Thoughts on the Market

Looking back on the 2016 and 2020 elections, it is clear that elections can have a significant impact on the U.S. economic outlook. The question is whether the coming midterm elections have any meaningful implications. Head of U.S. Public Policy Research and Municipal Strategy Michael Zezas and Chief U.S. Economist Ellen Zentner discuss.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of U.S. Public Policy Research and Municipal Strategy for Morgan Stanley. 

Ellen Zentner: And I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist. 

Michael Zezas: And on this special edition of the podcast, we'll be talking about the 2022 U.S. midterm elections and the potential impact on markets and the economy. It's Wednesday, June 1st, at 10 a.m. in New York. 

Ellen Zentner: Michael, I'm going to start us off here because 13 states have now completed their primaries ahead of the midterm elections. And as our key Beltway observer, I'd love to get your initial impressions. There's a fair amount of belief that Democrats will have a difficult time maintaining majorities in both houses of Congress and maybe some investor complacency around this sort of outcome. So what are you hearing from investors and how should they be thinking about the midterms? 

Michael Zezas: Yeah. I think the word complacency is the correct word to use here. I think in some ways this election hasn't gotten as much attention as it should because in prior elections there was a big macro issue at play, whether it be tax cuts and trade policy in 2016, or in 2020 whether or not another tranche of COVID stimulus aid could get approved based on the election outcome. This election, we think the outcomes will really drive more sectoral impacts. So whether or not tech regulation becomes possible or regulation around cryptocurrency, or could there be a path toward spending more money on renewables and traditional energy exploration. And then, of course, corporate taxes. And then when you couple that with polls and other items suggesting that Republicans are very likely to take control of one or more chambers of Congress, it's easy to put this issue aside and become complacent about it. But Ellen, this focus on the micro doesn't necessarily mean that the outcome doesn't matter for the macro, i.e., the U.S. economic outlook. Can we look back a bit to some prior elections and how they changed the trajectory of your economic outlook? 

Ellen Zentner: So, you know, I would start with 2016 where we had a Republican sweep and that led to the Tax Cut and Jobs Act being passed. It was a significant increase in the fiscal deficit and a good deal of stimulus to the economy. And so we really saw that bear out in 2017 where you already had a late cycle dynamic. At the time we called it ill timed policy, where you're throwing stimulus at the economy, when the economy doesn't really need it, you really want to do the majority of your fiscal stimulus when you're actually in a downturn. Trade policy then followed. And of course, late in 2018 started to really bite the global economy. And that's when we saw the Fed also move,v to the sidelines and start cutting rates because they saw a big slowdown in the global economy that was also hitting the U.S. economy. So fiscal policy there had both an uplifting effect and a depressing effect in the outlook. And then I would point to 2020 where the election outcome really opened the door for further fiscal stimulus related to COVID. So we had already done rounds of significant fiscal stimulus, but then in a Democratic sweep, you had two further rounds of fiscal stimulus related to COVID. And so that also had a very big effect on shaping the economy in terms of the excess savings that households were building up and the amount of excess money in the economy. And so I think those are the two best examples, of course, the two most recent examples. 

Michael Zezas: So a common thread between 2016 and 2020 was that the outcome had one party in control of both chambers of Congress as well as the White House. And it's long been part of our framework that one party control is a prerequisite for Congress providing proactive fiscal aid to the economy. So let's say the conventional thinking about this election is correct and the Republicans pick up control of one or both chambers of Congress. Then we'd expect that Congress would be more reactive to economic conditions than proactive, basically, that the economy would have to demonstrably worsen before you'd see Congress deliver aid. Would that shift in dynamic mean anything to your US economic outlook? 

Ellen Zentner: I mean, our baseline outlook fiscal policy is really not a big factor. The biggest factor coming from fiscal policy has already passed. So late last year we passed a significant infrastructure spending bill and while at the time that had a market impact, it doesn't really have an economic impact until about four quarters later when the bulk of those funds hit the economy. And so that's something that starts to lift growth in the fourth quarter of this year, we estimated by about 3/10 lift to GDP from those funds going out. Otherwise, in our baseline outlook, fiscal policy is just not a big factor. I think when we think about our bear case where we actually have a recession, that would be the first chance for fiscal policy to really kick in meaningfully. But even there, because we don't expect the downturn to be very deep, we expect nothing more than, say, the automatic stabilizers that typically go in to support the economy when jobless claims are rising, and the unemployment rate is rising and other economic factors are weakening. Finally, Michael, I want to ask you about election night and the days that follow. And I'm going to ask this because uncertainty around election outcomes also can impact the economy near term. So how likely is it we'll see the same sort of delays in vote tallies that we saw in 2020?. 

Michael Zezas: Yeah. I think investors should be on guard for a very similar time frame. The problem that drove this delayed tally in 2020 was the growth in use of vote by mail, and that really hasn't changed or is unlikely to change in our view. And of course, the problem is voting by mail, those ballots get tallied separately and sometimes later, as opposed to the machine votes which get tallied much quicker on election night. And like last time, it seems that Democrats tend to use vote by mail more than Republicans. So it creates this dynamic where on election night, initial leads could be misleading and you have to wait until the final votes are tallied in order to understand what the true margin is. So investors should prepare to wait a few days to fully understand, particularly if this is a close election, who is going to control the House of Representatives and who is going to control the Senate. That could create some volatile moments in the parts of the market that are most sensitive to these outcomes. Again, that's going to be sectors that are sensitive to corporate tax changes, tech regulation, crypto regulation and energy spending. 

Michael Zezas: Ellen, thanks so much for taking the time to talk with me. 

Ellen Zentner: As always, great talking with you, Michael. 

Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show. 

While there continues to be turbulence in many sectors, such as energy and food, some Asia and Emerging Markets may fare better than others through the second half of an already hectic 2022.

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Welcome to Thoughts on the Market. I'm Jonathan Garner, Morgan Stanley's Chief Asia and Emerging Markets Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about our mid-year outlook for Asia and Emerging Markets. It's Tuesday, May the 31st at 8 p.m. in Hong Kong. 

In our mid-year outlook, our advice was to stick with the markets and sectors which have performed well already this year. These are in the main plays on high energy, materials and food prices. In our coverage, this means commodity exporters including Australia, Indonesia and Saudi Arabia, which we have been overweight for some time. We also added another commodity exporter, Brazil, to this overweight group and reiterated our overweight on energy and materials. 

Despite outperformance, we continue to encounter skepticism that these markets and sectors can continue to perform. And this is mainly due to concerns over global growth, and in particular growth in China. Certainly, it's true that energy and materials tend to perform well late on in the cycle, whereas I.T hardware, semiconductors and consumer discretionary tend to do well coming out of recession. And it's also true that the Chinese economy is weak right now, with data showing a considerable slowdown in April and May. And that is a key reason why we remain cautious on China equities themselves. But we think the combination of underinvestment in the prior cycle in supply and the Russia-Ukraine conflict keep the commodity markets tight for the foreseeable future. 

The pattern of earnings revisions confirms our thesis. Analysts are upgrading numbers for stocks in Australia, Brazil, Indonesia and Saudi Arabia, in some cases at an accelerating pace. Whilst they’re downgrading for China, Korea and Taiwan, which are manufacturing exporting and commodity importing markets, Japan is slightly different, with balanced earnings revisions as corporate margins are helped by the recent trend to a weaker yen, amongst other factors. 

Hence, thus far, for some key emerging markets, notably Brazil and Indonesia, their commodity producing and exporting characteristics are offsetting, both from a currency and equity market perspective, the traditionally negative impact on growth from a stronger U.S. dollar and monetary policy tightening by the U.S. Federal Reserve. 

In time, this pronounced pattern of earnings dispersion may reverse and we are on the lookout for a trend reversal. This could be driven by factors like a change in COVID management approach in China or cessation of the conflict in Ukraine. For the time being though, we recommend keeping things simple in turbulent times. 

Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today. 

So far this year's economic story has been dominated by inflation and central bank policy, but as that landscape changes, is it time to shift focus back towards growth?

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 27th at 2 p.m. in London. 

2022 has given investors a lot to chew on. But out of the many developments of this year, one really stands out. It's inflation and the impact that high inflation has had on central bank policy. If you had to pick a defining economic trend in the last 40 years, it was probably the steady moderation of inflation. Then, if you had to pick a defining trend of the last decade, it was the issue of inflation being unusually low, a symptom of weak growth that warranted major central bank support. 

This year, the story changed. Rising prices started to be driven by strong demand that outstripped available supply, rather than COVID related disruptions. The persistence of these rising prices caught central banks and professional forecasters by surprise. Central bank policy then shifted rapidly, a shift that drove bond yields higher, market valuations lower, and defined much of the market's performance year to date. 

But now this story may be changing again, away from inflation and back towards growth. After rocketing higher over the first five months of the year, Morgan Stanley's economists do expect U.S. inflation to moderate for the rest of 2022. Some of this is that we're passing the peak rate of change, recall that on a year over year basis, prices today are being compared to May of 2021, a time when the U.S. vaccination rate was still low and activity was a long ways from being back to normal. 

We're also seeing encouraging signs that some of the worst disruption to supply chains are easing. Fewer ships are sitting off of U.S. ports, unloaded. The cost of freight is declining. Many retailers are now reporting plenty of inventory. And don't just take our word for it. Market based estimates of future inflation have been declining, in both the U.S. and Europe, over the last month. 

If this trend of moderating inflation can hold, there are some important implications. First, at a very simple but very important level, inflation that is high but falling, is much less frightening to the market than inflation that's high, but rising. This should help reduce the market's fear about a more extreme, 1970's style scenario. 

Second, it suggests that expectations of future central bank interest rates don't need to rise much further. That, in turn, could help bond yields stabilize, especially in the U.S. And more stable bond yields could help higher quality parts of the fixed income market, like mortgages and municipal bonds, that tend to be very sensitive to that interest rate volatility. 

The flip side is that as markets focus less on inflation, they will likely focus more on growth, where Morgan Stanley's economists see a sharp deceleration. While short term bounces are possible, we'd like to see more conservative estimates for earnings before assuming that the market's challenges are truly behind it. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you. 

With growth slowing and the Fed focused on fighting inflation, investors should note that the outlook for government bonds depends on more than just central bank policy.

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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, May 26th, at 11 a.m. in New York. 

For government bond markets, the start to 2022 will go down in the history books. Since the start of the year, central banks have delivered changes to monetary policies and associated forward guidance. And as a result, government bond markets have had their worst start to the year in decades. The repricing in markets ultimately came as a result of central banks surprising expectations among economists and market participants alike. 

Heading into the year, our economists thought that the Federal Reserve would continue to buy bonds well into 2022 and that it wouldn't be ready to raise policy rates until 2023. Since then, however, the Fed has stopped its asset purchases, announced plans to shrink its balance sheet starting in June and has hiked short term rates by 75 basis points already. 

Our economists now expect the Fed to deliver two more 50 basis point rate hikes this year, then downshift to a series of 25 basis point moves. At the end of the year, they see the Fed funds target range at 2.5% to 2.75%, and the Fed's balance sheet on its way to $6.5 trillion. 

However, investors should note that the outlook for government bonds depends on more than just central bank policies. For example, projected government deficits and related financing needs will decline substantially this year, and more fully in 2023. In addition, risks to global growth skew to the downside already. 

And as monetary policies tighten, downside risks to growth, and eventually inflation, will increase. These conditions, which traditionally support government bonds, factor into our view for how yields will evolve over the next 12 months. 

We expect U.S. Treasury yields to move higher through 2023, but not materially so. A continued focus on above target inflation should keep the Fed marching towards a neutral level for policy this year. 

Our economists anticipate a front loaded hiking cycle, with early increases in the Fed funds rate being more important than the potential for later ones. With this Fed forecast, we expect front end yields to trace market implied forward yields, largely consistent with two year Treasury yields reaching 3.25% by the end of the year. 

In contrast, demand from investors looking to hedge risks to a weaker outcome for global growth will likely show up in the longer end of the Treasury curve. We think the ten year yield will end the year near 3%, which is a level we were at not that long ago. 

As a result, we're forecasting an inverted yield curve at year end. With inflation remaining high and growth slowing, discussions of stagflation or outright recession should continue to lead investor debate this year. And ultimately, that should limit the degree to which Treasury yields rise into year end. 

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.

Stress on supply chains has driven a slowdown in globalization, but there are also investment opportunities emerging, particularly in Asia. Head of Public Policy Research and Municipal Strategy Michael Zezas and Asia and Emerging Markets Equity Strategist Daniel Blake discuss.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. 

Daniel Blake: And I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy Team. 

Michael Zezas: And on this episode of Thoughts on the Market, we'll continue our discussion of a theme that's been rightfully getting a lot of attention - "slowbalization", slowing globalization within an ever more multipolar world. It's Wednesday, May 25th, at 8 a.m. in New York. 

Michael Zezas: So Daniel, over the last few years, Morgan Stanley Research has published a lot of collaborative work across regions and sectors on the increasingly important themes of slowbalization and the multipolar world. But while in the past we focused more on the costs and challenges of this transition, today we want to put a greater emphasis on the opportunities from this theme, particularly in Asia. Investors are acutely aware that one of the key drivers behind this slowbalization trend is the tremendous disruption to the supply chain. You've been publishing a supply chain choke point tracker tool, so maybe let's start there with an update on the current state of supply chains in Asia and what your most recent tracker is indicating. 

Daniel Blake: Thanks, Mike. In short, this is showing that the supply chain in general remains very stressed. And in aggregate, we have not seen any material improvement over the last six weeks. Now, when we look at the aggregate measure put together by our economists, the Morgan Stanley Supply Chain Conditions Index, we are seeing that conditions are still slightly better than the peak of the disruptions and backlogs that occurred in late 2021, particularly around the delta wave in South East Asia. But we haven't seen much further improvement beyond that. Our checkpoint tracker does go down to the individual component or service level, and it shows that supply of certain auto and industrial semis and advanced packaging remains a constraint on downstream production. And we are seeing that show up in corporate results in the tech sector as well as the broader impact on margins that we're seeing into the consumer space. 

Michael Zezas: And one of the pressing issues that investors have been paying attention to is the new shocks to supply chains from China's COVID containment policy. Can you give us an update on the current impact of this policy?

Daniel Blake: Now, so far, this is having a more noticeable impact on the domestic Chinese economy rather than on export markets, with policymakers trying to prioritize industrial output through systems such as closed loop management, which sees workers living on site for extended periods to maintain as much production as possible. The challenge has been most acute where mobility is needed, including in the transportation of raw materials and industrial production within China. Geographically, we've seen the impact on the Pearl River Delta around Shenzhen, the Yangtze River Delta around Shanghai and neighboring provinces, and more recently the capital, Beijing, is seeing an outbreak. So progress has been made on reopening from full lockdowns in Shenzhen and Shanghai gradually, but our China economics team still estimate that about 25% of national GDP is being subject to some additional COVID restrictions. And again, we need to watch out for the progression of the outbreak closely.

Michael Zezas: When do you expect to see an easing of supply chain choke points and what factors could drive that easing? 

Daniel Blake: One of the points in the blue paper from late 2021 was the role on the demand side, the generous stimulus and acute shifts in spending patterns from COVID had in driving demand well above the world's productive capacity, even before you consider the supply disruptions we're seeing. So heading into summer 2022, we get the flip side, which is what our consumer analysts call the great reversion. Stimulus rolls off, fiscal spending does taper, and we see spending returning to categories like travel and tourism and leisure, as opposed to demand for goods and electronics. That may mean we get an outright contraction in some product segments. Now, this downturn may not be the best way, but it's the probably quickest way to get to an easing of supply chain choke points. And we are getting more evidence of this in order cuts across PC and smartphone in Asia. On the more constructive side, we're also seeing CapEx coming into areas like driving edge semiconductor foundry. But we'll also need to watch commodity markets, particularly as we've got agricultural trade channels into the European summer looking highly stressed. And we're seeing policy responses in some markets that are looking to prioritize domestic demand for industrial output and for agricultural output over export markets. So we don't think we're through the worst of this just yet. So we really need to watch for conditions to improve potentially later in 2022. 

Michael Zezas: Now let's zero in for a moment on some sector level observations. Semiconductors, for example, has been one of the sectors most in focus in the context of slowbalization. Can you talk about some of the particular challenges semis are facing in East Asia? 

Daniel Blake: There really are two dimensions, I think to this. One is the centrality of semiconductor companies at the leading edge and the concentration of global production in several key markets, and in particular in Taiwan and Korea. Now, when we look at the challenges here we can see policymakers in major capitals, in D.C. and Beijing, looking to try to encourage more localization, more internalization of supply chains. And that's putting some pressure, but also creating incentives for companies to add new capacity into the U.S., and we're seeing capacity coming into the Japanese market as well. So the challenge and opportunity I think for these leading companies is to try to manage those pressure points and protect return on invested capital as much as possible in the face of the need to strengthen and secure additional capacity in supply chains. The other element, which is important in terms of the challenges for semis, is more cyclical and we have seen a surge in demand, we've seen a build up of margins in the industry as it has benefited from this pull forward, from the work from home spending. And on the other side of that, we are going to see a downturn which is potentially exacerbated by the inventory buildup that has happened across the board in semis. Some semiconductor components are still in acute supply, but there are many that are not so disrupted, and when we look at the outlook we have seen inventory build up across the board. The risk is in the downturn, we start to see deeper order cuts because the inventory in aggregate is actually higher than what we've seen historically. 

Michael Zezas: Now shifting towards some macro level takeaways. The dynamic between the U.S. and China could be challenging, but is also creating potential opportunities for other countries such as Vietnam, India and Indonesia. Can you walk us through the tailwinds as well as the headwinds for these countries and what they're doing to take advantage of the situation? 

Daniel Blake: Yes, in Asia-Pacific, we have seen Vietnam already playing an important role for corporates as a complement to Chinese supply chains. It's smaller, but it's a natural extension of existing production facilities in China. But we've also seen policy and corporate momentum, the reform story, improving most notably in India, but also improving in Indonesia. And both markets have enacted quite deep and broad reform programs to lower corporate tax rates, to liberalize foreign direct investment rules, to invest in infrastructure and generally to make their market more attractive for multinational corporates as they're reassessing their supply chain strategy and looking to diversify. In terms of our preferences we are currently overweight Indonesia right now in our Asia Pacific, ex-Japan and Emerging Markets rankings. It benefits from strong commodity export dynamics and we also see long term opportunities coming through in terms of supply chain investments in Indonesia. But India has a very attractive long run story. If we can see continued execution, this market will present both domestic and export opportunities, and the production linked incentives being offered have been taken up by corporates and are helping to drive this foreign direct investment cycle. 

Michael Zezas: Daniel, thanks for taking the time to talk. It was great to have you here in person. 

Daniel Blake: Great speaking with you, Michael. 

Michael Zezas: And thanks for listening. For a look inside some of the human impacts of the recent supply chain disruptions, and how people are trying to resolve them, check out the latest season of Morgan Stanley's podcast "Now, What's Next?" on your podcast app of choice. If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show. 

So far this year cryptocurrencies have been on a swift downturn, increasingly in line with equity market moves. What's behind this correlation? And what should investors watch out for next?

Digital assets, sometimes known as cryptocurrency, are a digital representation of a value that function as a medium of exchange, a unit of account, or a store of value, but generally do not have legal tender status. Digital assets have no intrinsic value and there is no investment underlying digital assets. The value of digital assets is derived by market forces of supply and demand, and is therefore more volatile than traditional currencies’ value. Investing in digital assets is risky, and transacting in digital assets carries various risks, including but not limited to fraud, theft, market volatility, market manipulation, and cybersecurity failures—such as the risk of hacking, theft, programming bugs, and accidental loss. Additionally, there is no guarantee that any entity that currently accepts digital assets as payment will do so in the future. The volatility and unpredictability of the price of digital assets may lead to significant and immediate losses. It may not be possible to liquidate a digital assets position in a timely manner at a reasonable price.

Regulation of digital assets continues to develop globally and, as such, federal, state, or foreign governments may restrict the use and exchange of any or all digital assets, further contributing to their volatility. Digital assets stored online are not insured and do not have the same protections or safeguards of bank deposits in the US or other jurisdictions. Digital assets can be exchanged for US dollars or other currencies, but are not generally backed nor supported by any government or central bank.

Before purchasing, investors should note that risks applicable to one digital asset may not be the same risks applicable to other forms of digital assets. Markets and exchanges for digital assets are not currently regulated in the same manner and do not provide the customer protections available in equities, fixed income, options, futures, commodities or foreign exchange markets.

Morgan Stanley and its affiliates do business that may relate to some of the digital assets or other related products discussed in Morgan Stanley Research. These could include market making, providing liquidity, fund management, commercial banking, extension of credit, investment services and investment banking.

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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be talking about the crypto bear market. It's Tuesday, May 24th, at 2 p.m. in London. 

Bitcoin is down 55% from its November 2021 high, and currently trades at around $30,000. Over that same period, crypto market capitalization has lost over $1 trillion. All the while, Bitcoin's correlation with the equity markets has risen to new highs. So what is going on? Who is selling and what should we watch out for next? 

In 2018, retail investors were dominant in crypto markets, participating in 80% of trading volumes on Coinbase, the large crypto exchange. Today, the story couldn't be more different, with only 1/4 of trading volumes on Coinbase being with retail investors. Institutions, and more specifically crypto institutions, appear to have taken over, many of which are simply trading with each other. We think retail investors are more likely to buy and hold, but institutional investors are willing to both buy and sell crypto, if it means they can make a return. And because institutional investors are sensitive to the availability of capital and therefore interest rates, they trade crypto somewhat in sympathy with the way equities are traded. This shift in the type of market participant is key to understanding why crypto markets are selling off at the same time as the equity markets are experiencing a downturn. 

Cryptocurrency prices rose rapidly in 2020 and 2021, attracting a new set of investors. Bitcoin rose 10x from March 2020 to its first peak in April 2021. Ether, the second largest crypto, rose even more, over 40x in a similar period. The stimulus provided by central banks and governments throughout the pandemic was the key driver of the crypto bull market. As the Federal Reserve indicated late last year that it plans to raise interest rates and reduce the size of its balance sheet, crypto markets began to weaken. 

