decline or rise as we look ahead over the next couple of years?
Ben Swinburne In 2020, the reach of podcasting in the U.S. accelerated to 25% of the population. If we think about that level of adoption, in a lot of other instances, Andrew, that's a part of the S curve where we start to really see the adoption rate accelerate. In other words, you're going from sort of early adopter to mass market. So that's our expectation here. We actually saw that in streaming music years ago. So, we're optimistic that we're going to see that from here. And frankly, when I look at the investment, the amount of money companies are pouring into content and monetization technology, I'd be really surprised if we don't see it accelerate. The other thing I would add is that even though podcasts consumption held up well in 2020, it was still negatively impacted by the pandemic. People were not commuting, not going to the gym, not going to work. All of that reduced the amount of time people were consuming audio content on their phones. So that is still the primary use case for all audio consumption but including podcasts. So we have started to see already improving data in the last several months on audio consumption as people have started to go back to work and go to school and hit the gym again.
Andrew Sheets So then, Ben, can you talk a little bit more about what's been happening on the merger and acquisition front in podcasting? And how this media is getting reshaped by some of the changes that we've seen?
Ben Swinburne Absolutely. Yeah, it's a very active market. You can sort of break down the M&A into two broad areas: content and sort of advertising technology. If you think about the media business, in the sort of the pre-internet days, you had media producers and media distributors, it's a pretty simple value chain. The internet, by its nature, but also because it's much less regulated, has created an environment for more vertical integration. Podcasting is rapidly moving in that direction, with distributors buying up podcast IP and creators rapidly. Now, that can probably only go so far because, like music, podcasting is a business built on ubiquitous distribution. So, where we've seen exclusives, they just haven't really worked, and that makes sense from an advertising monetization point of view. On the monetization front, there is a lot of work left to do. I mean, we're still looking at a very, while attractive media for advertisers, pretty old school in the way the ad products actually work. Now this is starting to change. We're seeing more things like advanced measurement, attribution, programmatic buying-- all wonky things us media people like to talk about. But the most popular ad format in podcasting is host-read ads. It's Bill Simmons reading a promo code to go to a website and buy a product. You know, this is like Howard Stern 25 years ago. So, from that point of view, it's still early days.
Andrew Sheets So, to kind of put some numbers around that, I mean, could you give us a sense of how much is currently being spent on podcast advertising versus other types of advertising that are out there?
Ben Swinburne Oh, yeah, absolutely. I mean, the video market is $100 billion in the United States. Between linear television and streaming video, the radio, traditional radio market in the United States is sort of $15 to $18 billion. And as I mentioned before, podcasting, we think will probably be around 2 billion this year.
Andrew Sheets Got it. So, it's still even as ubiquitous as it's starting to seem. It's still very small, still very nascent relative to some of these much bigger areas where companies are already spending a whole lot of money.
Ben Swinburne That's right.
Andrew Sheets So, Ben, you cover a large number of the largest entertainment and media companies. What do you think is going to be their strategy for podcasting going forward? And do you see this as more of a US opportunity, a global opportunity or something in the middle?
Ben Swinburne We think the strategy going forward is primarily one that monetizes podcasting through advertising. And to be successful in that, you're going to need a significant content offering. But also, importantly, a scaled and advanced technology platform. And so, we're seeing companies that are going after this opportunity really invest aggressively in both. In terms of U.S. versus global, we definitely see it as a global opportunity. However, if we think about the TAM for podcast advertising, radio is the obvious one. Radio is very much a U.S. marketplace. A lot of radio outside the U.S., think of BBC One in the U.K., is in fact ad free. So, the global radio advertising opportunity skews very much U.S. That's why it's so important that podcasting can attract digital advertisers or buyers of digital advertising - those that might buy search or display ads - that opens up podcasting to a much larger opportunity and global.
Andrew Sheets And Ben, I was hoping you could also talk a little bit about what are the demographics of podcast listeners and how does that impact the advertising landscape?
Ben Swinburne So as you can probably guess, particularly since we're in the early adopter phase of podcasting, it does skew, sort of technology savvy, educated and often higher income from an audience point of view. That's part of why advertisers are so attracted to the space and why the ad rates are so high. Clearly, the long-term bull case is widespread adoption now as reach goes from 25% of the population to hopefully 50% and 75%, by definition the audience is going to look much more representative of the overall population, which will bring with it, you know, lower income or advertising targets that have lower propensity to spend. So that will get reflected in ad rates and probably different kinds of ad products. But ultimately, even if that puts some downward pressure on ad rates, we think the growth in engagement will more than offset that, creating a nice growth story over time.
Andrew Sheets Ben, I thought you made a really interesting point about just the types of advertising that are most effective here, you know, often, host read, often funny are very engaging. I mean, is there a good precedent in advertising for something that feels that personal? And, is there any other, implications for that just about how advertising feels and sounds, more broadly going forward?
Ben Swinburne It's a great point, and it's a good news, bad news situation, I think, for the industry. The good news is that host read ads are incredibly effective. The demand outstrips supply, frankly, and the more widespread, highly popular podcasts that can be developed, the more opportunities there will be for monetization. The bad news is that to really scale the business host read ads are just it's hard to scale them. You can only have so many in an hour. And if you want to start really doing sophisticated, digitally driven ad buys and ad provisioning, you've got to automate all that. And doing host read ads in an automated fashion across the long tail of millions of podcasts really can't be done. The industry now is working on lots of technology and ad products to try to create an ad product or an ad unit that is hopefully not as effective as host read, but more effective than traditional radio.
Andrew Sheets So, Ben as somebody whose father back in the day used to sell advertising for a radio station. What do you think are the questions that companies who want to advertise in a podcast should be asking to try to maximize that effectiveness?
Ben Swinburne Well, a lot of the measurement in attribution technology today remains pretty early stage, frankly. Most of the podcast business historically has been measured by downloads. But just because you download a podcast doesn't mean you listen to it. And frankly, nobody really downloads podcasts anymore because they're all streamed. That just gives you an example of a key area like measurement that needs to evolve. You can go even beyond that when you think about multichannel attribution. For example, let's say I listen to a podcast ad and then I go online and I buy that product. How does the advertiser know that I went to buy that product because I heard that ad? Those things are all happening at a pretty sophisticated level online in general today. But podcasting is not plugged into that ecosystem in a real way yet.
Andrew Sheets And finally, Ben, you know, based on your work and your forecasts, what do you think the next five years hold for the podcasting industry?
Ben Swinburne We expect to see continued substantial investment in podcasting content, monetization technology and also personalization and curation. I think one of the challenges that consumers have, as I mentioned earlier is there's well over two million podcasts in a lot of these major platforms, so figuring out what to listen to is challenging. Sampling a song which might be 3 or 4 minutes long is a commitment. Sampling a 30/45 minute podcast is a whole different situation. And so those companies that can help consumers find what they want to listen to, that could be a huge advantage in the marketplace. And I'd say, much like we've seen in streaming video, we think we'll see an explosion of compelling podcast content across genres and across countries. There is so much talent out there which, when combined with the global growth and connectivity and connected devices, means we will all be plugged in all of the time, hopefully feeding our minds and hearts with information and stories from around the world.
Andrew Sheets Fantastic. I think that's a great place to leave it. Ben, great chatting with you.
Ben Swinburne Great speaking with you, Andrew.
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
With supply chain pressures and rising costs still weighing on markets, retail investors continue to see long term value.
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Welcome to Thoughts on the Market. I'm Mike Wilson, chief investment officer and chief U.S. equity strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 18th at 11:30 a.m. in New York. So let's get after it.
Last week, we noted it may take a bit longer for the Ice portion of our Fire and Ice narrative to play out. More specifically, we cited the potential for markets to look through the near-term supply bottlenecks and shortages as temporary. With the Biden administration directing substantial resources toward addressing the problem, that conclusion is even easier to make. Second, the budget reconciliation process has been pushed out and is unlikely to be resolved until later this year. This delays the negative earnings revisions from higher taxes we think have yet to be incorporated into 2022 consensus forecasts. In short, while earnings revisions' breadth is falling from extreme levels, it isn't falling fast enough to cause a deeper correction in the broader index, at least not yet.
Perhaps most importantly for the broader index is the fact that retail continues to be a major buyer of the dip. We highlighted a few weeks ago that the correction in September was taking longer to recover than the prior dips this year. In fact, both the primary uptrend and the 50-day moving average had finally been breached on significant volume. Could it be that the retail investor had finally run out of dry powder or willingness to buy the dip?
Fast forward to today, and the answer to that question is a definitive “no”. Instead, our data show retail investors remain steadfast in their commitment to buying equities, particularly on down days. Until these flows subside or reverse, the index will remain supported even as the fundamental picture deteriorates. As already noted, earnings revision breadth is rolling over. Some of this is due to higher cost and supply shortages, which investors seem increasingly willing to look through as temporary.
We remain more skeptical as the data also supports sustained supply chain pressures, rising costs and the potential for weaker demand than anticipated next year. Last week, our economics team published its latest Business Conditions Index survey, which showed further material deterioration. While most of this decline is due to supply issues, rather than demand, we're not sure it will matter that much in the end if earnings estimates have to come down one way or the other.
As part of our mid-cycle transition call, we have been expecting business confidence to cool. We think it's important to note that our survey suggests it's not just manufacturing businesses that are struggling with cost and supply issues. Service businesses are also showing material deterioration in confidence to manage these pressures. Whether and when it proves to be a concern for equity markets remains unknown, but we think it will matter between now and January. Until proven one way or the other, the seasonal path of least resistance for equity markets is flat to higher.
Similar to our Business Conditions Index, consumer confidence surveys have also fallen sharply. Like business managers, the consumer appears to be more concerned with rising costs rather than income. Yet, the retail investor continues to aggressively buy the dip. This jibes with the conclusion other investors are making -- that demand remains robust, and we just need to get through these supply bottlenecks and price spikes. One other possible explanation is that individuals are worried about inflation for the first time in decades, and they know it's not temporary. Stocks offer protection against that rise to some degree, and so we may be finally witnessing the great rotation from bonds to stocks that has been predicted for years. While we have some sympathy for that view in the longer term, the near-term remains challenged by the deteriorating fundamentals in our view. In short, we'd like to see both business and consumer confidence improve before signaling the all clear on supply and demand trends.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Consumer saving is up, way up. But whether investors put this money into the markets may have more to do with how much wealth is already in play.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 15th at 2:00 p.m. in London.
Over the course of the pandemic, strong government support and some of the difficulties of spending money as usual, led to a large surge in consumer savings. This was a global trend, seen from the U.S. to Europe to China. For markets, one of the most bullish arguments out there is that these savings can still come into the market. In sports terms, there's cash sitting on the sidelines waiting to come into the game.
But we think this story is more complicated. Yes, there are a lot of savings out there by almost every measure that we look at. But to continue with the analogy, while investors may have cash sitting on the sidelines, they also have a lot of wealth already on the field.
To put some numbers around this, the amount of cash currently held in US Money Market funds is about 20% of gross domestic product relative to a 30-year average of 15%. But total household wealth, that is the value of all the homes, stocks, bonds, businesses and stamp collections, is now about 590% of GDP, 170pp higher than its average over that same 30-year period. So, yes, overall Americans are holding more cash than normal, but they also have more, a lot more, of everything else.
Meanwhile, that everything else is riskier. Stocks, which generally represent the most volatile asset that most households hold has been a growing share of this overall wealth. U.S. households now hold more stocks relative to their other assets than at any time in history. It's possible that people decide to put more money into the market, but many may decide that they already have a reasonable amount of exposure as it is.
Indeed, this echoes the comments of someone with real world insights into this dynamic: Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management. Recently on this podcast, Lisa mentioned similar dynamics within the over $4T of assets managed by Morgan Stanley's Wealth Management Group - cash holdings were still ample, but exposure to the equity market for investors was historically high, as market gains have boosted the value of these stock holdings.
For investors, we think this has two important implications.
First, we think the figures above suggest that many investors actually do have quite a bit of exposure to the market already relative to history. That exposure could rise But while it's always more fun to imagine a market that has to rise because everybody needs to be more invested, we just don't think that that is what the household data really suggests.
Second, that high exposure means that fundamentals, rather than more risk taking, may be more important to getting the market to move higher. Strong earnings growth has been an under-appreciated boost to markets this year and will be important for further strength. Third quarter earnings season, which is now beginning, will be an especially important element to watch around the world.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.
Last week, over 130 countries announced an agreement to overhaul international tax rules. The changes may seem high-level, but should investors pay closer attention?
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Michael Zezas Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.
Todd Castagno And I'm Todd Castagno, Head of Global Valuation, Accounting and Tax within Morgan Stanley Research.
Michael Zezas And on this edition of the podcast, we'll be talking about recent developments around a major overhaul of international tax rules and what it means for investors. It's Thursday, October 14th at 10 a.m. in New York.
Michael Zezas So, Todd, I really wanted to talk with you after last week's announcement by more than 130 countries about an agreement to undertake a major overhaul of international tax rules. Central to the agreement appears to be a change in how companies are taxed and a new 15% global minimum tax rate. So, investors might see a headline like this and think it's one of those things that sounds important, but maybe a bit too high level to matter. But you think investors should pay attention to this.
Todd Castagno Right, it's big news. There are really two key motives driving what is referred to as a two-pillar global tax agreement, and this motivation provides really important context. So let's start with pillar one. There's a growing desire from certain countries to change who gets to tax the largest and most profitable corporates. So Michael, in a modern marketplace, companies can engage and transact with consumers in countries where they may not have much or any physical presence. So the first pillar of this agreement proposes to reallocate profits of the largest and most profitable companies to where they transact with customers. Then there is desire to stop what's often referred to as the 'race to zero' in terms of corporate tax rates. So under pillar two of the agreement, countries will need to adopt a 15% minimum tax rate structure on corporate foreign income. So why should investors care? A few reasons: Not to overstate the obvious, but tax rates are likely going up for multinationals if this is implemented. There are also important geopolitical dynamics. These changes have the potential to significantly change where corporates invest. And countries have been increasingly imposing unilateral taxes, particularly on digital services. Those taxes are complicating trade relationships. Pillar one seeks to remove those taxes so trade dynamics may actually improve.
Michael Zezas OK, so assuming these guidelines are implemented globally, what's your expectation about which industries overall could see the most headwinds?
Todd Castagno Well, it's an interesting question. Not all sectors and industries will be impacted equally. According to our analysis, technology hardware, media services, pharmaceuticals and broader health care appear most exposed to both pillars.
Michael Zezas OK, so the concept is that some industries' tax burdens are going to be affected more than others. Can you walk us through a specific example?
Todd Castagno Yes. Technology hardware appears predominately exposed to both pillars. Why is that? Manufacturing and IP are centrally located, and the industry currently benefits significantly from tax incentives, which often drive a very low tax rate. This illustrates a potential political tension, as countries are currently motivated to provide more tax and R&D incentives given the current supply constraints. So, it'll be interesting to see how countries attempt to incentivize under a new minimum tax rate system.
Michael Zezas OK, so last question here. Just because countries have agreed to pursue these tax changes doesn't mean these changes are imminent. They obviously require countries to go back and change their own laws. And regular listeners may know that our base case is that the US could soon raise corporate taxes, including a potential hike in the global minimum tax rate to 15%. So, how much do the current tax changes proposed in the U.S. already reflect this international tax agreement?
Todd Castagno So what's notable is pillar two really emerged as a function of the tax bill passed under the prior U.S. administration. Today, the U.S. is the only country with a minimum tax remotely similar to what's being proposed under pillar two. However, there are both rate and structural differences. Our base case is 15% in line with the agreement. But Michael, as you know, Congress and administration have proposed higher rates. What's also important is the structure. So, today's U.S. system applies a minimum rate on aggregate foreign income. What's notable about Pillar two is it would apply that rate on a country-by-country basis. So, what that means is many companies may be exposed to a new minimum tax rate structure versus what's in the U.S. today.
Todd Castagno But before we close, Michael, taking all this into account, what could this mean for markets moving forward? Do we think these changes are already in the price?
Michael Zezas You know, it's an important question that really defies having a simple answer. In the view of our Equity Strategy Team, the impact of these tax changes to U.S. companies bottom lines probably isn't fully appreciated yet and could cause some short-term market weakness. But beyond that, these tax changes are part of a broader fiscal package that spends more than it taxes. And so that should continue to support robust economic growth into 2022. So that makes the medium-term outlook rosier for risk assets.
Michael Zezas Todd, thanks for taking the time to talk today.
Todd Castagno Great talking with you, Michael.
Michael Zezas As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
With supply chain delays in air, ocean and trucking on the minds of investors worldwide, what could it mean for the labor market and consumers headed into the holiday season?
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Ellen Zentner Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research.
Ravi Shanker And I'm Ravi Shanker, Equity Analyst covering the North American transportation industry.
Ellen Zentner And on this episode of the podcast, we'll be talking transportation - specifically the role of freight in tangled supply chains. It's Wednesday, October 13th at 10:00 a.m. in New York.
Ellen Zentner So, Ravi, many listeners have likely heard recent news stories about cargo ships stuck off the California coast waiting to unload cargo into clogged ports or overworked truck drivers struggling to keep up. And there's a very human labor story here, a business story and an economic story all rolled together, and you and your team are at the center of it. So, I really wanted to talk with you to give listeners some clarity on this. Maybe we can start first with the shipping. You know, talk to us about ocean and air. You know, where are we now?
Ravi Shanker So, this is a very complicated problem. And like most complicated problems, there isn't an easy explanation for exactly what's going on and also not an easy solution. What's happening in ocean is a combination of many issues. You obviously have a surge in demand coming out of Asia to the rest of the world because of catch up following the pandemic and low inventory levels. In addition to that, you've had some structural problems. For instance, the giant Panamax container ships that they started using in recent years have created a bit of a boom-and-bust situations at the ports - dropping off far too many containers that can be processed, and then there's like a lull and then many more containers show up. So that's a bit of an issue. Third, there's obviously issues with labor availability of the ports themselves, given the pandemic and other reasons.
Ravi Shanker And lastly, as we’ll touch on in a second, there is a shortage of rail and truck capacity to evacuate these containers out of the ports. And it's a combination of all of these, plus the air freight situation. Keep in mind that kind of one of the statistics that has come out post the pandemic is that roughly 65% of global air freight moves in the in the belly of a passenger plane rather than a dedicated air freighter. And a lot of these passenger planes obviously have been grounded because of the pandemic over the last 18 months. This has eliminated a lot of the airfreight capacity. Some of that has spilled over into ocean. And so, all of this has kind of created a cascading problem, and that's kind of where we are right now.
Ellen Zentner So let me ask a follow up there. You know, in terms ofinternational air flights, it looks like international travel is picking up. But when would you expect it to be back to normal levels?
Ravi Shanker So I think that actually happens at some point in 2022. So, we also cover the airlines and we saw a significant amount of pent-up demand in U.S. domestic air traffic when people started getting vaccinated and when mobility restrictions were dropped. We think something very similar will happen on the international side when international restrictions are dropped, and we're already starting to see some of that take place. Whether that fixes the ocean problem completely or not is something we need to wait and watch for.
Ellen Zentner So, you know, once we get goods here, we have to move them around. And I know I've heard you say before just how much of it has to move on the back of a truck. So, let's talk about the trucking industry. You know, there's been some structural and labor issues there, but that's even before the pandemic, right?
Ravi Shanker That is even before the pandemic. Kind of, you and I collaborated to write a pretty in-depth piece as early as December 2019. We revisited that last year. There are a bunch of new regulations that have gone into place in the trucking industry over the last few years. It's no coincidence that we've had two of the tightest truck markets in history in the last three years. And these factors, whether it's the ELD mandate in 2018, the Driver Drug and Alcohol Clearinghouse in 2020, some of the insurance issues that the industry has seen over the last year; those have really created a structural tightness in the trucking industry. The pandemic made things a lot worse. Obviously, it pushed some driver capacity temporarily, maybe even permanently out of the marketplace. The driving schools were largely closed for the last 18 months, and so that limited the influx of new drivers into the space. And so, some of this pressure will ease, but we think a lot of the driver and the insurance issues that we're seeing in the trucking side the last 18 months are structural and not cyclical.
Ellen Zentner So, Ravi, it certainly does seem like the labor supply issues could stretch on for longer. If we think about demographic trends in the U.S., it does appear that generations Y and Z are really leaning away from trucking jobs and toward gig economy like jobs. Some call them new generation jobs. When you think something like driverless trucks would be in place in a way that could alleviate some of those issues, or is that so far off on the horizon?
Ravi Shanker We've been writing about driverless trucks since 2015, even longer than that, and we are now getting to a point where we think this can be quite real on somewhat of an investable time horizon. We think the first level for autonomous trucks will be ready for commercial use by the end of 2023 or early 2024. And we actually expect to see some very clear demonstrations of the viability of the technology and the commercial deployment of the technology within the next few months, actually. So, we think autonomous trucks can be a solution to fill that gap for the driver shortage if the demographics kind of are going to be against us for a while, and that could start happening pretty soon.
Ravi Shanker With the outlook in mind on the supply chain disruptions you've seen so far and what's currently taking place, Ellen, how does that inform how you look at the inventory cycle and your forecast for inflation for the overall economy?
