Thoughts on the Market

With the fight against inflation quieting down in many regions, Asia saw a relatively small step up in inflation. Will that leave 2023 open to the possibility of growth outperformance?

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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 our 2023 outlook for Asia economics. It's Thursday, January 5th at 9 a.m. in Hong Kong. 

If 2022 was all about inflation, we believe 2023 will be about the aftermath of this battle with inflation. All eyes are now on how the world's largest economies will stack up after this battle with inflation. While Asia, along with the rest of the world, face multiple stagflationary shocks in 2022, we think that Asia weathered these shocks better. Indeed, we believe Asia will enter a rapid phase of disinflation and is well-positioned for growth outperformance in 2023. 

The step up in Asia's inflation was smaller compared to other regions. Furthermore, Asia's inflation had more of a cost-push element, meaning it was driven to a large extent by increases in cost of raw materials. And we believe Asia's inflation already peaked in third quarter of 2022. 

Asia's inflation should be rapidly returning towards central bank's comfort zone. We expect this to be the case for 90% of Asian economies by mid 2023. Cost-push factors are fading, resulting in lower food and energy inflation. Core good prices are descending rapidly, given the deflation in goods demand. Moreover, labor markets were not that tight in Asia, and wage growth has remained below its pre-COVID rates. Because of this backdrop, we've argued that central banks in Asia do not need to take policy rates deeper into restrictive territory. 

In fact, all of the central banks in the region will likely stop tightening in first quarter of 2023. This pause in Asia's rate hiking cycle, coupled with an easing in U.S. 10 year bond yields and with the peak of USD behind us, should lead to easier financial conditions in 2023. 

While weak external demand will remain a drag at least through the first half of 2023, Asia's domestic demand is supported by three factors. First, the easing of financial conditions will lift the private sector sentiment. Second, we are witnessing a strong uplift in large economies like India and Indonesia, supported by healthy balance sheets. Finally, China's reopening will lift consumption growth and have a positive effect on economies in the region, principally via the trade channel, helping Asian economies to get onto the path of growth outperformance. We expect Asia's growth to improve from a trough of 2.8% in first quarter of 2023, to 4.9% in second half of 2023, while DM growth will slow from 0.9% in first quarter of 2023 to 0.3% in second half of 23. Growth differentials will likely swing back in Asia's favor, rising back towards the levels last seen in 2017 and 2018. 

There are, of course, risks to our optimistic outlook for Asia. If U.S. inflation stays elevated for longer, this would lead to more tightening by the Fed than is expected and could drive renewed strength in the USD. This in turn would prolong the rate hike cycle in Asia, keeping financial conditions tight and exert downward pressures on growth. A delayed reopening in China could impact China's growth trajectory with adverse spillover implications for the rest of the region. 

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.

The House of Representatives continues its struggle to appoint a new Republican Speaker. What should investors consider as this discord sets the legislative tone for the year?

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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, January 4th, at 10 a.m. in New York. 

The focus in D.C. this week has been on choosing the new speaker of the House of Representatives. Choosing this leader, who largely sets the House's voting and workflow agenda, is a necessary first step to opening a new Congress following an election. This process is usually uneventful, with the party in the majority typically having decided who they'll support long before any formal vote. But this week, something happened, which hasn't in 100 years. The House failed to choose a speaker on the first ballot. As of this recording, we're now three ballots in and the Republican majority has yet to agree on its choice. 

So is this just more DC noise? Or do investors need to be concerned? While it's too early to tell, and there don't appear to be any imminent risks, we think investors should at least take it seriously. The House of Representatives will eventually find a way to choose a speaker, but the Republicans' rare difficulty in doing so suggests it's worth tracking governance risk to the U.S. economic outlook that could manifest later in the year. 

To understand this, we must consider why Republicans have had difficulty choosing a speaker. In short, there's plenty of intraparty disagreement on policy priorities and governance style. And with a thin majority, that means small groups of Republican House members can create the kind of gridlock we're seeing in the speaker's race. This dynamic certainly isn't new, but the speaker's situation suggests it may be worse than in recent years. So whoever does become the next speaker of the House could have, even by recent standards, a higher degree of difficulty keeping their own position and holding the Republican coalition together. 

That's a tricky dynamic when it comes to negotiating on politically complex but economically impactful issues, such as raising the debt ceiling and keeping the government funded, two votes that will likely take place after the summer. 

On both counts, some conservatives have in the past been willing to say they will vote against those actions and in some cases have actually followed through. But aside from the debt ceiling situation in 2011, these votes have largely been protests and did not result in key policy changes. That's still the most likely outcome this year. And as listeners of this podcast are aware, we've typically dismissed debt ceiling and shutdown risks as noise that's not worth much investor attention. But we're not ready to say that today. Because while policymakers are likely to find a path to raising the debt ceiling, this negotiation could look and feel a lot more like the one in 2011 where party disagreements appeared intractable, even if they ultimately were not. That could remind investors that the compromise involved contractionary fiscal policy, which could weigh on markets if the U.S. economy is also slowing considerably per our expectations. This is a risk both our Chief Global Economist, Seth Carpenter, and I flagged in the run up to the recent U.S. midterm election. 

Of course, it's only January, and 6 to 9 months is a lifetime in politics. So, we don't think there's anything yet for investors to do but monitor this dynamic carefully. We'll be doing the same and we'll 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 new weight management medications are being developed, might the obesity market parallel the likes of hypertension or high blood pressure to become the next blockbuster Pharma category?

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Welcome to Thoughts on the Market. I'm Terence Flynn, Head of the U.S. Pharma Sector for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, today I'll talk about the global obesity challenge and some of the key developments we expect in 2023. It's Tuesday, January 3rd, at 4 p.m. in New York. 

If you're like most people, you're probably seeing a lot of post-holiday ads for gym memberships, diet apps and nutrition services. So this seems like a relevant time to provide an update on obesity. A few months ago, we hosted an episode on this show discussing the global obesity epidemic and how it's now reached an inflection point because of new weight management drugs that show a lot of promise and benefits. 

We continue to believe that obesity is the "new hypertension or high blood pressure", and that it looks set to become the next blockbuster pharma category. Obesity has been classified by the American Medical Association, and more recently the European Commission, as a chronic disease, and its treatment is on the cusp of moving into mainstream primary care management. Essentially, the obesity market is where the treatment of high blood pressure was in the mid to late 80's, before it transformed into a $30 Billion market by the end of the 90's. 

One of the main reasons the narrative around obesity is inflecting is because the focus is shifting to the upstream cause, as opposed to the downstream consequences of diabetes and cardiovascular disease. Now, given this change in focus, we expect excess weight to become a treatment target. The World Health Organization estimates that about 650 million people are living with obesity, and the associated personal, social and economic costs are significant. Over time, we're expecting about a quarter of obese individuals will engage with physicians, up from about 7% currently. Now, this compares to approximately 80% for high blood pressure and diabetes. Furthermore, well over 300 million of these people could potentially receive a new anti-obesity medicine. 

Looking back historically, previous medicines for obesity had minimal efficacy and were plagued by safety issues, which also contributed to limited reimbursement coverage. In our view, this is all poised to change as the more efficacious GLP-1 drugs are adopted and utilized and the companies begin to generate outcomes data to support the derivative benefits of these drugs beyond weight loss. 

Of course, as with biopharma, there are many de-risking clinical, regulatory and commercial steps in the development of the obesity market. This year, we're most focused on a key phase three outcomes trial called "SELECT", which we expect to read out this summer to conclude that "weight management saves lives". 

Furthermore, we think the innovation wave should continue as companies are working on a next generation of injectable combo drugs that could come to the market later this decade for obesity and Type two diabetes. And beyond the possibility of turning the tide on the obesity epidemic, it's also exciting to see room in the markets for multiple players and investment opportunities in a market that could reach over $50 billion by 2030. 

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.

Original Release on November 15th, 2022: 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.

Original Release on December 7th, 2022: As India enters a new era of growth, investors will want to know what’s driving this growth and how it may create once-in-a-generation opportunities. Head of Global Thematic and Public Policy Research Michael Zezas and Chief India Equity Strategist Ridham Desai 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. 

Ridham Desai: And I'm Ridham Desai, Morgan Stanley's Chief India Equity Strategist. 