The downturn is now starting to have a broader impact on the crypto ecosystem. In mid-May a stablecoin called Terra Dollar, or UST, lost its peg to the U.S. dollar, which meant it was no longer trading at $1 USD and instead trades closer to $0 USD. UST lost its peg as it was backed by cryptocurrencies, which themselves were losing value, and because market makers no longer trusted the ability of the stablecoin to retain its dollar peg. There was a negative spillover into Bitcoin and other cryptos, with the largest stablecoin called Tether briefly losing its dollar peg intraday. Tether is the other side of half of all bitcoin traded on exchanges, so its stability is extremely important for the broader crypto market. The dollar asset reserves that backed Tether will continue to be scrutinized and questioned by market participants. Stablecoins are used to create leverage in decentralized finance crypto systems, and that leverage is now falling as crypto traders, that may have bought Bitcoin or other cryptos, have faced margin calls. 

In general, the elevated prices were traded on speculation, with limited real user demand. NFT and digital land prices are next areas to watch. Of course, many are looking for signs of a market turnaround. The retail investors may have been outnumbered by institutions, but they haven't gone away. The downturn may continue if central banks persist in their policy of tightening, but the strong hands of these retail investors have historically served as a support to falling prices. 

Thank you for listening. If you enjoy thoughts on the market, share this and other episodes with a friend or colleague today. 

As we enter the second half of 2022, the market is signaling a continued de-rating of equities, lingering challenges for consumers, and an increased bearishness among equity investors.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, May 23rd at 9 a.m. in New York. So let's get after it. 

As we’ve discussed our mid-year outlook the past few weeks, I'd like to share some key takeaways on today's podcast. First, the de-rating of equities is no longer up for debate. However, there is disagreement on how low price earnings multiple should fall. We believe the S&P 500 price earnings multiple will fall towards 14x, ahead of the oncoming downward earnings revisions, which is how we arrive at our near-term overshoot of fair value of 3400 for the S&P 500. 

Second, the consumer is still a significant battleground. While COVID has been a terrible period in history, many U.S. consumers, like companies, benefited financially from the pandemic. Our view coming into 2022 was that this tailwind would end for most households, as we anniversaried the stimulus, asset prices de-rated and inflation in non discretionary items like shelter, food and energy ate into savings. Consumer confidence readings for the past six months support our view. Yet many investors have continued to argue the consumer is likely to surprise on the upside with spending, as they use excess savings to maintain a permanently higher plateau of consumption. 

Third, technology bulls are getting more concerned on growth. This is new and in stark contrast to the first quarter when tech bulls argued work from home benefited only a few select companies, while most would continue to see very strong growth from positive secular trends for technology spend. Some bulls have even argued technology spending is no longer cyclical but structural and non-discretionary, especially in a world where costs are rising so much. We disagree with that view and argue technology spending would follow corporate cash flow growth and sentiment. 

We have found many technology investors are now on our page and more worried about companies missing forecasts. While some may view this as bullish from a sentiment standpoint, we think it's a bearish sign as formerly dedicated tech investors will be more hesitant to buy the dip. In short, we believe technology spending is likely to go through a cyclical downturn this year, and it could extend to even the more durable areas like software. 

Finally, energy is the one sector where a majority of investors are consistently bullish now. This is not necessarily a contrarian signal in our view, but we are a bit more concerned about the recent crowding as energy remains the only sector other than utilities that is up on the year. With oil and gasoline prices so high, there is a growing risk we have reached a level of demand destruction. We remain neutral on energy with a positive bias for the more defensive names that pay a solid dividend.

Bottom line, equity clients are bearish overall and not that optimistic about a quick rebound. While this is a necessary condition for a sustainable low in equity prices, we don't think it's a sufficient one. While our 12 month target for the S&P 500 is 3900, we expect an overshoot to the downside this summer that could come sooner rather than later. We think 3400 is a level that more accurately reflects the earnings risk in front of us, and expect that level to be achieved by the end of the second quarter earnings season, if not sooner. Vicious bear market rallies will continue to appear until then, and we would use them to lighten up on stocks most vulnerable to the oncoming earnings reset. 

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

2022 is off to a rocky start for markets, but there is an organization to this downturn that is unlike recent episodes of market weakness, meaning investors can use tried-and-true strategies to bring order to the chaos.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 20th, at 3 p.m. in London. 

There are a lot of ways to describe the market at the moment. One that I'm increasingly fond of is "organized chaos". 

Chaos because, well, the year is off to a historically bad start. Year to date, the S&P 500 is down about 20%. The U.S. aggregate bond index is down about 9%. And almost every asset class that isn't commodities has posted negative returns. This weakness has been both large and relentless. For the stock market, it's been seven straight weeks of losses. 

Yet all of this weakness has also been surprisingly organized. The worst performing parts of the stock market have been the most expensive, least profitable parts of it. After being unusually low for a long time, bond yields and credit spreads have risen. After outperforming to an extreme degree, growth stocks and U.S. equities are now lagging. Indeed, if you don't know how a particular asset class has done this year, "moving closer to its long run valuation average" is a pretty good guess. 

So as difficult as 2022 has been, many tried and true strategies are working. Rules based approaches, also known as systematic strategies, have in some cases been performing quite well. Relative value strategies, which trade within an asset class based on relative valuation, yield, momentum or fundamentals, have been working unusually well. 

That's different from four prior episodes that saw similar or greater weakness than we see today. Those episodes being the global financial crisis of 2007 to 2009, the European sovereign crisis of 2011 and 2012, the volatility shocks of 2018 and Covid's emergence in 2020. Each of these four instances were notable for being disorganized, stressed, with very unusual movements below the market surface. 

Why does this matter? First, it suggests that investors should move toward relative value in this environment, which has been working, rather than taking large directional positions. 

Second, it suggests that this downturn is different from those that we've known since 2008. It is still difficult, but it is more gradual, less stressed, and more about specific debates around growth and risk premiums, than existential questions such as whether the banking system or the European Union will survive. While that difference has many potential implications, one specific one is that it’s less problematic for high quality credit, which did unusually poorly during these more recent crises, but which we think will do better this time around. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.

With rising prices already on the minds of investors and consumers, the outlook in Europe remains challenged across supply chains, inflation rates and energy markets. Chief European Economist Jens Eisenschmidt and Global Oil Strategist and Head of the European Energy Team Martijn Rats discuss.

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Jens Eisenschmidt: Welcome to Thoughts on the Market. I'm Jens Eisenschmidt, Morgan Stanley's Chief European Economist. 

Martijn Rats: And I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist and Head of the European Energy Research Team. 

Jens Eisenschmidt: And today on the podcast, we will be talking about the outlook for the European economy for the next 12 months in the very challenging context of rising energy prices and sustained inflationary pressure. It's Thursday, May 19, at 4 p.m. in London. 

Jens Eisenschmidt: So, Martin, I wanted to talk with you today about some burning issues that seem to be topmost on everybody's mind these days, namely rising energy prices and inflation. These challenges are affecting literally everyone. And Europe, in particular, is acutely feeling the impact from the war in Ukraine. Let's maybe pick up with a topic you discussed on this podcast back in January. So even prior to the war in Ukraine, you talked about five enduring tailwinds boosting commodities. So far in 22, commodities are on track to outperform equities for the second consecutive year. Now that we are approaching the mid-year mark, what's your outlook for the second half of 22 in terms of commodities and which ones are likely to outperform the most in the current environment? 

Martijn Rats: Some things have changed, but also a lot of things are still the same when it comes to the outlook for commodities. Commodities move in long cycles. The last decade was, on the whole, more challenging, but we think that we're still in the relatively early innings of what could be a long cycle ahead. You already mentioned the five enduring tailwinds that we've previously written about and discussed on podcasts like this. First of all, is inflation. Commodities often do well in inflationary periods, and the inflationary pressures are still there, that's one. Secondly, geopolitical risk. Thirdly, there's the energy transition. For a broad range of commodities the energy transition is a demand tailwind, but for a lot of others, it's basically a red flag not to invest in supply. Then fourthly, a lot of commodities have gone through a long period of very little investment. That sets up a tighter supply outlook. And then finally there's reopening. A lot of reopening has already played out, but there are still important pockets of reopening that have yet to fully materialize. A lot of that thesis is still the same. And I would expect that this will carry the commodity asset class for some time. Now, in terms of how things have changed at the start of the year, we were more optimistic about demand for a lot of commodities, and those expectations have come down a little bit because the economic slowdown, because of China. But we were also more optimistic about the supply for those commodities. We've seen a lot of headwinds in terms of the supply of a broad range of commodities, particularly because of the war in the Ukraine. So net net our balances are broadly still equally tight, if not slightly tighter, and that's to still set up the commodity asset class quite well. Also for the second half, the ones that we prefer the most, it's mostly the energy commodities. We think they'll do better than the metals. That is already happening as we speak, but there is more to come in that relative trade in the second half as well. 

Jens Eisenschmidt: Let's talk a little bit about oil. You've said that you continue to see upside to oil prices, even though the nature of your thesis has changed since the start of the year. Could you walk us through your thinking specifically around oil? 

Martijn Rats: Yes. At the start of the year, we were thinking that oil demand could grow this year by something like 3.5 to 4 million barrels a day, year over year compared to 2021. And that expectation had turned out to be too optimistic. There are basically two reasons for that. First of all, is China. The Zero-Covid policies in China and the stringent lockdowns that have come with that means that at the moment we're probably losing something like 1.5 to 2 million barrels a day of oil demand in China right now. Now, that might not last the entire year, but there is a material effect. And then also economic growth expectations have come down. And as a result, we also had to moderate our oil demand forecasts. But then on the supply side, we had to make even bigger changes. Russian production has fallen by broadly a million barrels a day already, and we think that that will continue to fall by another million barrels a day in the second half of the year. So when you add it all up, I'm sure our demand expectations have fallen, but they are already at a level that I would say is reflective of the current situation while there's still meaningful supply risks and when you put those two things combined, actually our balances are even slightly tighter than they were at the start of the year. Hence the call, as we've had it for a while, for $130 brent by the third quarter. 

Jens Eisenschmidt: Turning to the European gas markets. Gas prices in Europe are roughly five times as high as in the U.S., reflecting the increased risk to Russian supply created by the war in Ukraine. What are your expectations in terms of Europe following through on its intent to phase out Russian gas? And what potential scenarios do you see playing out here? 

Martijn Rats: The story about European gas is is quite a bit different from what it is to oil. There is clearly heightened risk in the European gas market right now that is reflected in price. As a result, the price is well above historical levels, is well above the levels that prevail in the United States. But that also means that a lot of the world's seaborne gas, a lot of those cargoes of LNG at the moment are ending up in Europe. At the same time. Russian flows of natural gas into Europe are low, but they by and large continue. And when you put all of that together, actually, judging by, you know, the normal fundamental metrics that we look at, the European gas market right here, right now today is actually relatively soft. But all of that is, of course, drowned out by the risk that Russian supplies may be impacted. Now, that remains very difficult to call in the short run. That's also the reason why you see European gas prices being so volatile. What does strike us to be the case is that Europe will wean itself off Russian gas over the next sort of 5, 6, 7 years towards the end of the decade. That will require a lot of LNG to come to Europe and also a fair amount of demand erosion. Neither of these things will happen with low prices. We have low conviction on what happens to European natural gas prices in the short run, admittedly, but we have high conviction that gas prices will need to stay high, if not very high by historical standards for several years to come to allow the European gas markets to move away from Russian supplies.

Jens Eisenschmidt: Maybe one last word on metals. What are your expectations for metals, especially vis a vis what you just said about energy? 

Martijn Rats: If you look at metals for most of the metals, practically all of them, China is a huge factor in setting the demand outlook. So where would we be cautious at the moment is in the precise trajectory of the demand recovery in China. At the same time, we are quite concerned about the supply outlook, particularly as of Russia. So if you put all of that together, the metals suffer much more from weak Chinese demand, whilst the energy commodities are much more impacted by tight supply because of the Russian situation. So our preference over the last couple of months, for some time already, to be honest, has been to prefer the energy commodities. Whilst we think that the metals will probably stay a little weaker for some time to come because of their dominant exposure to Chinese demands factors. So there is a strong story to be told about many of the metals over the next sort of 5, 6, 7 years around energy transition. But right here, right now, we're biding our time a little bit with the metals. Jens, the 1Q GDP and inflation numbers confirms that supply shocks are hitting hard on the European economy, even after its strong post-COVID recovery in 2021. In your mid-year outlook, you refer to the set of challenges facing Europe as a perfect storm. Tell us why the situation looks so challenging from where you stand. 

Jens Eisenschmidt: Yes, you're right, Martin. It's very difficult in these days to get very optimistic about the growth outlook. I mean, we started the year actually on a much brighter note with a growth outlook of 3.9% for 22 for the euro area and had to revise it consecutively down to 3 to 2.7 and now to 2.6. And this is all on the back of as you mentioned, supply side shocks. First of all, we would have, of course, a huge hit to disposable income through inflation. Also, as we don't really see the wage developments catching quite up to that number. We are facing here a shock to confidence that we have seen emanating from both the war, but also from more generally the developments surrounding us. We have recently seen news from increased chances for more supply chain issues coming our way, for instance, out of China. Plus, on the other side of the Atlantic, the Federal Reserve has started to aggressively rein into their inflation that has significant domestic demand component to it. Overall, it's very difficult to see really bright spots here. That's why we have arrived at 2.6% in our forecast, that is despite significant dynamics coming out from the reopening and fiscal stimulus being on the road. So overall, it's a very challenging environment we are in. 

Jens Eisenschmidt: Martijn, thanks for taking the time to talk. 

Martijn Rats: Thanks, Jens was great to speak with you. 

Jens Eisenschmidt: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

As we continue to track the trends of 'slowbalization' and the shift towards a multipolar world, Mexico stands out as an economy uniquely positioned to benefit from these changes. Head of Public Policy Research and Municipal Strategy Michael Zezas and Mexico Equity Strategist Nik Lippmann discuss.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. 

Nik Lippmann: I'm Nik Lippmann, Mexico Equity Strategist for Morgan Stanley. 

Michael Zezas: And on this episode of Thoughts on the Market, we'll be discussing the trend towards slowbalization within a multipolar world, a move that's been accelerated by recent geopolitical events, and in particular, the opportunity for Mexico and global investors. It's Wednesday, May 19th, at 1 p.m. in New York. 

Michael Zezas: So we've talked a lot on this podcast about the trends of slowbalization and the shift to a multipolar world. It's basically the idea that the globe is no longer solely organizing around the same political economy principles. And that, for example, the rise of China as an economic power with a political system that's distinctly different from the West, creates some barriers to economic interconnectedness. And we've talked a lot about how that can create new costs for Western companies and inflationary pressures, as all of a sudden you need to make investments, for example if you're Europe, to build an infrastructure to import natural gas from the U.S. so you don't have to buy it from Russia anymore. But this trend isn't all about creating headwinds and costs for the economy, we think there's opportunity, too. And there's regions that we think stand to benefit from an uptick in investment as American and European companies need to recreate that labor and market access in other parts of the globe. Mexico is one country that stands out to us, and so we want to speak with Nik Lippmann. Nik, can you tell us why you think Mexico is poised to benefit here? 

Nik Lippmann: So I'm sitting down in Mexico watching all this stuff play out from a number of different angles. And it's clear to me that Mexico will play a role. It's right next to the U.S., you have trade tariff protection, and multiple levels of rights are protected by the USMCA. And Mexico has advanced tremendously in terms of advancing the value chain and moving up in terms of complexity. So it's come a long way over the last sort of two decades. And today what we see in Mexico is really a strong ecosystem for electronics and cars and even some aerospace. When I look at this recovery, post-COVID in Mexico, I see kind of an average recovery, to be honest. But right below the headline number, we see something else going on. We see electronics growing 40%. 

Michael Zezas: So you mentioned a lot has changed in Mexico recently that makes this possibility more likely. What is it that changed? Why couldn't this have been a greater opportunity for Mexico earlier? 

Nik Lippmann: I think that after the trade tensions with China, the pandemic, we've just been getting, you know, higher freight costs. We've been getting a number of obstacles to the existing trade framework. So there are certain external policy factors that clearly play in and it's clear that the chip has kind of changed over the course of the beginning of this year and opened the eyes to some of the risks that could be emerging in other parts of the world. It's clear that Mexico's able and fairly high quantities of labor. There will be needs to educate and develop further infrastructure. But Mexico's position and its proven track record in terms of making electronics and cars. I think that can be expanded into other things. And we're seeing the early stages of that on the ground already today.

Michael Zezas: So geopolitics is an obvious catalyst for Mexico to be a beneficiary generally. Specifically, what sectors of the economy in Mexico stand out to you as an opportunity? 

Nik Lippmann: So when we look at what Mexico does today, it makes cars and refrigerators and microwave ovens and stationary computers. It doesn't make laptops, tablets, and I don't think it will ever make tablets, mobile phones. I would imagine that we start seeing ecosystems and I always focus on ecosystems rather than individual companies, that you start having an emergence of some of the low tech health care, aerospace is growing tremendously, even pharma. And I think one of the things that I would expect to happen and it's difficult to have clear evidence today, but I would expect some corporates to at least diversify their existing supply chains rather than just relying on one country. I think Mexico just tends to benefit in that process. 

Michael Zezas: And so as a market strategist, what do you expect to see or how do you expect to see this play out in Mexico's equity markets? 

Nik Lippmann: By and large, I think this is a 3 to 5 year system or thesis or theme that will have a tremendous impact on potentially improving the narrative of Mexico. And it's going to impact a wide range of their corporates that would come on the U.S. side of the border. From the car space to electronics and machinery and what have you. And it doesn't happen from one day to another. But the country's fairly well positioned. I think in terms of the investability impact, clearly a couple of sectors stand out, such as real estate. This is a more than a near-term in theme that would cause us to change the recommendation from here till the year end 22. I think it's a key fact in terms of how we suggest investors to have allocation within Mexico focus on industrials, external sectors and real estate with exposure to the U.S.. And I think for a lot of investors in U.S. corporates, in manufacturing and out of the auto space and other sectors, this is a super important longer term theme that can affect and maybe redevelop to some degree in Mexico investment narrative. 

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

Nik Lippmann: Thanks, Mike, for inviting me. 

Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show. 

As we forecast the remainder of an already uncertain 2022, new questions have emerged around economic data, inflation and the potential for a recession. Chief Cross Asset Strategist Andrew Sheets and Chief Global Economist Seth Carpenter discuss.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets. Morgan Stanley's Chief Cross-Asset Strategist. 

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

Andrew Sheets: And today on the podcast, we'll be talking about our outlook for strategy and markets and the challenges they may face over the coming months. It's Tuesday, May 17th, at 4 p.m. in London. 

Seth Carpenter: And it's 11 a.m. in New York. 

Andrew Sheets: So Seth, the global Morgan Stanley Economic and Strategy Team have just completed our mid-year outlook process. And, you know, this is a big collaborative effort where the economists think about what the global economy will look like over the next 12 months, and the strategists think about what that could mean for markets. So as we talk about that outlook, I think the economy is the right place to start. As you're looking across the global economy and thinking about the insights from across your team, how do you think the global economy will look over the next 12 months and how is that going to be different from what we've been seeing? 

Seth Carpenter: So I will say, Andrew, that we titled our piece, the economics piece, slowing or stopping with a question mark, because I think there is a great deal of uncertainty out there about where the economy is going to go over the next six months, over the next 12 months. So what are we looking at as a baseline? Sharp deceleration, but no recession. And I say that with a little bit of trepidation because we also try to put out alternative scenarios, the way things could be better, the way things could be worse. And I have to say, from where I'm sitting right now, I see more ways for the global economy to be worse than the global economy to be better than our baseline scenario. 

Andrew Sheets: So Seth, I want to dig into that a little bit more because we're seeing, you know, more and more people in the market talk about the risk of a slowdown and talk about the risk of a recession. And yet, you know, it's also hard to ignore the fact that a lot of the economic data looks very good. You know, we have one of the lowest unemployment rates that we've seen in the U.S. in some time. Wage growth is high, spending activity all looks quite high and robust. So, what would drive growth to slow enough where people could really start to think that a recession is getting more likely?

Seth Carpenter: So here's how I think about it. We've been coming into this year with a fair amount of momentum, but not a perfectly pristine outlook on the economy. If you take the United States, Q1, GDP was actually negative quarter on quarter. Now, there are a lot of special exceptions there, inventories were a big drag, net exports were a big drag. Underlying domestic spending in the U.S. held up reasonably solidly. But the fact that we had a big drag in the U.S. from net exports tells you a little bit about what's going on around the rest of the world. If you think about what's going on in Europe, we feel that the economy in the eurozone is actually quite precarious. The Russian invasion of Ukraine presents a clear and critical risk to the European economy. I mean, already we've seen a huge jump in energy prices, we've seen a huge jump in food prices and all of that has got to weigh on consumer spending, especially for consumers at the bottom end of the income distribution. And what we see in China is these wave after wave of COVID against the policy of COVID zero means that we're going to have both a hit to demand from China and some disruption to supply. Now, for the moment, we think the disruption to supply is smaller than the hit to demand because there is this closed loop approach to manufacturing. But nevertheless, that shock to China is going to hurt the global economy. 

Andrew Sheets: So Seth, the other major economic question that's out there is inflation, and you know where it's headed and what's driving it. So I was hoping you could talk a little bit about what our forecasts for inflation look like going forward. 

Seth Carpenter: Our view right now is that inflation is peaking or will be peaking soon. I say that again with a fair amount of caution because that's been our view for quite some time, and then we get these additional surprises. It's clear that in many, many economies, a huge amount of the inflation that we are seeing is coming from energy and from food. Now energy prices and food prices are not likely to fall noticeably any time soon. But after prices peak, if they go sideways from there, the inflationary impulse ends up starting to fade away and so we think that's important. We also think, the COVID zero policy in China notwithstanding, that there will be some grudging easing of supply chain frictions globally, and that's going to help bring down goods inflation as well over time. So we think inflation is high, we think inflation will stay high, but we think that it's roughly peaked and over the balance of this year and into next year it should be coming down.

Andrew Sheets: As you think about central bank policy going forward, what do you think it will look like and do you think it can get back to, quote, normal? 