Ellen Zentner It's been very complicated as, you know, about as complicated as you having to cover freight. You know, I think about the relationship that we have with our equity analysts across the firm, you know, these conversations I have with you are extremely important because it gives me a view of when can we get goods to where they need to go.
Ellen Zentner So the inventory cycle has been delayed. There are many sectors that are running below normal inventory to sales ratios. And so, we do need production to pick up globally and we can see that exports globally are picking up. So, if I think of building a composite view of, you know, you saying air could be normalized first half of the year, but say certainly by the middle of the year. Trucking is probably going to continue to be a drag for a bit, but when I think about what you say about ocean, it sounds like all together by the middle of the year, things should start to look and move more normally. So, you're going to have a lot of inventory building that happens next year, that should have happened this year. And ironically, that's going to really add to growth, to GDP growth next year.
Ellen Zentner Now all of this taking longer to normalize means that inflation pressures due to supply chain bottlenecks and COVID related pressures are going to remain higher for longer. All that's going to start to get alleviated around the middle of the year, but it means that we have to wait longer. And so that's how I'm thinking about it in terms of the inventory cycle and inflation. You know, it's going to support inventory building next year, but it's going to keep inflation elevated for longer.
Ravi Shanker Right. So, looks like light at the end of the tunnel by middle of next year, but a tricky few months still to navigate. Obviously, the biggest thing to look forward to in the next couple of months, I think, is its holiday season. And I know that in the transportation and supply chain world, everyone is working overtime to make sure that Christmas isn't canceled. What do you think Christmas season means for retailers and the broader economy?
Ellen Zentner Yes, I think our retail team is pretty constructive on the consumer, as are we. Buying power from consumers is very strong. That's helped by labor income, continued government support, as well as some of the savings, excess savings that we have available to pull from. But the goods have to be there as well. We know that shelves are going to be lighter. Let's put it this way, this season than normal. You know, I've heard media reports crying out, you know, do your holiday shopping now. I've heard reports of big retailers using their own ships to transport goods here, although you would sit there and tell them “Yeah, but who's going to unload it for you when it gets here?"
Ellen Zentner But all in all, it doesn't sound like from our retail analysts, it's a bad set up for retail. I mean, one thing that I would think about as an economist is if you've got fewer goods through the holiday season with strong consumer demand, which we expect, well then you certainly don't have to go through a big markdown season on the other side of the holiday, which is going to support prices for longer after that. So, I think that's all an interesting combination.
Ellen Zentner Well, I think this was a really interesting conversation, Ravi, and I think it starts to tie in some of the themes and what everyone's really focused on. It certainly has far-reaching effects across the broad economy and the global economy. So, thank you so much for taking time to talk today, Ravi.
Ravi Shanker Well, thanks for having me on. It's great talking with you as well, Ellen. And I think if there was one major takeaway for our listeners from this podcast, it is please shop early this holiday season.
Ellen Zentner Shop early, shop often. That's what I do.
Ellen Zentner Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Investors appear nervous about the economic outlook as 3rd quarter earnings season approaches. Are stagflation concerns justified… or perhaps overdone?
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Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about why we think the current stagflation concerns in Europe are likely overdone. It's Tuesday, October the 12th, at 2:00pm in London.
In early September, we argued that investors should reengage with cyclical value stocks ahead of a likely stabilization in macro sentiment and in anticipation of higher bond yields. At this time, the former catalyst is yet to occur, however the latter has prompted a sharp bounce in value stocks, which we think has further to run - this would be in line with our bond strategists target of 1.8% on US 10-year yields by the end of this year. Interestingly, the rally in European value so far has been concentrated in the more disrupted names where specific catalysts have boosted performance - such as the rising oil price lifting energy stocks and higher bond yields boosting financials. In contrast, the more traditional cyclical sectors have been modest underperformers, suggesting to us that investors still remain nervous about the global economic outlook.
In recent weeks, this nervousness has taken on a stagflationary tone, with equity and bond prices both falling. In particular, the extent and speed of the rise in interest rates and commodity prices, especially gas and oil, has provoked incremental concerns around the outlook for corporate margins, household disposable incomes and the risk of demand destruction. These concerns are unlikely to dissipate overnight, however we think there is a good chance that stagflationary fears and supply chain issues will start to ease through the fourth quarter, which should allow cyclical shares to rally alongside the value names.
If we are wrong and stagflation concerns grow further from here, then we'd expect to see consumer confidence fall sharply, yield curves start to flatten, and defensives outperform. So far, none of these are happening, even in the UK where stagflation concerns are most acute, and the Bank of England is sounding hawkish on the potential for future rate hikes.
Away from the economic data, the other major concern weighing on European investors just here is the upcoming third quarter reporting season, which will start in the next couple of weeks. After three consecutive quarters of record profit beats, we expect a more modest outturn this time, however one that is still more good than bad. In contrast, we think investors are more cautious, especially around the ability of companies to protect their margins by passing on higher input costs to their end customers.
While some businesses will no doubt struggle in this regard, we believe that the majority of companies will be able to manage the situation well enough to avoid a margin squeeze. Rising input costs are a problem when top line growth is modest and corporate pricing power weak - however, this is definitively not the case today. For example, the latest CBI survey of UK manufacturers show total order volumes and average selling prices at 40-year highs.
At the current time, equity markets still feel fragile and could remain volatile for a few more weeks yet. However, as we move through the fourth quarter, we'd expect an OK earnings season, coupled with evidence that the worst of the third quarter dip in the US and China economies are behind us, to ultimately send European equity markets higher into year end. Our key sector preferences remain unchanged at this time. We like the more value-oriented sectors such as financials, commodities and autos, and are more cautious on expensive stocks in an environment where higher interest rates start to encourage investors to become more valuation sensitive going forward.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
As the weather chills and we head towards the end of the mid-cycle transition, the S&P 500 continues to avoid a correction. How long until equities markets cool off?
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 11th at 11:30 a.m. in New York. So, let's get after it.
With the turning of the calendar from summer to fall, we are treated with the best weather of the year - cool nights, warm days and clear skies. In contrast, the S&P 500 has become much more volatile and choppy than the steady pattern it enjoyed for most of the year. This makes sense as it's just catching up to the rotations and rolling corrections that have been going on under the surface. While the average stock has already experienced a 10-20% correction this year, the S&P 500 has avoided it, at least so far.
In our view, the S&P 500's more erratic behavior since the beginning of September coincided with the Fed's more aggressive pivot towards tapering of asset purchases. It also fits neatly with our mid-cycle transition narrative. In short, our Fire and Ice thesis is playing out. Rates are moving higher, both real and nominal, and that is weighing disproportionately on the Nasdaq and consequently the S&P 500, which is heavily weighted to these longer duration stocks. This is how the mid-cycle transition typically ends - multiples compressed for the quality stocks that lead during most of the transition. Once that de-rating is finished, we can move forward again in the bull market with improving breadth.
With the Fire outcome clearly playing out over the last month due to a more hawkish Fed and higher rates, the downside risk from here will depend on how much earnings growth cools off. Decelerating growth is normal during the mid-cycle transition. However, this time the deceleration in growth may be greater than normal, especially for earnings. First, the amplitude of this cycle has been much larger than average. The recession was the fastest and steepest on record. Meanwhile, the V-shaped recovery that followed was also a record in terms of speed and acceleration. Finally, as we argued last year, operating leverage would surprise on the upside in this recovery due to the unprecedented government support that acted like a direct subsidy to corporations.
Fast forward to today, and there is little doubt companies over earned in the first half of 2021. Furthermore, our analysis suggests those record earnings and margins have been extrapolated into forecasts, which is now a risk for stocks. The good news is that many stocks have already performed poorly over the past six months as the market recognized this risk. Valuations have come down in many cases, even though we see further valuation risk at the index level. The bad news is that earnings revisions and growth may actually decline for many companies. The primary culprits for these declines are threefold: payback in demand, rising costs, supply chain issues and taxes.
At the end of the day, forward earnings estimates will only outright decline if management teams reduce guidance, and most will resist it until they are forced to do it. We suspect many will blame costs and even sales shortfalls on supply constraints rather than demand, thereby giving investors an excuse to look through it. As for taxes, we continue to think what ultimately passes will amount to an approximate 5% hit to 2022 S&P 500 EPS forecasts. However, the delay in the infrastructure bill to later this year has likely delayed these adjustments to earnings.
The bottom line is that we are getting more confident earnings estimates will need to come down over the next several months, but we are uncertain about the timing. It could very well be right now as the third quarter earnings season brings enough margin pressure and supply chain disruption that companies decide to lower the bar. Conversely, it may take another few months to play out. Either way, we think the risk/reward still skews negatively over the next three months, even though the exact timing of cooler weather is unclear. Bottom line, one should stay more defensive in equity positioning until the winter arrives.
Thanks for listening! If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Investor worries over growth and inflation have revived the term stagflation—but with growth indicators historically solid, is it an accurate description?
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 8th at 2:00 p.m. in London.
Near where I live in London, service stations are out of petrol - or to my fellow Americans, the gas stations are out of gas. In Europe, natural gas prices have roughly tripled in the last three months. Year-over-year, Consumer Price Inflation has risen 5.3% in the United States, 5.8% in Poland, 7.4% in Russia, and 9.7% in Brazil. It's not hard to see why one term seems to come up again and again in our conversations with investors: stagflation.
Stagflation, broadly, is the idea that you get very weak growth, but also higher inflation together. Yet it's equally hard to miss in these conversations that while this term is widely cited, it's often ill defined. If stagflation means the 1970s, a time of wage price spirals and high unemployment, this clearly isn't it. Unemployment is falling around the world, and inflation markets imply pressures will moderate over time, rather than spiral higher.
Market pricing is also very different. Over the last 100 years, the 1970s represented an all-time high in nominal interest rates and an all-time low in equity valuations. Today, it's the opposite. We're near a record low in yields and a record high in those valuations.
Instead, what if we say that stagflation is a period where inflation expectations are rising, and growth is slowing? That's an easier, broader definition to apply, but even that hasn't really been happening.
In the U.S., market expectations for inflation are roughly where they were in early June. U.S. economic data remains solid. The economic data is a little bit more mixed in Europe, but even here, growth indicators generally remain historically strong.
So this clearly isn't a simple story, but we do think there are three takeaways for investors.
First, recall that stagflation was also a very hot market topic in 2004/2005. Growth and markets had bounced back sharply in 2003, but by mid 2004, the rate of change on that growth had started to slow. And then energy prices rose.
By spring 2005, the market started to worry that it could be the worst of both worlds. In April of that year, U.S. consumer price inflation hit 3.5% while measures of growth stalled. Stagflation graced the cover of the Economist magazine and the editorial pages in the New York Times. Equity valuations fell throughout 2004/2005 even as earnings rose, consistent with the current forecast that my colleague Michael Wilson and our U.S. Equity Strategy team.
The second important point is that inflation is already showing up and impacting monetary policy. In just the last three weeks, central banks have increased interest rates by +25bp in New Zealand, +25bp in Russia, +50bp and Peru, +50bp in Poland, +75bp in the Czech Republic and +100bp in Brazil. That's a lot of activity. And all of this is keeping my colleagues busy and also creating opportunity in these markets.
Third, while stagflation means different things to different people, past periods of rising inflation and slowing growth have often had one thing in common: higher energy prices. As such, we think some of the best cross-asset hedges for stagflation lie in the energy space.
The market is very focused on stagflation; it just hasn't quite decided what that term really means. The 1970s are a long way away from our expectations or market pricing. Scenarios of slower growth and rising inflation clash with our economic forecasts of, well, the opposite. And recent moves in inflation expectations and other growth indicators don't fit this story as nicely as one would otherwise think.
Instead, we think investors should focus on three things: 2005 is an interesting and rather recent example of a stagflation scare after a mid-cycle transition. Inflation is impacting central banks, creating movement and opportunity. And finally, the energy sector provides a potentially useful hedge against scenarios where the current disruption is more persistent. Now, with that out of the way, I'm off to find some petrol.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.
Affordability pressures continue to mount as housing supply tightens. How long will home prices continue setting records and what could it mean for credit availability?
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James Egan Welcome to Thoughts on the Market. I'm James Egan, Co-Head of U.S. Securitized Products Research here at Morgan Stanley.
Jay Bacow And I'm Jay Bacow, the other Co-Head of U.S. Securitized Products Research here.
James Egan And on this edition of the podcast, we'll be talking about continued growth in the housing market and the current state of supply. It's Thursday, October 7th at 10:00 a.m. in New York.
Jay Bacow So, Jim, last time we were on this podcast, it seemed like we were seeing record home prices. However, every month since, we've continued to break those records. What's going on? When do we expect to see home prices start to turn?
James Egan The most recent print - and so we're talking about Case-Shiller National here that we got in September, it referenced July; 19.7% year over year growth. We're rounding to 20%. Now, we've set new records each of the last few months, but if we remove this specific chapter in history, the prior record from the early 2000s was a little bit over 14%. So, we're well north of anywhere we've been.
Jay Bacow All right. But if we are at a record right now, I thought previously you had talked about things slowing down. So, what's going on there?
James Egan So, when we talk about the view for home prices, right? We talk about demand, we talk about supply, we talk about affordability, and we talk about mortgage credit availability. And one of the things we highlighted the last time we were on this podcast was that affordability. Those pressures that were building up there were going to lead to a slowdown in home price growth in the second half. The most recent print, as I said, September - references July - technically, we're in the second half of the year. We do think as we move through the third quarter and really as we get into the fourth quarter is when you're going to start to see those affordability pressures take hold.
James Egan Most notably, mortgage rates - look, they haven't increased dramatically from all-time lows in January, but they're still off of those lows. Most importantly, they're not setting new lows. And that means they're not acting as a release valve for this increase in home prices. And we're seeing that manifest itself in terms of growing affordability pressures. The monthly payment on the median priced home is up over $200 since January - that's over a 20% increase. On top of that, when we look at consumers attitudes towards buying homes, they're at the lowest point they've been now since the early 1980s, far lower than they were at any point during the global financial crisis earlier this century. But affordability pressures are just one piece of the puzzle here. There are other aspects that might be keeping home prices elevated.
Jay Bacow When I’m thinking about home prices, you know, obviously one of the factors is going to be supply; that’s Economics 101. We’ve talked beforehand about how we’re not building enough homes. Is that just the biggest factor here?
James Egan I do think that we can’t ignore supply. I mean, when we think about this growth we’ve seen in home prices, the most consistent or persistent part of that narrative has been a shortage in supply.
James Egan Now there are a lot of ways that we can go about attempting to size the shortage in supply in the housing market. But two of the things we looked at recently were kind of net supply versus net demand, but also the vacancy rate. So, if we start with that first calculation, we look at net supply in terms of the total amount of single unit completions added to the market every year, the total amount of multi-unit completions added to the market every year, and we control for a small obsolescence rate. Some of the housing stock does come out of use every single year. And we compare that net supply to net demand or household formations.
James Egan And you know what? Going back to the early 1980s, those two metrics track each other pretty well. That relationship really fell apart post the global financial crisis. From 2009 to 2019 net demand has exceeded net supply by a total, a cumulative total of 5 million units. Now that’s just one way to size the shortage from purely a building perspective. Another way is to look at vacancy rates. Owner vacancy rates right now are tied for the lowest they’ve been since the Housing Vacancy Survey started getting published in the 1950s. If we were to raise owner vacancy rates to their average level of the past 40 years, that would take over 1.5 million units. So, from a building perspective, we’re anywhere from a 1.5 to 5 million units short.
Jay Bacow Alright but new home sales will obviously change the amount of absolute supply. But then there’s also existing home sales – now somebody’s gotta buy a home, someone’s going to sell that home. That’s also gotta be part of that calculation. How do I think about the interplay between new home sales and existing home sales on the supply front?
James Egan I mean, you hit the nail on the head there, right? We talk about new builds in terms of a supply perspective, but they're just one piece of the puzzle here. We have to think about existing inventories. We talk about shadow inventories as well with respect to things like foreclosures that play a role in supply, that play a role in housing activity, that play a role in home prices. But it's not just new inventory that's short, existing inventory is short as well. If we look at the number of single unit homes available for sale, we have that data going back to the 1980s and it's never been lower than it is right now. It would take, depending on how we measure it, 1.1 to 1.5 million additional existing units being listed for sale to bring that number back to long run averages.
James Egan So supply is really tight across the board. Now, the pace at which that supply is tightening, that has slowed down. We're not seeing the same year over year decreases that we were seeing in 2020. So, we are starting to see a little bit of a plateau there. We do think that you're going to start to see supply increasing a little bit. But these incredible tights from a supply perspective we think are playing a pretty substantial role in keeping home prices this elevated despite the growing affordability pressures that we've noted both earlier and on previous podcasts.
Jay Bacow All right. So we addressed supply, we addressed demand, we addressed affordability. The last pillar is credit availability.
James Egan Yes, we think that credit availability kind of plays two roles in both supporting the healthy foundation of the housing market here, but also important for the trajectory of the housing market going forward. Credit availability itself. We were easing, from a lending standard perspective, on the margins from 2013 through 2020 - February of 2020 specifically. Then we gave up six years’ worth of easing over the course of the next six months. Lending standards have started to ease a little bit from here, but we're starting from a very conservative place, if you will. That starting point means that we think that delinquencies foreclosures will remain controlled. But the fact that we believe we're going to see easing from here also means that we can see more demand than we otherwise would materialize despite the fact that we're seeing these affordability pressures.
James Egan Both of those are positive, but there are reasons to think that we'll see credit easing from here, one of which being the level we're coming from, another being how mortgages are performed. But a big factor here is also what we're hearing out of the administration down in D.C. But Jay, can you kind of walk through what we're seeing from these various FHFA announcements, what the implications could be here?
Jay Bacow When we look at the FHFA announcements, there's been a series of them and it's not just FHFA, it's also been from HUD and Ginnie Mae. And they're all aligned with what we believe are the current administration's goals to increase access to homeownership and reduce some of the affordability pressures. And one of the ways that they've done that is they've allowed the GSEs to increase capital via producing more loans that are either for investors and none are occupied where the guarantee fee is accretive to their business via warehousing more cash window loans, along with changing the regulatory relief for doing credit risk transfer deals. And we think the GSEs are going to take this capital and with this capital, they're going to expand the credit box, perhaps in the form of LLPA changes or G-Fee reductions, which will make it both cheaper for homeowners to get a mortgage and perhaps shift the credit box a little bit wider, particularly on the lower end of the credit box. Doing this will help align the affordability pressures and lack of access to homeownership with the current administration's goals.
James Egan So, when we think about everything we've talked about on this podcast, from supply to credit availability, what that means for home prices moving forward; look, affordability pressures are real, and they've been building. But a tight supply environment, even if we're seeing it ease a little bit and credit availability easing from here, both of those things should work to keep home prices growing. We think they contribute to the healthy foundation. The pace of growth it will slow from almost 20% today. It'll slow into the end of the year. We think throughout 2022 it continues to slow but remains in the mid-single digits from a growth perspective.
James Egan So, Jay, thanks for taking the time.
Jay Bacow Always a pleasure. Thanks, Jim.
James Egan As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
Discussions in D.C. over the infrastructure framework, budget reconciliation bill and debt ceiling could impact more than just politics. What could it mean for stocks and bond yields?
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between US public policy and financial markets. It's Wednesday, October 6th at 10:30 a.m. in New York.
When we checked in last week, the debate was all about fiscal policy. Would Democrats go small and just focus on passing the bipartisan infrastructure framework, or BIF? Or go big, linking the BIF to the bigger plan to expand the social safety net, environmental spending and the tax base. The difference matters, as a small approach could halt the increase in bond yields we've seen in recent weeks, whereas a big approach could keep them moving higher.
In short, it looks like the Democrats are at least going to continue to try and go big, as was our expectation. No votes were taken last week as it became obvious that there wasn't enough support for the small approach, which wouldn't fly with a bloc of progressives in the Democratic party. So, despite moderates' demands for a BIF vote by week's end, Democrats were forced to extend negotiations with a new soft deadline for action of October 31st. That reinforced to us the link between both pieces of legislation. So, in our view, we're still headed toward a multitrillion dollar package being enacted in the fourth quarter, which should boost deficits, medium term growth expectations, and therefore bond yields along with it.
But in the meantime, the rise in bond yields could take a break as Washington, D.C. deals with the debt ceiling. The Treasury Department says the ceiling must be raised or suspended by October 18th, less than two weeks from today, or else the U.S. could face default and an economic crisis. Republicans and Democrats continue to be at odds over how to avoid this. Without getting into the weeds on this too much, just know that at this point, neither party is showing an inclination to resolving this in a timely manner. That could create substantial uncertainty and it's one of the reasons that our U.S. equity team continues to expect stock prices could remain volatile in the near term.
So stay tuned - DC's influence on markets is sure to be felt through the end of the year.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
New data on an oral antiviral treatment could have significant impact on the COVID treatment landscape. What’s next for treatments, booster shots and child vaccines.
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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.
Matthew Harrison And I'm Matthew Harrison, Biotechnology Analyst.
Andrew Sheets And on this special edition of the podcast, we'll be talking about several new developments in the fight against COVID 19. It's Tuesday, October 5th at 3 p.m. in London,
Matthew Harrison and it's 10:00 a.m. in New York
Andrew Sheets So Matt. I really wanted to catch up with you today because there are a number of different storylines involving COVID 19 going on at the moment, from child vaccines to the situation with booster shots. But I suppose the headline story that's getting the most attention is data released last Friday on Merck's new oral COVID treatment pill Molnupiravir or I think I said that right. I'm sure I didn't. So maybe let's start there. What is this treatment and why does it matter?