Michael Zezas: And on this special episode of Thoughts on the Market, we'll discuss India's growth story over the next decade and some key investment themes that global investors should pay attention to. It's Wednesday, December 7th, at 7 a.m. in New York. 

Michael Zezas: Our listeners are likely well aware that over the past 25 years or so, India's growth has lagged only China's among the world's largest economies. And here at Morgan Stanley, we believe India will continue to outperform. In fact, India is now entering a new era of growth, which creates a once in a generation shift in opportunities for investors. We estimate that India's GDP is poised to more than doubled to $7.5 trillion by 2031, and its market capitalization could grow 11% annually to reach $10 trillion. Essentially, we expect India to drive about a fifth of global growth in the coming decade. So Ridham, what in your view are the main drivers behind India's growth story? 

Ridham Desai: Mike, the full global trends of demographics, digitalization, decarbonization and deglobalization that we keep discussing about in our research files are favoring this new India. The new India, we argue, is benefiting from three idiosyncratic factors. The first one is India is likely to increase its share of global exports thanks to a surge in offshoring. Second, India is pursuing a distinct model for digitalization of its economy, supported by a public utility called India Stack. Operating at population scale India stack is a transaction led, low cost, high volume, small ticket size system with embedded lending. The digital revolution has already changed the way India handles documents, the way it invests and makes payments and it is now set to transform the way it lends, spends and ensures. With private credit to GDP at just 57%, a credit boom is in the offing, in our view. The third driver is India's energy consumption and energy sources, which are changing in a disruptive fashion with broad economic benefits. On the back of greater access to energy, we estimate per capita energy consumption is likely to rise by 60% to 1450 watts per day over the next decade. And with two thirds of this incremental supply coming from renewable sources, well in short, with this self-help story in play as you said, India could continue to outperform the world on GDP growth in the coming decade. 

Michael Zezas: So let's dig into some of the specifics here. You mentioned the big surge in offshoring, which has resulted in India's becoming "the office of the world". Will this continue long term? 

Ridham Desai: Yes, Mike. In the post-COVID environment, global CEOs appear more comfortable with work from home and also work from India. So the emergence of distributed delivery models, along with tighter labor markets globally, has accelerated outsourcing to India. In fact, the number of global in-house captive centers that opened in India over the past two years was double of that in the prior four years. During the pandemic years, the number of people employed in this industry in India rose by almost 800,000 to 5.1 million. And India's share in global services trade rose by 60 basis points to 4.3%. In the coming decade we think the number of people employed in India for jobs outside the country is likely to at least double to 11 million. And we think that global spending on outsourcing could rise from its current level of U.S. dollar 180 billion per year to about 1/2 trillion U.S. dollars by 2030. 

Michael Zezas: In addition to being "the office of the world", you see India as a "factory to the world" with manufacturing going up. What evidence are we seeing of India benefiting from China moving away from the global supply chain and shifting business activity away from China? 

Ridham Desai: We are anticipating a wave of manufacturing CapEx owing to government policies aimed at lifting corporate profits share and GDP via tax cuts, and some hard dollars on the table for investing in specific sectors. Multinationals are more optimistic than ever before about investing in India, and that's evident in the all-time high that our MNC sentiment index shows, and the government is encouraging investments by building both infrastructure as well as supplying land for factories. The trends outlined in Morgan Stanley's Multipolar World Thesis, a document that you have co authored, Mike, and the cheap labor that India is now able to offer relative to, say, China are adding to the mix. Indeed, the fact is that India is likely to also be a big consumption market, a hard thing for a lot of multinational corporations to ignore. We are forecasting India's per capita GDP to rise from $2,300 USD to about $5,200 USD in the next ten years. This implies that India's income pyramid offers a wide breadth of consumption, with the number of rich households likely to quintuple from 5 million to 25 million, and the middle class households more than doubling to 165 million. So all these are essentially aiding the story on India becoming a factory to the world. And the evidence is in the sharp jump in FDI that we are already seeing, the daily news flows of how companies are ramping up manufacturing in India, to both gain access to its market and to export to other countries. 

Michael Zezas: So given all these macro trends we've been discussing, what sectors within India's economy do you think are particularly well-positioned to benefit both short term and longer term? 

Ridham Desai: Three sectors are worth highlighting here. The coming credit boom favors financial services firms. The rise in per capita income and discretionary income implies that consumer discretionary companies should do well. And finally, a large CapEx cycle could lead to a boom for industrial businesses. So financials, consumer discretionary and industrials. 

Michael Zezas: Finally, what are the biggest potential impediments and risks to India's success? 

Ridham Desai: Of course, things could always go wrong. We would include a prolonged global recession or sluggish growth, adverse outcomes in geopolitics and/or domestic politics. India goes to the polls in 2024, so another election for the country to decide upon. Policy errors, shortages of skilled labor, I would note that as a key risk. And steep rises in energy and commodity prices in the interim as India tries to change its energy sources. So all these are risk factors that investors should pay attention to. That said, we think that the pieces are in place to make this India's decade.

Michael Zezas: Ridham, thanks for taking the time to talk. 

Ridham Desai: 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.

Original Release on December 2nd, 2022: 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.

Original Release on November 22nd, 2022: 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. 

Summary

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.

Original Release on November 17th, 2022: 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. 

When attempting to determine what the global economy looks like, some economic indicators at an investors disposal may be more useful, while others lag behind.

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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, December 22nd at 2 p.m. in London. 

At the heart of investment strategy is trying to determine what the global economy will look like and what that could mean to markets. But this question has a catch. Market prices often move well ahead of the economic data, partly because markets are anticipatory and partly because it takes time to collect that economic data, creating lags. When thinking about all the economic indicators that an investor can look at, a consistent question is which of these are most and least useful in divining the future? 

One early indicator we think has relatively powerful forecasting properties is the yield curve, specifically the difference between short term and long term government borrowing costs. These differences can tell us quite a bit about what the bond market thinks the economy and monetary policy is going to do in the future, and can move before broader market pricing. One example of this, as we discussed on the program last week, is that an inverted yield curve like we see today tends to mean that the end of Fed rate hikes are less helpful to global stock markets than they would be otherwise. 

But at the other end of the spectrum is data on the labor market, which tends to be much more lagging. At first glance, that seems odd. After all, jobs and wages are very important to the economy, why aren't they more effective in forecasting cross-asset returns? 

But drill deeper and we think the logic becomes a little bit more clear. As the economy initially weakens, most businesses try to hang on to their workers for as long as possible, since firing people is expensive and disruptive. As such, labor markets often respond later as growth begins to slow down. And the reverse is also true, coming out of a recession corporate confidence is quite low, making companies hesitant to add new workers even as conditions are recovering. Indeed, with hindsight, one of the ironies of market strategy is it's often been best to sell stocks when the labor market is at its strongest, and buy them when the labor market is weakest. 

And then there's wages. Wage growth is currently quite high, and there's significant concern that high wage growth will lead to excess inflation, forcing the Federal Reserve to keep raising interest rates aggressively. While that's possible, history actually points in a different direction. In 2001, 2007, and 2019, the peak in U.S. wage growth occurred about the same time that the Federal Reserve was starting to cut interest rates. In other words, by the time that wage growth on a year over year basis hit its zenith, other parts of the economy were already showing signs of slowing, driving a shift towards easier central bank policy. 

Investors face a host of economic indicators to follow. Among all of these, we think the yield curve is one of the most useful leading indicators, and labor market data is often some of the most lagging. 

Happy holidays from all of us here at Thoughts on the Market. We'll be back in the new year with more new episodes. 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.

As congress wraps up for 2022, and we look towards a divided government in 2023, there are a few possible legislative moves on the horizon that investors will want to be prepared for.

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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, December 21st at 11 a.m. in New York. 

As Congress wraps up its business for the year, it's a good time to level-set on what investors should watch out for out of D.C. in 2023. While it's not an election year, and a divided government means legislative achievements will be tough to come by, it's always a good idea to be prepared. So here's three things to watch for. 

First, cryptocurrency regulations. Turmoil in the crypto market seems to have accelerated lawmaker interest in tackling the thorny issue. And even if Democrats and Republicans can't come together on regulation, the Biden administration has been studying how regulators could use existing laws to roll out new rules. For investors, the most tangible takeaway from our colleagues is that crypto regulation could support large cap financials by evening the regulatory playing field with the crypto firms. 