Seth Carpenter: I will say, when it comes to monetary policy, that's a question we want to ask globally. Right now, central banks globally are generically either tight or tightening policy. What do I mean by that? Well, we had a lot of EM central banks in Latin America and Eastern Europe that had already started to hike policy a lot last year, got to restrictive territory. And for those central banks, we actually see them starting to ease policy perhaps sometimes next year. For the rest of EM Asia, they're on the steady grind higher because even though inflation had started out being lower in the rest of EM Asia than in the developed market world, we are starting to see those inflationary pressures now and they're starting to normalize policy. And then we get to the developed market economies. There's hiking going on, there's tightening of policy led by the Fed who's out front. What does that mean about getting back to an economy like we had before COVID? One of the charts that we put in the Outlook document has the path for the level of GDP globally. And you can clearly see the huge drop off in the COVID recession, the rapid rebound that got us most of the way, but not all the way back to where we were before COVID hit. And then the question is, how does that growth look as we get past the worst of the COVID cycle? Six months ago, when we did the same exercise, we thought growth would be able to be strong enough that we would get our way back to that pre-COVID trend. But now, because supply has clearly been constrained because of commodity prices, because of labor market frictions, monetary policy is trying to slow aggregate demand down to align itself with this restricted supply. And so what that means is, in our forecast at least, we just never get back to that pre-COVID trend line. 

Seth Carpenter: All right, Andrew, but I've got a question to throw back at you. So the interplay between economics and markets is really uncertain right now. Where do you think we could be wrong? Could it be that the 3%, ten-year rate that we forecast is too low, is too high? Where do you think the risks are to our asset price forecasts? 

Andrew Sheets: Yeah, let me try to answer your question directly and talk about the interest rate outlook, because we are counting on interest rates consolidating in the U.S. around current levels. And our thinking is partly based on that economic outlook. You know, I think where we could be wrong is there's a lot of uncertainty around, you know, what level of interest rate will slow the economy enough to balance demand and supply, as you just mentioned. And I think a path  where U.S. interest rates for, say, ten year treasuries are 4% rather than 3% like they are today, I think that's an environment where actually the economy is a little bit stronger than we expect and the consumer is less impacted by that higher rate. And it's going to take a higher rate for people to keep more money in savings rather than spending it in the economy and potentially driving that inflation. So I think the path to higher rates and in our view does flow through a more resilient consumer. And those higher rates could mean the economy holds up for longer but markets still struggle somewhat, because those higher discount rates that you can get from safe government bonds mean people will expect, mean people will expect a higher interest rate on a lot of other asset classes. In short, we think the risk reward here for bonds is more balanced. But I think the yield move so far this year has been surprising, it's been historically extreme, and we have to watch out for scenarios where it continues. 

Seth Carpenter: Okay. That's super helpful. But another channel of transmission of monetary policy comes through exchange rates. So the Fed has clearly been hiking, they've already done 75 basis points, they've lined themselves up to do 50 basis points at at least the next two meetings. Whereas the ECB hasn't even finished their QE program, they haven't started to raise interest rates yet. The Bank of Japan, for example, still at a really accommodative level, and we've seen both of those currencies against the dollar move pretty dramatically. Are we in one of those normal cycles where the dollar starts to rally as the Fed begins to hike, but eventually peaks and starts to come off? Or could we be seeing a broader divergence here? 

Andrew Sheets: Yeah. So I think this is to your point about a really interesting interplay between markets and Federal Reserve policy, because what the Fed is trying to do is it's trying to slow demand to bring it back in line with what the supply of things in the economy can provide at at current prices rather than it at higher prices, which would mean more inflation. And there's certainly an important interest rate part to that slowing of demand story. There's a stock market part of the story where if somebody's stock portfolio is lower, maybe they're, again, a little bit less inclined to spend money and that could slow the economy. But the currency is also a really important element of it, because that's another way that financial markets can feed back into the real economy and slow growth. And if you know you're an American company that is an exporter and the dollar is stronger, you likely face tougher competition against overseas sellers. And that acts as another headwind to the economy. So we think the dollar strengthens a little bit, you know, over the next month or two, but ultimately does weaken as the market starts to think enough is priced into the Fed. We're not going to get more Federal Reserve interest rates than are already implied by the market, and that helps tamp down some of the dollar strength that we've been seeing. 

Andrew Sheets: And Seth thanks for taking the time to talk. 

Seth Carpenter: Andrew, it's been great talking to you. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

The mid-year outlook for European stocks sees markets encountering a variety of challenges to equity performance, but there may still be some interesting opportunities for investors.

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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the tricky outlook for European stocks for the second half of the year, and where we think the best opportunities lie. It's Monday, May the 16th at 2 p.m. in London. 

Although the global macro backdrop feels particularly complicated just here, we think the outlook for European equities is relatively straightforward... and, unfortunately, still negative. Over the last month or so our European economists have revised their GDP forecast lower, their inflation forecast higher, and brought forward the timing of ECB interest rate hikes - an unappealing combination for risk assets, even before we consider elevated geopolitical risks. Looking into the second half of the year, we think this backdrop will persist, with European economic growth slowing considerably, but with inflation remaining sticky at around 7% and putting considerable pressure on consumer finances. 

As well as the consumer, we think corporates are also going to feel the squeeze from this backdrop of slowing growth and rising prices. So far, Europe's corporate earnings trend has held up remarkably well this year. However, we think this is about to change and that a new downgrade cycle is likely to start in the coming months. This cycle is likely to reflect two drivers. First, weaker top line demand as new orders slows. And second, a squeeze on corporate margins as companies struggle to pass on their own input costs to customers. If we look at the gap between real GDP growth, which is low, and inflation, which is high, then the decline in margins could be really quite severe. 

Historically, the impact on equity performance from a period of weaker earnings is often offset by a rise in the price-to-earnings ratio, as it usually coincides with more dovish central bank policy. However, this is unlikely to be the case this time, given that inflation is so high and central banks were relatively late to start their hiking cycle. Hence now the pace of rate hikes starts to accelerate as earnings starts to slow. 

Of course, some of this difficult backdrop is already priced into markets, given that investor sentiment appears to be low. However, we do not believe that all of the bad news is yet discounted. European equity valuations are now down to a price-to-earnings ratio of 12.5, which is below the long run average. However, equity markets rarely trough on valuation grounds alone, and a further drop down towards 10-11x looks plausible to us over the summer. While we remain cautious on European equities at the headline level, we do see some interesting opportunities for investors to make money within the markets. 

First, at the country level, we continue to like the UK equity market and specifically the FTSE 100, which is the cheapest major global stock market. And it also benefits from having high defensive characteristics, which means it tends to outperform when global stocks are falling. 

Second, from a sector perspective, we prefer defensive names such as healthcare, telecoms, tobacco and utilities. We do expect to turn more positive on cyclicals later in 2022, but for now it is too early. On average, the best time to buy cyclicals is one month before economic leading indicators trough. The problem now is that these indices haven't started to fall yet. 

Lastly, we continue to favor value stocks over growth stocks. While the latter have underperformed quite significantly so far this year, we think valuations and positioning still remain too high and that a broader reset of expectations is needed before they become attractive again. One value strategy we particularly like here is buying stocks with attractive dividends, as we think these stocks offer an appealing alternative to bonds and provide some protection from higher rates and inflation. 

Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today. 

Stock-based employment compensation has gained popularity in recent years, and even investors who don’t receive employment compensation in stock should be asking, is SBC potentially dilutive to shareholders?

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Welcome to Thoughts on the Market. I'm Todd Castano, Head of Global Valuation, Accounting and Tax within Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the interesting conundrum around stock based compensation. It's Friday, May 13th at 2 p.m. in New York. 

I don't need to tell listeners that 2022 has been rough on equity prices. And while it may be difficult to look at the double digit drop in the S&P or on your 41k, I'm going to share an interesting ripple effect from the market correction. And that's the impact on employee stock based compensation. And while some listeners may be saying, "this doesn't affect me because I don't receive compensation in stock", it doesn't mean it's not having an effect on your portfolio. But let me start at the beginning. 

For those unfamiliar, stock based compensation, often called SBC, is a form of compensation given to employees or other parties like vendors in exchange for their services. It's a very common way for companies to incentivize employees and to align employee and shareholder interest. When a company does well, everyone does well. Stock options, restricted stock, restricted stock units are currently the most common types of stock based compensation. 

Stock based compensation issuance has gained in popularity, particularly with startups and new issuances, allowing companies without much cash on hand to offer competitive total compensation rates and to attract and retain talent. In fact, 2021 marked the largest annual growth percentage in SBC cost at 27% year over year. Primarily because of new entrants to the equity market through initial public offerings and from the recovery from COVID that triggered performance based bonuses. Let's put a number on it. Stock based compensation is now approaching $250 billion annually, mostly concentrated in technology and communication service sectors. 

So here's where it gets interesting. While stock based incentives encourage employees to perform, they also don't require upfront cash payments. It follows that they also dilute the ownership of existing shareholders by increasing the potential number of shares outstanding. 

So now you may see where I'm going with this in terms of shareholders and your portfolio. While companies have been issuing more stock awards to employees, the double digit year to date decline in equity market has put a lot of these awards underwater. In other words, employees are essentially being paid less, meaning stock based compensation could have the opposite effect, lowering morale and sending some employees to the exits. 

To put another number on it, we estimate nearly 40% of Russell 3000 companies currently are trading below their average stock grant values. Healthcare technology firms in particular appear most exposed. And considering we're in a tight labor market, companies may be forced to issue more grants to offset equity value decreases, further diluting ownership to existing shareholders. 

I point all this out because SBC is generally treated as a non-cash expense and ignored from earnings. Market data vendors also often exclude outstanding awards from market capitalization calculations. So investors may underappreciate the potential dilution SBC brings to their shares. With more dilution on the way as companies attempt to right size employee pay. 

For investors, we believe stock compensation is a real economic expense and should be incorporated in valuation. It may not appear so in bull markets, but this correction has eliminated that reality. 

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

As consumers deal with rising interest rates, persistent inflation, and a desire to get outside in the ever changing COVID environment, the question is, what does this all mean for the future of eCommerce growth?

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Welcome to Thoughts on the Market. I'm Andrew Rubin, Morgan Stanley's Latin America Retail and eCommerce Analyst. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the outlook for global e-commerce in the years ahead. It's Thursday, May 12th, at 2 p.m. in New York. 

Amid rising interest rates and persistent inflation, we've seen quite a lot of debate about the health of the consumer and the effect on eCommerce. If you couple those factors with consumers' desire to return to in-person experiences as COVID recedes, you can see why we've fielded a lot of questions about what this all means for eCommerce growth. 

To answer this question, Morgan Stanley's Internet, eCommerce and Retail teams around the world drew on both regional and company level data to fashion what we call, the Morgan Stanley Global eCommerce Model. And what we found was that the forward looking picture may be more robust than some might think. 

While stay at home trends from COVID certainly drove outsized eCommerce growth from 2019 to 2021, we found the trend should stay stronger for longer, with eCommerce set to grow from $3.3 trillion currently to $5.4 trillion in 2026, a compound annual growth rate of 10%. 

And there are a few reasons for that. First, the shift toward online retail had already been in place well before the COVID acceleration. To put some numbers behind that, eCommerce volumes represented 21% of overall retail sales globally in 2021. That's excluding autos, restaurants and services. So, while the rise of eCommerce during the first year of COVID in 2020 is easily explained, the fact that growth persisted in 2021, even on a historically difficult comparison, is evidence, in our view, of real behavioral shift to shopping online. 

Another factor that supports our multi year growth thesis is a trend of broad based eCommerce gains, even for the highest penetration countries and categories. As you might expect, China and the U.S. represent a sizable 64% of global eCommerce volumes, and these countries are the top drivers of our consolidated market estimates. 

But we see higher growth rates for lower penetrated regions, such as Latin America, Southeast Asia and Africa, as well as categories like grocery and personal care. Interestingly, however, in our findings, no country or vertical represented a single outsized growth driver. Looking at South Korea, which is the global leader in e-commerce, we expect an increase from 37% of retail sales in 2021 to 45% in 2026. For the electronics category worldwide, which leads all other major categories with 38% penetration, we forecast penetration reaching 43% in 2026. And while there are some headwinds due to logistics in certain countries and verticals, we believe these barriers will continue to come down. 

Another encouraging sign is that globally, we have yet to see a ceiling for eCommerce penetration. We identify three fundamental factors that underpin our growth forecasts and combine for what we see as a powerful set of multi-year secular drivers. First, logistics. We see a big push towards shorter delivery times and lower cost or free delivery. The convenience of delivery to the door is a top differentiating factor of eCommerce versus in-store shopping. And faster speeds can unlock new eCommerce categories and purchase occasions. Second, connectivity. Internet usage is shifting to mobile, and smartphones and apps are increasingly the gateway to consumers, particularly in emerging markets. And these consumers, on average, skew younger and over-index for time spent on the mobile internet. And third is Marketplace. We see a continued shift from first party owned inventory to third party marketplace platforms, connecting buyers and sellers. 

For investors, it's important to note that global eCommerce does not appear to be a winner-take-all market. And this implies opportunity for multiple company level beneficiaries. In particular, investors should look at companies with forecast share gains, exposure to higher growth categories, and discounted trading multiples versus history. 

Thanks for listening. If you enjoyed the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

Original Release on April 26th, 2022: Global supply chains have been under stress from the pandemic, geopolitical tensions, and inflation, and the outlook for transportation in 2022 is a mixed bag so far. Chief U.S. Economist Ellen Zentner and Equity Analyst for North American Transportation Ravi Shanker discuss.

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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research, 

Ravi Shanker: and I'm Ravi Shanker, Equity Analyst covering the North American Transportation Industry for Morgan Stanley Research. 

Ellen Zentner: And today on the podcast, we'll be talking about transportation, specifically the challenges facing freight in light of still tangled supply chains and geopolitics. It's Tuesday, April 26, at 9:00 a.m. in New York. 

Ellen Zentner: So, Ravi, it's really good to have you back on the show. Back in October of last year we had a great discussion about clogged supply chains and the cascading problems stemming from that. And I hoped that we would have a completely different conversation today, but let's try to pick up where we left off. Could we maybe start today by you giving us an update on where we are in terms of shipping - ocean, ground and air? 

Ravi Shanker: So yes, things have materially changed since the last time we spoke, some for the better and some for the worse. The good news is that a lot of the congestion that we saw back then, whether it was ocean or air, a lot of that has eased or abated. We used to have, at a peak, about 110 ships off the Port of L.A. Long Beach, that's now down to about 30 to 40. The other thing that has changed is we just went from new peak to new all time peak on every freight transportation data point that we were tracking over the last two years. Now all of those rates are collapsing at a pace that we have not seen, probably ever. It's still unclear whether this legitimately marks the end of the freight transportation cycle or if it's just an air pocket that's related to the Russia Ukraine conflict or China lockdowns or something else. But yes, the freight transportation worlds in a very different place today, compared to the last time I was on in October. Ellen, I know you wanted to dig a little more deeply into the current challenges facing the shipping and overall transportation industry. But before we get to that, can you maybe help us catch up on how the complicated tangle created by supply chain disruptions has affected some of the key economic metrics that you've been watching over the last six months? That is between the time we last spoke in October and now. 

Ellen Zentner: Sure. So, we created this global supply chain index to try to gauge globally just how clogged supply chains are. And we did that because, what we've uncovered is that it's a good leading indicator for inflation in the U.S. and on the back of creating that index, we could see that the fourth quarter of last year was really the peak tightness in global supply chains, and it has about a six month lead to CPI. Since then, we started to see some areas of goods prices come down. But unfortunately, that supply chain index stalled in February largely on the back of Russia, Ukraine and on the back of China's zero COVID policy, starting to disrupt supply chains again. So the improvement has stalled. There are some encouraging parts of inflation coming down, but it's not yet broad based enough, and we're certainly watching these geopolitical risks closely. So, Ravi, I want to come back to freight here because you talked about how it's been underperforming for a couple of months now and forward expectations have consistently declined as well. You pointed to it as possibly being just an air pocket, but you're pointing, you're watching closely a number of things and anticipate some turbulence in the second half of the year. Can you walk us through all of that? 

Ravi Shanker: What I can tell you is that it's probably a little too soon to definitively tell if this is just an air pocket or if the cycles over. Again, we are not surprised, and we would not be surprised if the cycle is indeed over because in December of last year, we downgraded the freight transportation sector to cautious because we did start to see some of those data points you just cited with some of the other analysts. So we were expecting the cycle to end in the middle of 22 to begin with, but to see the pace and the slope of the decline and a lot of these data points in the month of March, and how that coincides with the Russia-Ukraine conflict and that the lockdowns in China, I think, is a little too much of a coincidence. So we think it could well be a situation where this is an air pocket and there's like one or two innings left in the cycle. But either way, we do think that the cycle does end in the back half of the year and then we'll see what happens beyond that. 

Ellen Zentner: OK, so you're less inclined to say that you see it spilling over into 2023 or 2024? 

Ravi Shanker: I would think so. Like if this is just a normal freight transportation cycle that typically lasts about 9 to 12 months. The interesting thing is that we have seen 9 to 12 months of decline in the last 4 weeks. So there are some investors in my space who think that the downturn is over and we're actually going to start improving from here. I think that's way too optimistic. But if we do see this continuing into 2023 and 2024 I think there's probably a broader macro consumer problem in the U.S. and it's not just a freight transportation inventory destocking type situation. 

Ellen Zentner: So Ravi, I was hoping that you'd give me a more definitive answer that transportation costs have peaked and will be coming down because of course, it's adding to the broad inflationary pressures that we have in the economy. Companies have been passing on those higher input costs and we've been very focused on the low end consumer here, who have been disproportionately burdened by higher food, by higher energy, by all of these pass through inflation that we're seeing from these higher input costs. 

Ravi Shanker: I do think that rates in the back half of the year are going to be lower than in the first half of the year and lower than 2021. Now it may not go down in a straight line from here, and there may be another little bit of a peak before it goes down again. But if we are right and there is a freight transportation downturn in the back of the year, rates will be lower. But, and this is a very important but, this is not being driven by supply. It's being driven by demand and its demand that is coming down, right. So if rates are lower in the back half of the year and going into 23, that means at best you are seeing inventory destocking and at worst, a broad consumer recession. So relief on inflation by itself may not be an incredible tailwind, if you are seeing demand destruction that's actually driving that inflation relief. 

Ellen Zentner: That's a fair point. Another topic I wanted to bring up is the fact that while freight transportation continues to face significant headwinds, airlines seem to be returning to normal levels, with domestic and international travel picking up post-pandemic. Can you talk about this pretty stark disparity? 

Ravi Shanker: Ellen it's absolutely a stark disparity. It's basically a reversal of the trends that you've seen over the last 2 years where freight transportation, I guess inadvertently, became one of the biggest winners during the pandemic with all the restocking we were seeing and the shift of consumer spend away from services into goods. Now we are seeing the reversion of that. So look, honestly, we were a little bit concerned a month ago with, you know, jet fuel going up as much as it did and with potential concerns around the consumer. But the message we've got from the airlines and what we are seeing very clearly in the data, what they're seeing in the numbers is that demand is unprecedented. Their ability to price for it is unprecedented. And because there are unprecedented constraints in their ability to grow capacity in the form of pilot shortages, obviously very high jet fuel prices and other constraints, I guess there's going to be more of an imbalance between demand and supply for the foreseeable future. As long as the U.S. consumer holds up, we think there's a lot more to come here. So Ellen, let me turn back to you and ask you with freight still facing such big challenges and pressure on both sides on the supply chain. What does that bode for the economy in terms of inflation and GDP growth for the rest of this year and going into next year? 

Ellen Zentner: So I think because, as I said, you know, our global supply chain index has stalled since February. I think that does mean that even though we've raised our inflation forecasts higher, we can still see upside risk to those inflation forecasts. The Fed is watching that as well because they are singularly focused on inflation. GDP is quite healthy. We have a net neutral trade balance on energy. So it actually limits the impact on GDP, but has a much greater uplift on inflation. So you're going to have the Fed feeling very confident here to raise rates more aggressively. I think there's strong consensus on the committee that they want to frontload rate hikes because they do need to slow demands to slow the economy. They do almost need that demand destruction that you were talking about. That's actually something the Fed would like to achieve in order to take pressure off of inflation in the U.S.. But we think that the economy is strong enough, and especially the labor market is strong enough, to withstand this kind of policy tightening. It takes actually 4 to 6 quarters for the Fed to create enough slack in the economy to start to bring inflation down more meaningfully. But we're still looking for it to come in, for core inflation, around 2.5% by the fourth quarter of next year. So, Ravi, thanks so much for taking the time to talk. There's much more to cover, and I definitely look forward to having you back on the show in the future. 

Ravi Shanker: Great speaking with you Ellen. Thanks so much for having me and I would love to be back. 

Thanks for listening. If you're interested in learning more about the supply chain, check out the newest season of Morgan Stanley's podcast, Now, What's Next? If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

U.S. markets and the Federal Reserve have been grappling with high inflation this year, but could changes in global supply chains help make this problem easier?

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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, May 10th, at 9 a.m. in New York. 

Inflation is perhaps the key to understanding the markets these days. Elevated inflation is what's driving the Fed to raise interest rates at the fastest pace in a generation. And at the risk of oversimplifying, when interest rates are higher, that means it costs more to get money. And when money is no longer cheap, anything that costs money is harder to buy and therefore might have to fall in value to find a buyer. This is the dynamic the Fed believes will eventually dampen price increases throughout the economy, and it's the dynamic that's likely contributed to stock market prices already declining. 

But what if inflation were to start easing without the Fed raising rates? Could the Fed slow its rate hikes and, consequently, help stop the current stock market sell off? It's an intriguing possibility and investors who want to understand if such an outcome is likely need to carefully watch global supply chains. And to be clear, when we're talking about the supply chain, we're talking about whether companies can produce and deliver sufficient goods in a timely manner to meet demand. When they cannot, as became the case during the pandemic when consumers stopped going out and started buying more things than normal for their homes, prices rise as choke points emerge in key markets where demand outstrips supply. By that logic, if goods producers are able to ramp up production or if consumers shift back to normal, balancing consumption of goods and services, inflation would ease, putting less pressure on the Fed to raise rates. 