Matthew Harrison Yes. Thanks, Andrew. So Molnupiravir is an oral antiviral against COVID. The way it works is that it stops the virus from replicating effectively, and that reduces the amount of virus in someone's body. It was studied here in patients that were recently diagnosed with COVID 19. And it cut the rate of hospitalization in those patients by 50%. So those that didn't get treated with the drug went to hospital at a rate of 14%, and those that did get treated went to hospital rate of 7%. I think the thing I would want to highlight is that this is something you obviously take after you get infection and vaccines remain the primary way to prevent infection.
Andrew Sheets So this is kind of one of the things I felt that was so fascinating when that news was announced. Because on the one hand, this seems like very good news, another treatment that appears highly effective against COVID 19. And yet the market reaction was actually to really punish many of the makers of the current COVID vaccines, so how much do you think this could influence the COVID treatment landscape? And do you think the market or people might be overreacting to some of the impact on whether or not people will still get vaccines or vaccines will remain important?
Matthew Harrison Vaccines, their primary measure is prevention. Right? This is a drug to treat people once you get disease. But the hope is, and the way we get out of the pandemic, is still by vaccinating everybody to prevent disease from happening and disease from spreading. So, I think of this drug, along with antibodies as drugs that you use to treat people who either have breakthrough infections or those that aren't vaccinated. But you also have antibodies for people that are at higher risk, patients that might not be compliant with taking oral drugs. Or, you know, a whole another segment of the market that we haven't talked about is those that need to be protected either because they can't get a good response to the vaccine, because they're perhaps immunocompromised or otherwise, and those that need some sort of preventative treatment. Where Merck is studying this pill as a preventative treatment, but the antibodies are already authorized as preventative treatments. So, there's a different section of the landscape, I would say, for each of these drugs.
Andrew Sheets So, Matt, what impact do these potentially positive results on a pill mean for vaccine hesitancy in the outlook for vaccinations?
Matthew Harrison I think that's one of the things that the market is is struggling a lot with, and I think that's part of the reason you saw many of the vaccine stocks under pressure, right? There's definitely one segment of the market that thinks, if you have effective treatments, especially easy to use treatments like orals, that could give people another reason who don't want to have the vaccine to say, "Look, even if I do get sick, I do have an easy to take treatment." And so, on the margin, right, it may impact vaccination uptake, though the flip side is what I would say is I think what we're seeing in the U.S. is at least that you're seeing broad vaccination mandates and you and you are seeing those mandates lead to increases in vaccination, especially employer based mandates. And so, there are other factors driving vaccine uptake.
Andrew Sheets So I think it's safe to say we care about the numbers here on this Thoughts of the Market podcast. Could you just run through the various costs of different treatments if we're thinking about vaccines, you know, potential thoughts on where an oral pill could be and then the antibody treatments, which are obviously another form of treatment that we're seeing being used. Just to give people some sense of how much the relative cost of each one of those things is.
Matthew Harrison Yes, so vaccines per shot in the U.S., depending on manufacturer, run between $16.50 And $19.50 in the U.S. So a course of vaccination, let's say costs on average about $40. There are some administration fees and otherwise, but direct to drug costs. Merck has signed a contract with the US government for $1.2 Billion for 1.7 Million courses, so that runs about $700 per course for the oral right now. And then the U.S. government also has contracts with a variety of manufacturers for antibodies, which run about $2100 per course. So treatments are more expensive than vaccination and then usually with treatments, there are other associated medical costs which I didn't cover, and I don't have a great estimate for. But obviously, as those patients that might be getting treatments because they're also hospitalized, those costs are more significant.
Andrew Sheets So I want to jump next to the topic of child vaccinations. Last week, Pfizer and BioNTech announced that they had submitted data to the Food and Drug Administration that their coronavirus vaccine is safe and effective in children ages 5-11. What do you think? Is the timeline ahead for the next steps here?
Matthew Harrison Yes, right, so they have submitted preliminary data, but they have not submitted the final request for an emergency use authorization. The expectation here is that there will be some back and forth between Pfizer and the regulator to finalize the exact package of data after the FDA has reviewed the initial data. That will then trigger the final submission where they ask for the request for emergency use authorization. Most of us think that would occur sometime, let's say, in the next couple of weeks. And then historically right, the FDA, once they receive that final package, takes on order of two to three weeks to approve the EUA authorization. So, I think this ranges from maybe the earliest in late October towards sometime into early November.
Andrew Sheets Matt, I also wanted to cover the issue of booster shots, which is the other kind of large development in the fight against COVID 19, and I think there's been a little bit of confusion on the topic. So, you know, what's the latest in terms of who is eligible for a booster in the U.S. and what the CDC is recommending?
Matthew Harrison Originally the FDA had asked their external advisory committee whether or not boosters should be made available for everyone where the original vaccine was authorized, so that would be those 16 and up. The advisory committee then asked to narrow that slightly and specifically what the advisory committee asked was: those 65 years or older, as well as those at high risk, either because of underlying medical conditions or because of occupational hazard. So that would include, hospital workers or workers who are otherwise frontline workers in a high-risk scenario. The CDC has a separate committee called ACIP, which a few days later looked into this as well, and they had voted essentially for those at high medical risk and those 65 years and older. But they had said they were somewhat uncomfortable, and it was a very close vote to be clear, about those at increased occupational risk. After that meeting, the CDC themselves or the director of the CDC said that they believe the booster shot should be made available for all of those groups and essentially overrode the committee on the last piece around occupational risk. So right now, its 65 older, immunocompromised, those at high medical risk and those at high occupational risk.
Andrew Sheets So Matt, the final thing I wanted to ask you about is one of the most positive things that seems to have come out of this this terrible pandemic is mRNA vaccination technology. It seems to be a type of medical technology that has really exceeded expectations for how quickly and how effectively a vaccine could be rolled out.
Andrew Sheets So Matt, if you think about this technology looking ahead, what do you think are the applications that potentially could go beyond COVID? And also, at what point do you think some of these vaccinations might need to be updated and how difficult will that be?
Matthew Harrison So in terms of applications and next steps for RNA, there's a wide variety of disease areas that they're looking at. But in general, the technology is being used to make missing proteins in your body, which occurs a lot with rare genetic diseases. To potentially help various tissues that may need certain proteins or enzymes to help them heal. And also looking at ways that you could, for example, with oncology patients that you could tell the body's own immune system for key flags or markers of the tumors versus normal tissue so that you could redirect the immune system to specifically go after the cancerous tumor. In terms of needing a updated COVID vaccine. I think that all depends on the variant outlook. Currently, what we see is just giving another dose of the current vaccine provides very good protection against Delta. And so, I think as we look out on the outlook, right, it's about if Delta combines with something else, then maybe there is the potential for an update. But the manufacturers are well primed for that, and that process is a couple months process, probably if they had to do that. So, they can adapt quickly.
Andrew Sheets Something important to keep an eye on. As always, Matt, it's been great talking with you.
Matthew Harrison Thanks, Andrew.
Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.
After 16 years, German Chancellor Angela Merkel is stepping down. While the full implications for Europe remain unclear, some contours of the post-Merkel government are now taking shape.
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Welcome to Thoughts on the Market. I am Reza Moghadam, Morgan Stanley's Chief Economic Advisor. Along with my colleagues, we bring you a variety of market perspectives. Today, I'll be talking about the implications of the recent German elections and how investors should view the road ahead after a government is formed. It's Monday, October 4, at 2pm in London.
After 16 years as German Chancellor, Mrs. Merkel is stepping down. In the run up to the recent elections, there was considerable anxiety in European capitals. Angela Merkel, after all, has been the steady hand that has guided not only Germany's but also Europe's response through numerous crises.
These anxieties have not been entirely laid to rest by the results of last week's election. For the first time since 1950s, forming a government would require a coalition of at least three - rather than the traditional two - political parties, which raises concerns about cohesion of the new government.
However, there are reasons to be optimistic about broad continuity - that a centrist, pro-European and pro-business coalition would eventually emerge in Berlin.
There are perhaps two key issues of importance for investors as discussions get underway. First, who will succeed Mrs. Merkel? And second, what would be the exact composition of the coalition and, therefore, its policies?
The candidate most likely to succeed Mrs. Merkel is Olaf Scholz, whose Social Democratic Party narrowly topped the polls. Mr. Schulz is continuity incarnate. He has been Germany's Finance Minister and vice chancellor under Mrs. Merkel. He brings strong pro-European credentials, especially having played a role in ensuring Germany's support for the European Recovery Fund, which is Europe's main vehicle for providing support for the hardest hit countries during the pandemic. Mr. Schulz has also been a very strong proponent of EU banking and capital markets unions.
Is there an alternative to Mr. Schulz? Yes, the candidate who led the election campaign for Mrs. Merkel's center right Christian Democrats, Armin Laschet. However, given the poor election results for Christian Democrats and Mr. Laschet's much less favorable public standing, a German government led by Mr. Laschet is unlikely. But it is worth noting that Mr. Schulz and Mr. Laschet are both centrist politicians and not that far apart on key policies.
Now let me turn to the second important issue for markets: who are the likely coalition partners for Mr. Schulz or, for that matter, Mr. Laschet?
Here, the electoral mathematics are very clear. The Green Party and the pro-business Free Democrats are highly likely to be in the next government.
The Greens have one key demand: €50B (or 1.5% of GDP) per year in new investment to reach net zero carbon emissions by 2050. Investment in Germany has been constrained by self-imposed austerity, and increasing investment of that magnitude is likely to underpin growth and innovation and set a benchmark for other European countries.
What about the Free Democrats? They are against tax increases and fiscally conservative, but pro green investment. Therefore, they would want to ensure that any fiscal plans are business friendly, and any deficit financing limited.
In summary, the contours of the post-Merkel German government are becoming clearer.
There will likely be continuity through Mr. Schulz, or perhaps Mr. Laschet. There Is likely to be a strong green investment agenda, and the presence of the Free Democrats ensures support for Mr. Schulz's brand of fiscal moderation and prudence. It is also very clear that while continuing to take a cautious line on fiscal policy, the next German chancellor and government are likely to put a high premium on European solidarity.
The process for forming a new government in Germany will likely take time as it requires drawing up a detailed policy agreement that respects the red lines of each political party. But the new government should be in place by the end of this year, just in time for the German presidency of the G7 in 2022.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
On part two of this special episode, Lisa Shalett and Andrew Sheets dive into meme stocks and individual investor trading advantages… and pitfalls.
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Andrew Sheets Welcome to Thoughts of the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on part 2 of the podcast, I’ll be continuing my discussion with Lisa on the retail investing landscape and the impact on markets. It's Friday, October 1st, at 2p.m. in London.
Lisa Shalett And it's 9:00 a.m. here in New York City.
Andrew Sheets So, Lisa, over the last 12 months, we've seen a real boom in the amount of activity in the stock market from these so-called retail investors. And, you know, given your perspective over several market cycles, you know, what do you think is kind of similar and different in terms of individual investor activity now versus what we've seen in the past?
Lisa Shalett So you know what's similar to episodes of retail participation that we've seen in the past? I think the first is momentum and crowding. So, as we know in prior market cycles, you know, periods like a 1999-2000 tech bubble, for example. We had a lot of enthusiasm around stocks that perhaps didn't have great profit fundamentals or whose valuation paradigms shifted to expand beyond things like profit to things like, you know, share of eyeballs and things of that nature. And we're you know, we've certainly during this market cycle with the emergence of, you know, zero commission trading platforms, you know, seen some of that type of activity where stocks seem to be moving based on other dynamics, be they momentum, be they you know, social media chatter.
Lisa Shalett Obviously, I think one of the things that is different is this role of social media. I think that this idea that a set of investors will crowd or attempt to drive the market through social media postings is an interesting one, if you will. And I think we're going to need to see how it plays out. But I think what we know is very often when we get into periods in the market where we're drawing in a large share of brand-new investors, you know, they are not particularly experienced and they, you know, seemingly have had success by dint of, you know, the benign nature of the environment, which is what we've kind of had. We've had a relatively low vol, high central bank involvement environment. We know how these parties tend to end. And since this seems to happen every couple of times in a generation, this generation of new investors, I think, you know, may be set up to, you know, quote unquote, learn the hard way. But that remains to be seen.
Andrew Sheets Lisa, I know another question that you spend a lot of time thinking about is whether or not investors should look to be active or passive in how they're trying to take exposure to markets. How are you thinking about that and kind of what type of environment do you think we're in today?
Lisa Shalett We try to take a pretty, you know, systematic and methodical and analytic approach to the active/passive decision. We want to make sure that when we're giving advice that if we think that there's idiosyncratic alpha opportunity out there above and beyond what, you know, the passive market can deliver and we're asking our clients to pay for it, that it's there and with high probability and that it exists. And so, you know, what are the environments where that tends to be true? What we have found is it tends to be environments where you have large valuation dispersions in the market, where you have high levels of controversy in terms of earnings estimate dispersion, tends to be environments where there could be policy inflection points. And so based on some of those type of variables, over the last two to three months, our models have moved us to a maximum setting towards active management. When we look at the passive index today, one of the things that, you know, we continue to point out to our clients is the extent to which the S&P 500 index, for example, has become very concentrated in a short list number of names. So, you know, we contrast that recommendation that we're making right now for a maximum stock picking or maximum active manager selection stance with, you know, perhaps where we were at the beginning of the cycle last March when policy actions are so profound in terms of driving liquidity and the stimulus was coming from the federal government. When you're in an environment where "the rising tide lifts all the boats" and performance dispersion is very narrow and you have, you know, very high breadth where, you know, almost all stocks are rising and they're rising together. Those are certainly markets that are very well played using the passive index. But that's how we make that contrast. And today we are trying to encourage our clients to move to a more active stance where they're reducing their vulnerability to some of the characteristics of the S&P 500 index that we think are fragile.
Andrew Sheets Very interesting. So, Lisa the last question I want to ask you is when you think about that retail, that individual investor, what do you think are actually the advantages that this group has, maybe underappreciated advantages? And then what do you think are kind of some of the most common pitfalls that you see and strategies to try to avoid?
Lisa Shalett Yeah, no, that's a great question. So, one of the advantages of being an individual investor is you can truly take a long-term view. At least most of our clients can. And so, they don't need to worry about, "mark to market," they don't need to worry about quarterly returns and quarterly benchmarks. They don't even need to worry about benchmarks at all, quite frankly. And that allows the individual investor to take a long view, to be patient to utilize tools like dollar cost averaging in over time and to not necessarily have to buy into the pressures of market timing.
Lisa Shalett I think the pitfalls for individual investors are you know, individual investors are just that, they are individuals. Individual investors tend to be motivated by very human behavioral finance concepts of fear and greed. And so, I think one of the things that very often we as private wealth advisors battle are emotions. And when our clients, you know, feel a degree of fear, they will do things that potentially are drastic, i.e., they will, you know, sell and take profit and incur a tax event and get out of the market. And then the challenges of market timing, as we know, are always twofold. Right? If you're going to get out, you've got to have a discipline of when to get back in. And we know that those two things: getting in and getting out, are very hard to do and do well without destroying wealth, without concretizing losses and without, you know, leaving money on the table. So, you know, I think the value of advice, as we always say, is keeping clients in that first bucket, keeping them attached to a long run, process driven plan that avoids market timing, that allows you to take the long view, that measures things in years, not quarters and months, and avoid some of the pit falls.
Andrew Sheets I think that's a great place to end it. Lisa, thanks for taking the time to talk and we hope to have you back soon.
Lisa Shalett Thank you very much, Andrew. I appreciate it.
Andrew Sheets As a reminder, if you enjoy Thoughts of the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people find the show.
On part one of this Special Episode, Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management, discusses the new shape of retail investing and the impact on markets.
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Andrew Sheets Welcome to Thoughts of the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.
Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets And today on the podcast, we'll be discussing the retail investing landscape and the impact on markets. It's Thursday, September 30th, at 2p.m. in London.
Lisa Shalett And it's 9:00 a.m. here in New York City.
Andrew Sheets Lisa, I wanted to have you on today because the advice from our wealth management division is geared towards individual investors, what we often call retail clients instead of institutional investors. You tend to take a longer-term perspective. As chief investment officer, you're juggling the roles of market analyst, client adviser and team manager ultimately to help clients with their asset allocation and portfolio construction.
Andrew Sheets Just to take a step back here, can you just give us some context of the level of assets that Morgan Stanley Wealth Management manages and what insight that gives you potentially into different markets?
Lisa Shalett Sure. The wealth management business, especially after the most recent acquisition of E-Trade, oversees more than four trillion dollars in assets under management, which gives us a really extraordinary view over the private wealth landscape.
Andrew Sheets That’s a pretty significant stock of the market there we have to look at. I'd love to start with what you're hearing right now. How are private investors repositioning portfolios and thinking about current market conditions?
Lisa Shalett The individual investor has been incredibly important in terms of the role that they're playing in markets over the last several years as we've come out of the pandemic. What we've seen is actually pretty enthusiastic participation in in markets over the last 18 months with folks, you know, moving, towards their maximum weightings in equities. Really, I think over the last two to three months, we've begun to see some profit taking. And that motivation for some of that profit taking has as kind of come in two forms. One is folks beginning to become concerned that valuations are frothy, that perhaps the Federal Reserve's level of accommodation is going to wane and, quite frankly, that markets are up a lot. The second motivation is obviously concern about potential changes in the U.S. tax code. Our clients, the vast majority of whom manage their wealth in taxable accounts, even though there is a lot of retirement savings, many of them are pretty aggressive about managing their annual tax bill. And so, with uncertainty about whether or not cap gains taxes are going to go up in in 2022, we have seen some tax management activity that has made them a little bit more defensive in their positioning, you know, reducing some equity weights over the last couple of weeks. Importantly, our clients, I think, are different and have moved in a different direction than what we might call overall retail flow where flows into ETFs and mutual funds, as you and your team have noted, has continued to be quite robust over, you know, the last three months.
Andrew Sheets So, Lisa, that's something I'd actually like to dig into in more detail, because I think one of the biggest debates we're having in the market right now is the debate over whether it's more accurate to say there's a lot of cash on the sidelines, so to speak, that investors are still overly cautious, they have money that can be put into the market. You know, kind of versus this idea that markets are up a lot, a lot of money has already flowed in and actually investors are pretty fully invested. So, you know, as you think of the backdrop, how do you think about that debate and how do you think people should be thinking about some of the statistics they might be hearing?
Lisa Shalett So our perspective is, and we do monitor this on a month-to-month basis has been that that, you know, somewhere in the June/July time frame, you know, we saw, our clients kind of at maximum exposures to the equity market. We saw overall cash levels, had really come down. And it's only been in the last two to three weeks that we've begun to see, cash levels rebuilding. I do think that that's somewhat at odds with this thesis that there's so much more cash on the sidelines. I mean, one piece of data that we have been monitoring is margin debt and among retail individual investors, we've started to see margin debt, you know, start to creep up. And that's another indication to us that perhaps this idea that there's tons of cash on the sidelines may, in fact, not be the case, that people are, "all in and then some," you know, may be something worth exploring in the data because we're starting to see that.
Andrew Sheets So, Lisa, the other thing you mentioned at the onset was a focus on the tax environment, and that's the next thing I wanted to ask you about. You know, I imagine this is an issue that's at the top of minds of many investors. And your thoughts on both what sort of reactions we might get to different tax changes and also your advice to how individuals and family offices should navigate this environment.
Lisa Shalett Yeah, so that's a fantastic question, because in virtually every meeting, you know, that I'm doing right now, this question comes up of, you know, what should we be doing? And we usually talk to clients on two levels. One is on it in terms of their personal strategies. And what we always talk about is that they should not be making changes in anticipation of changes in the law unless they're really in need of cash over the next year or two. It's really a 12-to-18-month window. In which case we would say, you know, consult with your accountant or your tax advisor. But typically, what we say is, you know, the changes in the tax law come and go. And unless you have an imminent, you know, cash flow need, you should not be making changes simply based on tax law. The second thing that we often talk about is this idea or this mythology among our client base that changes in the tax law, you know, cause market volatility. And historically that there's just no evidence for that. And so, like so many other things there's, you know, headline risk in the days around particular news announcements. But when you really look at things on a 3-month, 6-month, you know, 12- and 24-month trailing basis on some of these things, they end up not really being the thing that drives markets.
Andrew Sheets Lisa, one of the biggest questions—well, you know, certainly I'm getting but I imagine you're getting as well—is how to think about the ratio of stocks and bonds together within a portfolio. You know, there's this old rule of thumb, kind of the 60/40, 60% stocks, 40% bonds in portfolio construction. Do you think that's an outdated concept, given where yields are, given what's happening in the stock market? And how do you think investors should think about managing risk maybe differently to how they did in the past?
Lisa Shalett Yeah, look, that's a fantastic question. And it's one that we are confronted with, you know, virtually every day. And what we've really tried to do is take a step back and make a couple of points. Number one, talk about goals and objectives and really ascertain what kinds of returns are necessary over what periods of time and what portion of that return, you know, needs to be in current cash flow, you know, annualized income. And try to make the point that perhaps generating that combination of capital appreciation and an income needs to be constructed, if you will, above and beyond the more traditional categories of cash, stocks and bonds given where we are in terms of overall valuations and how rich the valuations are in both stocks and bonds, where we are in terms of cash returns after inflation, and with regards to whether or not stocks and bonds at the current moment are actually behaving in a way that, you know, you're optimizing your diversification.