Second, watch for permitting reform on oil and gas exploration. While a late year effort led by Democratic Senator Joe Manchin didn't muster enough votes for passage. It's possible Republicans may be willing to revisit the issue in 2023 when they control the House of Representatives. If this were to pass, watch the oil markets, which might be sensitive to perceptions of future increased supply, supporting the recent downtrend in prices. 

Lastly, keep an eye out for the U.S. to raise more non-tariff barriers with regard to China. While we're not aware of any specific deadlines in play, many of the laws passed in recent years that augment potential actions like export controls put the U.S. government on a sustained path toward drawing up more tariff barriers. Hence the continued momentum toward restricting many types of trade around semiconductors. We'll be particularly interested in 2023 if the U.S. takes actions that start to relate to other industries, which would reflect a broadening scope of U.S. intentions and the US-China trade conflict. That is potentially a challenge to our strategists' currently constructive view on China equities. 

Of course, these aren't the only three things out of D.C. that investors should watch for, and history tells us to expect the unexpected. We'll do just that and keep you in the loop here. In the meantime, happy holidays and have a safe and blessed new 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.

With the recent breakthrough in fusion energy technology, the debate around the feasibility of nuclear fusion as a commercialized energy source may leave investors wondering, is it a holy grail or a pipe dream? Global Head of Sustainability Research and North American Clean Energy Research Stephen Byrd and Head of Thematic Research in Europe Ed Stanley 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 North American Clean Energy Research. 

Ed Stanley: And I'm Ed Stanley, Morgan Stanley's Head of Thematic Research in Europe. 

Stephen Byrd: And on the special episode of Thoughts on the Market, we'll discuss the potential of nuclear fusion technology in light of a key recent breakthrough in the space. It's Tuesday, December 20th, at 10 a.m. in New York. 

Ed Stanley: And 2 p.m. in London. 

Stephen Byrd: Ed, you recently came to this podcast to discuss your team's work on "Earthshots", technologies that can accelerate the pace of decarbonization and mitigate some of the climate change that's occurring as a result of greenhouse gas emissions, trapping the sun's heat. In a sense, Earthshots can be defined as urgent solutions to an intensifying climate crisis and nuclear fusion as one of these potential radical decarbonization technologies. So, Ed, I wondered if you could just start by explaining how nuclear fusion fits into your excellent Earthshots framework. 

Ed Stanley: Absolutely. So in Earthshots we laid out six technologies we thought could be truly revolutionary and changed the course of decarbonization. Three of those were environmental and three were biological innovations. In order of investability, horizon carbon capture was first, smart grids were next, and then further out was nuclear fusion on the environmental side. In early December the U.S. Department of Energy announced the achievement of fusion ignition at the Lawrence Livermore National Laboratory. So Steve, passing back to you, can you give us a sense of why this was considered such an important moment? 

Stephen Byrd: Yeah Ed, you know, as you mentioned, ignition was achieved at the government lab. And this is very exciting because this shows the potential for fusion to create net energy as a result of achieving fusion. So essentially what happened was two megajoules of energy went into the process of creating the ignition, and three megajoules of energy were produced as a result. So a very exciting development. But as we'll discuss, a lot of additional milestones yet to achieve. 

Ed Stanley: And there's been significant debates around nuclear fusion in recent days caused by this. And from the perspective of a seasoned utilities analyst, but also with your ESG hat on, is fusion the Holy Grail it's often touted to be, or do you think it's more of a pipe dream? And compared to nuclear fission, how much of a step change would it be? 

Stephen Byrd: You know, that's a fascinating question in terms of the long term potential of fusion. I do see immense long term potential for fusion, but I do want to emphasize long term. I think, again, we have many steps to achieve, but let's talk fundamentally about what is so exciting about fusion energy. The first and foremost is abundant energy. As I mentioned, you know, small amount of energy in produces a greater amount of energy out, and this can be scaled up. And so this could create plentiful energy that's exciting. It's no carbon dioxide, that's also very exciting. No long live radioactive waste, add that to the list of exciting things. A very limited risk of proliferation, because fusion does not employ fissile materials like uranium, for example. So tremendous potential, but a long way to go likely until this is actually put into the field. So in the meantime, we have to be looking to other technologies to help with the energy transition. So Ed, just building on what we're going to really need to achieve the energy transition and thinking through the development of fusion, what are some of the upcoming milestones and technology advancements that you're thinking about for the development and deployment of fusion energy? 

Ed Stanley: The technology milestones to watch for, I think, are generally known and ironically, actually relatively simple for this topic. We need more power out than in, and we need more controlled energy output, and certain technology breakthroughs can help with that. But we also need more time, more money, more computation, more facilities with which to try this technology out. But importantly, I think the next ten years is going to look very different from the last ten years in terms of these milestones and breakthroughs. I think that's going to be formed by four different things: the frequency, geographically, disciplinary and privately. And by those I mean on frequency it took about 25 years for JET in 2020 to break its own output record that it set in 1995. And then all of a sudden in 2021, 22, we saw four more notable records broken. Geographically, two of those records broken were in China, which is incredibly interesting because it shows that international competition is clearly on the rise. Third, we're seeing interdisciplinary breakthroughs to your point on integrating new types of technology. And finally, the emergence of increasingly well-funded private facilities. And this public private competition can and should accelerate the breakthroughs occurring in unexpected locations. But Stephen, I suppose if we cut to the chase on the when, how long do you think commercial scale fusion will take to come to fruition? 

Stephen Byrd: You know, it's a great question Ed. I think the Department of Energy officials that gave the press release on this technology development highlighted some of the challenges ahead. Let me talk through three big technology challenges that will need to be overcome. The first is what I think of as sort of true net energy production. So I mentioned before that it just took two mega jewels to ignite the fuel and then the output was three megajoules. That's very exciting. However, the total energy needed to power the lasers was 300 megajoules, so a massive amount. So we need to see tremendous efficiency improvements, that's the first challenge. The second challenge would be what we think of as repeatable ignition. That relates to creating a consistent, stable set of fusion, which to date has not been possible. Lastly, for Tokamak Technologies, Tokamaks are essentially magnetic bottles. The crucial element for commercialization is making these high temperature superconducting magnets stronger. That would enable everything else to be smaller and that would lead to cost improvements. So I think we have a long way to go. So Ed, just building on that idea of commercialization, you know, with the economics of fusion technologies looking more attractive now than previously given this breakthrough that we've seen at the U.S. DOE lab, what's happening on the policy and regulatory side. Do you see support for nuclear fusion? And if you do, in which countries do you see that support? 

Ed Stanley: I mean, it's a great question. And governments and electorates around the world, particularly in Europe, where I'm sitting, have what can only be described as a complicated relationship with nuclear energy. But on support for fusion broadly, yes, I think there is tentative support. It depends on the news flow and I think excitement last week shows exactly that. But personally, I think we are still too early to worry too much about policy and regulation. In simple terms, you can't actually regulate and promote and subsidize something where the technology isn't actually ready yet, which is part of the point you've made throughout. But that question also reminds me of a time about 15 years ago when I received national security clearance to visit the U.K.'s Atomic Energy Authority in Europe. And at that time, they were the clear global leader in fusion research. Obviously, that was hugely exciting as a young teenager. But something that the lead scientist said to me at that point struck me and it remains true today, that no R&D project on the planet receives as much funding relative to its frequency of breakthroughs as Fusion does. Which tells you just how committed that governments and now corporates around the world are in trying to unlock carbon free nuclear waste, free energy. But as you have said, quite rightly, that has taken and it will continue to take patience. 

Stephen Byrd: That's great. Ed, thanks for taking the time to talk. 

Ed Stanley: It's great speaking with you, Stephen. 

Stephen Byrd: 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 focus begins to shift from inflation and interest rates to a possible oncoming earnings recession, what has the market already priced in? And what should investors be looking at as risk premiums begin to rise?

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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 19th, at 11 a.m. in New York. So let's get after it. 

While many commentators blame last week's selloff in stocks on the Fed, we think it was more about the equity market looking ahead to the oncoming earnings recession that we think is getting worse. The evidence for this conclusion is last week's drop in valuations, which was driven exclusively by a rising equity risk premium as 10 year yields remain flat. In fact, since mid-November, the equity risk premium has risen 50 basis points to 2.5%. While still very low relative to where we think it will eventually settle out next year, it's a good step in the right direction that tells us the equity market is at least contemplating the earnings risk. Until now, all of the bear market valuation compression has been about inflation, the Fed's reaction to it and the rise in interest rates. 