So what's the state of global supply chains now? Are there any signs of supply chain easing that may make the Fed's job and investors near-term market experience easier? To answer this question my colleague, Asia and Emerging Market Equity Strategist Daniel Blake, formed a team to create a supply chain choke point tracker. What can we learn from this? In short, the picture is mixed. There's several factors that could lengthen global supply chain stress. COVID spread in China, for example, has led to lockdowns affecting about 26% of GDP, hampering their production of goods. And Russia's invasion of Ukraine, and resulting sanctions response by the U.S. and Europe, has crimped the global supply of oil, natural gas and key agricultural goods. But there's some good news too. Many companies are reporting initial investment and progress towards diversifying and, in some cases, reshoring supply chains, which over time should reduce choke points. 

Still, the challenging news for markets is that a mixed supply chain picture means that monetary policymakers are unlikely to see supply chain easing as a reliable outcome, at least in the near term. Unfortunately, that likely means we'll continue to see risk markets struggle with how to price in a Fed that stays on track to fight inflation through higher interest rates. 

Thanks for listening. If you're interested in learning more about the supply chain, check out the newest season of Morgan Stanley's podcast, Now, What's Next? If you enjoyed this show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

While the war in Ukraine has had an effect on the current pricing in European energy markets, there is more to the story of why high prices could persist for years to come. Chief Cross-Asset Strategist Andrew Sheets and Head of European Utilities and Clean Energy Research Rob Pulleyn discuss.

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

Rob Pulleyn: And I'm Rob Pulleyn, Head of the European Utilities and Clean Energy Research Team. 

Andrew Sheets: And today on the podcast, we'll be talking about the outlook for European energy supply and demand, in both the near and long term. It's Monday, May 9th, at 4 p.m. in London. 

Andrew Sheets: So, Rob, we talked a lot on this podcast since March about the effect of the Russia-Ukraine conflict on energy in Europe. I want to talk to you today in part because there are some interesting implications over the long term in the European energy and power markets. But just to level set a little bit what's been going on in European power prices. 

Rob Pulleyn: Sure. For context, Andrew, what's been happening is that European power prices versus 12 months ago are up between 150 and over 300%, depending on which country. They're pretty much at all time highs or slightly off them from where we were earlier this year. Now, what does that flow through to customer bills in places like the UK? Year over year customer bills are going up 60% so far, other country's a little bit lower due to some market intervention. But this is the backdrop. 

Andrew Sheets: Now, you've been talking to a lot of global investors around what's been going on in Europe. What's your most likely case? What's your base case? And then what are some realistic scenarios around that? 

Rob Pulleyn: We outlined four scenarios in the new note. The base case is that we get close to the FIT for 55 climate plan from last year, which envisages 65% renewables penetration by the end of the decade. Now, this is a long way short of the Repower EU plan, which would envisage about twice as much again in terms of the renewable capacity and getting to about an 80% penetration by the end of the decade. And so we see significant growth in renewables. We think coal will be phased out more or less by 2030, but with more burn in the next few years, less gas until gas supplies can be diversified. In terms of market intervention, we continue to think this will be relatively benign for utility stocks because effectively governments need to find a way to help the customer, but also ensure that utilities actually invest in the new power system that governments want. 

Andrew Sheets: But Rob, under your central scenario where power prices are significantly higher, isn't there a feedback mechanism there? Aren't people going to look at their sharply higher utility bills and say, I'm going to use less electricity, I'm going to put in double glazing, I'm going to improve my insulation, I'm going to do all these things that mean I use less energy. Which would hopefully mean less energy gets used and the power price impacts would be less significant. How much can energy efficiency influence the story or not? 

Rob Pulleyn: Now you're quite right. Demand destruction, one way or another, is part of the equation here. There's many renovation tools or new technologies which are now significantly more attractive in economic terms, simply because gas prices and power prices are so high. And whilst previously we thought there'd be a slow burn on many of those routes under the guise of decarbonization, now under cold, hard economics, as you highlight these things should all accelerate. And if I was going to point to one area of incremental policy support, I think it's got to be green gasses like hydrogen. I think that's a genuine route to both diversify gas supplies and also decarbonize. 

Andrew Sheets: So Rob, how do you think about the interplay between the economic backdrop and these power prices? Because it's been the energy shock from the conflict in Ukraine that's driven power prices up, but it's also been something that's led people to worry that European growth might slow, which would reduce the demand for power. So how does that play out as you're thinking about these various scenarios? 

Rob Pulleyn: Sure, it's a great question, Andrew. And let's just start by saying that as it stands today, utility bills contribute around about one third to the inflation rate that we have at the moment. And therefore, if these power prices and gas prices will persist as they stand, then that inflation will also be reasonably persistent. Now, of course, there is still upside risk to power price and gas prices in several scenarios, particularly those where supplies are interrupted, which would then create higher inflation on top of the rates we currently have. This would therefore then flow into the bear case that our economists have for GDP growth. And so the economic impact would of course, be there. Ultimately, GDP is sensitive to the input costs and energy is one of the biggest there is. 

Andrew Sheets: Rob, I also want to ask you about where technology fits into all of this. There are both some exciting advances in energy technology. On the renewable side, renewable energy is getting more efficient. We're seeing some interesting advances in battery storage. When you are trying to model European power consumption out over the next decade, how much of a technological impact are you putting in your numbers? 

Rob Pulleyn: Yeah. So the easy one to talk about is renewables, which is currently about 38% of the European stack. The Repower EU would imply something around 80%, which coincidentally is actually also the German target. Fit for 55 has a plan of 65% across the EU by 2030. We're modeling 62%. So significant increase from where we are today. And of course, where we are with power prices at the moment, then investing in European renewables is actually looking very attractive. I mean, very simply put, the offtake price is increasing more than the input cost inflation. That should lead to, you know, the right incentives to build more of these things. We talked about green gasses earlier. Now, whether it be market forces, the gas price, whether it be government support, ultimately we think green gasses is going to be accelerated and that can certainly help the economy beyond the power generation sector. So within European gas demand, power generation is around about 30% of it. The other two thirds, broadly evenly split, are residential heating and industrial heating furnaces and processes. And certainly hydrogen could be, in the long term, a solution for those aspects. Battery storage is a question we get a lot, particularly from the states where actually we're seeing some quite, quite stunning improvements in battery uptake. In Europe that is relatively small scale, but something which could also dramatically increase across the decade. 

Andrew Sheets: So, Rob, with all of this in mind, what should investors be looking at in European utilities and energy? 

Rob Pulleyn: Our preferred beneficiaries within the narrow definition of utilities and clean energy would be to combine the defensive nature of networks with clean energy growth. Right. And I think ultimately that that will be a very powerful combination for what the market's looking for with a macro backdrop. Your benefit for green growth from all the policy support and from the high power prices, at the same time, retaining these defensive qualities that the market increasingly seems to have an appeal for. A slightly more optimistic take would be to try and get that real power price sensitivity through some of the outright power producers, whether that's nuclear, hydro or renewables. Those stocks should benefit from significant earnings upgrades over the next few years. 

Andrew Sheets: Rob, thanks for taking the time to talk. 

Rob Pulleyn: Well, has been great speaking to you, Andrew. Thank you very much. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

While oil prices usually rise and fall with the overall stock market, current prices have broken from this trend and oil may continue to outperform on a cross-asset basis.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 6th, at 2 p.m. in London. 

Yesterday, U.S. equities fell more than 3% and U.S. 10 year Treasury bonds fell by more than 1%. This unusual pattern has only occurred 6 other days in the last 40 years. Markets are clearly continuing to struggle with major cross-currents, from a Federal Reserve that's raising interest rates, to mixed economic data, to the war in Ukraine. 

But one asset that's bucking the confusion is oil prices. Oil usually rises and falls with the overall stock market because the prices of both are seen as proxies for economic activity. But that relationship has broken down recently. As stock markets have fallen, oil prices have held up. We think that oil will continue to outperform on a cross-asset basis. 

Part of this story is fundamental. Demand for energy remains high, while energy supply has been slow to grow. The green transition is a big part of this. Consumers are likely to shift towards electric vehicles, but most cars currently on the road still burn fuel. Energy companies, seeing the shift in energy consumption coming, are more reluctant to invest in new production today. This has left the global oil market very tight, without much spare capacity. 

There's also a fundamental difference in the way asset classes discount future risks. Equity and credit markets are very forward looking, and their prices today should reflect how investors discount risks over the next several years. But commodity prices are different; when you need to fill up a car, or a plane, you need that fuel now. 

That distinction in timing doesn't always matter. But if you're in an environment where economic activity is strong right now, but it also might slow in coming years, equity and credit markets can start to weaken even as energy prices hold up. I think that's a pretty decent description of the current backdrop. 

A final part of this story is geopolitical. Oil prices could rise further if the war in Ukraine escalates, a scenario that would likely push prices down in other asset classes. But if geopolitical risk declines, there could be better growth, more economic confidence, and more energy demand, meaning oil might not fall much relative to forward expectations. That positive skew of outcomes should be supportive of oil. 

In the short term, high oil prices could weigh on consumer spending. In the long run, it creates a more powerful incentive to transition towards more energy efficiency and newer, cleaner energy sources. In the meantime, we forecast higher prices for oil, and for oil linked currencies like the Norwegian Krone. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

As “The Gig Economy” has evolved to become the Multi-Earner economy, an entire ecosystem reinventing how people earn a living, equity investors will want to take note of the related platforms that are making an impact on the market. European Head of Thematic Research Edward Stanley and U.S. Economist Julian Richers discuss.

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Ed Stanley: Welcome to Thoughts on the Market. I'm Edward Stanley, Head of Thematic Research in Europe. 

Julian Richers: And I'm Julian Richards from Morgan Stanley's U.S. Economics Team. 

Ed Stanley: And today on the podcast, we'll be talking about a paradigm shift in the future of work and the rise of the multi-earner era. It's Thursday, May the 5th at 3 p.m. in London. 

Julian Richers: And 10 a.m. in New York. 

Ed Stanley: So, Julian, I'd wager that most of our listeners have come across news articles or stories or even anecdotes about YouTubers, TikTok stars who've made an eye popping amount of money making videos. But you and I have been doing some research on this trend, and in fact, it appears to be much larger than just people making videos. It's an entire ecosystem that can reinvent how people earn a living. In essence, what we used to call the 'gig economy' has evolved into the multi earning economy—the side hustle. And people tend to be surprised at the sheer extent of side hustles that are out there: from blogging to live streaming, e-commerce, trading platforms, blockchain-enabled gaming. These are just a handful of some of the platforms that are out there that are facilitating this multi-earning era that we talk about. But explain for us and for our listeners why the employment market had such a catalyst moment with COVID. 

Julian Richers: With COVID, really what has fundamentally changed is how we think about the nature of work. So people had new opportunities and new preferences. People really started enjoying working remotely. Lots of people embraced their entrepreneurial spirit. And everything has just gotten a lot faster and more integrated the more we've used technology. And so you add on top of this, this emergence of these new platforms, and it's dramatically lowering the hurdle to go to work for yourself. And that's really how I think about this multi-earn era, right? It's working and earning in and outside of the traditional corporate structure. 

Ed Stanley: And talk to us a little bit about the demographics. Who are these multi-earners we're talking about? 

Julian Richers: So right now in our survey, we basically observe that the younger the better. So really the most prolific multi-earners are really in Gen Z. But it's really not restricted to that generation alone, right? It's pretty clear that Gen Z really desires these nontraditional work environments, you know, the freedom to work for oneself. But the barriers are really lowered for everyone across the board that knows how to use a computer. So, yes, Gen Z and it's definitely going to be a Generation Alpha after this, but it's not limited to that and we see a lot of millennials dipping their toes in there as well. 

Ed Stanley: And how should employers be thinking about this trend in terms of what labor's bargaining power should be and where it is, and the competition for talent, which is something that we hear quite consistently now in the press? 

Julian Richers: My view on this is that we're really seeing a quite dramatic paradigm shift in the labor market when it comes to wages. So for the last two decades, you had long periods of very weak labor markets that have just led to this deterioration in labor bargaining power. Now, the opposite, of course, is true, right? Workers are the scarce resources in the economy, and employers really need to look far and wide for them. And then add on top of this, uh, this multi-earn story. If it's that easy for me to wake up and go to work for myself on my computer, doing things that I enjoy, you'll need to pay me a whole lot more to put on a suit and come back to my corporate job. So Ed, with this background in mind, why should equity investors look at this trend now? 

Ed Stanley: It's a great question, and it's one that we confront a lot in thematic research. And we think about themes and when they become investable. For equity investors, themes tend to work best when we reach or surpass the 20% adoption curve. And that applies for technology and it applies for themes. And after this 20% point, typically investors needn't sacrifice profit for growth, which is a really important dichotomy in the markets, particularly at the moment where inflation is is clearly high and the markets are resetting from a valuation perspective. So this multi-earner theme and it's enabling technologies have hit or surpassed this 20% threshold I've talked about. While this structural trajectory is is incredibly compelling, the stock picking environment is obviously incredibly challenging at the moment. 

Julian Richers: So Ed, at the top, you mentioned that there are actually more of these multi-earn platforms out there than people might think. What's the ecosystem like for 'X-to-earn' and how many platforms and verticals are really out there? 

Ed Stanley: So the way we tried to simplify it, given that it is so broad and sprawling and increasingly so, was to try to bucket them. And we bucketed them into nine verticals with one extra one, which essentially is the facilitators—these are the big recruitment companies who are also trying to navigate this paradigm shift alongside these 'X-to-earners, these multi-earners. And we lay this out from the most mature to the least mature. And in the most mature category, we have content creators. We have the e-commerce platforms. We have delivery, as in grocery and delivery drivers, and then we start to get into the least mature verticals. This is trading as an earnings strategy which has been very volatile and continues to be so. Gig-to-earn, where people are spending time doing small tasks which don't take up large amounts of time typically and can be done on the side of corporate roles. And then right at the most emergent, or least mature, end of the spectrum, we have play-to-earn. And these tend to be based on blockchain platforms where participation is rewarded, in theory, by tokens which are native to that blockchain. So incredibly emerging technology and one that we're, we're looking to watch closely. 

Julian Richers: Yeah. So among those platforms, is there one that you think is particularly worth watching? 

Ed Stanley: Well, I think actually it comes down to that that latter point, I think many of the ones at the more mature end of the spectrum are pretty self-explanatory. A lot of that, I think, is second nature, particularly for younger users who are trying to make money on on these platforms. But it's at that more emerging end of the spectrum, the blockchain enabled solutions, where a lot of this is incredibly new and the innovation is happening at a really quite alarming rate. That blockchain enabled solution essentially is a new challenge to legacy institutions who don't anymore have to compete just with these traditional earning platforms, but they also have to compete with the labor monetization tools that blockchains facilitate. And they'll also have to compete with the lifestyle that these tools offer, which essentially is that freedom to work for yourself and to earn multiplicatively. 

Julian Richers: So, my last question ties back to the question that you had for me about how employers should think about this. What does this trend actually mean for corporates? 

Ed Stanley: So, this is something that certainly seems to be inflationary in the short term and I think we both agree appears to be structurally inflationary in the longer term. The real question both corporates and investors seem to have is, 'what happens to all of this in a recession?' And the recession point is something that is obviously gathering traction in the markets. It's gathering traction in the news. And a lot of this will become potentially untenable as a sustainable earning platform. And so these earning platforms cannot yet be assumed to be stable, sustainable revenue streams, particularly during downturns. And so, these are the kind of debates that are happening. But longer term, through a recession and out the other side, we still believe that the ability to scale, the low upfront costs, the low opportunity costs or perceived low opportunity costs of careers, are really what's driving this, and that is not going to go away just because of a recession. And so with that, Julian, thank you very much for taking the time to talk to me. 

Julian Richers: Great speaking with you, Ed. 

Ed Stanley: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.

2022 has presented a complex set of challenges, meaning investors may want to take a step back and consult rules-based indicators and strategies for some clarity.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Wednesday, May 4th, at 2 p.m. in London. 

2022 is complicated. Cross-asset returns are unusually bad and investors still face wide ranging uncertainties, from how fast the Federal Reserve tightens, to whether Europe sees an energy crisis, to how China addresses COVID. 

But step back a bit, and the year is also kind of simple. Valuations were high, policy is tightening and growth is slowing, and prices have fallen. Cheaper stocks are finally outperforming more expensive ones. Bond yields were very low and are finally rising. 

So what should investors do, given a complex set of challenges, but also signs of underlying rationality? This can be a good time to step back and look at what our rules-based indicators are saying. 

Let's start by focusing on what these indicators say about where we are in the cycle, and what that means for an investment strategy. Our cycle indicator looks at a range of economic data and then tries to map this to historical patterns of cross-asset performance. 

Our indicator currently sees the data as significantly above average. We call this 'late cycle', because historically readings that have been sharply above the average have often, but not always, occurred later in an economic expansion. This is not about predicting recession, but rather about thinking probabilistically. If the odds of a slowdown are rising, then it will affect cross-asset performance today, even if a recession ultimately doesn't materialize. 

At present, the 'late cycle' readings of this indicator are consistent with underperformance of high yield credit relative to investment grade credit, the outperformance of defensive equities, a flatter yield curve and being more neutral towards bonds overall. All are also current Morgan Stanley Research Views. 

A second question that comes up a lot in our meetings is whether or not there's enough worry and concern in the market to help it. After all, if most investors are already negative, it can be harder for bad news to push the market lower and easier for any good news to push the market higher. We try to quantify market sentiment and fear in our sentiment indicator. Our sentiment indicator works by trying to look at a wide variety of data, but also paying attention to not just its level but the direction of sentiment. At the moment, sentiment is not extreme and it's also not yet improving. Therefore, our indicator is still neutral. 

Given the swirling mix of storylines and volatility, a third relevant question is what would a fully rules-based strategy do today? For that we turn to CAST, our cross-asset systematic trading strategy. CAST asks a simple question with a rules-based approach; what looks most attractive today, based on what has historically worked for cross-asset performance. 

CAST is dialing back its market exposure, especially in commodities where it has become more negative on copper, although it still likes energy. CAST expects the Renminbi to weaken against the U.S. dollar, and Chinese interest rates to be lower relative to U.S. rates. In stocks, it is positive on Japan and healthcare, and negative on the Nasdaq and the Russell 2000. All of these align with current Morgan Stanley Research fundamental views and forecasts. 

Rules based tools help in markets that are volatile, emotional, and showing more storylines than a reasonable investor can process. For the moment, we think they suggest cross-asset performance continues to follow a late cycle playbook, that sentiment is not yet extreme enough to give a conclusive tactical signal, and that following historical factor-based patterns can help in the current market environment. These tools won't solve everything, but given the challenges of 2022 so far, every little bit helps. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you. 

As U.S. voters continue to show support for trade policy in regards to China, investors will want to track which actions could have consequences for China equities and currency markets.

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Welcome to Thoughts on the Market. I'm Michal Zezas, Head of Public Policy Research and Municipal Strategy for Morgan stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Tuesday, May 3rd, at 2 p.m. in New York. 

You might recall that, for much of 2018 and 2019 financial markets ebbed and flowed on the tensions between the U.S. and China over trade policy that led to escalation of tariffs, export restrictions and other policies that still hinder commerce between the countries today. We remind you of those events because they could echo through markets this year as calls in the U.S. for concrete trade policy action have recently grown louder. The main catalyst for this has been reports showing that China has fallen short of its purchase commitments within the Phase One trade deal signed in February of 2020. And polls show that voters would continue to view U.S. trade protections favorably, which, of course, translates to strong political incentives for lawmakers to pursue 'tough on China' policies. So in light of this, it's worth calling out three potential policy actions and their potential effect on equities and currency markets. 

The first is a trade tool known as a '301 investigation.' I'll spare you the mechanics, but a 301 investigation allows the U.S. to impose tariff or non-tariff actions in response to unfair trade practices. Media reporting has indicated that the Biden administration is considering deployment of a 301 investigation. Should the U.S. adopt non-tariff measures under Section 301 against China, such as further restrictions on the technology supplied to Chinese firms, China may respond with non-tariff measures on specific American goods. For investors, a tariff escalation would likely be a drag on bilateral trade in affected sectors and discourage manufacturing capital expenditures. As a result, broad equity market sentiment in China would likely be dampened, and it could mean further downside to our already cautious view on China equities. 

The second potential action would be passage of the 'Make It In America Act,' which would enhance domestic manufacturing in some key industries and reduce reliance on foreign sources by reinforcing the supply chain in the U.S. The House and Senate have both passed versions of this bill, and we expect a blended version will become law this year. For investors, this event may be largely in the price. Currency markets will likely see it as just a continuation of ongoing competition between the two nations, without an immediate escalation. The effect on equity markets would be similarly mixed. 

Finally, the U.S. could escalate non-tariff barriers in places such as tech exports. This last policy action could be significant, since non-tariff measures negative effects tend to be bigger and more profound than direct tariff hikes. We expect China to respond in kind, perhaps by launching an 'unreliable entity' list, which would mean prohibitions on China-related trade, investment in China and travel and work permits. 

Currency markets would likely react, seeing this as a meaningful escalation, resulting in fresh U.S. dollar strength due to concerns about companies foreign direct investment into China. And for China equities, once again, it would mean further downside to our already cautious view. 

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

Credit markets are facing various headwinds, including policy tightening and slowing growth, and credit investors are looking for where they might see the best risk adjusted returns. Chief Cross-Asset Strategist Andrew Sheets and Global Director of Fixed Income Research Vishy Tirupattur discuss.

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

Vishy Tirupattur: And I am Vishy Tirupattur, Global Director of Fixed Income Research. 

Andrew Sheets: And today on the podcast, we'll be talking about the challenges facing credit markets. It's Monday, May 2nd at 1 p.m. in London. 

Vishy Tirupattur: And 8 a.m. in New York. 

Andrew Sheets: So Vishy, it's great to have you back on the show because I really wanted to speak to you about what's been happening in credit markets. There's been a lot of volatility across the whole financial landscape, but that's been particularly acute in fixed income and we've seen some large moves in credit. So maybe before we get into the rest of the discussion, let's just level set with what's been happening year to date across credit. 

Vishy Tirupattur: It's been a really rough ride to credit investors. Investment grade returns are down 12% for the year and for high yield investors are down 6% for the year and leveraged loan markets are up slightly, 1.4% up for the year. So pretty dramatic differences across different segments of the credit markets. Higher quality has significantly underperformed lower quality. 