Lisa Shalett So with all those considerations in mind, what we have found ourselves doing is speaking to the stock portion of returns as being comprised not only of, you know, the more traditional long-only strategies that we diversify by sector and by, you know, global regions. But we're including thinking about, you know, hedged vehicles and hedge fund vehicles as part of those equity exposures and how to manage risk. When it comes to the fixed income portion of portfolios, there's a need to be a little bit more creative in hiring managers who have a mandate that can allow them to use things like preferred shares, like bank loans, like convertible shares, like some asset backs, and maybe even including some dividend paying stocks in their income generating portion of the of the portfolio. And what that has really meant to your point about the 60-40 portfolio is that we're kind of recrafting portfolio construction across new asset class lines, really. Where we're saying, OK, what portion of your portfolio and what products and vehicles can we rely on for some equity like capital appreciation and what portion of the portfolio and what strategies can generate income. So, it's a lot more mixing and matching to actually get at goals.
Andrew Sheets Tomorrow I’ll be continuing my conversation with Lisa Shalett on retail investing and the implications for markets. As a reminder, if you enjoy Thoughts of the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people find the show.
The eventual size of the Democratic Party’s fiscal policy legislation – for taxes and for spending – will likely impact the bond market as well as the policy landscape.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between US public policy and financial markets. It's Wednesday, September 29th at 1:00 p.m. in New York.
It's shaping up to be one of the most consequential legislative weeks on record in the US. At stake is the size and fate of Democrats' fiscal policy ambitions, specifically their goals of a major tax increase to fund a substantial expansion of infrastructure spending and the social safety net. But intraparty disagreements on the content of these efforts have left investors wondering: what will the final package do to the U.S. fiscal outlook and, therefore, the trajectory for bond yields? Will the Democrats go big, keeping yields moving higher, or go small, potentially meaning the worst of the recent increase in bond yields is behind us?
Our current thinking is that the Democrats eventually end up going big. Why? Because neither of the two legislative vehicles they're considering are possible without the other - they're linked. Moderates, particularly in the Senate, may be happy with approving the smaller bipartisan infrastructure framework, or BIF. But progressives don't appear content with just this achievement and continue to argue they'll withhold their votes on the BIF until the whole of the party endorses a specific plan for the bigger budget reconciliation bill. This de facto linking of the two bills may mean that Democrats' planned votes this week to pass the BIF gets delayed, but it keeps the party on track for what we think would be a combined increase in spending of over $3T over 10 years, adding upwards of $1T to the deficit over the first five years. That would help keep support under the economic recovery and the upward trajectory of bond yields over the medium term. It could also mean equity markets are choppy in the near term as they digest a meaningful incoming tax hike.
But breaking that link and going small is something we have to consider too. If progressives give in and vote for the BIF without a dependable agreement on reconciliation, the moderates will be in the driver's seat on the rest of the negotiation - and already key moderate Democratic leaders have said they'd delay the timing and dilute the size of the reconciliation bill. In that case, we'd substantially mark down our expectations for the impact to deficits, as well as for the scope of tax hikes. For this outcome to become more likely, look for a public signal from the White House to persuade progressives to vote for the BIF by explicitly endorsing the strategy of voting on it before reconciliation is agreed to.
We hope this can be a guide to track how the situation develops over the next few days. And we’ll of course be paying close attention and be back next week to size it all up again.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.
With incoming global growth data missing consensus expectations, emerging markets equity earnings revisions could fall back into negative territory for the first time since May 2020.
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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Markets Equity Strategist for Morgan Stanley Research. Along with my colleagues, bringing you their perspectives, today I'll be talking about a key recent development, which is the deterioration in the global growth outlook and what it means for Asia and EM equities. It's the 29th of September at 7:30 a.m. in Hong Kong.
Incoming global growth data is starting to miss expectations by a wide margin. This appears to be mainly due to the impact of Delta-variant covid on consumer confidence, but also continued supply chain bottlenecks on the corporate sector. The Global Economic Surprise Index, i.e., the extent to which top-down global macro data beats or misses economists' expectations, has fallen in a straight line from a level of +90 in mid-June to -24 currently. It was last this low at the end of March 2020, at the beginning of the global impact of the pandemic, and before that in the second quarter of 2018, at the start of US-China tariff hikes and the imposition of non-tariff barriers to trade.
So in short, there's been a sudden downward lurch relative to expectations for global macro in relation to the narrative from consensus of a continued strong recovery, broadening out by geography, and entering a virtuous circle of rising consumption and investment. Global equity markets have wobbled recently but are still trading close to their all-time highs set in early September. We think the key to understanding what happens next is to understand the relationship between Economic Surprise data and earnings revisions. We’ve found that changes in the Global Economic Surprise index tend to have a good leading relationship for how bottom-up analyst earnings revisions evolve three months later. And that, in turn drives market performance.
And this matters because the covid recession and recovery have already witnessed exceptionally sharp movements, both in economic data - relative to consensus - and earnings estimate revisions. Indeed, they've been more extreme even than the volatility that we saw at the time of the Global Financial Crisis. So, at this level of -24 on economic surprise, our analysis suggests 12-month forward EPS expectations will likely decline by around 150bps over the next three months. That may not sound like much, but it compares with a current positive QoQ upward revision of 530bps and a peak QoQ revision of 1100bps in May of this year.
Within our coverage, some markets have already gone through the transition adjustment to slower expected earnings revisions - most notably China, where we remain cautious. Our analysis finds that strong performance and strong revisions are positively correlated and vice versa for weak performance and poor revisions. Japan, Russia and South Africa are the standouts recently for positive revisions, and they may show some resilience to the deteriorating global situation. China, Indonesia, Malaysia and Thailand have had the worst revisions and generally poor performance; but China has also been underperforming due to investors assigning a lower valuation to the market due to this year's regulatory reset. Overall, we continue to prefer Japan to EM and China.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
Real interest rates are on the rise in Europe and the US and central banks are responding. This may impact currency markets headed into the fall. Matt Hornbach, Global Head of Macro Strategy, explains.
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Welcome to Thoughts on the Market. I'm Matt Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Tuesday, September 28th, at 12:30p.m. in New York.
Just like clockwork, markets have become much more interesting and volatile after Labor Day in the U.S. Investors have been confronted with several issues that have collided in a big bang after what had been a relatively quiet summer. And central bank reactions have been a key part of the story going into the fall.
To start, supply disruptions in commodity markets have led to inflation fears that have manifested themselves in higher market prices for inflation protection, mostly in Europe and the U.K. In response, the Bank of England has expressed more concern over the inflation outlook, since inflation is having a negative impact on the region's growth outlook. This combination of factors has caused real interest rates in Europe and the UK to remain extremely low and has also put downward pressure on the value of the British pound and the euro.
Meanwhile, the U.S. economy has been more insulated from the commodity price shock, and inflation protection in the U.S. was already fully valued. In other words, worries about inflation in the U.S. began to build last year and, as a result, investors had already prepared themselves for the elevated inflation prints we're experiencing in the U.S. today. This means that real interest rates in the U.S. are left marching to the beat of other drummers.
In particular, real interest rates in the U.S. have begun to respond to Federal Reserve monetary policy machinations. Last week, the Fed signaled that tapering its asset purchases could begin near term. That means the Fed will start purchasing less Treasury and agency mortgage-backed securities, leading to a decline in the amount of monetary accommodation the Fed has been providing.
The question is, is this tapering akin to tightening policy? Participants on the Federal Open Market Committee would have you believe that tapering isn't the same thing as tightening policy. And technically they would be correct. When the Fed purchases assets in the open market such that its balance sheet grows, it is easing monetary policy. It's a different form of cutting interest rates. When the Fed's balance sheet no longer grows because it has stopped purchasing assets on a net basis, it is no longer easing monetary policy. In the transition between these two states, the Fed's balance sheet continues to grow, but at a slower rate than before. In this way, the process of tapering is akin to easing policy, but by less and less each month.
But, and this is a big 'but', the process of tapering is the first step towards the process of tightening. Without the Fed tapering its asset purchases and slowing the growth of its balance sheet, rate hikes wouldn't appear on the radar screens of investors. So, the prospect of tapering this year has shown a spotlight on the prospect of rate hikes next year. And that has driven real interest rates higher in the U.S.
So, what happens now? As long as real interest rates in the U.S. rise gradually, as they have done so far this year, the overall level of interest rates in the U.S., as you can see in the Treasury market, should also rise gradually. And if U.S. interest rates rise relative to those in Europe, which already began in August and we think will continue through the balance of the year, then the value of the U.S. dollar should appreciate relative to the euro.
Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.
Our analyst’s equity positioning models have held up well and we continue to rely on an understanding of historical cycles as we move through this mid-cycle transition. Chief Investment Officer Mike Wilson explains.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, September 27th, at 11:30a.m. in New York. So let's get after it.
Our equity strategy process has several key components. Most importantly, we focus on the fundamentals of growth and valuation to determine whether the overall market is attractive and which sectors and stocks look the best. The rate of change on growth is more important than the absolute level, and we use a market-based equity risk premium framework that works well as long as you apply the correct regime when using it. In that regard, we're an avid student of market cycles and believe historical analogs can be helpful. For example, the mid-cycle transition narrative that has worked so well this year is derived directly from our study of historical, economic and market cycles.
The final component we spend a lot of time studying is price. This is known as technical analysis. Markets aren't always efficient, but we believe they are often very good leading indicators for the fundamentals - the ultimate driver of value. This is especially true if one looks at the internal movements and relative strength of individual securities. In short, we find these internals to be much more helpful than simply looking at the major averages.
This year, we think the process has lived up to its promise, with the price action lining up nicely with the fundamental backdrop. More specifically, the large cap quality leadership since March is signaling what we believe is about to happen - decelerating growth and tightening financial conditions. The question for investors at this point is whether the price action has fully discounted those outcomes already, or not.
Speaking of price, equity markets sold off sharply last Monday on concerns about a large Chinese property developer bankruptcy. While our house view is that it likely won't lead to a major financial contagion like the Global Financial Crisis a decade ago, it will probably weigh on China growth for the next few quarters. This means that the growth deceleration we were already expecting could be a bit worse. The other reason equity markets were soft early last week had to do with concern about the Fed articulating its plan to taper asset purchases later this year, and perhaps even moving up the timing of rate hikes. On that score, the Fed did not disappoint, as they essentially told us to expect the taper to begin in December. The surprise was the speed in which they expect to be done tapering - by mid 2022. This is about a quarter sooner than the market had been anticipating and increases the odds for a rate hike in the second half of '22.
After the Fed meeting on Wednesday, equity markets rallied as bonds sold off sharply. Real 10-year yields were up 11bps in two days and are now up 31bps in just eight weeks. That's a meaningful tightening of financial conditions and it should weigh on asset price valuations, including equities. It also has big implications for what should work at the sector and style level. In short, higher real rates should mean lower equity prices. Secondarily, it may also mean value over growth and small caps over Nasdaq, even as the overall equity market goes lower. This would mean a doubly difficult investment environment, given how most are positioned.
For the past month, our strategy has been to favor a barbell of defensive quality sectors like healthcare and staples, with financials. The defensive stocks should hold up better as earnings revisions start to come under pressure from decelerating growth and higher costs, while financials can benefit from the higher interest rate environment. Last week, this barbell outperformed the broader index. On the other side of the ledger is consumer discretionary stocks, which remain vulnerable to a payback in demand from last year's over consumption. Within that bucket, we still favor services over goods where there remains some pent-up demand in our view.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
This week, the Fed hinted that a taper announcement in November could be in store, adding one more wrinkle into events that investors will need to navigate this fall.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, September 24th, at 2:00 p.m. in London.
The Federal Reserve, or the Fed, probably receives more attention than any other institution in today's market. At one level, that's easy to explain; it's the central bank for the world's largest economy and reserve currency, and just so happens to be buying $120B of bonds every month.
At another level, though, it feels a little excessive. Investors have woken up to the exact same interest rates and purchases from the Fed every day for more than a year. And if you look at global stock markets since May of last year, they've basically just risen in lockstep with the overall level of earnings.
Still, the Fed matters, and this week it made some consequential announcements. It suggested strongly that it would begin to slow, or taper, those bond purchases, and do so soon, ending them completely by the middle of next year. Its members increased their expectation for how much they thought interest rates would rise in 2023 and 2024. All of this was driven by ongoing improvement in the economy and signs that inflationary pressures were finally building.
One could be forgiven for thinking that the market would look at fewer purchases by the central bank, and higher interest rates, and think this was a bad thing. But markets are fickle, especially over short horizons, and stocks rose sharply both the day of and the day after the Fed's announcement. Interest rates also rose, following the lead of the Fed's shifting projections. Of those two reactions, we find those of the bond market much easier to justify.
What really matters, however, is not what these changes mean for the market over the next two days, but over the next two years. And here, three things stand out.
First, the Fed hasn't completely left the party, so to speak, but it is sliding towards the exit. Bond purchases by the Fed should still be with us for nine more months, but the signs of a different phase of central bank policy have clearly begun.
Second, this next phase, the so-called taper, is likely to be a major focus for investors. The last time the market focused on slowing Fed purchases in 2013 and 2014, equity markets generally climbed. But yields rose and gold prices sank. We see a similar impact for both bonds and gold this time around, with our interest rate strategists particularly focused on how fast the Fed will raise rates - a pace that they think the market is still underestimating.
Third, the Fed's actions are divergent from other central banks. While the Fed is shuffling towards the proverbial exit, the Bank of Japan and European Central Bank are much farther away and haven't even seemed to start moving. We think this results in a stronger dollar, relative to the Euro and the Yen, and will lead to better stock market performance in the latter regions.
A shifting Fed is just one of several events markets need to navigate over the next several weeks. We think these events remain challenging and investors will get a better opportunity to be more aggressive later in the year.
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Why two D.C. policy items—the bipartisan infrastructure framework and debt ceiling deliberations—could add one more complication for equities markets.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between US public policy and financial markets. It's Thursday, September 23rd, at 10:30 a.m. in New York.
Markets this week have had a lot to focus on - from the Fed's policy decisions to fresh concerns about global growth. But expect that focus to shift next week, or possibly sooner, to events in Washington, D.C. In particular, watch out for two events that could catalyze some market volatility.
First, keep an eye on the planned vote on the bipartisan infrastructure framework, or BIF for short. This vote, which could come as soon as Monday, is a key test for whether or not the Democrats will be able to 'go big' on fiscal policy. That's because the BIF - which would add about $550B of new spending over 10 years to the budget - was supposed to be paired with a bigger, budget reconciliation bill that could reach as high as $3.5T over 10 years. The linking of the two was meant to align the interests of moderate and progressive Democrats in Congress. But that reconciliation bill isn't ready yet for a vote alongside the BIF. So, if the smaller bill gets approved, the moderates will have gotten most of what they want and could be more demanding on the bigger bill, either stalling it or shrinking its size. At the moment, it's far from clear that the BIF can get enough votes to pass on its own, meaning the 'all or nothing' dynamic on fiscal policy remains intact. But if the BIF succeeds, that would suggest a smaller fiscal package, smaller deficit impact, and a key challenge to our view that bond yields will rise meaningfully into year end.
We'd also keep a close eye on the deliberations around raising the debt ceiling and avoiding a government shutdown. While the 'x' date - the day by which the debt ceiling needs to be raised or suspended in order to avoid a payment default on Treasuries - is likely the more impactful deadline - which our economists expect will be late October, early November - markets may be more focused on September 30th, the date by which Congress must authorize a continuing resolution for new spending, or else the government shuts down. While we ultimately expect these issues to be resolved in a manner that doesn't materially impact the US growth outlook, the path to resolution on these issues likely requires escalated uncertainty in the near term. Since Democrats have paired the continuing resolution with a debt ceiling hike, which Republicans flatly oppose on the idea that Democrats should go it alone using reconciliation, there's no clear path forward at the moment. For example, the House just passed a continuing resolution, which the Senate is unlikely to be able to carry forward given insufficient Republican support. So, headlines around a government shutdown should pick up, and with it the takes that the situation increases the risk that the debt ceiling can't be raised in a timely manner.
Taken together, these two concerns could weigh on the equity market, where our colleagues in cross-asset strategy have suggested performance could be sluggish in the near term as investors grapple with the transition from early to mid economic cycle dynamics. The shift from clear D.C. stimulus support to D.C. uncertainty could be one part of that shift.
Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.
On this special episode, we address key questions around struggles in China's property sector, as well as any potential spillover into the broader economy.
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Chetan Ahya Welcome to Thoughts on the Market, I'm Chetan Ahya, Chief Asia Economist for Morgan Stanley,
Robin Xing and I'm Robin Zing Morgan Stanley's Chief China Economist.
Chetan Ahya And on this special edition of the podcast we'll be diving into the path forward for China's economy amid challenges in the property sector. It's Wednesday, September 22nd, at 7:30 a.m. in Hong Kong.
Chetan Ahya So, Robin, as many listeners likely read earlier this week, China's property market is the subject of a lot of market and media focus right now. And near-term funding pressures for some of China's property developers have led to volatility as markets weigh concerns on any ripple effect into China's economy or even the global economy. To put funding pressures in context, in dollar terms, cumulative default in China's high-yield property names this year are already higher than that combined between 2009 and 2020. Robin, I want to get into your base case for China's economy as policymakers manage the property sector outcome. But to understand the backdrop for listeners, maybe it's worthwhile to take a step back to understand China's regulatory reset and the impact it's had on the housing market.
Robin Xing So what we call China's regulatory reset is China's ongoing shift in governance priorities, which policymakers drafted last year. And it covers a number of areas, including technology, education, carbon emission, but also property developers in an effort to address the financial stability risks. So the property related financing has actually been tightening since summer 2020. You know, first with new financing rules for real estate companies--what's called the 'three red lines'--which put a leverage cap on developers, then a cap on property, long exposure for banks, and lately, very strict mortgage approval for homebuyers. In this environment, highly leveraged developers are more prone to refinancing risks. And now the question is, will there be more credit events to come? Going forward, tighter financing conditions may stay for developers, which could increase the risk of credit events.
Robin Xing So, Chetan, you have been a close watcher for China's debt and the deleveraging dynamics since 2015. First, with its industrial sectors, then it's local government. Then we fast forward to today's housing market. Now, just to gauge how much deleveraging developers still have to undergo, how are we tracking on the three red lines as laid out by regulators? As I recall, developers are required to attain the 'green category,' meeting all three requirements by end of the first half 2023.
Chetan Ahya Yeah, thanks, Robin. So, look, I think, first of all, just to appreciate the way China manages its debt challenges is it ensures that the process is taken up in an organized manner and that there are no uncontrolled defaults, which can have ramifications on the financial system as well as overall financial conditions. And property sector is no different. And on that front, our property analyst has been highlighting that out of 26 developers that we cover, only one developer still fails to meet all the three red lines and nine developers have already passed two of those red lines. The remaining 16 developers have already met all the three requirements, and most developers do target to attain green category by the end of next year. Currently, the total debt exposure of the property developers in China is around 18.4trn RMB, which is similar to the annual contract sales or annual sales of these companies, so the deleveraging pressure when you look at it in the context of the level of debt relative to sales, it does seem to be manageable for us
Chetan Ahya Having said that, Robin, and when you think about the importance of the property sector to the economy, it's quite a significant sector. Property and property related sectors account for 15% of GDP. So, if there is a problem and a developer faces a challenge in meeting its debt obligations, do you think that China can manage the ramifications?
Robin Xing Yes, we do think regulators already have a playbook based on past default cases, which included the property developers. That said, the timing of deployment is what may matter most. Potentially Beijing's first goal would be to maintain normal operations of construction projects so default happens at the holding company level and not at the project level, which could reduce spill over to the physical property market. The second goal would be to go for voluntary debt restructuring and avoid a liquidation scenario which could substantially increase the recovery rate, though both of these actions would require coordination across authorities, creditors, and the company in this scenario. We expect the property sales and the investment in China to slow and the new starts would remain weak for the remainder of the year. However, it would not be a very fast and sharp deterioration because current inventory levels for the housing market are low, with around eight months for the major tier-one/tier-two cities. So, it's much lower than previous downturns. So, the overhang on housing new starts should be much smaller. All in all, in this swift intervention and policy easing scenario, we see China's GDP to rebound modestly from the 4.7% in the third quarter in two-year CAGR terms to slightly above 5% in the fourth quarter.
Chetan Ahya So, Robin, when you think of the developments in the property market right now, in the context of the fact that the government has also been taking additional regulatory measures which have been weighing on the private business sentiment, do you think that the government can take up easing measures to ensure that this does not have a meaningful impact on the growth outlook?
Robin Xing Yes, your concerns are very legitimate. Given the importance of the property sector to China's economy, Beijing may decide to take action sooner rather than later in order to support the economy. In our base case, we are near an inflection point of policy easing. That would be led by faster fiscal spending to support infrastructure investment from September to December, complemented by another 50 basis point reserve requirement ratio cut by the People's Bank of China probably in mid to late October. We also see some easing in mortgage quotas in the fourth quarter. This altogether should drive a modest rebound in broad credit growth in the fourth quarter, marking the end of a 10-month credit growth downturn. What's more, this momentum can be amplified in early next year when the fiscal spending and the credit quota could be front loaded.