While we called for the end of the tactical rally two weeks ago, last week's price action provided the technical reversal to confirm it. Specifically, the softer than expected inflation report on Tuesday drove the equity markets up sharply in the morning, only to fail at the key resistance levels we highlighted two weeks ago. More importantly, the price action left a negative tactical pattern that looks like the mere image of the pattern back in October, when the September inflation report came in hotter than expected. We made our tactical rally call on the back of that positive technical action in October and last week provides the perfect bookend to our trade. 

Seasonally, the setup is now bearish too. At the end of every calendar quarter, many asset managers play a game of chasing markets higher or lower to protect or enhance their relative year to date performance. Most years, the equity markets tend to drift higher into year end, as liquidity dries up, asset managers are able to push prices higher of the stocks they own. However, in down years like 2022, the ability and/or willingness to do that is lower, which reduces the odds of a year end rally lasting all the way until December 31st. This is the other reason we pulled the plug on our tactical rally call. With last week's technical reversal so clear, we think the set up is now more bearish than bullish. Meanwhile, we are feeling more confident about our 2023 forecast for S&P 500 earnings per share of $195. This remains well below both the bottoms up consensus of $231 and the top down forecasts of $215. In fact, the leading macro survey data has continued to weaken. I bring this up because we often hear from clients that everyone knows earnings are too high next year, and therefore the market has priced it. However, we recall hearing similar things in August of 2008, the last time the spread between our earnings model and the street consensus was this wide. 

The good news is that we don't expect a balance sheet recession next year or systemic financial risk. Nevertheless, the earnings recession by itself could be similar to what transpired in 2008 and 09. The main message of today's podcast is don't assume the market prices this negative of an earnings outcome until it happens. Secondarily, if our earnings forecast proves to be correct, the price declines for equities will be much worse than what most investors are expecting. Based on our conversations, the consensus view on the buy side is now that we won't make new lows on the S&P 500 next year, but will instead defend the October levels or the 200 week moving average, approximately 3500 to 3600 on the S&P 500. We remain decidedly in the 3000 to 3300 camp with a bias toward the low end given our view on earnings. With the year end Santa Claus rally now fading, there is reason to believe the decline from last week is the beginning of the move lower into the first quarter for stocks that we've been expecting, and when a more sustainable low is likely to be made. 

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 cross-asset performance has continued to be weak, there is hope that the end of the Fed’s rate hiking cycle could give markets the boost they need, but does history agree with these investor’s hopes?

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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 16th, at 3 p.m. in London. 

We expect the Federal Reserve to make its last rate hike in the first quarter of next year. What does that mean? Aggressive rate increases from the Fed this year have corresponded to weak cross-asset performance, leading to a lot of hope that the end of these rate hikes will provide a major boost to markets, especially to riskier, more volatile assets like stocks and high yield bonds. 

But the lessons of history are more complicated. While on average, both stocks and bonds do well once the Fed stops raising rates, there's an important catch. Stock performance is weaker in the handful of instances where the Fed has stopped while short term yields are higher than long term yields. That so-called inverted yield curve is exactly what we see today and suggests it's not so straightforward to say that the end of rate hikes means that stocks outperform. 

Specifically, we can identify 11 instances since 1980 when the Federal Reserve was raising rates and then stopped. In most of these instances, the yield curve was flat and slightly upward sloping, which means 2 year yields were a little bit lower than 10 year yields. That means  the market thought that interest rates at the time of the last Fed rate hike could stay at those levels for some time, applying that they were in a somewhat stable equilibrium and that the economy wouldn't see major change. Unsurprisingly, the markets seemed to like that stability, with global equities up about 15% over the next year in these instances. 

But there's another, somewhat rare set of observations where the last Fed rate hike has occurred with short term interest rates higher than expected rates over the long term. That happened in 1980, 1981, 1989, and the year 2000, and suggests that the market at that time thought that interest rates were not in a stable equilibrium, would not stay at current levels, and might need to adjust down rather significantly. That's more consistent of bond markets being concerned about slower growth. And in these four instances, global equity markets did much worse, falling about 3% over the following 12 month period. 

We see a couple of important implications for that. First, as we sit today, the yield curve is inverted, suggesting that that rarer but more challenging set of scenarios could be at work. My colleague Mike Wilson, Morgan Stanley's Chief U.S. Equity Strategist and CIO, is forecasting S&P 500 to end 2023 at similar levels to where it is today, suggesting that the equity outlook isn't as simple as the market rallying after the Fed stops raising rates. 

Secondly, for bond markets, returns are more consistently strong after the last Fed rate hike, whether the yield curve is inverted or not. From a cross-asset perspective, we continue to prefer investment grade bonds over equities in both the U.S. and Europe. 

Questions of when the Fed stops raising rates and what this means remains a major debate for the year ahead. While an end to rate hikes is often a broad based positive, this impact isn't as strong when the yield curve is inverted like it is today. 

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.

While the consumer has been a pillar of strength this year, continued high inflation, household debt and slowing payroll growth could pose challenges to consumer spending. 

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Welcome to Thoughts on the Market. I'm Sarah Wolfe from Morgan Stanley's U.S. Economics Team. Along with my colleagues, bringing you a variety of perspectives, today I will give you a year end 2022 update on the U.S. consumer with a bit of our outlook for 2023. It's Thursday, December 15th, at 10 a.m. in New York. 

So it's very clear the consumer has been a pillar of strength this year amid a very tough macro environment, but as rates keep rising and the labor market slows, consumers will likely need to find ways to cut costs. We are already seeing some weakness in subprime consumers and trade down among middle and higher income households. 

While the wallet shift away from goods and towards services is definitely playing out, we continue to see relatively more strength than expected from consumers across both categories. This is because households have lowered their savings rates significantly as they draw down excess savings. We do not expect a material drawdown in excess savings, however, into next year as savings dwindle. We are already seeing it this morning in the November retail sales data, where spending slowed down fairly dramatically across most goods categories. We're talking about home furnishing, electronics and appliances, sporting goods, motor vehicles. On the other hand, the one category of retail sales that reflects the services side of the economy, dining out, was very strong in the retail sales report and has continued to be very strong. 

Looking at the trends that will  force consumers to spend less, rising interest rates are lifting the direct costs of new borrowing and slowly feeding through into higher overall debt service costs. For example, new car loan rates are at their highest level since 2010, mortgage rates are at 20 year highs, they've come off a little bit,  and commercial bank interest rates on credit card plans are at 30 year highs. It takes time for new debt issued at higher rates to lift household debt service costs, especially as over 90% of outstanding household debt is locked in at a fixed rate. But it's happening. 

Looking at the data by household income shows more stress from higher rates among subprime borrowers. Credit card delinquencies are modestly below pre-COVID levels, but are accelerating at the fastest pace since the financial crisis. In the auto space, delinquencies across subprime auto ABS surpassed 2019 levels earlier this year and have stabilized at relatively high rates over the last six months. 

Lower income households are also most affected by the combination of higher interest rates and higher inflation. They rely more heavily on higher interest rate loan products and variable rate credit card lines. Consider this, the bottom 20% income quintile spend 94% of their disposable income on essential items, including food, energy and shelter. This compares to only 20% of disposable income for the top 20% income quintile. As such, higher inflation on essential items weighs more heavily on lower income households. Higher inflation is also pushing lower income households to buy fewer full price items and wait for promotions. They are also choosing smaller items, value packs, or less expensive brands. 

While price inflation has turned a corner, it's not enough to ease the pressure on consumers from elevated price levels, rising rates and additionally a decelerating labor market. We expect labor income growth to slow next year alongside a weakening labor market, troughing in mid 2023, in line with sharply slower payroll growth and softer wage gains. Wage pressures are coming off in industries that saw the largest wage gains over the past year due to labor shortages, including leisure and hospitality and wholesale trade. But for the moment, with jobs still growing, consumer spending remains positive as well. Together, our base case for real spending is a weak 1% year over year growth in 2023, down from 2.6% this year. In the end, the extent that consumers pull back spending will hinge on how the labor market fares. 