Andrew Sheets: So Vishy where I think this is also interesting is that investors in other asset classes often really look to credit as both a warning sign potentially to other markets and as an overall indicator in the health of the economy, so when you think about what's been driving the credit weakness, you know, how much of it is a economic concern story? How much of it is an interest rate story? How much of it is other things? 

Vishy Tirupattur: Andrew, we should always remember that the total returns to bond investors come from two parts. There's an interest rate component and there is a credit quality component. And what has driven the markets thus far in the year is really higher interest rates. As you know, Andrew, interest rates have dramatically increased from the beginning of the year to now, and a lot of expectations of future interest rates is already reflected in price. Those higher interest rate expectations have really contributed to the underperformance of the higher quality bonds, which tend to be a lot more interest rate sensitive than the lower quality bonds. The lower quality bonds tend to be a lot more sensitive to perceptions of the quality of the credit, as opposed to the level of interest rates. And that is really what explains the market moment thus far. 

Andrew Sheets: So Vishy, after such a tough start to the year for credit, do you think those challenges persist and do you think we see the same pattern of performance, of investment grade underperforming high yield which is underperforming loans, translate over the rest of the year? 

Vishy Tirupattur: Andrew I think that is a change that is afoot here. A pretty aggressive rate of interest rate hikes is already priced into the interest rate market. Even though investment grade returns have been affected negatively, predominantly by higher level of interest rates, going forward we think that is changing. I think we are going to see changes in the expectations of credit worthiness of bonds, the credit risks in the tail parts of the credit markets taking a greater significance in terms of credit market returns going forward. 

Andrew Sheets: So in essence, Vishy, we've just had a period where higher quality credit has underperformed as interest rates have been the main factor driving bonds. But looking ahead, that interest rate move is, we think, largely done for the time being, whereas the market might start to focus more on the extra risk premium that needs to be applied for economic risk. 

Vishy Tirupattur: Indeed, I think the focus of the credit markets will change from a concern about incrementally higher interest rates to concerns about the quality of the credit markets. So credit concerns are building, the economy is showing signs of downdraft, we saw the negative GDP print. So we think going forward, the market will think about credit quality more than interest rate effects on the total returns. 

Andrew Sheets: And Vishy, if investors are looking at this large downdraft in the investment grade market, where do we see the best risk adjusted return within the investment grade credit market? 

Vishy Tirupattur: So within the investment grade markets, the back up in rates has really created pockets of value in low dollar price bonds. And this is where we think the best opportunity for investors lies. In the high yield world, we think double B's or triple C's is a good trade. 

Andrew Sheets: The final question I'd ask you that comes up a lot is, what is the outlook for defaults? How are you thinking about forecasting defaults, and are there aspects of the fundamental balance sheet trends of companies today that, you know, seem pretty important as we think about that cycle? 

Vishy Tirupattur: I'm glad you asked me that question, Andrew. Even though the economy is weakening a bit and credit concerns are rising a bit, it by no means means we will see a spike in default rates. Default rates are at historically low levels now. Defaults are probably going to rise from here, but not dramatically spike. We expect that defaults will remain below the long term average for some time to come. In fact, if we look at the fundamentals of the credit markets, they have been strongest they have ever been going into a credit cycle. Andrew let me turn it back to you. You know, one can argue that this rise in yields that we have seen from the beginning of the year to now will mean significant changes to fixed income asset allocation. And in fact, makes fixed income asset allocation much more interesting. On your total return focused optimal portfolio, what's the better risk reward proposition in the fixed income markets? 

Andrew Sheets: I think it's pretty interesting. You know, if you've been investing in the markets over the last decade you really feel like a broken record when you say that bond yields are low. I mean, bond yields have been low and then they've often kept going lower. So it's pretty notable that in a relatively short period of time, you know, in the last nine months, the yield picture has really changed. And bond prices going down is the way that yields go up, and we've seen the largest drawdown in bond prices since 1980 in the U.S. So that pain is painful to investors, that that drop in prices has hurt portfolios. If there's a silver lining, it means that the yields now on offer are a lot better. So as you mentioned, you know, U.S. investment grade credit yielding 4-4.25%, well that's a whole lot higher than it's been even recently. I think investors after a long drought of a lack of fixed income options, are going to start to come back to the bond market and say, look, this now has a better place in my portfolio. We've been underweight bonds from July of last year and through April 6th of this year. But we've closed that position and we now think the risk reward for bonds is a lot more balanced and investors who were underweight should start adding back. 

Vishy Tirupattur: So given the increase in rates, income is back into a fixed income, right? 

Andrew Sheets: It exactly is. And again, I think it's also interesting because, you know, investors, I think, no longer have to compromise quite so much between bonds that offer income and bonds that can offer some stability to a portfolio. You know, I think the other thing that's so interesting about the view that that you and our credit strategy team have changed, you know, moving up in quality and credit, moving from a preference of high yield over investment grade to the other way around is, you know, that's a similar signal that we're getting from a lot of our top down cross asset framework tools. When the unemployment rate is this low, when the yield curve is this flat, that tends to be a time when risks to high yield bonds are elevated relative to history. So I think that the bottom up, you know, fundamental view that you and the credit strategy team are talking about fits really well with some of the broader cross asset signals that we're seeing as we look across the global space. 

Andrew Sheets: Vishy, thanks for coming back on the show. It's always great to hear your insights. 

Vishy Tirupattur: Thanks for having me, Andrew. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

As investors look to diversify their portfolios, there are two big stories to keep an eye on: the historic rise in bond yields and the increased adoption of ESG strategies. Chief Cross-Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.

Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.

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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.

Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.

Andrew Sheets And today on the podcast, we'll be continuing our discussion on retail investing, ESG, and what’s been happening in Fixed income. It's Friday, April 29th at 4:00 p.m. in London.

Lisa Shalett And it's 11:00 a.m. in New York.

Andrew Sheets Lisa, the other enormous story in markets that's really impossible to ignore is the rise in bond yields. U.S. Treasury yields are up almost 100 basis points over the last month, which is a move that's historic. So maybe I'd just start with how are investors dealing with this fixed income move? How do you think that they were positioned going into this bond sell off? And what sort of flows and feedback have you been seeing?

Lisa Shalett I think on the one hand, we've been fortunate in that we've been telegraphing our perspective to be underweight treasuries and particular underweight duration for quite a long time. And it's only been really in the last three or four weeks that we have begun suggesting that people contemplate adding some duration back to their portfolios. So the first thing is I don't think it has been a huge shock to clients that after what has been obviously a 40 plus year bull market in bonds that some rainier days are coming. And many of our clients had moved to short duration, to cash, to ultra-short duration, with the portions of their portfolios that were oriented towards fixed income. I think what has been more perplexing is this idea of folks using the bond sell off as an opportunity to move into stocks under the rationale of, quote unquote, there is no alternative. That's one of the hypotheses or investment themes that we’re finding we have to push up against hard and ask people are they not concerned that this move in rates has relevance for stock valuations? And over the last 13 years, the moves that we have seen in rates have been sufficiently modest as to not have had profound impacts on valuations. These very high above average multiples have been able to hold. And very few investors seem to be blinking an eye when we talk about equity risk premiums collapsing. So, you know, the answer to your question is clients in the private client channel avoided the worst outcomes of exposure to long duration rates, were not shocked, and have actually used some of the selloff in bonds or their short duration positions to actually fund increasing stock exposures. So that's I think how I would describe where they're at.

Andrew Sheets And that's really interesting because there are these two camps related to what's been happening. One is, look at bonds selling off. I want to go to the equity market. But at the same time as bond yields have gone from very low levels to much higher levels, the relative value argument of bonds versus stocks, this so-called equity risk premium, this additional return that in theory you get for investing in more risky equities relative to bonds has really been narrowing as these yields have come up. Lisa, how do you think about the equity risk premium? How do you think about, kind of, the relative value proposition between an investment grade rated corporate bond that now yields 4-4.25% relative to U.S. equities?

Lisa Shalett One of the things that we're trying to remind our clients is they live in an inflation adjusted world and real yields matter. And from where we're sitting, the recent dynamic around real rates and real rates potentially turning positive in the Treasury market is a really important turning point for our clients because today if you just look at the equity risk premium adjusted for inflation, it's very unattractive. And so, that's the conversation we're starting to have with people is you got to want to get paid. Owning stocks is great, as long as you're getting paid to own them. You got to ask yourself the question, would I rather have a 2.8-3% return in a 10-year Treasury today if I think inflation is going to be 2.5% in 10 years or do I want to own a stock that's only yielding an extra premium of 200 basis points.

Andrew Sheets When you think about what would change this dynamic, you mentioned that if anything, yields have gone up and investors seem to be more reticent about buying bonds given the volatility in the market. There's a scenario where people buy bonds once the market calms down, what they're looking for is stability. There's an argument that's about a level, that it's about, you know, U.S. 10-year bond yields reaching 3%, or 3.5%, or some other number that makes people say, OK, this is enough. Or it's that stocks go down and that they no longer feel like this kind of more stable or maybe better inflation protecting asset. Which of those do you think would be the more realistic catalyst or the most powerful catalyst that you see kind of driving a change in behavior?

Lisa Shalett I think it's this idea of inflation protected resilience, right? There is this unbelievable faith that, quite frankly, has been reinforced by recent history that the U.S. stock indices are magically resilient to anything that you could possibly throw at them. And until that paradigm gets cracked a little bit and we see a little bit more damage at the headline level, I mean, we've seen, you know, some of the data that says at least half of the names in some of these indices are down 20, 40%. But until those headline indices really show a little bit more pain and a little bit more volatility, I think it's hard for people to want to take the bet that they're going to go back into bonds.

Andrew Sheets Lisa, another major trend that we've seen in investing over the last several years has been ESG - investing with an eye towards the environmental, social and governance characteristics of a company How strong is the demand for ESG in terms of the flows that you're seeing and how should we think about ESG within the context of other strategies, other secular trends in investing?

Lisa Shalett So ESG, I think, you know, has gone through a transformation really in the last 12 months where it's gone from an overlay strategy, or an option and preference for certain client segments, to something that's really mainstream. Where clients recognize and have come to recognize the relevance of ESG criteria as something that's actually correlated with other aspects of corporate performance that drive excellence. If you're paying this much attention to your carbon footprint as a company or you're paying this much attention to your community governance and your stakeholder outcomes, aren't you likely paying just as much attention to your more basic financial metrics like return on assets? And there's a very high correlation between companies that are great at ESG and companies who are just very high on the quality factor metrics. Now what's interesting is as we've gone through this last six months of inflation and surging energy prices around the Russia-Ukraine conflict and the recovery from COVID, what I think the world has recognized is the importance of investing in energy infrastructure. Now for ESG investors that has meant doubling down on ESG oriented investments in clean and green. For others it may mean investing back in traditional carbon-oriented assets. But ESG, from where we're sitting, has gone mainstream and remains as strong, if not stronger than ever.

Andrew Sheets Lisa, thanks for taking the time to talk. We hope to have you back on soon.

Lisa Shalett Thank you very much, Andrew.

Andrew Sheets And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.

With questions around equity outperformance, tech overvaluation and currency headwinds in the U.S., retail investors may want to look internationally to diversify their portfolio. Chief Cross-Asset Strategist Andrew Sheets and Chief Investment Officer for Wealth Management Lisa Shalett discuss.

Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.

----- Transcript -----

Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.

Lisa Shalett And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.

Andrew Sheets And today on the podcast, we'll be discussing the role of international stocks in a well-diversified portfolio. It's Thursday, April 28th at 4:00 p.m. in London.

Lisa Shalett And it's 11:00 a.m. in New York.

Andrew Sheets Lisa, it's so good to talk to you again. There's just an enormous amount going on in this market. But one place I wanted to start was discussing the performance of U.S. assets versus international assets, especially on the equity side. Because you've noticed some interesting trends among our wealth management clients regarding their U.S. versus international exposure.

Lisa Shalett One of the things that we have been attempting to advise clients is to begin to move towards more global diversification. Given the really unprecedented outperformance of U.S. equity assets, really over the last 12 to 13 years, and the relative valuation gaps and most recently, taking into consideration the relative shifts in central bank policies. With obviously, the U.S. central bank, moving towards a very aggressive inflation fighting pivot that, would have them moving, rates as much as, 200-225 basis points over the next 12 months. Whereas other central banks, may have taken their foot off the accelerator, acknowledging both, the complexities of geopolitics as well as, some of the lingering concerns around COVID. And so, having those conversations with clients has proven extraordinarily challenging. Obviously, what's worked for a very long time tends to convince people that it is secular and not a cyclical trend. And you know, we've had to push back against that argument. But U.S. investors also are looking at the crosscurrents in the current environment and are very reticent and quite frankly, nervous about moving into any positions outside the U.S., even if there are valuation advantages and even if there's the potential that in 2023 some of those economies might be accelerating out of their current positions while the U.S. is decelerating.

Andrew Sheets It's hard to talk about the U.S. versus the rest of world debate without talking about U.S. mega-cap tech. This is a sector that's really unique to the United States and as you've talked a lot about, is seen as kind of a defensive all-weather solution. How do you think that that tech debate factors into this overall global allocation question?

Lisa Shalett I think it's absolutely central. We have, come to equate mega-cap secular growth tech stocks with U.S. equities. And look, there's factual basis for that. Many of those names have come to dominate in terms of the share of market cap the indices. But as we've tried to articulate, this is not any average cycle. Many of the mega-cap tech companies have already benefited from extraordinary optimism baked into current valuations, have potentially experienced some pull forward in demand just from the compositional dynamics of COVID, where manufactured goods and certain work from home trends tended to dominate the consumption mix versus, historical services. And so it may be that some of these companies are over earning. And the third issue is that, investors seem to have assumed that these companies may be immune to some of the cost and inflation driven dynamics that are plaguing more cyclical sectors when it comes to margins. And we're less convinced that, pricing power for these companies is, perpetual. Our view is that these companies too still need to distribute product, still need to pay energy costs, still need to pay employees and are going to face headwinds to margins.

Andrew Sheets So what's the case for investing overseas now and how do you explain that to clients?

Lisa Shalett] I think it's really about diversification and illustrating that unlike in prior periods where we had synchronous global policy and synchronicity around the trajectory for corporate profit growth, that today we're in a really unique place. Where the events around COVID, the events around central bank policies, the events around sensitivity to commodity-based inflation are all so different and valuations are different. And so, taking each of these regions case by case and looking at what is the potential going forward, what's discounted in that market? One of the pieces of logic that we bring to our clients in having this debate really focuses on, the divergence we’ve seen with currencies. The U.S. Dollar has kind of reached multiyear extreme valuations versus, the yen, and the euro and the pound. And currencies tend to be self-correcting through the trade channels, and translation channels. And we don’t know that American investors are thinking that all through.

Andrew Sheets Well, I'm so glad you brought up the currency angle because that is a really fascinating part of the U.S. versus rest of world story for equities. If we take a market like Japan in yen, the Nikkei equity index is down about 4% for this year, which is better than the S&P 500. But in dollars, as you mentioned the yen has weakened a lot relative to the dollar, the Nikkei is down almost 14% because the yen has lost about 10% of its value year to date. So, when you're a investor investing in a market in a different currency, how do you think about that from a risk management standpoint? How do you think about some of these questions around taking the currency exposure versus hedging the currency exposure?

Lisa Shalett Well, for the vast majority of our clients who may be, owning their exposures through a managed solution, through a mutual fund, through an ETF, currency hedging is fraught. And so very often, we try to encourage people to just, play the megatrend. Don't overthink this. Don't try to think that you're going to be able to hedge your currency exposures. Just really ask yourself, do you think over the next year or two the dollar's going to be higher or lower? We think odds are pretty good that the dollar is going to be lower and other currencies are going to be stronger, which creates a tailwind for U.S. investors investing in those markets.

Andrew Sheets I guess taking a step back and thinking about the large amount of assets that we see within Morgan Stanley Wealth Management. What are you think, kind of, the most notable flows and trends that people should be aware of?

Lisa Shalett As we noted, one of the most, structurally inert parts of people's portfolio is in their devotion to US mega-cap tech stocks. I think, disrupting that point of view and convincing folks that while these may be great companies, they perhaps are no longer great stocks is one that that has really been an effort in futility that seems only to get cracked when an individual company faces an idiosyncratic problem. And it's only then when the stock actually goes down that we see investors willing to embrace a new thesis that says, OK, great company. No longer great stock.

Andrew Sheets Tomorrow I’ll be continuing my conversation with Lisa Shalett on retail investing, ESG, and what’s been happening in fixed income.

Andrew Sheets And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.

The U.S. Congress has been quietly making progress on a couple of key pieces of legislation, and investors should be aware of which bills will matter to markets.

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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, April 27th, at 11 a.m. in New York. 

Compared to the Russia Ukraine situation, which rightfully has investors focus when it comes to geopolitics, congressional deliberations in D.C. may seem less important. But this is often where things of consequence to markets happen. So we think investors should keep an eye on Congress this week, where progress is quietly being made on key pieces of legislation that will matter to markets. 

Let's start with legislation directed at boosting energy infrastructure investment. Reports suggest that Democratic senators are seeking to revive the clean energy spending proposed in the build back better plan, and pair it with fresh authorization for traditional energy exploration. The deliberations have momentum for a few reasons. While environment conscious Senate Democrats may have in the past balked about supporting traditional energy investment, they could now see this effort as the last chance to boost clean energy investment for years, given the chance that Democrats lose control of Congress in the midterm elections. Russia's invasion of Ukraine and the resulting need to boost American energy production to aid Europe, may also be persuasive. And while there are several roadblocks to this deal getting done, in particular negotiations about which taxes to increase in order to fund it, investors should pay attention. Such a deal could unlock substantial government energy investments that benefit both the clean tech, and oil and gas sectors of the market. The downside could be that corporate tax increases become its funding source, and if the corporate minimum tax proposal becomes part of the package, that drives margin pressure in banks and telecoms. 

Investors should also keep an eye on the competition and innovation bill that includes about $250 billion of funding for re-shoring semiconductor supply chains, and federal research into new technologies. The bill, known in the Senate as the U.S. Innovation and Competition Act and the House as the COMPETES Act, is in part motivated by policymakers view that the U.S. must invest in critical areas to maintain a competitive economic advantage over China. While this kind of industrial policy is uncommon in the mostly laissez faire U.S. economic system, these policy motives make it likely, in our view, to be enacted this year. That should help the semiconductor sector, which has been facing uncertainty about how to cope with the risks to its supply chains from export controls and tariffs enacted by the U.S. This week these two bills move into conference, which means in the coming weeks we should have a better sense as to what the final version will look like, and if our view that it will be enacted this year will be right or wrong. 

So summing it up, don't sleep on Congress. There's slowly but surely working on policies that impact markets. We'll of course track it all, and keep you in the loop. 

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague or leave us a review on Apple Podcasts. It helps more people find the show.

Global supply chains have been under stress from the pandemic, geopolitical tensions, and inflation, and the outlook for transportation in 2022 is a mixed bag so far. Chief U.S. Economist Ellen Zentner and Equity Analyst for North American Transportation Ravi Shanker discuss.

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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research, 

Ravi Shanker: and I'm Ravi Shanker, Equity Analyst covering the North American Transportation Industry for Morgan Stanley Research. 

Ellen Zentner: And today on the podcast, we'll be talking about transportation, specifically the challenges facing freight in light of still tangled supply chains and geopolitics. It's Tuesday, April 26, at 9:00 a.m. in New York. 

Ellen Zentner: So, Ravi, it's really good to have you back on the show. Back in October of last year we had a great discussion about clogged supply chains and the cascading problems stemming from that. And I hoped that we would have a completely different conversation today, but let's try to pick up where we left off. Could we maybe start today by you giving us an update on where we are in terms of shipping - ocean, ground and air? 

Ravi Shanker: So yes, things have materially changed since the last time we spoke, some for the better and some for the worse. The good news is that a lot of the congestion that we saw back then, whether it was ocean or air, a lot of that has eased or abated. We used to have, at a peak, about 110 ships off the Port of L.A. Long Beach, that's now down to about 30 to 40. The other thing that has changed is we just went from new peak to new all time peak on every freight transportation data point that we were tracking over the last two years. Now all of those rates are collapsing at a pace that we have not seen, probably ever. It's still unclear whether this legitimately marks the end of the freight transportation cycle or if it's just an air pocket that's related to the Russia Ukraine conflict or China lockdowns or something else. But yes, the freight transportation worlds in a very different place today, compared to the last time I was on in October. Ellen, I know you wanted to dig a little more deeply into the current challenges facing the shipping and overall transportation industry. But before we get to that, can you maybe help us catch up on how the complicated tangle created by supply chain disruptions has affected some of the key economic metrics that you've been watching over the last six months? That is between the time we last spoke in October and now. 

Ellen Zentner: Sure. So, we created this global supply chain index to try to gauge globally just how clogged supply chains are. And we did that because, what we've uncovered is that it's a good leading indicator for inflation in the U.S. and on the back of creating that index, we could see that the fourth quarter of last year was really the peak tightness in global supply chains, and it has about a six month lead to CPI. Since then, we started to see some areas of goods prices come down. But unfortunately, that supply chain index stalled in February largely on the back of Russia, Ukraine and on the back of China's zero COVID policy, starting to disrupt supply chains again. So the improvement has stalled. There are some encouraging parts of inflation coming down, but it's not yet broad based enough, and we're certainly watching these geopolitical risks closely. So, Ravi, I want to come back to freight here because you talked about how it's been underperforming for a couple of months now and forward expectations have consistently declined as well. You pointed to it as possibly being just an air pocket, but you're pointing, you're watching closely a number of things and anticipate some turbulence in the second half of the year. Can you walk us through all of that? 

Ravi Shanker: What I can tell you is that it's probably a little too soon to definitively tell if this is just an air pocket or if the cycles over. Again, we are not surprised, and we would not be surprised if the cycle is indeed over because in December of last year, we downgraded the freight transportation sector to cautious because we did start to see some of those data points you just cited with some of the other analysts. So we were expecting the cycle to end in the middle of 22 to begin with, but to see the pace and the slope of the decline and a lot of these data points in the month of March, and how that coincides with the Russia-Ukraine conflict and that the lockdowns in China, I think, is a little too much of a coincidence. So we think it could well be a situation where this is an air pocket and there's like one or two innings left in the cycle. But either way, we do think that the cycle does end in the back half of the year and then we'll see what happens beyond that. 