Chetan Ahya So, Robin, if I were to summarize, essentially what we are talking about is two sets of policy actions to be taken up by the government. First, to ensure that the debt restructuring is taken up in an organized and timely manner. And second is that to the extent to which there will be some negative impact on business sentiment, we're expecting the government to implement policy easing measures.
Chetan Ahya However, if the government were to delay these supportive measures, what will be the implications on your growth forecast?
Robin Xing That's certainly a scenario we hope to avoid. So basically, should policy makers fail to take actions in time to manage this restructuring and contain its spillover effect, we could see a rise in liquidity pressures on many more developers as banks cut credit lines and home buyer sentiment cools down. In this case, the fourth quarter growth could fall below 4%, far lower than the annual growth target, which was 6% for this year and probably around 5.5% for next year. In short, such delayed action, more spillover scenario would likely warrant a much bigger stimulus in earlier 2022 to meet the growth target to stabilize the job market.
Chetan Ahya Robin, thank you for taking the time.
Robin Xing It's been great speaking with you.
Chetan Ahya And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or a colleague today.
This Climate Week, we preview environmental policy proposals within the $3.5 Trillion Budget Reconciliation Bill. What will it mean for investors and the response to climate change?
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Jessica Alsford Welcome to Thoughts on the Market. I'm Jessica Alsford, global head of Sustainability Research team at Morgan Stanley.
Stephen Byrd And I'm Stephen Byrd, head of Morgan Stanley's North American Research for the Power & Utilities and Clean Energy Industries.
Jessica Alsford And on this special Climate Week episode, we'll be talking about some landmark climate and environmental policy proposals in the U.S. and the future of energy. It's Tuesday, September the 21st, at 2:00 p.m. in London.
Stephen Byrd And 9:00 a.m. in New York.
Jessica Alsford So, Stephen, earlier this month, the U.S. House of Representatives released a draft of some climate and environmental policies as part of its $3.5T budget reconciliation package. I want to dig into your takeaways, but first of all, maybe you could walk us through some of the headline proposals.
Stephen Byrd Absolutely, Jessica. This is one of the most exciting pieces of proposed legislation we've seen in the United States, at least with respect to clean energy. And I'll just highlight a handful of very important provisions that are currently in the draft. First, there's a very bold, clean electricity performance program or CEPP that would provide significant incentives for utilities and other loads of green entities to increase their renewables every year. Secondly, there would be a new tax credit for energy storage and biofuels. Third, a major extension of tax credits for wind, solar, fuel cells and carbon capture and payment levels are higher in many cases. Fourth, significant incentives for domestic manufacturing of clean energy equipment. Fifth, what we would call direct pay for tax credits, which basically provides owners with the immediate cash benefit of tax losses. That provides enhanced financing efficiency and better cash flow. Six, a nuclear power production tax credit. Seven, a major clean hydrogen tax credit. And lastly, number eight, significant capital to reduce the risk of wildfires. So very significant. Covers a lot of different areas within the entire clean energy spectrum.
Jessica Alsford Absolutely. There's a huge amount in there. I guess maybe just to pick out some key points, are there any particular technologies that you think could really incrementally benefit from this bill versus what the status quo is at the moment?
Stephen Byrd Yes, there's definitely a handful of technologies that would benefit in a very significant way. I would say. Probably first on my list is green hydrogen. The proposed payment is three dollars a kilogram - this is the subsidy amount - which is a very large amount of subsidy, in our view, would really kick start growth of green hydrogen across the board in the United States. We did a deep dive into the economics of producing green hydrogen over time, and we do think this amount of subsidy would be a huge boost to the growth of green hydrogen, would defray much of the cost producing green hydrogen. So, any company involved in green hydrogen, I think would see a significant benefit here.
Stephen Byrd Another, nuclear power, not new nuclear projects, but existing nuclear assets would receive significant financial support. That is going to serve essentially as a stabilizing force to ensure that we don't see additional shutdowns of nuclear power plants. So that's a big win. I'd say, also, energy storage gets a tax credit for the first time and demand for energy storage is already very high in the United States, but a tax credit that would essentially line up with wind and solar would, we think, provide further incentive for more rapid growth of energy storage. So those are a couple that I would highlight as significant beneficiaries from this proposed legislation.
Jessica Alsford Now, this text is the initial draft and say we should probably expect to see changes. What are you hearing in terms of these proposals and how much could actually make it into a final bill?
Stephen Byrd This is really interesting. We do think that much of this language will survive. There is one provision, a very important one, that has received pushback. That's the first on the list that I mentioned. This is the Clean Electricity Performance Program or CEPP. Senator Joe Manchin, who's quite important, as well as a few others, have pointed out concerns with the current drafting of the language, a few companies have also expressed concerns. So, we could see changes there, maybe even elimination of that provision. However, many of the other elements of this package do appear to have quite a bit of support. So solar, wind, energy storage, even green hydrogen, we think has a significant amount of support. So, we do think much of this will survive. The one that's been singled out recently is that CEPP.
Jessica Alsford Now also on climate, the Biden administration and the EU have actually jointly announced that Global Methane Pledge, which is aiming to reduce methane emissions by at least 30% from 2020 to 2030. Now, what are your thoughts on this? How significant is it for the utility sector?
Stephen Byrd Yes, Jessica, I think this cuts both ways in terms of the methane emissions goal. I think on the positive side, I think many investors, especially ESG investors, would like to see significant commitments to reducing methane emissions. And, you know, we can see why certainly methane is so much more harmful from a greenhouse gas perspective relative to CO2. So, I think many investors will applaud this. The big concern will be the cost and the customer bill impact. Right now, given the increase in natural gas prices in the United States and really globally, there is already a concern around the increase in customer bills for those customers who buy natural gas. So, this would increase the cost.
Stephen Byrd That said, utilities have a long history of being able to recover these costs. So, on the positive side, this could result in better growth in earnings per share, as well as improved ESG perception and reality in the sense of lower emissions. The key question is how are we going to manage the cost of this? And right now, that's causing quite a bit of investor concern. So, it's a bit of a mixed message. I'd say in the long term, though, a positive from a better growth perspective and lower emissions perspective.
Jessica Alsford And finally, from me in this context of the U.S. really increasing its focus on halting climate change, what are the opportunities that you think investors should be looking at?
Stephen Byrd So we do see several business models and technologies that should benefit significantly from this policy shift. I would say developers of solar, wind and energy storage will see continued strong support under this legislation. Their incentives would remain in place until the next decade. We would see a lot of benefit for fuel-cell companies and companies involved in the development and transportation of green hydrogen - that would be a major area of support. Existing nuclear power plant owners would receive quite a bit of support as well. So, we do see quite a bit of benefit within this legislation, really providing strong economic support really across the board, but a few areas such as hydrogen that do stick out. But I'd say broadly, if this legislation is passed, clean energy investors would view this as a significant benefit for the entire sector because it is so comprehensive.
Stephen Byrd Before we close, Jess, I wanted to ask you about how this might move the needle globally. Europe is clearly out in front on climate legislation, but assuming some or all of these proposals make it into a final bill, how likely is it that we could see similar government action globally?
Jessica Alsford It's a timely question, Stephen, really, because we now have COP 26 conference coming up in November. It's being held in Glasgow this year, and we're expecting over 100 world leaders to attend. So, this really should be a catalyst for seeing far more climate focused action globally. Aside from the EU and the US, all eyes are certainly going to be on China. And here, our chief China economist has been writing about a shift in regulatory priorities, so China now are thinking more about a balance between growth and sustainability. And specifically on climate, there are three pillars where we expect to see action from China. First of all, investments in technology. Secondly, carbon pricing and finally on the green financing side.
Jessica Alsford Stephen, on Climate Week, thanks for taking the time to talk.
Stephen Byrd Any time, Jess. Great speaking with you.
Jessica Alsford As a reminder, if you enjoy Thoughts on the Market, please do take a moment to rate and review us on the Apple Podcasts app. It does help more people to find the show.
Although many commentators point to the S&P 500 near all-time highs as a rationale for higher stock prices, markets may be facing a bumpy road ahead.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, September 20th, at 12:30pm in New York. So let's get after it.
For regular listeners to this podcast our mid-cycle transition narrative is probably getting fairly repetitive. A strong narrative that makes sense is worth riding until the end, and we're not there yet. However, we do think we've entered the final chapter. To recall, the mid-cycle transition began back in March. Initially, it's a more difficult time for the average stock, while the higher quality stocks and indices hold up. Over the last six months that's pretty much exactly what's happened - small caps and lower quality stocks have underperformed the S&P 500 significantly.
But now we're entering the final chapter and that's the time when the index starts to underperform the average stock. This happens because that's where investors have been hiding; and at this stage of the transition, investors can no longer hide from the reality of what the mid-cycle transition brings. First, we have a deceleration in economic and earnings momentum. On the economic front, the data has already rolled over pretty hard. While many are blaming the Delta variant for this slowdown in the economy, we think it's more about the payback in demand from a fiscal stimulus and recovery that was unsustainably strong earlier this year. Furthermore, because this recession and recovery were much sharper than normal, we should expect a greater deceleration in growth during the mid-cycle transition phase this time. Finally, due to the nature of this recession being centered around a health crisis, the fiscal support from the government was unusually strong. This led to very high operating leverage and profitability. The normalization means that we could see negative operating leverage for a few quarters as costs are layered back in just as top line growth slows. The bottom line: earnings revisions over the next few quarters will probably look relatively worse than the economic revisions of late.
The other headwind for markets that comes at this stage of the mid-cycle transition is the Fed moving away from maximum accommodation. In the 1994 and 2004 versions, the Fed began hiking interest rates. In the 2011 mid-cycle transition, the Fed simply let quantitative easing expire. This time around it's the tapering of asset purchases and we think the Fed will signal that more definitively at this week's meeting. In short, financial conditions should tighten and that means higher interest rates, higher risk premiums or both. Either one means lower equity valuations, which is really the key part of the final chapter of the mid-cycle transition. Once that derating is complete, we can then move forward to the mid-cycle phase, which usually leads to a reacceleration in growth, a broadening out of stock performance and higher equity prices.
So how bad will it get? We've been suggesting a 10-15% correction in the S&P 500 is inevitable once we get to the final stage. However, given how long this has taken to play out, the drawdown could end up being closer to 20% if the growth slowdown ends up being worse than normal. In 2011, we had a 19% drawdown, so it's not unprecedented. Therefore, we continue to think investors should hunker down a bit more than normal and skew portfolios toward defensive quality rather than large cap growth quality.
Of course, markets can surprise us, which begs the question, what could change our view and allow the S&P 500 to avoid the 10-20% drawdown? First on the list is another fiscal stimulus directed right at the consumer that sustains the well above trend of demand. This could come from either U.S. or China. Second would be a Fed that completely reverses course this week and says they no longer plan to taper asset purchases this year or even next year. Both seem unlikely at this stage, but if markets become somewhat dislocated, we could then see a reaction from policymakers later this fall.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
We look at how soaring energy prices in Spain, gas prices in the U.S. and aluminum prices globally could all be linked to coal mines in China.
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Andrew Sheets Welcome to Thoughts on the Market, I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley.
Martijn Rats And I'm Martijn Rats, Morgan Stanley's global oil strategist and head of the European energy team.
Andrew Sheets And on this special episode, we'll be talking about how soaring energy prices in Spain, gas prices in the U.S. and aluminum prices globally could all be linked to coal mines in China. It's Friday, September 17th, at 3 p.m. in London.
Andrew Sheets So, Martin, there's a pretty striking story going on globally in commodities that's been hitting close to home here in Europe. I think a good place to start is just to run through how much prices for things like coal, natural gas and aluminum have been rising this year.
Martijn Rats Thanks, Andrew. The price rally in many of these commodities has been rather extraordinary. The global consumption of coal peaked in 2013. So eight years ago. And yet we're now looking at thermal coal prices that are close to all time highs. At the start of the year, the price of thermal coal in the seaborne market was in the order of $80/ton. Now we're looking at $180/ton. With that also, the price of aluminum has risen very strongly. At the start of the year, we were around about $2000/ton. At the moment we're knocking on nearly $3000/ton. The price of natural gas both in the seaborne market traded as LNG as liquefied natural gas, but also in Europe, delivered through pipelines at several trading hubs where gas is trading. In Europe, we've seen extraordinary rallies. Typical prices have gone from in the order of $6-7 per MMBTU to $22, $23, $24 per MMBTU. And with that, then also electricity prices have increased very sharply. In Germany, in France, Spain, the U.K., electricity prices have broadly tripled from about sort of 50 euros a megawatt hour to about 150 euros per megawatt hour.
Andrew Sheets So one of the reasons I was so keen to talk to you today is that this is a really interesting and interlinked story. What's going on?
Martijn Rats I think there is a common set of factors between all of these rallies. In China, electricity demand is up, coming out of covid and also because of hot weather. Normally, China produces its majority of its electricity from coal and from hydropower, i.e. dams and rivers. But because of underinvestment and because of drought, both of these source of electricity production have really struggled this year. That meant that China had to curtail aluminum production, which is particularly electricity intensive to make. China is a big producer of aluminum globally, so that made the global aluminum price spike. At the same time, it meant that China had to look for coal in the seaborne market and also for natural gas, which is another fuel you can use for electricity production. That tightens the global market for coal and for natural gas. And then those prices spiked, particularly in Europe, because normally natural gas that is shipped around the world in LNG tankers, a lot of that ends in Europe. But this year, a far lower share of it ended in Europe. That meant that our inventories of natural gas didn't really build over the summer. We're now going into the winter with unusually low levels of natural gas inventories. Natural gas prices in Europe then spiked. And because that sets the price for electricity, then electricity prices also spiked. It's a global story that is very interconnected across regions and across commodities.
Andrew Sheets So, Martin, I know this is hard to comment on, but how do you think this resolves itself? And what do you think are the key factors to watch here going forward as we think about these interconnected commodity markets?
Martijn Rats Well, I think these rallies and particularly the sharpened sort of nature of them have really driven home three things. First of all, how interconnected the commodity markets really are. You can get, you know, drought in China and electricity prices go up in Spain. It really is that interconnected. I think the second thing that these rallies drive home is how difficult this is to forecast. As in, even three months ago, six months ago, most market participants would not have expected that in particular, commodities would have rallied so much. As we go into the energy transition, we really should use less coal. And therefore, coal markets were by and large expected to be very well supplied. Natural gas has been quite abundant, really on a global basis ever since the emergence of U.S. shale about a decade ago. And that market, too, was widely expected to remain abundant. So to see these types of price rallies really drives home how difficult it is to forecast these rallies. And frankly, for that reason, we should be open minded about, you know, these deeply held consensual views about how all of this is going to play out. The third thing I think that is worth stressing is that these rallies also show how little margin of safety there is in the broader energy system, and particularly as we do go into the energy transition with seemingly little margin of safety, that creates room for instabilities and spikes in the future as well.
Andrew Sheets And, Martin, by the energy transition, we're talking here about this idea that we're really going to be moving away from coal based production, fossil fuels, not just because they're worse for the environment, but they're increasingly less economic relative to many of these renewable technologies that are now out there.
Martijn Rats Yeah, that is exactly right. You know, to address climate change and to decarbonize, we need to move to more sustainable low carbon sources of energy. But what is currently going on is that this prospect is leading those that typically invest in the traditional fossil fuels to lower their investment levels already well in advance, whilst actually our consumption patterns are changing quite slowly. So there's a real question whether the prospect of the energy transition is impacting the supply side of energy before it impacts really the demand side of energy. And that's that could then be the source of those price squeezes and instabilities that I just mentioned.
Andrew Sheets So, Martin, meanwhile, U.S. gasoline prices have moved up to some of their highest levels since 2014. Is this related to this story and the other commodities or is something else going on here now?
Martijn Rats So far, oil is not quite wrapped up in this story quite as much. Oil still has its own standalone dynamic, more or less. And the reason for that is that have loose connections to each other. But oil is truly global. So the United States has reduced its dependance on imported oil very, very significantly over the years, but still, the American oil market is connected to the global oil market. And in the global oil market, we see recovery in demand. The oil market is simply tight and that is driving U.S. gasoline prices. So the dynamic there is different. But where these stories could converge is in terms of the impact of little investment in the future, because clearly part of the story that I just told about natural gas and coal has an element to it of low investment levels that are now showing their consequences and partly responsible for creating these squeezes. In the oil market, we are also now going through a number of years already with low investment levels. Now, there's still some slack in the system, but what is now happening to coal and natural gas could well happen to oil markets in two, three, four years from now when OPEC's spare capacity has been depleted and demand has recovered. So in that sense, U.S. gasoline prices are a different story, but they could become the same story in a few years from now.
Martijn Rats So now, Andrew, I look at it from an energy and commodity perspective, but you take a very much a macro view. What do you make of all of this?
Andrew Sheets So I think the irony here is, is that both investors or general people who want to reduce carbon based emissions and the energy companies would both prefer higher energy prices, albeit for maybe different reasons. But higher prices are one mechanism to reduce the amount of consumption of these various fossil fuels and commodities. So there is a free market element here. As these prices go up, people will use less electricity, they will use less natural gas, they will try to they will drive less. And that can have some positive environmental impacts. It can also have some negative economic impacts, as if that if that leads to less activity. If that transition has to happen a lot faster or maybe more uncomfortably than expected. I think the second thing is we do have to be on the lookout for this impact on corporate margins. When it comes to commodities and when it comes to the things you were just discussing, if you produce these things, it can be really good. And if you consume them, it can be really challenging. If prices are going up 50-100%, I don't think many people's budgets or earnings numbers account for that type of fluctuation. So, you know, this is something we're going to be watching very closely as we go into third quarter earnings and fourth quarter earnings. And also, I think investors need to be on the lookout for companies that potentially get squeezed if they are not able to pass on price increases onto the next part of the supply chain, onto their customers. And finally, I think this is a really good reminder that there's, I think, a temptation in markets often to really want to think that politics is this great explainer of everything. And I think this is a good reminder of the limitations of that. I mean, I think if you had told an investor at the start of 2020 that you would have Democratic control of the White House, the House of Representatives, the Senate, and then coal prices would go on and more than double. People would have thought that you were crazy. People would have thought that you didn't know what you were talking about. And yet that's happened. And it's happened because there's a drought in China and there's a lack of coal production for many other unrelated reasons. So I think this is just a good example that any time I think we look at markets with upcoming elections, yes, those can matter and they can matter a lot. But often other factors can also come into play. And we need to be mindful and I think kind of humble to that dynamic.
Andrew Sheets Martijn, thanks for taking the time to talk.
Martijn Rats Great speaking with you, Andrew,
Andrew Sheets And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.
Original Release on August 13th, 2021: Across numerous metrics, the current environment may be an unusually good time to borrow money. What does this mean for equities, credit and government bonds? Chief Cross-Asset Strategist Andrew Sheets explains.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 13th, at 4:00 p.m. in London.
Obvious things can still matter. Across a number of metrics, this is an unusually good moment to borrow money. And while the idea that interest rates are low is also something we heard a lot about over the prior decade, today we're seeing borrowing cost, ability, and need align in a pretty unique way. For investors, it supports Equities over Credit and caution on government bonds.
Let's start with those borrowing costs, which are pretty easy. Corporate bond yields in Europe are at all-time lows, while U.S. companies haven't been able to borrow this cheaply since the early 1950s. Mortgage rates from the U.S. to the Netherlands are at historic lows, and it's a similar story of cheap funding for government bonds.
But even more important is the fact that these costs are low relative to growth and inflation. If you borrow to pay for an asset—like equipment or infrastructure or a house—it’s value is probably going to be tied to the price levels and strength of the overall economy. This is why deflation and weak growth can be self-fulfilling: if the value of things falls every year, you should never borrow to buy anything, leading to less lending activity and even more deflationary pressure.
That was a fear for a lot of the last decade, when austerity and concerns around secular stagnation ruled the land. And that may have been the fear as recently as 15 months ago with the initial shock of covid. But today it looks different. Expected inflation for the next decade is now above the 20-year average in the US, and Morgan Stanley's global growth forecasts remain optimistic.
What about the ability to borrow? After all, low interest rates don't really matter if borrowers can't access or afford them. Here again, we see some encouraging signs. Bond markets are wide open for issuance, with strong year to date trends. Banks are easing lending standards in both the U.S. and Europe. And low yields mean that governments can borrow without risking debt sustainability.
So borrowing costs are low even relative to the prior decade, and the ability to borrow has improved. But is there any need? Again, we see encouraging signs and some key differences from recent history.
First, our economists see a red-hot capital expenditure cycle with a big uptick in investment spending across the public and private sector. Higher wages are another catalyst here, as they often drive a pretty normal pattern where companies invest more to improve the productivity of the workers they already have.
But another big one is the planet. If the weather this summer hasn't convinced you of a shift in the climate, the latest report from the IPCC, the UN's authority on climate change, should. Since 1970, global surface temperatures have risen faster than in any other 50-year period over the last two millennia.
Combating climate change is going to require enormous investment - perhaps $10 Trillion by 2030, according to an estimate from the IEA. But there's good news. The economics of these investments have improved dramatically, with the cost of wind and solar power declining 70-90% or more in the last decade. The cost of financing these projects has never been lower or more economical.