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 “Moonshots” attempt to address climate concerns with disruptive technology, more immediate solutions are needed, so what are “Earthshots”? And which ones should investors pay attention to? Head of Global Thematic and Public Policy Research Michael Zezas and Head of Thematic Research in Europe Ed Stanley 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. 

Ed Stanley: And I'm Ed Stanley, Morgan Stanley's Head of Thematic Research in Europe. 

Michael Zezas: And on this special episode of Thoughts on the Market, we'll discuss the potential of "Earthshots" as an investment theme in the face of intensifying climate concerns. It's Wednesday, December 14th, at 10 a.m. in New York. 

Ed Stanley: And 3 p.m. in London. 

Michael Zezas: While climate continues to be a key political and economic debate, it's clear we're moving into a new phase of climate urgency. There's a significant mismatch between the pace of climate technology adoption, and the planet's need for those solutions. Here at Morgan Stanley we've done work around "Moonshots", ambitious and radical solutions to seemingly insurmountable problems using disruptive technology. There are some big hurdles with moonshots, however. First, they require significant political support. Also, the process of gradual, iterative decarbonization technology adoption will occur more slowly than investors expect. Given this backdrop, there's a growing need for urgent solutions. Enter what we call "Earthshots". 

Michael Zezas: Ed, can you maybe start by explaining what Earthshots are and what the framework for identifying these Earthshots is relative to Moonshots? 

Ed Stanley: So a Moonshot is an early stage technology with high uncertainty, but also high potential to solve a very difficult problem. And for Moonshots, the key investments are in R&D and proof of concept. An Earthshot, on the other hand, is more of a middle stage technology with generally lower uncertainty, proven potential and Earthshots the key investment here is really around scaling the technology quickly and cheaply. And Earthshots are more radical alternatives to otherwise slow and steady status quo in the decarbonization world. And we think about them broadly in two sets. Some are nearer term decarbonization accelerants, and others are longer term warming mitigations and adaptations. And I guess we can get into a bit more detail on examples in a minute. But to your question on frameworks, it's exactly the same framework that we used in Moonshots, and that is academia, patenting, venture capital and then public markets. Academia around breaking new ground and how quickly that's happening. Patenting to protect that intellectual property. Then venture steps in to provide some proof of concept for that idea. And then public investment is typically needed to scale it. And you can track almost any invention over time using that sequence of events all the way back to the patent for the light bulb in 1880, all the way up to carbon capture today. 

Michael Zezas: Ed, what types of specific problems are Earthshots trying to solve, and which ones should investors pay particular attention to, both near-term and longer term? 

Ed Stanley: So if you look at the nearly 40 billion tonnes of carbon dioxide emissions that we put into the atmosphere every year and you split it by industry, our Earthshot technologies catered to over 80% of those emissions. Be it electrification, manufacturing, food emissions, there's a radical Earthshot technology for decarbonizing each of those. But if we break them down into two categories, we have environmental Earthshots and biological Earthshots. On the environmental side, we have carbon capture, smart grids, fusion energy. And on the biological, we have cell based meat, synthetic biology and disease re-engineering. If we go into a bit more detail on the environmental Earthshots, there's been a lot of noise in fusion in recent days. But I think carbon capture for now is where investors need to focus. And for those thinking how is carbon capture an Earthshot, we've been hearing about this technology for years now, well, the unit economics and tech maturity are only really now getting to that critical balance where it can scale. And the 21 facilities globally that are doing this only capture around 0.1% of global emissions. The largest project in Iceland annually captures around 3 seconds worth of global emissions. So we're still very early days and it's all about scale, scale, scale now. On the biological side, I think the $4 trillion TAM in synthetic biology, which is the harnessing of biology and molecules to create net carbon negative products, is truly fascinating. But the one that piqued my interest the most doing this research, and has actually seen comparatively negligible funding is disease re-engineering. And if the planet does continue to warm, despite our best efforts in decarbonizing and carbon capture, then another 720 million people by 2050 will be in zones that are susceptible to malaria, mainly in Europe and the U.S. And companies using gene editing are having great success. There's a 99.9% efficiency and efficacy of wiping out malaria in the zones that these trials have taken place. Perhaps less pressing immediately than carbon capture, but from a social perspective, with half a million people dying per year from malaria and that number set to grow if warming grows, I don't think it's a theme that investors can ignore for very much longer. 

Michael Zezas: Got it. And Ed, it's often said that each decade has one investment theme that outpaces others. And while this decade's in its early innings, there's several contenders. There's the new commodity supercycle, there's digitalized assets and cybersecurity. Another theme in the running is Clean Transition Technologies. How does Earthshots fit into the investment megatrends for the next decade? 

Ed Stanley: I mean, that's absolutely fair. Markets move in ebbs and flows of macro themes and micro themes being the winning investment each decade. We had gold in the seventies, oil in the 2000, and then interspersed with that Japanese equities and U.S. Tech in the eighties and nineties respectively. And we do appreciate it's rare when you look back in time for hard assets, which clean tech and Earthshot technologies typically are, for hard assets to win that secular theme crown, so to speak. But we're already seeing a changing of the guards in private markets away from long secular bets on technology, SAS, fintech towards hard assets and security infrastructure. So that is the shift in investing from bits to atoms, which is well underway. And that's happening because not since the Industrial Revolution really have we been so uniformly mobilized to transition to a new paradigm in such a short space of time. But opposing that, I guess we should ask where could we be wrong? Well, for climate tech to be the winning investment trade of the next ten years, the irony is that this trade no longer lies in the tech proving itself necessarily or reaching cost parity. I think we've done that in many cases, that is in the bag. The success or otherwise of this being the secular investment theme for the 2020s will lie much more in reducing permitting bottlenecks, for example, and skills bottlenecks around the installation of some of this Earthshot technology. And that, too, actually is where investors can find opportunities in vast reskilling that's needed. But on balance, yes, this, in my view anyway, is the secular trade of the next decade. 

Michael Zezas: And you've argued that a challenging macro environment is precisely the time to dig into Moonshots. It seems that would even be truer of Earthshots, would you agree? 

Ed Stanley: I think that's a reasonable assumption, yes. If you look at companies over time, over 30% of Fortune 500 companies were founded during recession years, and many more of those were founded coming out of recessions as well. And crudely, the reasons are twofold. One, product market fit and unit economics have to be ideal in a downturn when you have consumers feeling the pinch and business customers reining back on spending. But secondly, investors pull back on their duration and risk appetite, clearly, and capital becomes more concentrated, and the R&D bang for your buck you get in downturns, ironically, is better. But when you add on to that current stimulus packages like the IRA in the US, you have all of the component parts you need for innovation breakthrough. And I would actually stress even more simply, we need some of these breakthroughs, more physical world breakthroughs than digital ones. Because without these breakthroughs, we simply won't have enough lithium for the EV rollout, for example, we'll be 22% light. It's not just will this happen in a downturn, it has to happen in a downturn, irrespective of the macro. So, yes, now I think is an excellent time to be looking at Earthshots and not simply just at the peak of frothy markets. 

Michael Zezas: Well, Ed, thanks for taking the time to talk. 

Ed Stanley: It's 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 Podcasts app. It helps more people find the show. 

Over the past few years, the airline industry has faced fluctuations between too hot and too cold across demand, capacity and costs. Could conditions in 2023 be just right for increased profitability?

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Welcome to Thoughts on the Market. I'm Ravi Shankar, Morgan Stanley's Freight Transportation and Airlines Analyst. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss our 2023 outlook for the airline space and some key takeaways for investors. 

As 2022 draws to a close, the outlook for airlines going into next year continues to be bullish. We think that 2023 is going to be what we call a "Goldilocks" year for the airlines, simply because we go from three years of conditions being either too cold during the pandemic, or too hot last year, to conditions being just right. This should be enough for the airlines to remain stable and to top 2019 levels in terms of profitability. However, the biggest question in the space is about the macro backdrop and consumer resilience. 

Everything we are seeing so far suggests that there are no real cracks in terms of the demand environment. We expect a slight cool down on the leisure side, but some uptick on the corporate and international side going into next year. 

As for pricing, when the irresistible force of demand met the immovable object of capacity restrictions in 2022, the net result was a significant increase in price, which was up 20 to 25% above pre-pandemic levels. This is arguably the biggest debate between the bulls and the bears in the space, regarding where the industry eventually ends up. We believe the pricing environment will cool slightly sequentially as capacity incrementally returns, but will stabilize well above 2019 levels. In addition, the return of corporate and international travel will be a mixed tailwind to yield in 2023. 