Ellen Zentner: OK, so you're less inclined to say that you see it spilling over into 2023 or 2024? 

Ravi Shanker: I would think so. Like if this is just a normal freight transportation cycle that typically lasts about 9 to 12 months. The interesting thing is that we have seen 9 to 12 months of decline in the last 4 weeks. So there are some investors in my space who think that the downturn is over and we're actually going to start improving from here. I think that's way too optimistic. But if we do see this continuing into 2023 and 2024 I think there's probably a broader macro consumer problem in the U.S. and it's not just a freight transportation inventory destocking type situation. 

Ellen Zentner: So Ravi, I was hoping that you'd give me a more definitive answer that transportation costs have peaked and will be coming down because of course, it's adding to the broad inflationary pressures that we have in the economy. Companies have been passing on those higher input costs and we've been very focused on the low end consumer here, who have been disproportionately burdened by higher food, by higher energy, by all of these pass through inflation that we're seeing from these higher input costs. 

Ravi Shanker: I do think that rates in the back half of the year are going to be lower than in the first half of the year and lower than 2021. Now it may not go down in a straight line from here, and there may be another little bit of a peak before it goes down again. But if we are right and there is a freight transportation downturn in the back of the year, rates will be lower. But, and this is a very important but, this is not being driven by supply. It's being driven by demand and its demand that is coming down, right. So if rates are lower in the back half of the year and going into 23, that means at best you are seeing inventory destocking and at worst, a broad consumer recession. So relief on inflation by itself may not be an incredible tailwind, if you are seeing demand destruction that's actually driving that inflation relief. 

Ellen Zentner: That's a fair point. Another topic I wanted to bring up is the fact that while freight transportation continues to face significant headwinds, airlines seem to be returning to normal levels, with domestic and international travel picking up post-pandemic. Can you talk about this pretty stark disparity? 

Ravi Shanker: Ellen it's absolutely a stark disparity. It's basically a reversal of the trends that you've seen over the last 2 years where freight transportation, I guess inadvertently, became one of the biggest winners during the pandemic with all the restocking we were seeing and the shift of consumer spend away from services into goods. Now we are seeing the reversion of that. So look, honestly, we were a little bit concerned a month ago with, you know, jet fuel going up as much as it did and with potential concerns around the consumer. But the message we've got from the airlines and what we are seeing very clearly in the data, what they're seeing in the numbers is that demand is unprecedented. Their ability to price for it is unprecedented. And because there are unprecedented constraints in their ability to grow capacity in the form of pilot shortages, obviously very high jet fuel prices and other constraints, I guess there's going to be more of an imbalance between demand and supply for the foreseeable future. As long as the U.S. consumer holds up, we think there's a lot more to come here. So Ellen, let me turn back to you and ask you with freight still facing such big challenges and pressure on both sides on the supply chain. What does that bode for the economy in terms of inflation and GDP growth for the rest of this year and going into next year? 

Ellen Zentner: So I think because, as I said, you know, our global supply chain index has stalled since February. I think that does mean that even though we've raised our inflation forecasts higher, we can still see upside risk to those inflation forecasts. The Fed is watching that as well because they are singularly focused on inflation. GDP is quite healthy. We have a net neutral trade balance on energy. So it actually limits the impact on GDP, but has a much greater uplift on inflation. So you're going to have the Fed feeling very confident here to raise rates more aggressively. I think there's strong consensus on the committee that they want to frontload rate hikes because they do need to slow demands to slow the economy. They do almost need that demand destruction that you were talking about. That's actually something the Fed would like to achieve in order to take pressure off of inflation in the U.S.. But we think that the economy is strong enough, and especially the labor market is strong enough, to withstand this kind of policy tightening. It takes actually 4 to 6 quarters for the Fed to create enough slack in the economy to start to bring inflation down more meaningfully. But we're still looking for it to come in, for core inflation, around 2.5% by the fourth quarter of next year. So, Ravi, thanks so much for taking the time to talk. There's much more to cover, and I definitely look forward to having you back on the show in the future. 

Ravi Shanker: Great speaking with you Ellen. Thanks so much for having me and I would love to be back. 

Ellen Zentner: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

As U.S. equity markets digest higher inflation and a more hawkish Fed, the question is when this will turn into a headwind for earnings growth.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 25th and 11:00 a.m. in New York. So let's get after it. 

As equity strategists our primary job is to help clients find the best areas of the market, at the right time. Over the past year our sector and style preferences have worked out very well as the market has gone nowhere. However, the market has been so picked over at this point, it's not clear where the next rotation lies. When that happens, it usually means the overall index is about to fall sharply, with almost all stocks falling in unison. In many ways, this is what we've been waiting for as our fire and ice narrative, a fast tightening Fed into the teeth of a slowdown, comes to its conclusion. While our defensive posture since November has been the right call, we can't argue for absolute upside anymore for these groups given the massive rerating that they've experienced in both absolute and relative terms. In many ways, this is a sign that investors know a slowdown is coming and are bracing for it by hiding in these kinds of stocks. 

In our view, the accelerated negative price action on Thursday and Friday last week may also support the view we are now moving to this much broader sell off phase. Another important signal from the market lately is how poorly materials and energy stocks have traded, particularly the former. To us, this is just another sign the market's realization that we are now entering the ice phase, when growth becomes the primary concern for stocks rather than inflation, the Fed and interest rates. 

On that note, more specifically, we believe inflation and inflation expectations have likely peaked. There's no doubt that a fall in inflation should take pressure off valuations for some stocks. The problem is that falling inflation comes with lower nominal GDP growth and therefore sales and earnings per share grow, too. For many companies, it could be particularly painful if those declines in inflation are swift and sharp. Of course, many will argue that a falling commodity prices will help the consumer. We don't disagree on the surface of that conclusion, but pricing has been a big reason why consumer oriented stocks have done so well. If pricing becomes less secure, the margin pressure we've been expecting to show up this year, may be just around the corner for such stocks, even as the consumer remains active. 

We can't help but think we are at an important inflection point for inflation, the mirror image of our call in April of 2020. At the time, we suggested inflation would be a big part of the next recovery and lead to extremely positive operating leverage and earnings growth. Fast forward to today, and that's where we are. The question now is will that positive tailwind continue? Or will it turn into a headwind for earnings growth? Our view is that it will be more of the latter for many sectors and companies, and this is why we've been positioned defensively and in stocks with high operational efficiency. 

The bottom line is that asset markets have been digesting higher inflation and a more hawkish fed path in reaction to that inflation. However, we are now entering a period when slowing growth will determine how stocks trade from here. Overall, the S&P 500 looks more vulnerable now than the average stock, the mirror image of the past year. We recommend waiting for the index to trade well below 4000 before committing new capital to U.S. equities. 

Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show. 

Forecasts for China and other Emerging Markets have continued on a downtrend, extending last year’s underperformance, meaning investors might want to look into regions with a more favorable outlook.

Important note regarding economic sanctions. This research references country/ies which are generally the subject of selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.

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Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Markets Equity Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the key reasons why we recently reiterated our cautious stance on overall emerging market equities and also China equities. It's Friday, April 22nd at 8:00 p.m. in Hong Kong. 

Now, emerging market equities are underperforming again this year, and that's extending last year's underperformance versus developed market equities. And so indeed are China equities, the largest component of the Emerging Market Equities Index. This is confounding some of the optimism felt by some late last year that a China easing cycle could play its normal role in delivering a trend reversal. 

We have retained our cautious stance for a number of reasons. Firstly, the more aggressive stance from the US Federal Reserve, signaling a rapid move higher in US rates, is leading to a stronger US dollar. This drives up the cost of capital in emerging markets and has a directly negative impact on earnings for the Emerging Markets Index, where around 80% of companies by market capitalization derive their earnings domestically. Secondly, China's own easing cycle is more gradual than prior cycles, and last week's decision not to cut interest rates underscores this point. This decision is driven by the Chinese authorities desire not to start another leverage driven property cycle. Meanwhile, China remains firmly committed to tackling COVID outbreaks through a lockdown strategy, which is also weakening the growth outlook. Our economists have cut the GDP growth forecast for China several times this year as a result. 

Beyond these two factors, there are also other issues at play undermining the case for emerging market equities. Most notably, the strong recovery in services spending in the advanced economies in recent quarters is leading to a weaker environment for earnings growth in some of the other major emerging market index constituents, such as Korea and Taiwan. They have benefited from the surge in work from home spending on goods during the earlier phases of the pandemic. Meanwhile, the geopolitical risks of investing in emerging markets more generally have been highlighted by the Russia Ukraine conflict and Russia's removal from the MSCI Emerging Markets Index. 

So what do we prefer? We continue to like commodity producers such as Australia and Brazil, which are benefiting from high agricultural, energy and metals prices. We also favor Japan, which, unlike emerging markets, has more than half of the index deriving its earnings overseas and therefore benefits from a weaker yen. 

Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

U.S. Treasury bonds have seen significant losses over the last six months, but looking forward investors may be able to use bonds to help balance their cross-asset portfolio in an uncertain market.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, April 21st at 2pm in London. 

Like any good team, most balanced investment portfolios are built with offense and defense. Stocks are usually tasked to play that proverbial offensive role, producing the majority of inflation adjusted returns over the long run. But because these equity returns come with high volatility, investors count on bonds for defense, asking bonds to provide stability during times of uncertainty with a little bit of income along the way. 

At least that's the idea. And for most of the last 40 years, it's worked pretty well. But lately it really hasn't. The last 6 months have seen the worst total returns for U.S. 10 year Treasury bonds since 1980, with losses of more than 10%. Investors are likely looking at what they thought was the defense in their portfolio, with a mix of frustration and disbelief. 

On April 9th, we closed our long held underweight in U.S. bonds in our asset allocation and moved back up to neutral. Part of our reasoning was, very simply, that significantly higher yields now improved the forward looking return profile for bonds relative to other assets. 

But another part of our thinking is the belief that going forward, bonds will be more effective at providing defense for other parts of the portfolio. We think the path here is twofold. 

First, even as bonds have struggled year to date, the correlation of U.S. Treasuries to the S&P 500 is still roughly zero. That means stocks and bonds are still mostly moving independent of each other on a day to day basis, and supports the idea that bonds can lower overall volatility in a balanced portfolio if yields have now seen their major adjustment. 

Second, if we think about why bonds provide defense, it's that when the economy is poor, earnings and stock prices tend to go down. But a poor economy will also lead central banks to lower interest rates, which generally pushes bond prices up. 

Recently, this dynamic has struggled. Interest rates were so low, with so little in future rate increases expected that it was simply very hard for these rate expectations to decline if there was any bad economic data. 

But that's now changed and in a really big way. As recently as September of last year, markets were expecting just 25 basis points of interest rate increases from the Federal Reserve over the following 12 months. That number is now 275 basis points. If the U.S. economy unexpectedly slows or the recent rise in interest rates badly disrupt the housing market, two developments that the stock market might dislike, markets might start to think the Fed will do less. They will apply fewer rate increases and thus give support to bonds under this negative scenario. That would be a direct way that bonds would once again provide portfolio defense. 

Bonds still face challenges. But after a historically bad run, we are no longer underweight, and think they can once again prove useful within a broader cross asset portfolio. 

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Although consensus forecasts for European equities continue to trend up, there are a few key risks on the horizon that investors may want to keep an eye on during the upcoming earnings season and year ahead.

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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the upcoming earnings season here in Europe and why we think corporate margins look set to come under pressure in the coming months. It's Wednesday, April the 20th at 2pm in London. 

This week marks the start of the first quarter earnings season for European companies, and we expect to see another "net beat", with more companies exceeding estimates than missing. However, while this may sound encouraging, we expect the size of this beat to be considerably smaller than recent quarters, which have been some of the best on record. At the same time, we think commentary around future trends is likely to turn more cautious, given triple headwinds from elevated geopolitical risks, an increasingly stagflation like economy and intensifying pressures on corporate margins. And we think this last point is probably the most underappreciated risk to European equities at this time. 

Historically, European margins have been positively correlated to inflation. Which likely reflects the index's sizable exposure to commodity sectors, and also the fact that the presence of inflation itself tends to signal both a strong topline environment and a positive pricing power dynamic for companies. In this regard, we note the consensus sales revisions for European companies are currently close to a 20-year high. 

So far, so good. However, the influence of inflation on the bottom line depends much more on its relative relationship with real GDP growth. Put simply, when inflation is below real GDP growth margins tend to rise, but when inflation is above real GDP growth, as it is now, margins and profitability in general tend to fall. As of today, consensus forecasts for European margins have yet to turn down. However, we have seen earnings revisions turn negative in recent weeks, such as the gap between sales revisions, which are currently positive, and earnings revisions, currently negative, has never been wider. 

In addition to this warning signal on margins from higher input costs, companies are also continuing to deal with challenging supply chain issues, whether related to the conflict in Eastern Europe or to the recent COVID lockdowns in China. A recent survey from the German Chambers of Commerce suggested that 46% of companies supply chains are completely disrupted or severely impacted by the current COVID 19 situation in China. In contrast, just 7% of companies reported no negative impact at all. 

For now, the market appears to be ignoring these warning signs. Consensus 2022 earnings estimates for the MSCI Europe Index are still trending up and have now risen by 5% year to date. This compares to a much smaller 2% upgrade for U.S. earnings and actual downgrades for Japan and emerging markets. While commodity sectors are the main source of this European upgrade, the absence of any offsetting downgrades across other sectors feels unsustainable to us. 

Ahead of every earnings season, we survey our European analysts to gather their views on the credibility of consensus forecasts. This quarter, the survey generally supports our own top down views, with our analysts expecting a small upside beat to consensus numbers in the first quarter, but then seeing downside risks for the full year 2022 estimates. This is the first time in nearly two years that this survey has given us a cautious message. Taking it to the sector level, our analysts see the greatest downside risks to consensus estimates for banks, construction, industrials, insurance, media, retailing and consumer staples. In contrast, our analysts see upside risks to earnings forecasts for brands, chemicals, energy, mining, healthcare and utilities. 

Historically, a move higher in equity valuations often tends to mitigate the impact on market performance from prior periods of earnings downgrades. However, we are skeptical that price to earnings ratios will rise much from here, as long as global central banks remain hawkish. Consequently, we continue to see an unattractive risk reward profile for European stocks just here and suggest investors wait for a better entry point, after economic and earnings expectations have reset lower. 

Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today. 

As the U.S. Economy contends with higher inflation, supply chain stress, and rising recession risks, one indicator to keep an eye on is what’s going on at the sector level and how U.S. business conditions may help shape the economic outlook.

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Welcome to Thoughts on the Market. I'm Robert Rosener, Senior U.S. Economist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be sharing a read on how industries across the U.S. may be viewing the current economic environment. It's Tuesday, April 19th at noon in New York. 

As we move through the economic recovery and expansion that has been uneven, it's increasingly important to track what's going on at the sector level. And collaboratively with our equity analysts we do exactly that with our Morgan Stanley Business Conditions Index; a monthly survey to track what's going on across industries. With the MSBCI we try to put all of those stories together into one coherent macro signal, from 0 to 100, where 50 is the even mark, above 50 is expansion and below 50 is contraction.

It incorporates a variety of data points on hiring plans, capex plans, advance bookings and how those factors are evolving. Now, amid a more challenging and uncertain economic backdrop with higher inflation, supply chain stress and concerns about rising recession risks, I'd like to dive into a few key findings from our most recent survey to give listeners a picture of how U.S. businesses might be seeing the current environment. 

First, in our April survey the headline measure for the MSBCI fell to a two year low of 44. We saw that decline in the index as driven by a deterioration in sentiment, because it coincided with a sharp pullback in business conditions expectations - so how analysts are seeing the forward trajectory for activity. And that decline in sentiment was particularly concentrated in the manufacturing sector, where we had a sharp decline in the MSBCI manufacturing component, while service sector activity appeared to bounce a little bit but remained at low levels. 

When we look at the underlying details, the fundamental components of the survey were more mixed this month. So downside in our survey was led by business conditions expectations, as well as advance bookings and more strikingly, credit conditions. Now some of this can be noise, and we need to look very carefully through the data to see if we can identify a clear trend. Advance bookings, the decline there may have been more noise, but we are monitoring credit conditions very closely as the Fed tries to tighten financial conditions with its monetary policy stance. 

We also got a bit of insight into supply chain conditions in this report. Responses from analysts in our survey indicated some stalling in the improvement in April, and a pickup in the share of analysts who reported that conditions remained unchanged. Which is broadly consistent with what we've seen in other indicators. Nevertheless, analysts generally expect improvement in supply conditions over the next 3 months.

Finally, there was some good news in the survey on business investment plans, what we call capex, as well as hiring plans. There was some moderation, but the two factors remain bright spots in the report, with upside in capex plans, and hiring plans coming back but holding at a fairly solid level. 

So what does this all tell us about how businesses see the road ahead? First, there's important momentum in hiring and capex. With respect to inflation, the deterioration we saw in supply conditions during the month does point to some upside risk for prices in the near term, and that was also reflected in strong upward pressure in the MSBCI pricing measures during the month. We can also see that businesses are facing increased uncertainty about the outlook. That's clear looking at the deterioration in sentiment, and that's clear looking at the pullback in business conditions expectations. So firms are watching the pace and trajectory of economic activity carefully. So it will continue to be important to watch these stories to judge what's going on at the sector level and how that's all coming together to shape the economic outlook. 

Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

While ongoing inflation has had some positive effects, consumers continue to feel its ill effects and we are beginning to see net negatives for earnings growth as Q1 earnings season begins.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 18th at 3 p.m. in New York. So let's get after it. 

Last week, we discussed how stocks were sending different messages about growth than bonds. We laid out our case for why stocks are likely to be the most trusted on this messaging and reiterated our preference for late cycle defensives that we've held since November. This week, we lay out the case for why this earnings season may finally bring the downward revisions to forward earnings forecasts that have remained elusive thus far. 

While we appreciate how inflation can be good for nominal GDP and therefore revenue growth, we think the inflation we are experiencing now is no longer a net positive for earnings growth for several reasons. First, there's a latent impact of inflation on costs that are now showing up in margins. Secondarily, the spike in energy and food costs, which serve as a tax on the consumer that is already struggling with high prices. In other words, we think the positive effects of inflation on earnings growth have reached their peak, and are now more likely to be a headwind to growth, particularly as inflation forces the Fed to be increasingly bearish, which leads to another headwind - significantly higher long term interest rates. More specifically, the average 30 year fixed mortgage rate is now above 5%, which is more than 60% higher since the start of the year, and why mortgage applications are also down more than 60% from their peak last year. This hasn't gone unnoticed by the market, by the way, which has punished housing related stocks to the tune of 40% or more. Given the long tailed effect that housing has on the economy, we think this is a major headwind to economic and earnings growth more broadly. 

Perhaps this explains why the de-rating has been so severe in the economically sensitive areas of the market, while defensive areas have actually seen valuations expand. This suggests the market is worrying about higher rates and slower growth, even as the overall index remains expensive. This is also very much in line with our view for defensives to dominate in this late cycle environment. However, the overall index remains a bit of a mystery, with the price earnings multiple down only 11% in the face of much higher interest rates. We chalk this up to the incredibly strong flows into equities from asset owners, which include retail, pension funds and endowments. These investors seem to have made a decision to abandon bonds in favor of stocks, which are a much better inflation hedge. These flows are keeping the main index more expensive, thereby leaving the real message about growth at the sector level. As already suggested, we think that message is crystal clear and in line with our own view that growth is slowing and likely more than most are forecasting. Especially for 2023, when the risk of a recession is increased. 

With regard to that view, signs are emerging that first quarter earnings season may disappoint, particularly from a guidance and forward earnings standpoint. More specifically, earnings revisions breadth for the S&P 500 has resumed its downward trend over the past 2 weeks, and is once again approaching negative territory. This is largely being driven by declining revisions in cyclical industries where we've been more negative. These include consumer discretionary, industrials, tech hardware and semiconductors. Negative revisions are often an indication that forward earnings estimates are going to flatten out or even fall. When forward earnings fall, it's usually not good for stocks and may even break the pattern of strong inflows to equities, as investors rethink their decision to use stocks at this point as a good hedge against inflation. 

Bottom line, stick with more defensively oriented sectors and stocks as earnings visibility is challenged for the average company. Secondarily, wait for at least one or two rounds of earnings cuts at the S&P level before adding to broader equity risk. 

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While there continues to be a lot of market chatter surrounding recession risks and the U.S. Treasury yield curve, there are several key factors that make the most recent dip into inversion different. Chief Global Economist Seth Carpenter and Head of U.S. Interest Rate Strategy Guneet Dhingra discuss.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist, 

Guneet Dhingra: and I'm Guneet Dhingra, Head of U.S. Interest Rate Strategy. 

Seth Carpenter: And on this episode of Thoughts on the Market, we're going to be discussing the sometimes inconsistent signals of economic recession and what investors should be watching. It's Thursday, April 14th at 10 a.m. in New York. 

Seth Carpenter: All right, Guneet, as I think most listeners probably know by now, there's a lot of market chatter about recession risks. However, if you look just at the hard data in the United States, I think it's clear that the U.S. economy right now is actually quite strong. If you look at the last jobs report, we had almost 450,000 new jobs created in the month of March. And between that, the strength of the economy right now and the multi-decade highs in inflation, the Federal Reserve is ready to go, starting to tighten monetary policy by raising short term interest rates and running off its balance sheet. That said, every time short term interest rates start to rise, they rise more than longer term interest rates do, and we get a flattening in the yield curve. The yield curve flattened so much recently that it actually inverted briefly where 2's were higher than 10's in yield. And as we've talked about before on this very podcast, there has been historically a signal from an inverted 2s10s curve to a recession probability, rising and rising and rising. Some of the work you've been doing recently, I think you've argued very eloquently, that this time is different. Can you walk me through why this time is different? 