An attractive borrowing environment is good news for the issuers of debt - companies and governments. It's not so good for those holding these obligations. More supply means, well, more supply, one of several factors we think will push bond yields higher.
Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.
Although markets have been preparing for the notion of tax hikes, a flurry of recent legislative activity may suggest where tax policy will eventually land.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, September 15th, at 10:30AM in New York.
A flurry of legislative activity over the past week revealed a lot about where tax policy is likely going in the U.S. And while it’s not new news that taxes are likely going up, there are key market observations to be gleaned from the new details that have emerged.
First, as we’ve long expected, tax hikes appear to be falling short of the original White House request, reflecting the reality of what every Democrat, including moderates, could support. For example, the House Ways and Means committee’s proposals call for the corporate rate to go to 26.5%, not the 28% asked for. They also call for the highest capital gains rate to go up 5%, not the nearly 20% asked for. These numbers aren’t final, but from here we wouldn’t expect them to move higher. And that’s important for bond investors. In the short term, this means the total amount of revenue these measures can raise probably cannot offset the amount of spending being planned. That means some deficit expansion, and more bond supply could join with other macro factors, like improving growth and a fed on pace to taper, to push bond yields higher over the balance of the year.
Second, while the net fiscal package should mean deficit expansion and thus support for growth, the higher taxes could strain equity markets in the very near term. As our colleagues in cross asset strategy have pointed out, the substantial rally in U.S. stocks has left valuations stretched. Further, stocks could be sensitive to a slowing down in the goods economy as the growth cycle matures. Add new taxes to the mix, even the more modest hikes we expect, and it means that stock returns risk lagging for a bit as investors adjust to this more mixed, albeit still positive, macro outlook.
A final thought here: while we expect tax changes like these to come through, they are most certainly not a done deal. There are plenty of negotiating hurdles left to clear, and so we wouldn’t expect any finality on the debate until the 4th quarter of this year. We’ll, of course, keep you informed as the situation develops.
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With the summer growth scare in Europe possibly nearing an end—and relatively inexpensive valuations—cyclical stocks in Energy, Banking and Autos may be worth a fresh look.
Equities markets may be sending mixed messages on the economy and growth, but ultimately, it’s all about the earnings. Chief Investment Officer Mike Wilson explains.
Why stretched valuations, growth worries and a cavalcade of uncertain events in September and October could mean a challenging fall for U.S. stocks.
Negotiations on a number of government policy points such as taxes, fiscal spending and deficits have hit a fever pitch. Here are three potential outcomes through year-end.
Taiwan equities have been a standout among equities in 2021, but factors such as softening tech spend and slowing retail trading activity suggest challenges ahead.
Weak U.S. economic data in August has renewed concerns that a growth scare is underway. Is this a sign of things to come or just a speed bump in the expansion?
Original Release on August 30th, 2021: Although a key component of investing is getting the narrative right, perhaps a bigger component is knowing when the narrative could shift.
Original Release on August 25th, 2021: For investors, U.S. fiscal policy, tax increases and U.S.-China relations are three key items to watch as we head toward fall. We outline potential outcomes.
As summer transitions to fall, investors will be facing a host of key market events. Chief Cross-Asset Strategist Andrew Sheets covers the ones to watch.
Norway has made great strides in electric vehicle adoption over the last decade, so why has its oil consumption remained largely unchanged?
After last week’s Jackson Hole Symposium, markets cheered Fed Powell’s implied messaging on the pace of rate hikes. Did markets read it right?
Although a key component of investing is getting the narrative right, perhaps a bigger component is knowing when the narrative could change.
In a world where U.S. equities are currently less attractive, investors need options for places to put their money — this is one.
Equity investors have applied factor-driven strategies for years, but the approach has seen slow adoption in bond markets. Here’s why that may be changing.
For investors, U.S. fiscal policy, tax increases and U.S.-China relations are three key items to watch as we head toward fall. We outline potential outcomes.
Recent developments in space travel may be setting the stage for a striking new era of tech investment. Are investors paying attention?
An old adage says 'never bet against the US consumer's willingness to spend,' but new data on demand and consumption may say otherwise.
Despite a fair amount of uncertainty, global stock prices have continued to march higher. But under the surface, markets have become a bit more discerning.
As back-to-school approaches, we take a close look at school safety, child case numbers amid Delta and the path ahead for vaccines for younger children.
Last week, the U.S. Senate advanced both a budget blueprint and a $1 trillion bipartisan infrastructure bill. What can investors expect from the House of Representatives?
Despite recent uncertainty caused by the Delta variant, regulatory changes and the potential for a stronger dollar, European Equities are showing renewed strength that could last to the end of the year.
A strong second quarter earnings season wraps up this week, but lower than consensus earnings for next year and lower valuations could make the road ahead a bit bumpier.
Across numerous metrics, the current environment may be an unusually good time to borrow money. What does this mean for equities, credit and government bonds?
Investor interest in thematic equity products such as ETFs has rapidly surged, particularly among tech themes. Why the momentum may only grow.
On this episode, we examine how China’s regulatory reset on fintech, big tech, cryptocurrency and carbon emissions could affect China equities and business models.
Although the pandemic put U.S.-China trade tensions on a low simmer, several catalysts could now turn up the heat. Three takeaways for investors.
July’s strong labor market report suggests the Fed may be behind the curve on monetary policy— and markets could soon start to notice.
The Delta variant, slow progress on U.S. infrastructure and some recent disappointing data have markets worried about the economic recovery. Here’s another view.
Are current oil prices sustainable? Although oil prices have rallied sharply over the last year, the performance of oil equities has been modest by comparison.
The U.S. infrastructure bill is just the start of a larger fiscal process through year-end that may bring above average growth and higher U.S. Treasury yields.
Falling Treasury yields have investors wondering whether prices will keep rising. But some insight could be gained from the trajectory of U.S. auto prices.
As a strong earnings season wraps up, pressure is mounting on the Fed to reduce its current level of emergency monetary support. What will this mean for stocks?
On this episode we continue our close look at the COVID-19 Delta variant including boosters, the outlook for fall/winter and the impact on markets.
On this episode, we take a closer look at the Delta variant including infectiousness, possibilities of mutation, and whether we’re stuck with COVID-19 long-term.
Investors have been closely watching headlines on the bipartisan infrastructure plan, but for markets, what may matter most is the broader fiscal policy plan.
U.S. equity markets have transitioned through three of four typical changes associated with a mid-cycle transition. But the next, final phase—Fed tightening—may have the most impact.
How can governments worldwide manage the historically high debt incurred in response to the COVID-19 crisis? The answer may be a bit counterintuitive.
The Congressional debate over raising the “debt ceiling”—the total amount of money that the U.S. is authorized to borrow—has begun again. Should investors be concerned?
Consumer spending has an outsized impact on U.S. economic growth, representing 70% of the economy. We take a deep dive into savings, spending and the labor market.
Original Release on June 24th, 2021: Although the darkest days of COVID-19 are hopefully behind us, new variants, vaccine distribution issues and uncertainty about winter still remain key issues.
A popular read on yesterday’s drop in stocks and bond yields is concern over the COVID Delta variant and global growth. But that analysis may only be part of the story.
On this special edition of the podcast, we examine the path ahead for fixed income and the dollar amid increased concern over the COVID-19 Delta variant and economic growth.
Over the last 18 months, individual investor activity into single stocks has surged. But the bigger story may be the record amount of investment in ETFs.
As the year began, there was a high degree of optimism that 2021 could be a great year for Asia & EM equities. But instead, Asian equities have lagged the U.S. and Europe. So what went wrong?
The U.S. could be gearing up to approve $4 trillion in new spending over the next 10 years. A look at what that could mean for GDP and Treasuries.
Major U.S. indices may be climbing to all-time highs but broader weakness in individual stock prices could be sending investors a signal.
After performing strongly for much of this year, European stocks have traded sideways over the last month. But a closer look at the data suggests an optimistic outlook.
Although a typical explanation for market strength has been the large amount of cash being pushed into markets from central banks and investors, it’s not the whole story.
Last week, U.S. air travel surpassed 2019 levels. And this recovery in demand may be an important story for both fixed income and equity investors to understand.
Labor-intensive companies that should benefit from the reopening are feeling the pinch from rising wage costs. With growth stocks likely overbought, where do investors go from here?
U.S. home price growth has been on a tear, but will affordability pressures begin weighing on home sales? The answer is a bit complicated.
It's easy to forget just how different the world looked just six months ago. Does the renewed optimism suggest higher returns or just higher expectations?
Until recently, wages have been on a forty year decline, driving new calls for policymaker action. A look at the implications for GDP, inflation and income inequality.
Is U.S. infrastructure already priced into Treasury yields? The answer may lie with whether investors are accurately gauging the true size of the final package.
The robust return of business investment is set to be a key theme for investors. On this episode we examine the bullish outlook for communications equipment and infrastructure.
With the economic recovery in full bloom, companies and investors may now be faced with new questions around higher materials and labor costs.
Chief Cross-Asset Strategist Andrew Sheets continues his conversation with Biotech Equity Analyst Matt Harrison on COVID-19 variants and the future of the health care industry.
Although the darkest days of COVID-19 are hopefully behind us, new variants, vaccine distribution issues and uncertainty about winter still remain key issues.
Since last year, China's economic recovery has been strong… but uneven. After a hiccup in the second quarter, will manufacturing and consumers come to the rescue?
Last week, the Fed rattled markets by laying the groundwork for tapering its asset purchase program. But is this taper talk? Or just talking about talking about tapering?
Although the Fed’s surprise hawkish turn in its latest policy decision caught markets off-guard, the monetary tightening process may actually have begun months ago.
Original release on May 21st, 2021: Consumer spending should drive strong business investment in the months ahead, driving global GDP above its pre-COVID-19 path. But inflation may be a risk to watch.
Although investors often look to the past to assess current market conditions (such as a post-pandemic recovery or rising inflation), one year in particular may serve as an interesting guidepost.
Will negotiations on a U.S. infrastructure deal lead to a bipartisan bill or a Democrats-only bill? The answer matters quite a bit for fixed-income investors.
Over the past few weeks, European equity flows have been at the highest levels in three years. Could a period of consolidation be ahead?
While the outlook for growth and inflation looks strong through next year, both may disappoint lofty investor expectations—and bring consequences for some stock sectors.
This month’s U.S. consumer price inflation data showed a 5% rise versus a year ago, yet markets seemed unconcerned. A look at why markets could be looking past rising inflation readings.
The European Central Bank may soon announce the trial launch of a digital euro. Reza Moghadam, Morgan Stanley's Chief Economic Advisor, digs into potential risks and innovations.
With tensions not abating, investors should prepare for a world where these major economies are significantly less integrated. Michael Zezas explains.
Chief Cross-Asset Strategist Andrew Sheets and Head of Fixed Income Strategy Vishy Tirupattur cover a key topic on the minds of many investors: where to invest now?
Mortgage Backed Securities (MBS) and Collateralized Mortgage Obligations (CMO)
Principal is returned on a monthly basis over the life of the security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMO's average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMO's average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMO's market price to fall. Some MBS/CMOs may have “original issue discount” (OID). OID occurs if the MBS/CMO’s original issue price is below its stated redemption price at maturity, and results in “imputed interest” that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information. Government agency backing applies only to the face value of the CMO and not to any premium paid.
New macro data on employment and consumer prices are unlikely to settle market uncertainties about inflation and course of the recovery. Mike Wilson explains.
The pillars that have supported extraordinary action by the Federal Reserve are now starting to shift. That means support could be withdrawn. The question is, when?
Commodities prices have seen big moves over the last several months, but could a potentially stronger dollar and the mechanics of supply and demand cool the rally?
Although the Biden administration has been slightly less vocal with respect to China, investors shouldn’t sleep on the possibly of renewed U.S.-China tensions.
Why China’s ambitious blueprint to shape tech standards may have significant impact on the future of tech. Insight from Shawn Kim, Head of Asia Technology Research.
Despite some inflation and labor market risks, the outlook for the rest of the year anticipates strong growth in the U.S. economy. Chief U.S. Economist Ellen Zentner discusses with Andrew Sheets.
Concern has been rising that potentially higher inflation could make Congress lose its nerve on a multi-trillion dollar "Build Back Better" plan. Here’s our analysis.
Where and how consumers buy their groceries may be forever changed post-pandemic. We deliver some key takeaways on the food retail industry.
Fresh off of last week’s mid-year outlook, Chief Investment Officer Mike Wilson details investor reaction to some of the more out-of-consensus views.
Consumer spending should drive strong business investment in the months ahead, driving global GDP above its pre-COVID-19 path. But inflation may be a risk to watch.
While robust global growth is a positive for markets, it may also bring higher prices, tighter policy and higher interest rates. A look at some possible twists and turns ahead.
All indications suggest that Congress is serious about passing an infrastructure bill, but here’s why investors may want to consider all possible outcomes.
Graham Secker, Head of Morgan Stanley's European and UK equity strategy team, shares why Europe may be set to outperform global equity markets this year.
Chief Investment Officer Mike Wilson explains why sector and style preferences—along with selective stock picking—may be the key to success for the rest of 2021.
The debate over inflation was center stage this week and although the current environment is a far cry from the 1970s, rising prices could mean complications for both companies and central banks.
Labor shortages and inventory constraints are weighing on U.S. manufacturing and shipping. How severe could the impact be to U.S. GDP and multi-industry revenues?
Differing U.S. infrastructure policy approaches highlight the ongoing difficulties of bipartisanship in Washington. Here’s one possible outcome.
Original release April 16th, 2021: Keeping tabs on how other investors are trading can do more than just satisfy curiosity. It can provide a window into trends and current market debates.
Amid pricey valuations and growing evidence of labor and supply chain issues investors may want to adjust focus as we exit the early stages of the recovery.
With U.S. labor market numbers coming in below expectations, Andrew Sheets assesses how jobs data feeds into market and policy maker thinking about the road to recovery.
Amid declining rates of vaccinations in the U.S, virus mutations and a crisis in India, is herd immunity from COVID-19 still achievable? The latest insights from Biotech equity analyst, Matthew Harrison.
The Supreme Court is expected to deliver a decision soon on this key case for the future of the Affordable Care Act and the 20 million Americans who have acquired coverage under it. The outcome could have significant impacts for investor too.
The red-hot U.S. housing market brings to mind some unhappy memories of the 2006 bubble, but there are some key differences this time around.
The reality of reopening is anything but cut and dry. And how the market is pricing, or failing to price, nuances should continue to be a key theme.
Plans to introduce digital currencies are gaining momentum among the world’s central banks. But what level of disruption will it bring to the financial system?
Last night, President Biden laid out his vision to rebuild the existing U.S. infrastructure. Here are three takeaways and sectors to watch as negotiations unfold.
Summer months have historically seen lower, more volatile returns, but strong year-to-date gains and potentially higher inflation could intensify that trend.
Europe's 'unloved' quality among global investors is not the only reason to feel optimistic about the potential for outperformance among European equities. Chief European Equity Analyst Graham Secker explains.
High expectations around reopening may already be substantially priced into markets, pointing to new risks around how the reopening actually plays out.
Stresses on the electrical grid, climate policy, and national security are only a few of the issues we will confront as we transition to EVs.
Price, charging infrastructure and dirty battery production are limiting the impact of EVs, but look to fleet operations to lead the way to broader adoption.
With a sizable infrastructure bill moving through the U.S. Congress, support from coal producing states, often considered unlikely, may be a factor that ultimately ensures its passage.
Green investment is on investors' minds this Earth Week: Today, a look at key investment themes across carbon capture, plastics and agri-food developments.
Earnings season is well underway and some stocks are selling-off despite strong economic data. Is the recovery now completely discounted?
Keeping tabs on how other investors are trading can do more than just satisfy curiosity. It can provide a window into trends and current market debates.
Why the pet care industry—which was already growing pre-pandemic—may emerge as one of the fastest growing sectors over the next decade.
What stock sectors could fundamentally benefit from infrastructure spending? To answer this question, it’s important to follow the money.
Original release on March 25th, 2021: Amid a generally conservative outlook for emerging markets, key differentiators are their scope for policy action, pace of vaccine rollout and equity valuations.
How are oil & gas companies and U.S. utilities tackling the complex transition to a lower carbon future? Expect a lot of divergence in approach.
Since last year, bonds of all stripes have seen so-so returns and high stock market correlation. Is it time to question their value as a portfolio diversifier?
In a time of extraordinary policy response to the pandemic, will bond markets move towards the Fed or will the Fed shift its reaction function towards markets?
U.S. home buyers are now facing both higher mortgage rates and steadily climbing home prices. What does this mean for housing and mortgage markets?
Consumer spending trends are finally accelerating in service sectors such as dining and travel. A look at what this means for GDP, the jobs market and inflation.
Although the S&P 500 has continued to make new highs, underneath the surface, a shift in market leadership may be sending a signal about the hard work of reopening.
Over the last 30 years, April has been one of the best months of the entire year—and this year, the rainy month could have some extra advantages.
As the Biden administration unveils the Build Back Better plan, investors are asking: how will it be paid for? The answer is likely important for the economy and markets.
As China moves to make good on carbon targets, it will turn increasingly toward a large scale green investment strategy across its economy.
A look at why investors may want to position for a shift from early cycle conditions to more mid-cycle characteristics as the economy heads toward re-opening.
The expectation of increased inflation is stirring concerns among investors, but the actual market for expected inflation suggests the Fed is on the right track.
Amid a generally conservative outlook for emerging markets, key differentiators are their scope for policy action, pace of vaccine rollout and equity valuations.
Most Trump era barriers remain in place and new ones may even be implemented by the current administration. Markets should pay attention.
The Internet sector is more essential than ever. Our analyst looks at where pandemic habits will be stickiest and where the return to ‘normal’ may limit it.
We forecast a shorter and hotter business cycle than the consensus estimates, suggesting a move to mid-cycle portfolio positions earlier than expected.
Chief Cross-Asset Strategist Andrew Sheets and Biotech equity analyst Matthew Harrison continue their conversation, with a focus on international progress for COVID-19 vaccinations.
Chief Cross-Asset Strategist Andrew Sheets talks with Biotech equity analyst Matthew Harrison on dose availability, vaccine hesitancy and the timeline for herd immunity.
It may be hard for investors to conceptualize how substantial the impact of the American Rescue Plan Act may be, but three numbers provide perspective.
With the rapid recovery of the U.S. economy, it is possible that inflation will overshoot the Fed’s tolerances by as early as mid-2022.
After almost a year of extraordinary outperformance, could small caps could see more difficulties ahead as re-opening dynamics up the risk of cost pressures?
With global growth set to exceed expectations in 2021, emerging markets assets would appear set for outperformance. But this year, three factors cloud that narrative.
Conversations around the “Build Back Better” U.S. infrastructure plan are ramping up. What do investors need to know about its potential impact on markets?
Why the ongoing dynamics of trade, fiscal policy, taxation and geopolitical tensions mean investors need to focus on more than just the Fed and the business cycle.
Ahead of a possible re-opening, which companies might retain gains seen in the pandemic, which will revert to pre-COVID norms and which are mispriced?
The current correction may be driven in part by the rise in U.S. Treasuries yields, but Chief Investment Officer Mike Wilson still sees a bull market in the value and more cyclically exposed equity categories.
Do higher interest rates invariably lead to weaker equities and credit markets? The answer is a bit more complicated after factoring in economic optimism.
Home prices have been steadily climbing all across the U.S. How should Americans think about home prices, rising interest rates and affordability?
The stage is set for the Biden administration’s major infrastructure and environment initiative. Here's what investors need to know about the road ahead.
Although a shift to higher interest rates is noteworthy, historically, rising rates coupled with rising inflation may actually suggest better performance for some risk assets.
Which sectors could benefit from an era of rising inflation and higher interest rates? Chief Investment Officer Mike Wilson shares the outlook for investors.
Some traditional market aphorisms seem to have been in abeyance, but with bond yields rising, the old rules are starting to apply again.
What really happened during the Texas grid crisis and what does it say about the transition to clean energy and the future of utilities in America?
Although markets appear more confident that U.S-Mexico trade tensions are largely in the past, investors shouldn't discount potential risks.
Media and entertainment had a tricky 2020 with lockdowns pulling forward years of growth for some companies—and challenges to others. So, what happens now?
U.S. equities markets have continued to perform well, fueled by upbeat earnings and vaccination news. However, that’s often when surprises arise.
Whether the anticipated fiscal stimulus in the U.S. will be enough to push the economy into inflationary territory, and if we should be concerned about it, is a matter of much debate. Chief Cross-Asset Strategist Andrew Sheets discusses.
Recessions can create long-term scars on labor, investment and the pace of innovation. Is Europe more prepared to lessen COVID-related economic scarring than in past crises?
Concerns about the state of U.S.-China trade relations dominated investor thinking in 2018 and 2019. What’s the path forward for the Biden administration?
The scientific race toward quantum communication is already underway. A look at why the global space economy will be critical to its development.
Gold is sometimes perceived by investors as a good hedge against inflation, however its track record in this capacity is worth a closer look.
We dive into what’s ahead amid competing news headlines on the improving pace of vaccinations and worries over new variants.