Costs have been another big debate for the space over the last 18 to 24 months. New pilot contracts are one of the things that we are closely tracking. And we do think that inflation should start to moderate in the back half of the year as we lap some really difficult comps in the cost side, but also as airlines get a little more capacity in the sky with the delivery of new, larger gauge planes and the return of some pilots. There might be some risk for the space in 2024 and beyond, but for 23 we still think that capacity is going to be relatively constrained in the first half of the year, and only start to really ease up in the second half of the year. 

And lastly, jet fuel has been very volatile for much of 2022. Given this, we model jet fuel flat versus current levels, but continue to expect volatility in price and note that current levels already imply a year over year tailwind for most of 2023. 

So all in all, we do expect that 2023 earnings will be above 2019 levels. And we point out that the market has not yet priced this into the airline stocks, which are currently trading at roughly year end 2020 levels. 

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.

Looking to 2023, Emerging Markets and fixed income assets are forecasted to outperform, so what should investors pay close attention to in the new year? Head of FX and EM Strategy James Lord and Global Head of EM Sovereign Credit Strategy Simon Waever discuss.

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James Lord: Welcome to Thoughts on the Market. I'm James Lord, Morgan Stanley's Head of FX and EM Strategy. 

Simon Waever: And I'm Simon Waever, Global Head of EM Sovereign Credit Strategy. 

James Lord: And on this special episode of the podcast, we'll be discussing our 2023 outlook for global emerging markets and fixed income assets and what investors should pay close attention to next year. 

Simon Waever: It's Monday, December 12th, at 11 a.m. in New York. 

James Lord: A big theme from Morgan Stanley's year ahead outlook is the outperformance we're expecting to see from emerging markets. This isn't just about emerging market fixed income, though, which is what Simon and I focus on, but also equities. So across the board, we're expecting much brighter days ahead for EM assets. 

Simon Waever: And of course, the dollar is always key and it has been extremely strong this year. But what about next year? What do you think? 

James Lord: Yeah. So we are expecting the dollar to head down over 2023. In fact, it's already losing ground against a variety of G10 and EM currencies, and we're expecting this process to continue. So why do we think that? Well, there are a few key reasons. First, U.S. CPI should fall significantly over the next 12 months. This is because economic growth should slow as the rate hikes delivered this year by the U.S. Fed begin to bite. Supply chains are also finally normalizing as the world is getting back to normal following the pandemic. This should also help the Fed to stop hiking rates, and this has been a big reason for the dollar's rally this year. 

Simon Waever: Right. So that's in the U.S., but what about the rest of the world? And what about China specifically? 

James Lord: Yeah so, inflation is expected to fall across the whole world as well. And that is going to be a stepping stone towards a global economic recovery. Global economic recovery is usually something that helps to push the dollar down. So this is something that will be very helpful for our call. And third, we see growth outside of the U.S. doing better than the U.S. itself. This is something that will be led by China and other emerging markets. China is moving away from its zero-covid strategy and as they do so over the coming quarters, economic activity should rebound, benefiting a whole range of different economies, emerging markets included. So all of that points us in the direction of U.S. dollar weakness and EM currency strength over 2023. Simon, how does EM look from your part of the world? 

Simon Waever: Right, so away from effects, the main way to invest in EM fixed income are sovereign bonds and they can be either in local currency or hard currency. And the hard currency bond asset class is also known as EM sovereign credit, and these are bonds denominated in U.S. dollar or euro. We think sovereign credit will do very well in 2023 and we kept our bullish view that we've had since August. I would say external drivers were key this year in explaining why the asset class was down 27% at its worst. So that included hawkish global central banks, higher U.S. real yields, wider U.S. credit spreads and a stronger dollar. We think the same external factors will be key next year, but now they're going to be much more supportive as a lot of them reverses. 

James Lord: What about fundamentals, Simon? How are they looking in emerging markets? 

Simon Waever: Right. They do deserve a lot of focus themselves as well because after all, debt is very high across EM, far from all have access to financing and growth is not what it used to be. But they're also very dispersed across countries. For instance, you have the investment grade countries that despite not growing as high as they used to, still have resilient credit profiles and only smaller external imbalances this time around. Then you have the oil exporters that clearly benefit from high oil prices. Of course, there are issues in particularly those countries that have borrowed a lot in dollars but now have lost market access due to the very high cost. Some have, in fact, already defaulted, but on the other hand, a lot are also being helped by the IMF. And if we look ahead to 2023, there are actually not that many debt maturities for the riskiest countries. 

James Lord: And what about valuation, Simon? Is the asset class still cheap? 

Simon Waever: Yeah, I would say the asset class is still cheap despite the recent rebound, and that's both outright and versus other credit asset classes. We also see positioning as light, which is a result of the significant outflows from EM this year and investors having moved into safer and higher rated countries. So putting all that together, it leaves us projecting tighter EM sovereign credit spreads, and for the asset class to outperform within global bonds. And that includes versus U.S. corporate credit and U.S. treasuries. Within the asset class, we also expect high yield to outperform investment grade. But that's it for the hard currency bonds, what about the local currency ones? 

James Lord: Local currency denominated bonds could be a great way to position in emerging markets because you get both the currency and currency exposure, as well as the potential for bond prices to actually rise too. The bonds that you were just talking about Simon, are mostly dollar denominated, so you don't get that currency kicker. So not only do we think EM currencies should rally against the U.S. dollar, but yields should also come lower too, as inflation drops in emerging markets and central banks start cutting interest rates over the course of 2023, and do so much earlier than central banks in developed economies. We've also seen very little in the way of inflows into this part of the asset class over the past five years or so. So if the outlook improves, we could start seeing asset allocators taking another look, resulting in larger inflows over 2023. 

James Lord: 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 Apple Podcasts' app. It helps more people to find the show. 

2022 was an unusual year for stocks and bonds, and while the future is hard to predict, the start of 2023 is shaping up to look quite different across several metrics.

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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 9th, at 5 p.m. in London. 

We try to be forward looking on this program, but let's take a moment to appreciate just how deeply unusual this year has been. Looking back over the last 150 years of U.S. equity and long term bond performance, 2022 is currently the only year where both stocks and long term bonds are down more than 10%. 

Several factors conspired to create such an unusual outcome. To start, valuations for both stocks and bonds were expensive. Growth was weak in China, but surprisingly resilient in the developed markets. That resilient growth helped drive the highest rates of U.S. inflation in 40 years. And that high inflation invited a strong response from central banks, with the Federal Reserve's target rate rising at its fastest pace, over a 12 month period, since the early 1980s. 

Looking ahead, the next 12 months look different across all of those factors. 

First, starting valuations look different. U.S. BBB-rated corporate bonds began the year yielding just 3.3%, they currently yield 5.4%. The S&P 500 stock index began the year at 22x forward earnings, that's now fallen to 17.5x. And U.S. Treasury yields relative to inflation, the so-called real yield, have gone from -1% to positive 1.1%. 

Second, the mix of growth changes on Morgan Stanley's forecasts. After 12 months where U.S. growth outperformed China, U.S. growth should now decelerate while growth in China picks up as the country exits zero-covid. We think growth in Europe is likely to see a recession, further emphasizing a shift from developed market to emerging market leadership in global growth. 

That weaker developed market growth should mean weaker developed market inflation. After hitting 40 year highs in 2022, our forecasts show U.S. headline inflation falling sharply next year, with U.S. CPI hitting a year on year rate of just 1.9% by the end of 2023. Weaker demand, high inventories, lower commodity prices, healing supply chains, a cooler housing market, and easier year on year comparisons, are all part of Morgan Stanley's lower inflation forecast. 

As growth slows and inflation moderates, central banks will likely gain more confidence that they have taken rates high enough. After the fastest rate hiking cycle in 40 years, the next 12 months could see both the Federal Reserve and the European Central Bank make their final rate hike in the first quarter of 2023. 

We think different dynamics should mean different results. After a run of underperformance, we think these changes will help emerging market assets now do better and outperform developed market assets. After an unusually bad year for bonds, we continue to think that these shifts will support high grade fixed income. While the future is always hard to predict, we think investors should prepare for some very different stories. 