Guneet Dhingra: Yeah, absolutely. I mean, right now you cannot have a conversation with investors without discussing yield curve inversion and the associated recession risks. So I think the way I've been framing it, this time is different because of two particular reasons that haven't been always true. The first one is the yield curve today is artificially very distorted by a multitude of factors. The number one and the most obvious one is the massive amounts of central bank bond buying from the Fed, from the ECB, from the Bank of Japan over the last few years. And so that puts a lot of flattening pressure on the curve, which makes it appear that the curve is too flat, whereas in practice it's just the residual effect of how central banks have affected the yield curve. On top of that, what's also happening is the Fed is obviously trying to address the inflation risk and they are looking to make policy restrictive in the next couple of years. So take the dot plot for instance, right, at the March meeting the Fed gave us a dot plot where the median participant expects the Fed funds rate to get to close to 3% in 2023, and the neutral rate that they see for the economy is close to 2.5%. So in essence, the Fed is telegraphing a form of inversion and ultimately the markets are mimicking what the Fed is telling them, which naturally leads to some curve inversion. So overall, I would say a combination of artificially flattening forces, a restrictive fed, just means that 2s10s curve today is not the macro signal it used to be. 

Seth Carpenter: Got it, got it, so that helps and that squares things, I think, with the way we on the economics team are looking at it. Because in our baseline forecast, there is not a recession in the US. But if that's right, and if we end up avoiding a recession, you've got a bunch of clients, we've got a bunch of clients who are trying to make trades in a market. What are you telling investors that they should be doing, how do you trade in an environment with an inverted curve? 

Guneet Dhingra: Right. So I think the way I talk to investors about this issue is the 2s10s curve merely inverting is not the signal used to be, which means for the yield curve to be predictive for a recession this time, the level threshold is much lower. So, for instance, you can imagine an economy where 2s10s curve inverting to minus 50 or minus 75 is the real true signal for a slowdown ahead and a recession ahead. And so what I tell investors today is do not get concerned about the yield curve getting to 0 basis points, there's a lot more room for the yield curve to keep inverting. And the target you should have for yield curve flattening trade should be more like minus 50 or minus 75. 

Seth Carpenter: Got it. That that's a very big difference, very far away from where we are now. And in fact, as I mentioned earlier, the inversion that we did see was somewhat short lived and we've actually had a bit of a steepening off the back of it. I guess one question, and this is something that you've also written about is, what's driving that tightening? Is it because the Fed is going to be unwinding its balance sheet, doing so-called quantitative tightening. If the quantitative easing that they were doing flattened the curve, are you seeing the quantitative tightening is the thing that's going to be steepening the curve? 

Guneet Dhingra: I think instinctively, many investors think tightening is the opposite of easing, so that must mean quantitative tightening is the opposite of quantitative easing. And that's why I think a big fallacy lies in how people are simplifying the understanding of QT. I think the reality is quantitative tightening is perhaps not the perfect term for what the Fed is going to do next. The main thing to understand here is when the Fed does QE, the Fed chooses which part of the Treasury curve are they going to target, and that ultimately decides whether the curve will steepen or flatten. However, in this case, it's the U.S. Treasury, which is going to decide once the Fed stops reinvesting, how will the U.S. Treasury respond by increasing supply in the front end or the back end? And that decides whether the yield curve should steepen or flatten, quite the opposite from QE where the Fed decides. So the way I sort of summarize this to people is QT is not the opposite of QE, asset sales are. So Seth, you spent 15 years working at the Fed. Do you think the FOMC cares about an inverted curve? 

Seth Carpenter: I would not say that the core of the FOMC cares about an inverted curve the same way that the average market participant does. I think it's undeniable that the Fed is aware of all of the research, all of the history, all of the correlation between an inverted curve and a recession. But I don't think it's a dispositive signal. And by that what I mean is, if we got to the point where the 2s10s curve were pancake flat, it was a zero or even slightly inverted, but if at the same time we were still getting 400-500,000 nonfarm payrolls per month, I think then that signal from the yield curve would get dismissed against the evidence that the economy is very, very strong. So I think an inverted curve is the sort of thing that would cause the Fed to double check their math in some sense. But it's not going to be the signal by itself. And then, going back to what you had said earlier about the dot plot. I think that's very important. What the Fed is trying to do is engineer a so-called soft landing. That is, they are trying to tighten policy so that the economy slows a lot, but not too much. So that the inflationary pressures that we see start to abate. How would they do that? Well, in part, they'd be raising the short term interest rate. They'd be raising it above their own estimate of neutral. And as you pointed out, in their last dot plot they said they'll go up to maybe 3% before eventually coming back down to 2.5%. So achieving that soft landing is almost surely going to end up creating an inverted yield curve anyway. 

Guneet Dhingra: Yeah, so you talk about the Fed engineering a soft landing. Have they successfully done it in the past? And what makes you think that they can do it this time? 

Seth Carpenter: So two very, very important questions. The answer to the first one, have they done it in the past, is a bit in the eye of the beholder. If you listen to Chair Powell a couple of weeks ago, when he gave a speech at the National Association of Business Economists conference, he gave at least three different examples where he says historically the Fed has achieved a soft landing. If I was going to point to a soft landing, I would look at 1994 to 1995. The economy did slow pretty dramatically after the Fed had hiked rates fairly aggressively, and then the Fed paused the hiking and eventually reversed course, and the economic expansion continued. I think you could consider that to be a soft landing. The big difference this time is that this is the first rate hiking cycle since the 1970s where the Fed is actively trying to bring inflation down. Whereas the more recent cycles have been the Fed trying to keep inflation from rising above their target. So bringing it down as opposed to keeping it down are two very different things. So the way I like to think about it is the Fed's got a very difficult job. Can they do it? Yes, I absolutely think they can do it. And part of what gives me hope is the episode in late 2018 to early 2019, the last time the Fed was hiking, running off the balance sheet, raising short term interest rates. We had that period where the economy slowed, risk markets cracked. And what did the Fed do? They reversed course. Chair Powell has taken to using the word nimble a lot recently. I think if they can be that responsive to conditions, it increases the chances that they pull it off. But it's going to be difficult. 

Seth Carpenter: Well Guneet, I think we would both agree that we don't think an inverted yield curve is signaling a recession, but that doesn't mean that one can't happen. The world is an uncertain place, but thanks for joining us and taking the time to talk. 

Guneet Dhingra: Absolutely. Great speaking to you Seth. 

Seth Carpenter: And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

As investors continue to discuss the uncertainty surrounding the U.S. Treasury market, there may be some good news for bond holders as the year progresses.

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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. Public Policy and financial markets. It's Wednesday, April 13th at 10 a.m. in New York. 

It's been a tough year for bond investors so far. As inflation picked up, the Fed signaled its intent to hike rates rapidly. That pushed market yields for bonds higher and prices lower. And with the latest consumer price index showing prices rose 8.5% over the past year, bond investors could, understandably, be concerned that there's still more poor returns to come. 

But we're a bit more optimistic and see reason to think that bonds could deliver positive returns through year-end and, accordingly, play the volatility dampening role they typically play in one's multi-asset portfolio. Accordingly, our cross-asset team is no longer underweight government bonds. And our interest rate strategy team has said that the recent increase in longer maturity bond yields have put that group in overshoot territory. 

What's the fundamental basis for this thinking? In short, it has to do with something economists typically call demand destruction. Basically, it's the idea that as prices on a product increase, perhaps due to inflation, they reach a point where fewer consumers are willing or able to purchase that product. That in turn crimps economic growth and, accordingly, one would expect that longer maturity bond yields would rise less, or perhaps even decline, to reflect an expectation of lower inflation and economic growth down the road. 

And we're starting to see evidence of that demand destruction. Last week we talked about how the federal government was attempting to reduce the price of oil by selling some of its strategic petroleum reserve. But it's noteworthy that the biggest declines in the price of oil from its recent highs happened before this announcement, suggesting that the price surge at the pump was already crimping demand, resulting in prices having to come back down to put supply and demand in balance. You can also see similar evidence in the market for used cars. For example, used car dealer CarMax reported this week its biggest earnings miss in four years. Management cited car affordability as a key reason that it sold less cars year over year. 

So the bottom line is this: bond investors may have taken some pain this year, but that doesn't mean it's time to run from the asset class. In fact, there's good reason to believe it can deliver on its core goal for many investors, diversification in uncertain markets. 

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

In light of the U.S. Treasury yield curve recently inverting, many are asking if home prices will be affected and how the housing market might look going forward. Co-Heads of U.S. Securitized Product Research Jay Bacow and Jim Egan discuss.

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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. 

Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. 

Jay Bacow: And on this edition of the podcast, we'll be talking about the state of the mortgage and housing market, amidst an inverted yield curve. It's Tuesday, April 12th at 11 a.m. in New York. 

Jay Bacow: Now, Jim, lots of people have come on to talk about curve inversion and Thoughts on the Market. But let's talk about the impact to the mortgage and housing market. Now, the big question that everybody wants to know, whether or not they own a home or they're thinking about buying one, is what does an inverted curve mean for home prices? 

Jim Egan: When we look back at the history of, let's use the Case-Shiller home price index, we look back at that into the 80’s, it's turned negative twice over that 35-year period. Both of those times were pretty much immediately preceded by an inverted yield curve. However, there's a lot of other instances where the yield curve has inverted and home prices have climbed right on through, sometimes they've accelerated right on through. So if we're using history as our guide, we can say that an inverted yield curve is necessary but not sufficient to bring home prices down. And the logical next question that follows from that is, well, what's the common denominator? And in our view, there's a very clear answer, and that clear answer is supply. The times when home prices fell, the supply of homes was abundant. The times when home prices kept rising, we really did not have a lot of homes for sale. And when we look at the environment as we stand today, the inventory of homes for sale is at historic lows. 

Jay Bacow: OK, but that's the current inventory. What do you think about supply for the next year? 

Jim Egan: So I think there's two ways we have to think about the 12-month outlook for supply. The first is existing inventory, the second is new inventory, so building homes that come on market. Existing inventory is really driving that total number to historic lows. And we think it's just headed lower from here. One of the big reasons for that is, let's just talk about mortgage rates away from curve inversion. The significant increase we've seen in mortgage rates because of the unique construction of the mortgage market today, we think are going to bring inventories lower. And that's because an overwhelming majority of mortgage borrowers have fixed rate mortgages today, much more than in prior cycles in the past. And what that means is as rates go higher, as affordability deteriorates, which is something we've discussed in previous episodes of this podcast, that's for first time homebuyers. The current homeowner locked into those low fixed rates is not experiencing affordability pressure as mortgage rates go higher. In fact, they're probably less likely to put their home on the market. Selling their home and buying a new home would involve taking out a mortgage that might be 150 to 200 basis points higher. That can be prohibitively expensive in some instances, and so you actually get an environment where supply gets tighter and tighter, which could be supporting home prices. Now the other side of the equation is new homes. If existing inventory is at all-time lows, if prices continue to climb like they have, that should be an environment where we'll see more building. And we do think that inventories are already primed to come on the market over the next year because of the fact that look, we look at building permits, we look at housing starts, we look at completions, those numbers get talked about all the time when they come out monthly and they've been climbing. But they haven't been climbing all that much relative to history. What is up is kind of the interim points between those events, between housing start and completion. Units under construction is back to where we were in kind of late 2004, early 2005. Further up the chain units that have been permitted or authorized but haven't been started yet, that's starting to swell too. Now what’s currently in the pipeline isn't enough to alleviate the tight supply situation we find ourselves in. But it is enough to soften home price growth a little bit. But the real common denominator for home price growth in a curve inverted environment is that existing inventory number, which is at historic lows and continuing to go lower. 

Jay Bacow: All right, Jim. So mortgage rates are a lot higher, causing people to be locked in to their mortgage, and supply is low and you're saying probably going to stay that way. So what does that mean for housing activity going forward? 

Jim Egan: We think sales are going to fall. Housing sales normally fall either while the curve is inverted or shortly after the curve inverts, this time is no different. When we look at the impact that the incredible decrease in affordability that we've seen over the past 6 months, over the past 12 months, that also normally leads to sales volume slowing 6 months forward and 12 months forward. We've already started to see it. Existing home sales are starting to turn negative on a year over year basis, pending home sales are negative, purchase applications have decoupled even more than those statistics. So the ingredients for that decline in sales volumes that typically follow a curve inversion, they're already in place. We think that existing home sales have already peaked for at least the next year. But Jay, if we think existing home sales are going to fall, then that would mean fewer mortgages and fewer mortgages would mean less supply for mortgage-backed securities. Now that would be a good thing, right? 

Jay Bacow: Yeah, look, it's not advanced research to say that less supply is good for a market, and we think that's absolutely the case here. But the other side of the supply is demand, and the biggest source of demand, the largest holder of mortgages, is domestic banks. And domestic banks have a problem in an inverted yield curve that the incremental spread that they pick up to own mortgages versus their deposits is just going to be lower in an inverted yield curve. When we look at the data historically, we see that strong statistical correlation. That as the curve flattens, bank demand goes lower. It's also exacerbated by the fact that a lot of the mortgages that banks own are in their hold to maturity portfolios, over a trillion dollars. And those bonds yield less than where we project fed funds to be at the end of the year. So when we think about the demand for mortgages, the largest source of demand, it's going away. That's going to be a problem for mortgages. 

Jim Egan: OK, so the largest source of demand? Banks, they're going away. Who else is going to buy, if not the banks? 

Jay Bacow: Well, that's when we run into an even bigger problem. The second largest source of demand is the Fed, and the Fed has basically said in the minutes that were released last week, that they're going to be normalizing their mortgage holdings. Taking those two largest sources of demand it's likely to force money managers and overseas to end up buying mortgages, but probably at wider spreads than here. And that's why we're recommending still an underweight agency mortgages, which will cause spreads to go a little wider and maybe mortgage rates to go higher, further impacting the affordability problems that you were discussing earlier in the podcast, Jim. 

Jim Egan: All right Jay. Thanks for taking the time to talk today. 

Jay Bacow: Always great speaking with you, Jim. 

Jim Egan: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show. 

Original Release on March 31st, 2022: As interest in using cryptocurrencies for transactions continues to rise for both consumers and businesses, crypto has begun a cycle of increased stability and popularity - but the question is, can this cycle continue? 

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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be asking the question - are cryptocurrencies currency? It's Thursday, March 31st at 2:00 p.m. in London. 

Did you really buy that house with crypto? Or did you just sell your crypto for dollars and use dollars to buy the house? 

Crypto skeptics think that goods cannot be priced in cryptocurrencies like bitcoin, primarily because their price is too volatile. But at some point, if crypto begins to be used for enough purchases of everyday goods and services, prices may begin to stabilize. Increased stability will further entice consumers to use crypto, and the cycle will continue. The question has always been, will this virtuous cycle ever begin? The answer is now clear, it has already begun. Here are some examples. 

Firstly, paying with cryptocurrency needs to be as easy as paying with a credit or debit card today. Over 50 crypto companies and exchanges have issued their own crypto cards, and these are attached to the Visa or MasterCard payments networks, meaning they're accepted all around the world. In the last quarter of 2021, Visa said its crypto related cards handled $2.5 billion worth of payments. Now that may sound small, at less than 1% of all Visa's transactions, but it is growing quickly. The difficulty in increasing crypto adoption is getting the merchant to accept crypto. It needs to be easy and cheap, which is something lots of new crypto companies and products are trying to achieve. 

Secondly, many would argue that something can only be a currency if you can pay your taxes with it. Even that is changing today. Over the past year, local and some national governments have introduced or proposed laws that will allow its residents to use cryptocurrency to pay their taxes. El Salvador famously made bitcoin legal tender in its country in 2021. In the past week, Rio de Janeiro announced it will become the first city in Brazil to allow cryptocurrency payments for taxes starting next year. 

It isn't just emerging economies, though, that are trying to attract global crypto investors. The city of Lugano in Switzerland has teamed up with Tether, the creator of the largest stablecoin - a type of cryptocurrency that's kept stable versus the U.S. dollar, to make bitcoin and two other cryptocurrencies de facto legal tender. In the U.S., Colorado is hoping to become the first state to accept crypto for taxes later in the year, and Florida's governor is investigating the logistics of doing the same. Both these proposals may be difficult to put into law in the end, as the U.S. constitution doesn't allow individual states to create their own legal tender, but it hasn't stopped these proposals and more from coming in. 

In both these examples, the receiver of the crypto typically immediately converts to fiat currency, like U.S. dollars, through an intermediary service provider. So let's come back to our original question - did you really buy that house with crypto? In February, a house in Florida was sold for 210 Ether, the second largest crypto, or the equivalent of over $650,000 dollars. Interestingly, the seller received the ether but didn't liquidate into U.S. dollars soon afterwards due to market volatility, because the value of ether in U.S. dollars fell by around 10%. 

Consumers and businesses are increasingly wanting to transact in cryptocurrency. Maybe most are simply wanting to trade the value of the asset, but as it becomes easier to transact in crypto and legal structures are defined, cryptocurrencies could start to become currency. The question is, will the virtuous cycle continue or be broken? Cryptocurrencies are beginning the long journey of challenging U.S. dollar primacy, and the president's recent executive order on digital assets shows little sign of regulators getting in their way for now. 

Thanks for listening. If you enjoy Thoughts on the Market, share this and other episodes with a friend or colleague today.  

Since the Fed’s first rate hike and the inversion of the U.S. Treasury yield curve, the outlook on U.S. government bonds has changed, leading to a new take on U.S. Bonds.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, April 8th at 2:00 p.m. in London. 

We've made a key change in our strategic cross-asset allocations, closing our underweight to government bonds and are overweight in cash. We did this via U.S. Treasuries. This is a big debate among investors, many of whom are underweight bonds and questioning when to buy them back. There are a couple of reasons why we made this change. 

First, U.S. 10 year Treasury yields are now above the 2.6% year-end yield target of Morgan Stanley's U.S. interest rate strategists, meaning our forecast for U.S. bond returns are looking better on a cross asset basis. These forecasts should reflect the impact and the uncertainty of higher inflation, quantitative tightening and the growth outlook. 

Second, another part of our asset allocation framework is asking what economic indicators say about future cross asset performance. On these measures the outlook for U.S. bonds is also improving. For example, bonds tend to do better on a cross asset basis after the yield curve inverts, which recently happened. 

Another reason we were underweight bonds is that they often underperform other asset classes during the expansion phase of our cycle indicator, a tool we've developed within Morgan Stanley research to measure the ebb and flow of the economic cycle. But this underperformance starts to shift and stop when this indicator gets very extended, and on its current measures, well, it's very extended. 

Third, while this change was made with a 12 month horizon in mind, we could see some reasons to take action now rather than wait. Recently, cyclical stocks have been sharply underperforming defensive stocks, and that usually coincides with unusually good bond market performance as investors worry about growth. But recently, bonds have been underperforming, even as defensive stocks have worked. That divergence is unusual, but could normalize. 

We also have an important release of U.S. Consumer Price Inflation next week. While a peak in inflation has so far been elusive, Morgan Stanley's economists believe it may arrive with next week's number. 

Of course, there are many risks to adding back to bonds at the current juncture. One of those risks is that the U.S. Federal Reserve remains hawkish, and committed to a large number of rate hikes over the next 12 months. While that is certainly possible, the market is now expecting a faster rate hiking path, reducing the chance of a Federal Reserve surprise. 

To raise our weight of U.S. bonds back to neutral, we are closing or overweight to cash. Cash has performed well year to date, as many other asset classes have seen price declines. But this outperformance is unusual and warrants a more balanced approach for the time being. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen, and leave us a review. We'd love to hear from you.

As the European Central Bank prepares to meet, the war in Ukraine continues to add to uncertainty, forcing investors in Europe to adjust their expectations for the remainder of the year. Chief Cross Asset Strategist Andrew Sheets and Chief Europe Economist Jens Eisenschmidt discuss.

Important note regarding economic sanctions. This research references country/ies which are generally the subject of selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly incidental to general coverage of the issuing entity/sector as germane to its overall financial outlook, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions. 

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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset Strategist.

Jens Eisenschmidt And I'm Jens Eisenschmidt. Morgan Stanley's Chief Europe Economist.

Andrew Sheets And today on the podcast we'll be talking about the outlook for Europe's economy amid possible rate hikes, business reopenings and the war in Ukraine. It's Thursday, April 7th at 3 p.m. in London.

Andrew Sheets Jens, clearly we're dealing with a lot in Europe right now amid the Ukraine conflict and I want to get into that situation and the impacts on the economy. But given that the European Central Bank is meeting in just a few days and there is speculation about possible rate hikes, let's start there. Maybe you could give a bit of a background on what we expect the ECB is going to do.

Jens Eisenschmidt Thanks a lot, Andrew. First of all, let me say that we don't expect any change at next week's meeting relative to what the ECB has been saying in March at their last meeting. They're essentially keeping all options open. They have started on a gradual exit from their very accommodative monetary policy. They have increased the pace of policy normalization at their last meeting, and we do not expect the ECB to change that roadmap now. Just as a reminder, the roadmap is asset purchases could end in Q3 and any interest rate hike would come sometime thereafter. And any decision on ending asset purchases and rate hikes is highly data dependent. And that really it takes us to the current situation. Inflation continues to surprise to the upside. We just had a 7.5 percentage point print in March, and this undoubtedly does increase the pressure on the ECB to act. At the same time, there are significant downside risks to the outlook for growth in the Euro area stemming essentially from the Ukraine-Russia conflict, and this puts a premium on treading very carefully with any changes to the monetary policy configuration, hence the emphasis on optionality, flexibility and gradualism by the ECB.

Andrew Sheets Jens, when you talk about gradualism, that implies that the inflation that we're seeing in Europe is more temporary, is more transitory, isn't going to get out of hand. Can you talk a little bit about what is different at the moment between inflation in Europe and inflation in the U.S.?

Jens Eisenschmidt I think there are a lot of technical aspects that indeed you could be looking at on that question, but I think it's sufficient for our purposes here really to focus on the key difference. In the U.S. there's a huge internal demand component to inflation. While the same is not true for the euro area, where most of the inflation, you could argue, largest part is imported through energy. Another difference is that the outlook for the economy is slightly different. While you would say that in the U.S., if you're talking about an overheated economy, you have a very tight labor market, it's very difficult to see, you know, some sort of self-correcting forces bringing down inflation, which is why the Fed is embarking on a relatively aggressive tightening cycle. Here in the euro area, there is, of course, growth we see in '22 in our base case but at the same time, we are far away from such an overheating situation and even we are here now relying increasingly on fiscal stimulus to keep the growth momentum going given the high energy prices that are coming, dampening growth. So I think the situation is fundamentally a different one.