Michael Zezas, Head of U.S. Public Policy Research and Matthew Hornbach, Global Head of Macro Strategy, discuss the impact of stimulus and inflation on fixed income markets.
If you’re not familiar with the concept of a high-pressure economy, now might be a good time to get acquainted. A new forecast for the U.S. economy.
Historically speaking, as goes January, so goes the year. Here’s why higher volatility and dispersion of returns between sectors and stocks may define 2021.
10-yr bond yields could rise by about 0.5% in 2021, but the potentially record amount of government bond issuance may not be the driver.
Two big stories are underway in oil and energy markets: changing supply and demand factors amid COVID-19 vaccinations and the impact of ESG considerations. We dive into both.
Republicans and Democrats are still far apart on the shape of a new fiscal stimulus bill, but that doesn’t mean a pathway to passage isn’t emerging.
What Asia tech trends should investors be watching in the year ahead? Shawn Kim, Head of Asia Technology Research, shares five key themes for 2021.
Although last week's market correction was long overdue (and perhaps not finished), two differences separate the tech bubble of 1999-2000 and the present.
A handful of heavily shorted stocks took markets for a bit of ride this week. Does it say something larger about the future direction of equities markets?
On this episode, we look at the evolution of U.S. consumer spending trends—and parallel investment themes—as COVID-19 vaccines roll out this year.
When it comes to the next round of U.S. fiscal stimulus, in the near term it may be the journey that moves markets, not the destination.
It’s hard to ignore that pockets of excess have developed in financial markets. While past is not always prologue, a look back at the global financial crisis and tech bubble of 1999 provides perspective.
Data on housing supply, demand, affordability and credit availability paint an optimistic picture for U.S. housing. We dive into the outlook for residential credit and agency mortgage markets.
Investors are keeping a worried eye on the pandemic, expensive stock valuations and potentially higher inflation. But even in these areas there may be cause for optimism.
As a Democratic administration takes the reins in the White House and Congress, what policy moves should investors expect?
Investors have become infatuated with the S&P 500, but a rotation to new leadership suggests a look toward stocks that have been off the radar.
As Congress and a new administration ponder new stimulus to navigate the pandemic, what will 2021 look like for FX and government bond markets?
Rising yields and inflation can create anxiety for investors, but the impact depends on why they’re rising. Chief Cross-Asset Strategist Andrew Sheets explains.
As vaccines continue to roll out and the world eyes a return to normal, several key themes are emerging that could shape investment returns.
Does a robust recovery in 2021 spell the end of European Central Bank action? One inconvenient fact may stand in the way: the lackluster rise in inflation.
Although 2021 is likely to be a better year economically, asset markets may not repeat the remarkable run of the past 9 months. So where should investors look?
Why a reflationary backdrop in 2021 could provide a boost to Europe’s cyclical value stocks. A look at the year ahead with Graham Secker, Head of the European and UK Equity Strategy Team.
Chief Cross-Asset Strategist Andrew Sheets explains why a Democrat sweep of Congress and the White House suggests more reflation and rotation in portfolios.
With wins called for both Senate runoff elections in Georgia, Democrats are poised to control the Presidency and both chambers of Congress. What does this mean for further stimulus?
With Brexit finally a reality, Chief Economic Advisor Reza Moghadam details key elements of the agreement—and the resulting market implications for the EU and UK.
With valuations high, where will markets look to discount next? A look at some key themes developing in this new bull market.
Two events could change the trajectory of fiscal policy in 2021: the need to raise the debt ceiling and the coming expiry of key corporate tax breaks.
On this special edition of the podcast, we discuss the outlook for sustainability and ESG investing in 2021 with some key themes for investors to watch.
Markets often don't need a concrete reason to sell-off or rally. Sometimes it's just exhaustion of a trend that has carried too far.
A look at why investors should be mindful that seemingly small changes in yields can mean big swings in the prices of assets.
Vishy Tirupattur, Head of Fixed Income Research, talks with Andrew Sheets about why corporate credit investors could see better returns in the high yield space in 2021.
Bond investors may want to watch Georgia’s upcoming Senate runoff elections since Democrat wins could mean more fiscal expansion… and a potential fall for bond prices.
Why COVID-19, tech disruption and a shift to a more multipolar world may require a more tactical approach to the region in 2021.
Small caps and cyclicals outperformed significantly this year, particularly after announcement of a vaccine. Which factors could see momentum in 2021?
Although the first COVID-19 vaccine has now begun distribution in the U.S., the country still faces alarming numbers of new cases. We dive into the logistics of mass vaccination.
Many are skeptical of substantial rise in long term interest rates in the coming year, but we think market pressures will push them up more than the consensus and that the Fed will not get in the way. Chief Cross-Asset Strategist Andrew Sheets explains.
Congress is making progress on a COVID fiscal relief package, but previous efforts to strike a deal haven’t borne fruit. Why this time may be different.
Despite a year of high uncertainty, 2020 may end as a strong year for nearly every asset class—which means it may be time to step back and take a breath.
Corporate credit defaults have been relatively low considering the outsized shock of COVID-19. Do muted default rates also mean a muted recovery?
Will a Biden administration mean a reduction of trade barriers between the U.S. and China. The answer for investors: like most questions on trade, it’s a bit nuanced.
China’s consumers could emerge as a key GDP growth driver in 2021, fueled by COVID-19 vaccine availability, a recovery in the job market and pent-up savings by households.
Markets have spent November celebrating upbeat vaccine news and closure on U.S. election uncertainty. After a strong month, are equities headed for another reset?
Emerging market assets are poised to redeem some of their historic underperformance in 2021, but not all assets and indices in the class are equally positioned to take advantage of the cyclical upturn. Chief Cross-Asset Strategist Andrew Sheets explains.
A rare open disagreement between the Fed and the Treasury may have policy implications in the longer term. Michael Zezas, Head of U.S. Public Policy Research, explains.
Although the U.S. faces a challenging winter, vaccine availability and momentum could propel the economy to expand an impressive 6% in 2021. The forecast for investors.
As Thanksgiving approaches in the U.S., it’s worth taking a moment to be thankful for potential vaccines, a remarkably resilient economy and the strength of the human spirit.
Global economies are set for next phase of a V-shaped recovery in both developed and emerging markets. Why that could be good news for equities and credit markets.
Washington D.C. has become increasingly interested in tech regulation, but what’s the likelihood in the next two years? And what could it mean for tech stocks?
Although near-term worries about the coronavirus and higher interest rates could challenge company valuations, the 12-month U.S. equities outlook may be just what the doctor ordered.
Confidence in the ability of central bank to suppress market volatility through aggressive policy may be misplaced.
G10 central banks could inject another $2.8 trillion of liquidity next year—over twice the amount in any year prior to this one. How will this impact rates and currencies?
Although improving economic growth and rising inflation could present challenges for bond investors, “re-opening” could bring benefit for municipal bonds.
Although COVID-19 new case rates have been climbing in Europe, the impact of this second wave may not be as severe this time around.
Upbeat news on a coronavirus vaccine and a win for President-elect Biden drive stocks significantly higher. How should investors trade a potentially earlier re-opening?
All eyes are on the U.S. Presidential race as markets also weigh climbing coronavirus cases in the U.S., fiscal stimulus uncertainty and October’s jobs report.
Amidst the uncertainty, three topics should be front of mind for investors: implications of a divided government, the path to fiscal stimulus and tax changes.
Although some volatility may lie ahead, the end of the U.S. election cycle and progress on a potential coronavirus vaccine may bring some optimism to markets.
A look at the 2008 and 2016 U.S. elections suggests that a sweep by either Democrats or Republicans could push stocks and bond yields higher in 2021.
For investors, election night could hinge on moments when markets conclude who has won, not necessarily on when media networks call a winner.
U.S. equity markets have been stuck range bound due to three key concerns, but investors could use that uncertainty to their advantage.
In part two of our special election episode, we look at the policies that could potentially come out of divided party control among the White House, Senate and House, and how they might impact markets.
What is the road ahead for global markets between now and inauguration day? The answer may fall into two categories: straightaways and detours. Part one of a special two-part episode.
The yields on 10-year and 30-year Treasuries are now at multi-month highs, prompting some investors to ask “What’s going on?” Analysis from Head of U.S. Public Policy Michael Zezas.
Uncertainty about fiscal stimulus, the U.S. election and the pandemic could mean the correction isn’t over. However, one thematic opportunity could present itself.
Although many investors view markets as a highly efficient prognostic machine, the surprises of the 2016 election may have created more hesitancy to guess election outcomes.
On this Special Episode, Chief U.S. Economist Ellen Zentner talks with U.S. Equity Strategist Adam Virgadamo about the path to recovery and mispriced “reopening stocks.”
Although it’s possible that the results of the 2020 U.S. election won’t come on Nov. 3rd, there is some fresh evidence that it may unfold more smoothly than pundits predict.
Although there is uncertainty over new stimulus, a potential coronavirus second wave and the upcoming election, investors can use market volatility to their advantage.
Do tech-driven energy efficiencies—coupled with a shift in environmental attitudes—mean oil demand will fail to recover to pre-COVID levels?
With mixed signals coming from the White House and Congress, should investors be concerned about no further stimulus? Why there may still be good news.
With a U.S. fiscal stimulus deal looking more likely, the risk of long-term interest rates moving higher has now increased—a shift that could benefit recovery stocks.
For markets, a vaccine may be the most significant sign the world may return to a more normal future. But what are markets pricing in currently?
COVID-19 vaccines are navigating through the last stage of clinical trials, but hurdles still lie ahead for efficacy, distribution and FDA approval.
How will markets react if final U.S. election results take days or weeks? Head of U.S. Public Policy Research Michael Zezas shares advice for investors.
The recent correction may have been inevitable given rising risks for fiscal stimulus, a potential COVID-19 second wave and the upcoming election. But a resolution to these hurdles may also be possible longer-term.
Despite a needed correction in recent weeks, a suite of significant risks still hangs over U.S. markets. Chief Cross-Asset Strategist Andrew Sheets explains.
As hopes for an additional stimulus package wane in the run-up to the U.S. elections, some of the less likely paths to a deal may provide a way out of the current correction. Michael Zezas, Head of U.S. Public Policy Research, explains.
Action by Congress and the Fed, and its absence, has paved the way for the recent downturn in equities, putting markets back on a more sustainable footing. Chief Investment Officer Mike Wilson explains.
This week, the Fed announced a new framework that could keep interest rates unusually low. So why did markets collectively yawn at the announcement?
On this special edition of the podcast, Jessica Alsford, Head of the Global Sustainability Research Team talks with Michael Zezas about the important role ETFs are playing for ESG investing.
Why gridlock on the next U.S stimulus package—combined with election year uncertainty—suggests there could be more downside in September and October.
A downward adjustment in some high-flying U.S. tech stocks has put investors on edge this month, but an impasse on fiscal stimulus negotiations may be the real issue to watch.
As COVID-19 vaccine development continues in phase three studies, the logistics of FDA approvals, production and the complex hurdles of distribution are taking shape.
Could a possible delay in U.S. election night results mean volatility as markets price various outcomes for policies that impact sectors?
Although the current market correction is not wholly surprising given the outsized rally in August, what was the ultimate trigger… and what's next?
How to explain the steady, almost mechanical rise in markets despite often weak economic data? It may come down to expectations and trend lines.
Although consensus sees long-term interest rates staying low, could a potential $2 trillion fiscal stimulus mean rates will rise more (and faster) than markets currently expect?
Just how big would a state and local U.S. stimulus package need to be to support a V-shaped recovery and avoid credit downgrades?
China’s recovery could be progressing better than markets expected as consumers spend more money onshore and the nation’s export engine gains market share.
Chief Investment Officer Mike Wilson says although we’re likely at the beginning of a years-long cyclical bull market, one signal could be telling us that a correction is always possible.
Markets are pricing years of lower inflation due to fallout from the pandemic. But a simple barbershop visit illustrates why that view is worth examining.
Although U.S. presidential candidate Joe Biden has proposed an increase in corporate taxes, how likely are they to pass in their current form?
Although marketplace consensus believes that long-term interest rates are set to stay lower for longer, five factors suggest higher long-term rates could be ahead.
Markets have been surprisingly strong of late given the delay in further stimulus in the U.S.. Chief Cross-Asset Strategist Andrew Sheets discusses the potential causes and why a note of caution may be in order for investors.
Is it the end of the road for more economic aid from Congress this year? Michael Zezas, Head of U.S. Public Policy Research breaks down the impasse and outcomes.
After intense negotiations, European leaders have reached a historic coronavirus recovery deal. However, the hardest challenge may lie ahead: How to spend the resources wisely.
Chief Cross-Asset Strategist Andrew Sheets says although their base case for continued market strength is measured, there is an argument to be made for a bull case forecast.
Growth in money supply is one of the most powerful indicators for rising inflation—and it's currently rising at record levels. How should investors position portfolios?
With the precipitous drop in U.S. GDP and the effects of monetary and fiscal interventions, the rest of third quarter may be a moment for investors to take a breather.
As tensions between the U.S. and China tick higher, investors are weighing the chances of a potential U.S.-China economic decoupling—and what it might look like.
The impact of COVID-19 on consumer behavior and macro trends will likely affect investing fundamentals for years to come. Our experts weigh in on several high-level themes for investors.
Some U.S. stocks have reaped the benefits of a pull forward in demand thanks to effects of the pandemic. But with valuations rich, is a correction now ahead?
In the second of a special two-part episode, we talk with biotech equity analyst Matthew Harrison about market response to new data in the race for a vaccine.
In the first of a special two part episode, we talk with biotech equity analyst Matthew Harrison about new case projections ahead of fall and flu season.
Local and state governments across the U.S. are eagerly watching whether a new round of stimulus will help them address budget shortfalls. Will Congress deliver?
Understanding the regime of financial repression we are under, and recent changes in it, is key for successful investment. Chief Investment Officer, Mike Wilson explains.
While July contains a number of potentially positive market events, August and September could present a number of potentially problematic ones.
Could a new $1 trillion stimulus deal make its way through the halls of Congress before the summer recess? Why the likelihood of a deal is increasing.
U.S. equities—tech stocks in particular—have powered higher since March lows, but investors are still parsing Q2 earnings, a coming election and rising COVID-19 cases.
The sharp rebound in stock and corporate bond markets has made some question if markets are a bit too upbeat about a speedy recovery. There’s just one problem with this view.
Although the U.S. election is anything but predictable four months away, investors may still want to consider how markets would react to a Democrat sweep.
While excessive inflation can be disruptive, such as in the 1970’s, a deflationary mindset can often be more destructive—and difficult to reverse. What current inflation trends mean for investors.
Although Alexander Hamilton couldn’t have foreseen the current health crisis facing the U.S., his ideas remain relevant—and key to the recovery—more than 200 years later.
Although a worrying trend in new U.S. COIVD-19 cases has some investors understandably bearish, they may be overlooking two key points about earnings and sentiment.
Europe’s response to the coronavirus pandemic—both in managing the outbreak and in policy response—has been strong. Here’s what it means for asset classes in the region.
How should investors think about the recovery as the U.S. balances reopening with concerns over a second wave of coronavirus infections?
How should investors view a world where there may be room for more than one norm when it comes the balance of power among economies and commerce?
Many investors are still looking at the current recession as an anomaly rather than as the end of a cycle. Chief Investment Officer Mike Wilson explains the implications.
While the macro events of the last few months are certainly extreme by the standards of history, the current business cycle may be more normal than is appreciated.
Two common doubts about another round of fiscal stimulus center on the politics of passage and election year strategy. Here’s why Congress could agree on a package.
Equity markets became a bit frothy during early June as optimism over a recovery took hold. So while a correction may be afoot, it isn’t atypical for a young bull market.
The proposed €750 billion European Recovery Fund could represent more than just a recovery from COVID-19. It may also signal a new era of political and economic unity.
Policymakers and voters may care about deficits, but reducing current spending may not be a priority over other issues—and right now that may be a plus for the economy.
Over the last decade, global investors have been lukewarm toward European assets, but three encouraging developments may be set to change that investing narrative.
Depressed 10-year Treasury yields and a strong dollar have tempered the bullish outlook for U.S. equities. But a shift in both suggests a V-shape recovery could be more likely.
Why are markets climbing despite a pandemic and this week’s demonstrations across the U.S.? The answer may lie with how markets view progress.
Large cap biotech analyst Matthew Harrison talks with Chief Cross-Asset Strategist Andrew Sheets to discuss the latest timeline for a coronavirus vaccine, hurdles to success and possible market reactions.
Although market volatility continues to decrease, the volatility of popular momentum strategies is increasing—which suggests a coming rotation to early cycle stocks.
Although the impact of the coronavirus on markets, economies and jobs is truly unprecedented, it doesn’t mean investing precedents don’t still apply.
As U.S. states cope with challenged finances due to the coronavirus, could some look to online gaming to fill budget gaps?
Although the coronavirus recession shares traits with the 2008 financial crisis and other recessions, the rate and sustainability of a recovery could be quite different this cycle.
Will pent-up demand from U.S. consumers help drive a recovery from the coronavirus recession? A special conversation with our Chief Investment Officer and Chief U.S. Economist.
Why would inflation rise since the current recession means an acute shortage of demand for goods and services? Chief Cross-Asset Strategist Andrew Sheets explains.
Congress is weighing another round of fiscal stimulus, possibly by July. But the dynamics of passage in an election year could mean a narrow window to take action.
Current stock market price patterns look surprisingly similar to 2009 and the global financial crisis. The big difference for investors may be the knock-on effect of low interest rates.
As markets have begun to price expectations for negative rates in Britain and the U.S., Chief Cross-Asset Strategist Andrew Sheets breaks down the potential impact on consumers, savers and economic growth.
What China’s rebound from COVID-19 can—and can’t—tell us about the path, speed and pitfalls of economic reopening for other countries. Chief China Economist Robin Xing and Chief Cross-Asset Strategist Andrew Sheets look at the data, lessons so far, and how the country has had to modify its crisis playbook.
Can the Phase One trade deal détente stand, or will the U.S. and China return to a cycle of escalating tariffs that may impact prospects of a rebound in economic growth? Michael Zezas, Head of Public Policy Research and Municipal Strategy, takes a closer look.
Amid investor speculation about the shape of a recovery, Chief Investment Officer Mike Wilson urges a standard recession playbook.
How should an investor evaluate the issue of high levels of government debt as nations battle the impact of the coronavirus? A deep dive into the debate.
How can we best coordinate policy to support a timely recovery and what lessons can we learn from the past? Chief Global Economist Chetan Ahya and Chief Cross Asset Strategist Andrew Sheets discuss the policy path back from the global economic crisis brought on by COVID-19.
The hole in U.S. state budgets caused by coronavirus-driven revenue shortfalls will likely affect more than just muni bond investors. Head of Public Policy Michael Zezas explains.
As the rally in U.S. equities takes a break, investors may want to position for "early cycle." And that means re-thinking portfolios just as downbeat economic and earnings data arrives.
Why did April’s stock market gains seem oddly disconnected from recent poor economic data? Chief Cross Asset Strategist Andrew Sheets has the answer.
Consensus on the dollar has been bearish for years, only to be proven wrong time after time. But Global Head of Macro Strategy Matthew Hornbach says the mechanics of supply and demand could change that outcome.
As Congress debates aid for state governments, for investors, the principal concern is that a lack of additional federal aid might further depress state spending and drag on economic growth.
As some states begin to loosen quarantine restrictions, "stay at home stocks" may no longer be the place to be. Chief Investment Officer Mike Wilson explains.
Investment strategies tied to the business cycle are still relevant, especially as our key internal indicator shows the cycle has moved into a new phase. Andrew Sheets, Chief Cross-Asset Strategist, makes the case.
Congress has readied more funds to support U.S. businesses and households in order to shorten the pandemic-induced downturn. How far will they go? Chief U.S. Economist Ellen Zentner and Head of Public Policy Research Michael Zezas discuss the scale of the stimulus and its limits.
Congress has readied more funds to support U.S. businesses and households in order to shorten the pandemic-induced downturn. How far will they go? Chief U.S. Economist Ellen Zentner and Head of Public Policy Research Michael Zezas discuss the scale of the stimulus and its limits.
Although it remains to be seen how fast the U.S. can “re-open,” in the near term, markets may be betting on an economy that will normalize faster than feared.
The steep decline in oil prices is a fascinating story of demand, supply and even game theory. But Chief Cross-Asset Strategist Andrew Sheets says that story could reverse next year.
Emerging markets recovered quickly from the 2008 financial crisis, but could a more challenging backdrop in 2020 mean a different outcome this time? Insights from Chief Economic Adviser Reza Moghadam.
For investors in municipal bonds, the Fed’s recent creation of the Municipal Liquidity Facility and Mainstreet Lending Facility are a key positive. Head of Municipal Strategy Michael Zezas explains why.
When do we return to work? The market reaction? The drug pipeline? Chief Cross-Asset Strategist Andrew Sheets and Head Biotech Equity Analyst Matthew Harrison continue their discussion on the impact of the Covid-19 pandemic.
If there is one lesson to be learned from the financial repression era it's that when risk premium appears, investors may want to make moves before it evaporates.
How do you track a virus, a global economy and a road to recovery? On this special episode, an engaging conversation with our Chief Cross-Asset Strategist and Head Biotech Equity Analyst.
The U.S. Congress has been debating ways to flatten another worrying curve: the sliding economic growth curve. What form could additional fiscal stimulus take?