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 have kept China’s road to reopening top of mind, what comes after reopening and how might the Chinese economy and equity markets be impacted? Chief China Economist Robin Xing and Chief China Equity Strategist Laura Wang discuss.

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Laura Wang: Welcome to Thoughts on the Market. I'm Laura Wang, Morgan Stanley's Chief China Equity Strategist. 

Robin Xing: I'm Robin Xing, Morgan Stanley's Chief China Economist. 

Laura Wang: On this special episode of the podcast we'll discuss our 2023 outlook for China's economy and equity market, and what investors should focus on next year. It's Thursday, December 8th at 9 a.m. in Hong Kong. 

Laura Wang: So, Robin, China's reopening is a top most investor concern as we head into next year. You've had a long standing call that China will be reopening by spring of 2023. Is that still your view, given the recent COVID policy changes? 

Robin Xing: Yes, that's still our view. In fact, recent developments have strengthened our conviction on that reopening view. After several weeks of twists and turns following the initial relaxation on COVID management on November 10th, we think policymakers have made clear their intent to stay on the reopening path. We have seen larger cities, including Beijing, Guangzhou and Chongqing, all relaxed COVID restrictions in last week. We have seen the top policymakers confirmed shift in the country's COVID doctrine in public communication, and COVID Zero slogan is officially removed from any press conference or official document. They started the vaccination campaign, and last but not least, we have also see a clear focus on how to shift the public perception with a more balanced assessment of the virus. All of these enhanced our conviction of a spring reopening from China. 

Laura Wang: What are some of the key risks to this view? 

Robin Xing: Well, I think the key risk is the path towards a reopening. Before full reopening in the spring, China will try to flatten the curve in this winter. That is, to prevent hospital resources being overwhelmed, thus limiting access and mortality during the reopening process. This is because the vaccination ratio among the elderly remains low, with only 40% of people aged 80 plus have received the booster shot. Meanwhile, the medical resources in China are unevenly distributed between larger cities and the lower tier areas. As a result, we do expect some lingering measures during the initial phase of reopening. Restrictions that could still tighten dynamically in lower tier cities should hospitalizations surge, but we will likely see more incremental relaxation in large cities. So cases might rise to a high level, before a more nonlinear increase occurs after the spring full reopening. So this is our timeline of reopening, basically flattening the curve in the winter when the medical system is ready, to a proper full reopening in the spring. 

Laura Wang: That's wonderful. We are finally seeing some light at the end of the tunnel. With all of these moving parts, if China does indeed reopen on this expected timeline, what is your growth outlook for Chinese economy both near-term and longer term? 

Robin Xing: Well, given this reopening timeline, we expect that GDP growth in China to remain subpar in near term. The economy is likely to barely grow in the fourth quarter this year, corresponding to a 2.8% year over year. Growth were likely improved marginally in the spring, but still subpar as the continued fear of the virus on the part of the population will likely keep consumption at a subpar level up to early second quarter. But as normalization unfolds from the spring, the economy will rebound more meaningfully in the second half. Our full year forecast for the Chinese growth is around 5%, which is above market consensus, and that will be largely led by private consumption. We are expecting pent up demand to be unleashed once the economy is fully reopened by summertime. 

Robin Xing: So Laura, the macro backdrop we have been discussing have made for a volatile 2022 in the Chinese equity market. With widely anticipated policy shifts on the horizon, what is your outlook for Chinese equities within the global EM framework, both in near-term and the longer term? 

Laura Wang: This is actually perfect timing to discuss it as we have just upgraded Chinese equities to overweight within the global emerging market context, after staying relatively cautious for almost two years since January 2021. We now see multiple market influential factors improving at the same time, which is for the very first time in the last two years. Latest COVID policy pivot, as you just pointed out, and property market stabilization measures will help facilitate macro recovery and will also alleviate investors concerns about policy priority. Fed rate hikes cycle wrapping up will improve the liquidity environment, stronger Chinese yuan against U.S. dollar will also improve the attractiveness for Chinese assets. Meanwhile, we are also seeing encouraging signs on geopolitical tension front, as well as the regulatory reset completion front. Therefore, we believe China will start to outperform the broader emerging market again. We expect around 14% upside towards the end of the year with MSCI China Index. 

Robin Xing: How should investors be positioned in the year ahead and what effects do you think will be the biggest beneficiaries of China's reopening? 

Laura Wang: Two things to keep in mind. Number one, for the past three years, we've been overweight A-Shares versus offshore space, which had worked out extremely well with CSI 300 outperforming MSCI China by close to a 20% on the currency hedged basis over the last 12 months. We believe this is a nice opportunity for the relative performance to reverse given offshore's bigger exposure to reopening consumption, higher sensitivity to Chinese yuan strengthening and to the uplifting effect from the PCAOB positive result. Secondly, it is time to overweight consumer discretionary with focus on services and durables. Consumption recovery is on the way. 

Robin Xing: What are some of the biggest risks to your outlook for 2023, both positive and negative? 

Laura Wang: I would say the positive risks are more associated with earlier and faster reopening progress, whereas the negative risk would be more around higher fatality and bigger drag to economy, which means social uncertainty as well as bigger macro and earnings pressure will amount. And then geopolitical tension is also worth monitoring in the course of the next 12 to 24 months. 

Laura Wang: Robin, thanks for taking the time to talk. 

Robin Xing: Great speaking with you, Laura. 

Laura Wang: 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 colleagues today.

As India enters a new era of growth, investors will want to know what’s driving this growth and how it may create once-in-a-generation opportunities. Head of Global Thematic and Public Policy Research Michael Zezas and Chief India Equity Strategist Ridham Desai 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. 

Ridham Desai: And I'm Ridham Desai, Morgan Stanley's Chief India Equity Strategist. 

Michael Zezas: And on this special episode of Thoughts on the Market, we'll discuss India's growth story over the next decade and some key investment themes that global investors should pay attention to. It's Wednesday, December 7th, at 7 a.m. in New York. 

Michael Zezas: Our listeners are likely well aware that over the past 25 years or so, India's growth has lagged only China's among the world's largest economies. And here at Morgan Stanley, we believe India will continue to outperform. In fact, India is now entering a new era of growth, which creates a once in a generation shift in opportunities for investors. We estimate that India's GDP is poised to more than doubled to $7.5 trillion by 2031, and its market capitalization could grow 11% annually to reach $10 trillion. Essentially, we expect India to drive about a fifth of global growth in the coming decade. So Ridham, what in your view are the main drivers behind India's growth story? 

Ridham Desai: Mike, the full global trends of demographics, digitalization, decarbonization and deglobalization that we keep discussing about in our research files are favoring this new India. The new India, we argue, is benefiting from three idiosyncratic factors. The first one is India is likely to increase its share of global exports thanks to a surge in offshoring. Second, India is pursuing a distinct model for digitalization of its economy, supported by a public utility called India Stack. Operating at population scale India stack is a transaction led, low cost, high volume, small ticket size system with embedded lending. The digital revolution has already changed the way India handles documents, the way it invests and makes payments and it is now set to transform the way it lends, spends and ensures. With private credit to GDP at just 57%, a credit boom is in the offing, in our view. The third driver is India's energy consumption and energy sources, which are changing in a disruptive fashion with broad economic benefits. On the back of greater access to energy, we estimate per capita energy consumption is likely to rise by 60% to 1450 watts per day over the next decade. And with two thirds of this incremental supply coming from renewable sources, well in short, with this self-help story in play as you said, India could continue to outperform the world on GDP growth in the coming decade. 

Michael Zezas: So let's dig into some of the specifics here. You mentioned the big surge in offshoring, which has resulted in India's becoming "the office of the world". Will this continue long term? 

Ridham Desai: Yes, Mike. In the post-COVID environment, global CEOs appear more comfortable with work from home and also work from India. So the emergence of distributed delivery models, along with tighter labor markets globally, has accelerated outsourcing to India. In fact, the number of global in-house captive centers that opened in India over the past two years was double of that in the prior four years. During the pandemic years, the number of people employed in this industry in India rose by almost 800,000 to 5.1 million. And India's share in global services trade rose by 60 basis points to 4.3%. In the coming decade we think the number of people employed in India for jobs outside the country is likely to at least double to 11 million. And we think that global spending on outsourcing could rise from its current level of U.S. dollar 180 billion per year to about 1/2 trillion U.S. dollars by 2030. 

Michael Zezas: In addition to being "the office of the world", you see India as a "factory to the world" with manufacturing going up. What evidence are we seeing of India benefiting from China moving away from the global supply chain and shifting business activity away from China? 

Ridham Desai: We are anticipating a wave of manufacturing CapEx owing to government policies aimed at lifting corporate profits share and GDP via tax cuts, and some hard dollars on the table for investing in specific sectors. Multinationals are more optimistic than ever before about investing in India, and that's evident in the all-time high that our MNC sentiment index shows, and the government is encouraging investments by building both infrastructure as well as supplying land for factories. The trends outlined in Morgan Stanley's Multipolar World Thesis, a document that you have co authored, Mike, and the cheap labor that India is now able to offer relative to, say, China are adding to the mix. Indeed, the fact is that India is likely to also be a big consumption market, a hard thing for a lot of multinational corporations to ignore. We are forecasting India's per capita GDP to rise from $2,300 USD to about $5,200 USD in the next ten years. This implies that India's income pyramid offers a wide breadth of consumption, with the number of rich households likely to quintuple from 5 million to 25 million, and the middle class households more than doubling to 165 million. So all these are essentially aiding the story on India becoming a factory to the world. And the evidence is in the sharp jump in FDI that we are already seeing, the daily news flows of how companies are ramping up manufacturing in India, to both gain access to its market and to export to other countries. 

Michael Zezas: So given all these macro trends we've been discussing, what sectors within India's economy do you think are particularly well-positioned to benefit both short term and longer term? 

Ridham Desai: Three sectors are worth highlighting here. The coming credit boom favors financial services firms. The rise in per capita income and discretionary income implies that consumer discretionary companies should do well. And finally, a large CapEx cycle could lead to a boom for industrial businesses. So financials, consumer discretionary and industrials. 

Michael Zezas: Finally, what are the biggest potential impediments and risks to India's success? 

Ridham Desai: Of course, things could always go wrong. We would include a prolonged global recession or sluggish growth, adverse outcomes in geopolitics and/or domestic politics. India goes to the polls in 2024, so another election for the country to decide upon. Policy errors, shortages of skilled labor, I would note that as a key risk. And steep rises in energy and commodity prices in the interim as India tries to change its energy sources. So all these are risk factors that investors should pay attention to. That said, we think that the pieces are in place to make this India's decade.

Michael Zezas: Ridham, thanks for taking the time to talk. 

Ridham Desai: 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.

As bond markets appear to have already priced in what central banks will likely do in 2023, how will this path impact inflation and currencies around the world?

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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 2023 outlook and how investors should view some key macro trends. It's Tuesday, December 6th, at 10 a.m. in New York. 

During the pandemic in 2020 and 2021, central banks provided the global economy a safety net with uber-accommodative interest rate and balance sheet policies. In 2022, central banks started to aggressively pull away that safety net. In 2023, we expect central banks to finish the job. And in 2024, central banks will likely start to roll out that safety net again, namely by lowering interest rates. 

Bond markets, which are forward looking discounting machines, are already pricing in the final stages of what central banks will likely do in 2023. The prospect of easier central bank policies should bring with it newfound demand for long term government bonds, just at a time when supply of these bonds is falling from decade long highs seen in 2021 and 2022. 

Central bank balance sheets will continue to shrink in 2023, meaning central banks are not aggressively buying bonds - but investors shouldn't be intimidated. These expected reductions in central bank purchases are already well understood by market participants and largely in the price already. In addition, for the largest central bank balance sheets, the reductions we forecast simply take them back to the pre-pandemic trend. 

Of course, for central bank policies and macro markets alike, the path of inflation and associated expectations will exert the most influence. We think inflation will fall faster than investors expect, even if it doesn't stabilize at or below pre-pandemic run rates. 

Lower inflation around the world should allow central banks to stop their policy tightening cycles. As lower U.S. inflation brings a less hawkish Fed to bear, the markets should price lower policy rates and a weaker U.S. dollar. Lower inflation in Europe and the U.K. should encourage a less hawkish ECB and Bank of England. This should help growth expectations rebound in those vicinities as rates fall, which will result in euro and sterling currency strength. 

We do think the U.S. dollar has already peaked and will decline through 2023. A fall in the U.S. dollar is usually something that reflects, and also contributes to, positive outcomes in the global economy. Typically, the U.S. dollar falls during periods of rising global growth and rising global growth expectations. 

As we anticipate the dollar's decline through 2023, it's worth noting that in emerging markets, U.S. dollar weakness and EM currency strength actually tend to loosen financial conditions within emerging market economies, not tighten them. Emerging markets that have U.S. dollar debt will also see their debt to GDP ratios fall as their currencies rise, further helping to lower borrowing costs and, in turn, boosting growth. 

In a nutshell, we see the negative feedback loops that were in place in 2022 reversing, at least somewhat in 2023 via virtuous cycles led by lower U.S. inflation, lower U.S. interest rates, and a weaker U.S. dollar. 

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 tactical rally in stocks has continued and treasury bonds have experienced their own rally, leaving investors to wonder when this bear market might run out of steam.

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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 5th, at 11 a.m. in New York. So let's get after it.  

Last week, the tactical rally in stocks took another step forward after Fed Chair Jay Powell's speech at the Brookings Institution. After his comments and interview, long term Treasury yields came down sharply and continued into the end of the week. This sparked a similar boost higher in equities, led by the most interest rate sensitive and heavily shorted stocks. This fits nicely with our view from a few weeks ago, which suggests that any further rally would require lower long term interest rates. It also makes sense in the context of what we think has been driving this tactical rally in the first place - the growing hope for a Fed pivot that kick saves the economic cycle from a recession. 

So maybe the biggest question is why did Treasury bonds rally so much? First, we think it mostly had to do with Powell now pushing back on the recent loosening of financial conditions. Many investors we spoke with early last week thought Powell would try to cool some of the recent excitement, to help the Fed get inflation under control. Furthermore, investors seem positioned for that kind of hawkish rhetoric, so when that didn't happen we were off to the races in both bonds and stocks. 

Second, the jobs data on Friday were stronger than expected, which sparked a quick sell off in bonds and stocks on Friday, but neither seemed to gain any momentum to the downside. Instead, bonds rallied back sharply, with longer term bonds ending up on the day. Meanwhile, the S&P 500 held its 200 day moving average after briefly looking like a failed breakout on Friday morning. In short, the surprising strength in the labor market did not scare away the newly minted bond bulls, which is more focused on growth slowing next year and the Fed pausing its rate hikes. 

A few weeks ago, we highlighted how breadth in the equity market has improved significantly since the rally began in October. In fact, breath for all the major averages is now well above the levels reached during the summer rally. This is a net positive that cannot be ignored. It's also consistent with our view that even if the S&P 500 makes a new low next year as we expect, the average stock likely will not. This is typically how bear markets end with the darlings of the last bull finally underperforming to the degree that is commensurate with their outperformance during the prior bull market. Third quarter earnings season was just the beginning of that process, in our view. In other words, improving breadth isn't unusual at the end of a bear market. 

Given our negative outlook for earnings next year, even if we skirt an economic recession, the risk reward of playing for any further upside in U.S. equities is poor. This is especially true when considering we are now right into the original resistance levels of 4000 to 4150 we projected when we made the tactically bullish call seven weeks ago. 

Bottom line, the bear market rally we called for seven weeks ago is running out of steam. While there could be some final vestiges of strength in the year end, the risk reward of trying to play forward is deteriorating materially given our confidence in our well below consensus earnings forecast for next year. From a very short term perspective, we think 4150 is the upside this rally can achieve and we would not rule that out over the next week or so. Conversely, a break of last week's low, which coincides with the 150 day moving average around 3940, would provide some confirmation that the bear market is ready to reassert the downtrend in earnest. 

Defensively oriented stocks should continue to outperform until more realistic earnings expectations for next year are better discounted. We expect that to occur during the first quarter and possibly into the spring. At that point, we will likely pivot more bullish structurally. Until then, bonds and defensively oriented bond proxies like defensive stocks should prove to be the best harbor for this storm. 

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 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.

----- Transcript -----

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.

----- Transcript -----

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.

----- Transcript -----

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. 

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 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.