Asset prices often reflect the obvious before it becomes obvious. So the question for investors now is, "What is the market thinking about that's not obvious?"
Even as economic and public health data get worse, recent changes in three key factors make global credit markets an attractive option. Our Chief Cross-Asset Strategist, Andrew Sheets, explains.
The $2 trillion CARES Act includes a variety of provisions that will help preserve the financial health of state and local governments, hospitals and airports. Here’s what’s inside.
Although economic and earnings data could be gloomy over the next month, have equity markets already discounted the bad news? Detailed analysis from Chief Investment Officer Mike Wilson.
Governments and central banks face two issues: A flight to liquidity and a global economy that showed signs of fatigue even before the pandemic. For investors seeking opportunities, it’s an important distinction.
As a record 3.28 million workers file for unemployment, our Chief U.S. Economist and Chief U.S. Public Policy researcher weigh potential effects from the fiscal package now before Congress.
Congressional leaders have reached a deal on a $2 trillion stimulus bill to deal with fallout from the coronavirus crisis. Will it work? Two criteria to watch for.
Mike Wilson looks beyond the coronavirus outbreak at the two key conditions which have made the markets vulnerable to a recession.
On this episode, Chief Cross-Asset Strategist Andrew Sheets says that the 4%+ swings in equities markets have made investors skeptical about jumping back in. More U.S. testing could help.
Although the sell-off may not be over and the global economy has tough days ahead, a growing number of factors suggest that risk/reward in markets may be getting better.
As central banks and governments weigh a litany of stimulus efforts, what could the journey to economic recovery look like? Our Chief U.S. Economist and Head of U.S. Public Policy Research sum up the debates.
When markets get volatile, strange things start to happen in markets you might not expect. That's both a sign of stress, and in some cases, a sign of opportunity.
Just three months ago, market expectations were likely overoptimistic. That's how tops are made. Today, they are maybe too pessimistic… and that's how bottoms are made.
Although current market swings suggest that we are in serious, unpredictable times, a look through market history may reveal where we’re headed next.
The dual challenges of the coronavirus and the collapse of the OPEC plus arrangement intensifies the need for a fiscal response from Washington. Head of Public Policy Research Michael Zezas explains.
Investors reacted strongly as oil prices and coronavirus worries disrupted markets. Chief Cross-Asset Strategist Andrew Sheets and Chief U.S. Economist Ellen Zentner debate what’s next.
The recent correction in equity markets suggests that the fourth quarter rally in 2019 may have been a false breakout—and the rolling bear has unfinished business.
Two competing forces—hopes for further central bank moves vs. coronavirus uncertainty—are driving a notable rise in volatility. What signal should investors watch for signs of a potential rebound?
From an investment standpoint, are there lessons to be learned from Joe Biden’s strong showing on Super Tuesday? Yes, but not the ones you might think.
U.S. stocks fell Tuesday despite a half point rate cut by the Fed. Is conventional wisdom wrong that lower interest rates and central bank support are positives for stocks?
Global equity markets have endured several days of losses as worries over the coronavirus continue. The question for many investors is “What to do now?”
Markets have spent the week increasingly concerned about the coronavirus, but Chief Investment Officer Mike Wilson says there’s a lot more going on beyond the headlines.
Senator Bernie Sanders’ recent primary wins are causing some to debate the impact of potential new health care reform on markets. Head of U.S. Public Policy Research Michael Zezas shares three insights.
In a world of low interest rates and low growth expectations, one portfolio strategy seems likely to continue working for investors. Chief Investment Officer Mike Wilson explains.
Although current stock market performance suggests strong economic health, below the surface the story looks a bit different. Chief Cross Asset Strategist Andrew Sheets explains.
On today's episode: The impact of the coronavirus underscores the risks of unexpected disruptions of global supply chains. A look at the cost-benefits of globalization.
On today's episode: Investors are faced with a number of uncertainties from public health concerns to trade to central bank policy. But as the year plays out, those uncertainties could actually grow.
On today's episode: With no shortage of pundits weighing in on the Democratic primaries, it’s easy for investors to lean on assumptions. But Head of Public Policy Research Michael Zezas suggests some caution.
On today's episode: The recent, relatively small, overall market correction masks more significant shifts between asset classes. Mike Wilson, Chief Investment Officer, on the implications for our understanding of market optimism and future growth.
On today's episode, Discussions about financial markets often center on issues of demand. Andrew Sheets takes a look at the supply trends that may impact debt and equity markets globally in 2020.
On today's episode, Recent events have added little clarity to the policy choices U.S. voters will face in the November presidential elections, but that won't last forever.
On today's episode, U.S. equities face concerns over global growth—caused by the coronavirus and other catalysts—but plentiful liquidity from the Fed. Thoughts on positioning from Chief Investment Officer Mike Wilson.
On today's episode, To understand the impact of the Coronavirus on humanity, economics and markets, Chief Asia and Emerging Markets Equity Strategist Jonathan Garner draws parallels with the 2002 SARS outbreak.
On today's episode, Nations try to address the public health impact of the coronavirus alongside uncertainty about the global outlook for 2020. Perspective from Andrew Sheets, Chief Cross-Asset Strategist.
On today's episode, Only a decade ago, market analysts and political observers were saying sovereign deficits were bad. Cross-Asset Strategist Andrew Sheets explains why that view may be changing.
On today's episode, Although the U.S and China have found a way forward on trade negotiations, a clear path for U.S.-EU trade is getting slightly more complicated.
On today's episode, Skepticism was the prevailing investor attitude for most of 2019, but what a difference a quarter can make. So what changed? Chief Cross-Asset Strategist Andrew Sheets talks changing sentiment as 2020 kicks off.
On today's episode, How reliable is the maxim that a good economy means a presidential incumbent re-election? Head of U.S. Public Policy Michael Zezas looks at history.
On today's episode, Progress on trade and Brexit, upbeat sentiment and central bank support have investors optimistic on the bull case narrative. Even so, it’s worth a quick inspection for surprises.
On today's episode, Central bank support and low interest rates helped drive markets higher in 2019 despite lackluster earnings. But 2020 could remind investors why earnings trends are still what matters.
On today's episode, Although negotiations are progressing for U.S-China trade, investors shouldn’t overlook possible tensions with another key trading region: The EU.
Jonathan Garner, Chief Asia and Emerging Markets equity strategist kicks off his premiere episode with what is likely the most interesting—and overlooked—turnaround story in equity markets.
On today's episode, Rising labor, regulatory and cyber security costs are weighing heavily on many small caps. Is corporate income inequality as urgent an issue as individual inequality?
On today's episode, Geopolitical tensions have driven oil prices—and volatility—higher. But a quick glance at 2022 oil futures prices can tell us a lot about the market’s longer-term view.
On today's episode, As a Phase One trade deal nears completion, can investors worry less about the risks of tariff escalations? Not so fast, says head of U.S. public policy Michael Zezas.
On today's episode, As 2020 begins, central bank moves and reawakened geopolitical risk promise to be key market catalysts. Chief Investment Officer Mike Wilson details the potential impact on portfolios.
On today's episode, For three and a half years, Brexit has been a source of uncertainty for the United Kingdom and its markets. Now, with some business uncertainty reduced, a new narrative may be emerging.
On today's episode, why escalating labor costs, deglobalization and central bank policies may mean positioning portfolios toward stocks that benefit from rising inflation.
On today's episode, What important factors from 2019 could give investors context on the investing climate ahead? Consider valuations, policy and inflation.
On today's episode, What will the U.S-China “Phase One” trade deal mean for the global economy, corporate confidence and markets? Head of U.S. Public Policy Michael Zezas weighs in.
On today's episode, A dovish Fed, progress on trade and a path toward a potentially orderly Brexit are driving global equities higher but how much of the global recovery is already priced?
In this special two part bull/bear series, Chief Cross-Asset Strategist Andrew Sheets shares insight on the catalysts that could drive strong market returns in 2020.
On this episode with special guest Chetan Ahya, the firm’s Chief Global Economist, Trade tensions have put a damper on global manufacturing, but is the tide poised to turn after the first broad-based sentiment uptick in seven months?
On today's episode, Although some reports have suggested progress on a phase one deal, markets are still seeking a clear signal forward on trade—and that means tackling the more difficult phase two deal.
On today's episode, Central banks seem likely to continue their balance sheet expansion into next year, driving lower volatility, more cash into equities… and some great expectations.
In this special two part bull/bear series, Chief Cross-Asset Strategist Andrew Sheets shares insight on the catalysts that could hamper market returns in 2020.
On today's episode, On average, election-year market performance varies by about 9% for elections that are narrow contests vs. elections with a clear frontrunner. So how could 2020 pan out?
On today's episode, Whether it's called quantitative easing or not, the recent expansion in central bank balance sheets is having a profound impact on volatility - Chief Investment Officer Mike Wilson explains why.
On today's episode, With a key deadline for U.S. tariffs on EU autos now past, could European stocks outperform in 2020? Head of Public Policy Michael Zezas shares some analysis.
On this episode, Chief Investment Officer Mike Wilson explains why global reflation may be back—and could be a powerful longer-term theme for portfolio allocations.
On this episode, Chief Cross-Asset Strategist Andrew Sheets says oversupply may spell headwinds for commodities in 2020 but there are exceptions.
On this episode, Head of Public Policy Michael Zezas says performance in four key sectors could be a bellwether for how investors view the outcome of next year’s elections.
On this episode, Chief Cross-Asset Strategist Andrew Sheets says global growth should pick up in 2020, but unevenly. The key for investors will be identifying the right opportunities.
On this episode, Chief Cross-Asset Strategist Andrew Sheets analyzes the historical phenomenon of the “end-of-year equities rally.” Will 2019 follow suit?
On this episode, Head of U.S. Public Policy Michael Zezas says a potential boost to the U.S. economy has less to do with political parties than it does a unified policy vision.
On this episode, Chief Investment Officer Mike Wilson shares three reasons why equities markets have rallied over the past few months… and where they could go from here.
On this episode, Chief-Cross Asset Strategist Andrew Sheets continues his discussion on the 10-year outlook for the U.S. and Europe—and identifies the challenges ahead.
On this episode, Head of U.S. Public Policy Michael Zezas says one thing has become clear as we approach 2020: Investors need to plan today for market reactions next year.
On this episode, special guest Chetan Ahya, the firm’s Chief Global Economist, says a global growth recovery could be possible in 2020… assuming two key forces align.
On this episode, Chief Investment Officer Mike Wilson says the jury may be out on whether we’re at a trough for the U.S. economy, but two international markets may hold promise for investors.
On today's episode, Chief Cross-Asset Strategist Andrew Sheets takes a look at expected market returns over the next decade and explains how current policy affects future returns.
On today's episode, Head of U.S. Public Policy Michael Zezas takes a look at transformative policy proposals by 2020 Presidential candidates. How could big policies like Medicare-for-All reshape markets?
On today’s episode, a curious paradox: Although major indices are making new highs, many defensive stocks are leading the pack. Chief Investment Officer Mike Wilson explains why.
On today's episode, Optimism in markets has risen significantly over the past three weeks. But Chief-Across Asset Strategist Andrew Sheets asks, “Is optimism enough?”
On this episode, Head of U.S. Public Policy Michael Zezas explains why a global growth rebound could largely hinge on trade negotiations ahead of the December 15th tariffs.
On today's episode, Chief Investment Officer Mike Wilson says investors may want to steer clear of expensive growth stocks in favor of some defensive and cheaper-priced stocks.
On today’s episode, Chief Cross Asset Strategist Andrew Sheets highlights the one market in which the currency, government bonds and equities may all be solid defensive plays.
On today’s episode, Head of Public Policy Michael Zezas says unlike prior tariff pauses, the “phase one” agreement could have durability. However, much uncertainty remains.
On today's episode, Chief Investment Officer Mike Wilson says the U.S.-China trade deal is a step in the right direction, but the real story is still the corporate profits outlook.
On today's episode, Chief Cross-Asset Strategist Andrew Sheets explains how three of the dollar’s most attractive qualities could be shifting right before our eyes.
On today's episode, Head of U.S. Public Policy Michael Zezas says when it comes to trade, movement toward a meaningful compromise will likely come down to one fundamental variable.
On today’s episode, Chief Investment Officer Mike Wilson says both bulls and bears were likely a bit frustrated trying to trade last week's sell-off and rally. So what’s the next move for investors?
On today's episode, Chief Cross-Asset Strategist Andrew Sheets says despite the myriad models used to assess the direction of markets, three simple indicators may be the most valuable.
On today's episode, A number of trade-related events on the fall calendar could mean progress—or an escalation—on the trade impasse. Head of U.S. Public Policy Michael Zezas provides an overview.
On this special episode, Equity Analyst Richard Hill examines the coming seismic shift for investors as Baby Boomers pass the housing baton to Millennials and Generation Z.
On today’s episode, Chief Investment Officer Mike Wilson explains why markets may be having a change of heart on expensive—and sometimes unprofitable—growth stocks.
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets says oil prices tend to spike for two very different reasons and the distinction for investors is quite important.
On today's episode, Head of U.S. Public Policy Michael Zezas takes a look at transformative policy proposals by 2020 Presidential candidates. How could big policies like Medicare-for-All reshape markets?
On this special episode, Betsy Graseck, global head of banking research, explains how Millennials and Gen Z are reshaping the financial industry in their tech-savvy, mobile-first image.
On today’s podcast, investors are watching for progress on trade and signs of future Fed policy. But according to Chief Investment Officer Mike Wilson, it still comes down to Q3 earnings season.
On today's episode, Chief Cross-Asset Strategist Andrew Sheets says although lower interest rates help boost economic activity, the full impact is more complicated.
On today’s podcast, Head of U.S. Public Policy Michael Zezas says a potential improvement in some key U.S. economic indicators will need real progress on trade—not just headlines.
Which generations spend more: Boomers or Millennials/Gen Z? On this special episode, equity analyst Lauren Cassel takes a look at which sectors stand to gain in the years ahead.
On today’s podcast, Chief Investment Officer Mike Wilson dives into last week’s historic reversal between value and growth stocks. Can the value rally last?
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets asks the timely question, “If lower interest rates stimulate growth, why wouldn’t central banks lower them?”
Is America’s next heyday ahead? On this special episode, Chief U.S. Economist Ellen Zentner explains why America’s youth may be set to power U.S. GDP in the coming years.
On today's podcast, Investors may be feeling some déjà vu as upbeat news on trade drives a new rally. Could markets break out this time or is another correction ahead? Analysis from Chief Investment Officer Mike Wilson.
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets says as global growth weakens, investors tend to focus on the most desirable companies (which are already priced to perfection). So what does that mean for returns?
On today’s podcast, Head of U.S. Public Policy Michael Zezas takes a moment to consider the long-term effects regardless of whether or not the U.S. and China are unable to negotiate a meaningful trade arrangement.
On today's podcast, Chief Investment Officer Mike Wilson says a popular narrative forecasted a rebound for the second half of 2019. However, new data on lower U.S. factory activity could counter that expectation.
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets examines central bank actions to boost markets and the negative effects—intended or not—that these moves could have.
On today’s episode, Head of U.S. Public Policy Michael Zezas explains why a key principle of game theory could help investors navigate markets amid rising trade tensions.
On today’s podcast, would stock markets be full steam ahead with a healthy dose of Fed rate cuts or a lack of concerns over trade? Chief Investment Officer Mike Wilson provides some much needed perspective on the rising risks of recession.
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets dives into a key debate on the U.S. economy: How could the risk of recession be rising when consumer activity is so strong?
On today’s podcast: Amid a bond rally and stock volatility, August has been quite a ride. How should investors think about their allocations? Analysis from Michael Zezas, Head of Public Policy and Municipal Strategy.
Mike Wilson is off this week. Please check back Wednesday for more Thoughts on the Market.
On today’s podcast, Chief Across-Asset Strategist Andrew Sheets shares three takeaways from this week’s inversion of the yield curve, historically the signal of a possible recession.
On today’s podcast, Head of U.S. Public Policy and Municipal Strategy Michael Zezas explains how the challenges facing U.S. farmers can provide insight on the current bond market.
On today’s podcast, Chief Investment Officer Mike Wilson identifies several catalysts that could drive increased Q3 volatility. Are markets still facing a correction this quarter?
On today’s podcast, Chief Cross Asset Strategist Andrew Sheets looks at how the expectations markets are placing on central banks, as much as the actions of the banks themselves, are affecting outcomes.
On this episode, Head of Public Policy Research Michael Zezas walks investors through the current impasse on U.S.-China trade. How might new tariffs heighten downside risks for the U.S. economy?
On today’s podcast, Chief Investment Officer Mike Wilson asks whether the Fed rate cut and reemergence of trade tensions rattled markets or simply revealed the possibility of deteriorating fundamentals.
On today's podcast, Markets met the Fed rate cut with a collective shrug. Could investor expectations make it harder for the Fed to succeed? Chief Cross-Asset Strategist Andrew Sheets provides analysis.
On today’s podcast, Head of U.S. Public Policy Michael Zezas examines how continued trade policy uncertainty is weighing on corporate confidence and spending. Is a turning point ahead?
On today’s podcast, Chief Investment Officer Mike Wilson gauges the reaction to a potential Wednesday Fed rate cut. Have markets already priced in any rally?
Morgan Stanley's Carla Harris talks with Charles Hudson, founder and Managing Partner at Precursor Ventures, a seed-stage investor bringing an institutional perspective to startups in the earliest stages of their development.
On today’s podcast, Head of Public Policy and Municipal Strategy Michael Zezas considers the debate between the consensus view of a potential 25 basis point Fed rate cut vs a 50 basis point cut.
On today’s podcast, Chief Investment Officer Mike Wilson says what matters for markets now isn't how much the Fed or other central banks could cut—but why they would cut.
On today’s podcast, Chief Cross-asset Strategist Andrew Sheets digs into three key debates around central bank policy expectations, valuations and investor sentiment.
On today’s podcast, Head of U.S. Public Policy research Michael Zezas asks “Would a Democratic presidential win mean the end of the road for private health care insurance?
On today’s podcast, Chief Investment Officer Mike Wilson says a sustained breakout above 3,000 has eluded the S&P 500. Will the Fed’s potential rate cut be the catalyst?
On this episode, Chief Cross-Asset Strategist Andrew Sheets examines the models for stock performance, and how they are all leading to a similar conclusion.
On today’s podcast, as the 2020 Election nears, healthcare reform is a central debate once again. Head of U.S. Public Policy Michael Zezas shares potential outcomes for patients—and investors.
On today’s podcast, Chief Investment Officer Mike Wilson says markets are typically savvy on how and when to price news events. But are markets overlooking some potential bad news?
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets says that while conditions could line up for market success, the variables that need to align are many and diverse.
On today’s podcast, Head of U.S. Public Policy Michael Zezas says a pause on trade tariffs should be good news for markets and growth, but is the path forward any clearer?
On today’s podcast, markets are cheering this weekend’s pause on U.S.-China trade tensions. But is the potential progress enough to extend the longest business cycle in history?
On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets shares three possible trade outcomes from the G20—and how markets may react to a pause on new tariffs.
In today’s podcast, Head of U.S. Public Policy strategy Michael Zezas discusses how the great debate playing out in markets around trade is about more than direct impacts.
With corporate confidence softening, could movement on U.S.-China trade at the G20 be the catalyst for growth in the second half of the year? Chief Investment Officer Mike Wilson has analysis.
Morgan Stanley's economics team now expects the Fed to cut interest rates by half a percent possibly as soon as July. On today’s podcast, Chief Cross-Asset Strategist Andrew Sheets examines how markets could react.
On today’s podcast, Head of U.S. Public Policy strategy Michael Zezas says three likely U.S.-China trade scenarios will come out of the G20. But a tariff pause might be the trickiest for investors.
On today’s episode, Chief Investment Officer Mike Wilson shares a readout on the firm’s proprietary Business Conditions Index. Are the data softening more than investors realize?
On today’s podcast, Chief Cross-asset Strategist Andrew Sheets provides a bit of historical perspective on the logic of rooting for weaker data and lower interest rates.
Head of U.S. Public Policy Michael Zezas says that independent of current trade concerns, the trend toward globalized supply chains is fading, as companies respond both to political and market incentives.
Investors and media have been hyper-focused on trade and Fed policymaking. But according to Chief Investment Officer Mike Wilson, some key economic data points are the real story to watch.
On today’s podcast, Chief Cross-asset Strategist Andrew Sheets says that while discussion of a Fed rate cut may have helped markets rebound, several longer-term signals are troubling.
On today’s episode, Head of U.S. Public Policy Michael Zezas says further escalation of trade tensions could come with a cost. Are the risks of a global recession increasing?
On today’s TOTM, Chief Investment Officer Mike Wilson says trade tensions may be rattling markets, but the fundamentals are the real culprit behind the correction. So where are equities headed next?
On today’s podcast, Chief Cross Asset Strategist Andrew Sheets examines the notion that the Fed stands willing and able to reduce interest rates and support markets.
On today’s episode, Head of U.S. Public Policy Michael Zezas explains why a key principle of game theory could help investors navigate markets amid rising trade tensions.
On today’s podcast, Chief Investment Officer Mike Wilson says although some investors may assume recent equities volatility is based on trade worries, some key data points may be the real culprit.