Andrew Sheets And so Jens, maybe digging more into that growth outlook. You mentioned this rise in energy prices. There is uncertainty over the war in Ukraine. And yet in your team's base case, we see GDP growth in Europe growing about 3% this year, which would be pretty good by the standards of the last decade. What's behind that overall outlook?

Jens Eisenschmidt You're right. our base case has the euro area economy growing by 3% in '22 on the back of the ongoing recovery from the pandemic, 'reopening' in one word, which has lagged here relative to, say, the U.S., as well as due to the fiscal stimulus. But we see increasing headwinds emerging as you were just also referencing. We had this series of consumer confidence prints clearly affected by high inflation and the ongoing conflict, and we are watching attentively how this develops. Energy prices have skyrocketed. So, while we stick to our base call for now, we think that the balance of risks is slowly migrating to the downside. As for the ECB, the projections presented at their last meeting in March are more optimistic in terms of growth than ours. Now, clearly, if the ECB's view of the world prevails, so growth comes in better than we expect, we think the ECB will start to raise rates as early as September this year. Contrary to that, we think that incoming data will disappoint the ECB and this is why we have the first rate hike only in December. In any case, you can see the ECB is clearly on the path of policy normalization, the need for which is driven by the high inflation regime we are in and even the less favorable growth outlook won't change that fundamentally.

Andrew Sheets Jens, given that we were discussing the ECB, I'd also like to talk about what higher interest rates mean in Europe. How do you think about that debate and do you see a scenario where the ECB might be quicker to take rates from negative to zero, but then pause at zero for a more extended period of time?

Jens Eisenschmidt I think this is a fair question, given that the negative rate experiment, if you want to call it, is really unique in its scope in the Euro area. And there has been a lot of debate about the effect of negative rates on banks, and you can probably argue that revising or returning from negative to zero is a little bit of a different journey than just raising rates in positive territory like what the what the Fed is going to do or is about to do now. So I'd say while there are some merits in the argument that probably, you know, getting rid of negative rates in the front end will help banks and may be good for lending in some sense, I think overall, our assessment would be increasing rates is something that detracts from economic activity.

Andrew Sheets So Jens, you know, you mentioned some of the risks around energy supply, and I think it's safe to say this is the single biggest area of questions for investors who are in Europe or are looking at Europe is, how would the region respond to either cutting off its imports of gas and oil from Russia voluntarily or this disruption happening involuntarily? What would a complete cut off of Russian oil and gas mean for Europe's economy? And how does somebody in your position even go about trying to model that sort of outcome?

Jens Eisenschmidt So we have, of course, tried to get our head around this question and we we have published last week a note on exactly that issue. The typical approaches or the approaches that we have as economists here is really you look at the sectoral dependencies on on these flows of gas and oil, say. You make some assumptions and of course, it gives rise to ranges which are relatively wide. What we can say with certainty is that in a scenario of a complete cut off of Russian supplies in terms of oil and gas, we we are very, very likely in a recession in 22 in the euro area. And we are really talking about a significant recession risk. While only through higher energy prices, so oil going the direction of 150, but you know, other than that supply still flowing, we also see huge dampening impact on the economy with a shallow recession emerging not as bad as we would see in a total cutoff scenario. But I have to admit there's huge uncertainty.

Jens Eisenschmidt But Andrew, I was going to ask you a similar question as a strategist looking at different asset classes around the world. What's your team's view on Europe?

Andrew Sheets Well thanks, Jens. So I think, unfortunately, the outlook for Europe, as you mentioned, has deteriorated since the start of the year. This terrible conflict in Ukraine has introduced additional uncertainty and binary risks to Europe around energy security that are difficult for investors to price and to discount. So, we've lowered our price target for European equities, which now leaves very limited upside versus current prices. And I think the region is now less attractive than something like Japan, for example, where I think you still have some of the same positive arguments that apply to Europe. The valuations are low. The currency is weak. Investors, I do not think are overly positioned in the region, but with less risk around aggressive central bank policy and with less risk around energy security. So for those reasons, we now think Japan is going to be outperforming market on a on a global basis.

Andrew Sheets So Jens, all that said, the war in Ukraine is a wild card for our forecasts. What are the developments or indicators that you and your team are going to be watching?

Jens Eisenschmidt We are really dependent on what's happening in the political sphere, given that the cut off of energy supplies will be either a decision by Russia or by the EU to no longer accept delivery of any gas or oil or coal. And obviously, this is a political process for which you have many ingredients, so you would want to watch these ingredients and some of which are essentially in the conflict itself. So I think we are attentively watching the developments that the conflict is taking. And there for instance, the news flow coming out of potential war crimes that certainly has not helped the case of energy supplies flowing freely. So there is a discussion right now in the European Union to restrict import of coal. And I think it's exactly these sort of developments that you have to be watching. Another space that we attentively watch is energy markets because high energy prices are so detrimental for the growth outlook. And might remind you, we have one scenario, our so-called bear scenario, which sees energy prices almost as high as we have seen them or higher a little bit maybe as we have seen them in early March. That is a scenario which would get us very, very close to recessionary territory. So, in some sense, it's a situation where we have to watch the energy markets as much as we have to watch the political scene and see how this conflict evolves.

Andrew Sheets Well, clearly a lot that we'll need to follow. Jens, thanks for taking the time to talk.

Jens Eisenschmidt Great speaking with you, Andrew.

Andrew Sheets And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

As the U.S. government attempts to combat high gas prices by drawing on its oil reserves, investors should pay attention to the impacts on the U.S. economy and consumer behavior.

----- Transcript -----

Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, April 6th at 10 a.m. in New York.

Last week President Biden announced the largest release of oil reserves in history, about 1 million barrels per day for the next 6 months from the government's Strategic Petroleum Reserve. The move is intended to put downward pressure on the price of gasoline by increasing the supply of oil, thereby relieving pressure on the American consumer from higher costs at the pump. Will it work? That remains to be seen, but investors should pay close attention, not just because it impacts their cost of driving, but also because it impacts the outlook for the U.S. economy by affecting how consumers behave.

Our U.S. economics team, led by Ellen Zentner, has done some work worth highlighting here. The big takeaway is this; oil price shocks do dampen consumer activity, but not right away. The jump in oil prices seems to have to sustain itself before having a big impact. For example, consumption in real dollar terms seems to weaken after initial oil price increases, but it's not until 2 to 3 months after that shock that consumers start to buy less of other things in order to have enough money to pay the higher costs of filling up their cars. Looking at this effect on a specific product, for instance automobiles, you can see a similar pattern. Spending on cars doesn't seem to change in the first month after a price shock but drops almost 10% thereafter for 8 months.

So the bottom line is this; the White House's move on releasing oil reserves has some time to play out. But if it doesn't reduce gas prices in the next couple months, then it becomes one cost pressure among several, including labor costs, that could start slowing the U.S. economy from its currently healthy pace. It's one reason our equity strategy team continues to see higher costs creating some pressure in key sectors of the stock market, notably consumer services, apparel and staples.

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

Original Release on March 30th, 2022: As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.

-----Transcript-----

Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. 

Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. 

Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York. 

Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now? 

Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s. 

Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle? 

Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this... 

Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists. 

Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home. 

Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today? 

Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy. 

Michael Zezas: Well, Matt, thank you for taking the time to talk with me today. 

Matthew Hornbach: It was great talking with you, Michael, 

Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show. 

With the end of the first financial quarter of 2022 the market has begun to price in some of the continuing risks to economic growth, forcing investors to reconsider the trajectory for the rest of the year.

-----Transcript-----

Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 4th, at 11:00 a.m. in New York. So let's get after it. 

Given how bad first quarter returns were for both stocks and bonds, most investors were probably happy to see it end. Furthermore, the rally in the second half of March made it considerably better for stocks than it was looking just a few weeks ago. In the end, though, bond returns ranked worse than stocks from a historical perspective, with Treasuries posting the worst quarter in 50 years. 

The tough first quarter was very much in line with our view coming into 2022. To recall, we didn't see many fat pitches given the Fed's resolve to fight the surge in inflation in the face of slowing growth. Whether it was for technical or fundamental reasons, bond and stock markets ignored this risk into year-end. Apparently, they required a more obvious signal, which appeared on January 5th with the minutes of the Fed's December meeting. From that moment, both stocks and bonds made a sharp U-turn and never really looked back for the entire first month of the year. 

In short, headline indices for both stocks and bonds finally adjusted to the fire part of our narrative, a risk that started to price under the surface back in November. With inflation and the Fed the number one concern during the first quarter, it makes sense that bonds would be worse than equities. It also makes sense that stocks more vulnerable to higher interest rates underperformed. As an example, the Nasdaq performance was considerably worse than both the S&P 500 and the small cap Russell 2000, a very rare occurrence over the past few years. And this is after a major rally in the past two weeks that was led by the Nasdaq. Our conclusion is that markets were preoccupied in the first quarter with the Fed's sharp pivot, more than anything else, and it played out in asset prices appropriately. 

Of course, the other major driver for markets in the first quarter was the war in Ukraine. While tensions had been building since late last year, it's fair to say markets had ignored that risk, too. The only difference is that the Fed's pivot was well telegraphed, while Russia's invasion was far from a sure thing and more of an unknown known to most, including us. Obviously, such an event did materially factor into the risk for the first quarter by accentuating the fire and ice by making inflation worse whilst simultaneously dampening growth prospects. It also has rattled confidence for both businesses and consumers, especially in Europe. This was not in our calculus when we made our forecast for 2022. As such, we find ourselves incrementally more negative on growth trends than we were at the end of last year. 

Last fall, we pushed out the timing of the ice part of our narrative to the first half of this year, when we realized that the economy still had plenty of strength left for companies to deliver on earnings growth. But now investors face multiple headwinds to growth that will be harder to ignore. These include the payback in demand from last year's fiscal stimulus, demand destruction from higher prices, food and energy price spikes from the war that serves as a tax and inventory bills that have now caught up to demand. 

While the employment report for March last Monday was strong once again, the Purchasing Managers Survey for Manufacturing showed a sharp deterioration in the orders component. Relative to inventories it looks even worse, with the inventory component of the index now below orders for the first time since the recovery began. Think of this ratio as the book to bill for the broader manufacturing economy. Perhaps this survey is the moment of recognition for the slowdown, much like the Fed's minutes were for inflation and Fed policy. 

The bottom line is that the fundamental outlook for stocks has deteriorated in our view since the end of last year. While markets have reflected some of this deterioration, we think it remains vulnerable to disappointing growth and increased risk of a recession next year. As such, we continue to recommend investors position for this late cycle setup. More specifically, that means favor defensively oriented sectors like Utilities, REITs and Healthcare, while avoiding stocks more vulnerable to a payback in consumer demand. 

Thanks for listening. If you enjoyed Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show. 

Investors are looking to the U.S. Treasury bond market as concerns rise around what the flattening, and potential inversion, of the yield curve might mean.

-----Transcript-----

Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, April 1st at 2:00 p.m. in London. 

The so-called flattening and inversion of the U.S. yield curve is a dominant story in financial markets. As rates have risen, short term interest rates have risen more, meaning investors receive about the same yield on a 2 year U.S. Treasury as its 10 year version. This is unusual, and raises big questions for both bond investors and the economic outlook overall. 

Unsurprisingly, investors are usually paid more for investing in longer term bonds because these are generally more volatile. When that's not the case, it often means the market thinks the economy is going to be good in the near term, keeping short term central bank rates high, but possibly weaker in the longer term, which would imply lower future central bank rates and more supportive policy further out. 

And that feels like a pretty decent encapsulation of the current market debate. The U.S. economy is very strong at the moment, with the US unemployment rate recently falling to just 3.6%. But that strength is driving inflation and leading the Federal Reserve to raise interest rates more aggressively, rate increases that investors fear could weaken growth further out in the future. 

With implications like this it's no wonder that a lot of other asset classes, from credit markets, to equity markets, to commodities, really care about what the bond market is doing. And for these investors, we think there are a number of interesting implications. 

Let me start by saying that similar yields on 2 year and 10 year government bonds is not, in itself, a sell signal. Indeed, the last five times these rates were the same, global stocks rose by an average of about 10% over the following year. 

What we do see, however, is that a flat yield curve starts to support the outperformance of higher quality, more defensive assets. I try to explain this by the idea that investors do try to retain some growth in income exposure, given the strong current economic conditions, but try to move away from assets that could be much more vulnerable if growth deteriorates in the future. 

Specifically, when the U.S. 2 year and 10 year yields become similar, investment grade bonds start to outperform high yield bonds. Developed market stocks start to outperform emerging market stocks. And defensive sectors like health care and utilities outperform the broader market over the ensuing 12 months. 

Today, we think all of those strategies make sense. That's not because we necessarily think a recession is likely. Rather, we think it's a prudent reading of history in response to current bond market signals. 

Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.

As interest in using cryptocurrencies for transactions continues to rise for both consumers and businesses, crypto has begun a cycle of increased stability and popularity - but the question is, can this cycle continue? 

-----Transcript-----

Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be asking the question - are cryptocurrencies currency? It's Thursday, March 31st at 2:00 p.m. in London. 

Did you really buy that house with crypto? Or did you just sell your crypto for dollars and use dollars to buy the house? 

Crypto skeptics think that goods cannot be priced in cryptocurrencies like bitcoin, primarily because their price is too volatile. But at some point, if crypto begins to be used for enough purchases of everyday goods and services, prices may begin to stabilize. Increased stability will further entice consumers to use crypto, and the cycle will continue. The question has always been, will this virtuous cycle ever begin? The answer is now clear, it has already begun. Here are some examples. 

Firstly, paying with cryptocurrency needs to be as easy as paying with a credit or debit card today. Over 50 crypto companies and exchanges have issued their own crypto cards, and these are attached to the Visa or MasterCard payments networks, meaning they're accepted all around the world. In the last quarter of 2021, Visa said its crypto related cards handled $2.5 billion worth of payments. Now that may sound small, at less than 1% of all Visa's transactions, but it is growing quickly. The difficulty in increasing crypto adoption is getting the merchant to accept crypto. It needs to be easy and cheap, which is something lots of new crypto companies and products are trying to achieve. 

Secondly, many would argue that something can only be a currency if you can pay your taxes with it. Even that is changing today. Over the past year, local and some national governments have introduced or proposed laws that will allow its residents to use cryptocurrency to pay their taxes. El Salvador famously made bitcoin legal tender in its country in 2021. In the past week, Rio de Janeiro announced it will become the first city in Brazil to allow cryptocurrency payments for taxes starting next year. 

It isn't just emerging economies, though, that are trying to attract global crypto investors. The city of Lugano in Switzerland has teamed up with Tether, the creator of the largest stablecoin - a type of cryptocurrency that's kept stable versus the U.S. dollar, to make bitcoin and two other cryptocurrencies de facto legal tender. In the U.S., Colorado is hoping to become the first state to accept crypto for taxes later in the year, and Florida's governor is investigating the logistics of doing the same. Both these proposals may be difficult to put into law in the end, as the U.S. constitution doesn't allow individual states to create their own legal tender, but it hasn't stopped these proposals and more from coming in. 

In both these examples, the receiver of the crypto typically immediately converts to fiat currency, like U.S. dollars, through an intermediary service provider. So let's come back to our original question - did you really buy that house with crypto? In February, a house in Florida was sold for 210 Ether, the second largest crypto, or the equivalent of over $650,000 dollars. Interestingly, the seller received the ether but didn't liquidate into U.S. dollars soon afterwards due to market volatility, because the value of ether in U.S. dollars fell by around 10%. 

Consumers and businesses are increasingly wanting to transact in cryptocurrency. Maybe most are simply wanting to trade the value of the asset, but as it becomes easier to transact in crypto and legal structures are defined, cryptocurrencies could start to become currency. The question is, will the virtuous cycle continue or be broken? Cryptocurrencies are beginning the long journey of challenging U.S. dollar primacy, and the president's recent executive order on digital assets shows little sign of regulators getting in their way for now. 

Thanks for listening. If you enjoy Thoughts on the Market, share this and other episodes with a friend or colleague today.  

As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.

-----Transcript-----

Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. 

Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. 

Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York. 

Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now? 

Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s. 

Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle? 

Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this... 

Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists. 

Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home. 

Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today? 

Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy. 

Michael Zezas: Well, Matt, thank you for taking the time to talk with me today. 

Matthew Hornbach: It was great talking with you, Michael, 

Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show. 

As oil and gas prices rise, governments and investors must weigh investment in clean energy initiatives and new capacity in traditional energy commodities. Head of North American Power & Utilities and Clean Energy Research Stephen Byrd and Head of North American Oil and Gas Research Devin McDermott discuss.

Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.

-----Transcript-----

Stephen Byrd: Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Head of North American Power and Utilities, and Clean Energy Research. 

Devin McDermott: And I'm Devin McDermott, Head of Morgan Stanley's North American Oil and Gas Research. 

Stephen Byrd: And today on the podcast, we'll be discussing the key debate around energy security and energy transition amid the Ukraine Russia conflict. It's Tuesday, March 29th, at 9 a.m. in New York. 

Stephen Byrd: So, Devin, the Russia-Ukraine conflict has, among other concerns, really put a spotlight on energy supply and demand. I want to get into this perceived tension between energy security, that is making sure there's enough supply to meet demand, and the transition to clean energy. But first, maybe let's start with the backdrop. There's been a lot of discussion around higher energy prices. This is a world you live in every day, and I wondered if you could paint us a picture of both oil and natural gas supply and demand globally. 

Devin McDermott: Yeah, certainly, Stephen, and it's definitely been a dynamic market here over the last several years, coming out of COVID and the price declines that we saw then and the sharp recovery that we've been in now for about a year and a half across the energy commodity complex. If we start with oil first, we had record demand destruction in the second quarter of 2020 around global lockdowns, industrial activity slowing and along with that, oil prices broke negative for the first time in history. And then coming out of that, we've had the combination of a few factors that drove prices higher. The first has been demand has been on a very strong recovery path since that bottom in the second quarter of 2020, growing alongside people getting out again, aviation starting to pick up, the economy growing on the back of the stimulus that was injected over the past few years around the world, not just in the US. And then constrained supply, and that constrained supply comes from a mix of different factors, but the biggest of which is a reduction in investment around the world. The other factor is decarbonization goals, in particular with the global oil majors, which are big investors in global oil and gas capacity, and they've put their marginal dollar increasingly into low carbon initiatives, New Energy's platforms, renewables, driving decarbonization goals across their global footprint. Now, shifting over to the gas side, gas is a fascinating market. Globally, it's fairly regionally disconnected historically, but we've had this big investment over the past decade in liquefied natural gas or LNG that's really brought these regional markets together into one global picture. And we've been on, up until COVID, a declining path on prices. LNG projects take many years to build, they're expensive, they have long paybacks, and they were first to get chopped when companies cut capital budgets to preserve liquidity back in 2020, but demand was still growing through that timeframe. So it pushed us into this period of supply shortfall and higher prices. And actually, last year, on three separate occasions, we set new all time highs for global non-U.S. natural gas prices, and that recovery path and period of stronger for longer prices has persisted here into 2022. And even prior to Russia Ukraine, it was something that we thought would persist for at least the next several years. 

Stephen Byrd: You know, it's fascinating before the Russia-Ukraine conflict we already had, you know, tight markets, rising pricing. Now we really need to dig into the Russia-Ukraine conflict and all the impacts. Maybe let's just start Devin with, sort of, how big of a player Russia is in terms of oil and gas, and what the impact is of any current or future sanctions against Russia. 

Devin McDermott: Russia is one of the world's largest producers of oil and also one of the world's largest producers of natural gas. And to put some numbers around that, Russia represents about 10% of the world's oil supply, about half of that gets exported to the rest of the world. And they represent about 17% of the world's natural gas supply, about 7 of that gets exported to the rest of the world. These are big numbers. And if you look at Europe specifically, about 30% of their gas needs are coming from Russia on pipeline gas right now. So any disruptions to those flows have significant impacts to the global oil and gas market on top of this already tight backdrop. 

Stephen Byrd: And Devin I guess as we think about Europe, there's tremendous focus, as you point out Russia is a major player in energy and a major exporter. And I wonder if you could just talk to the current situation and what do you think would be feasible in terms of satisfying energy demand as Europe thinks about looking for other sources of energy? 

Devin McDermott: Yeah, it's a good question, Stephen and our European energy team has done a lot of work around this and they think that because of the events that have happened so far, not including any potential incremental sanctions or disruption of supply, that we'll lose about a million barrels a day of Russian oil here over the next several months, starting in April through the balance of this year. And again, just to put that in the context, that's about 10% of Russian supply, about 1% of the world's supply on a normalized pre-COVID basis. Now, some of the disruption in flows to Europe will be bought by other countries. You've seen India and China step in and pick up some of this Russian crude that's no longer going to Europe, but it's not going to fill the entire gap. So it leaves us tighter in the oil market than we were just a few weeks ago. On the natural gas side, it'll be a gradual pivot away from Russian pipeline gas within the European market toward a range of different things, one of which is LNG liquefied natural gas. But, as I mentioned before, that market was already in a shortfall, meaning there was not enough supply to meet demand prior to this. So this transition away from Russian gas is going to require substantial investment and take a long time, 5 to 10 years plus, to carry out. It means that these high prices that we're seeing likely have some sustainability to them. 

Devin McDermott: Stephen, that brings me to a question that I wanted to ask you on the clean energy side. Do you think that we might see a greater policy, and even energy consumer push, to clean energy both in the US and globally on the back of these elevated commodity prices and what's going on in Russia and Ukraine at the moment? 

Stephen Byrd: Yeah, Devin, we've been seeing a lot of interest among investors in exactly what is going to be the policy response both in Europe and the United States and elsewhere. And I'd say the EU has taken action already. The European Commission laid out a repower EU plan that is very aggressive in terms of additional renewables growth, additional growth in green hydrogen. We see quite a few European utilities and clean energy developers benefiting from the EU's increased emphasis and push towards more and more clean energy. And Rob Pulleyn, my colleague who covers European utilities and clean energy developers and is also a commodities strategist with respect to carbon, has been spending a lot of time on this, has laid out a suite of companies that would benefit quite significantly. There does seem to be a really big policy push in Europe. The United States is not clear. The real question is whether some version of build back better legislation will pass. We just don't know. Now, there is a reason to believe that there could be a compromise position in which some elements of a support for fossil fuel production are included, along with the whole suite of clean energy support that we already know is there. That said, it's possible that compromise simply won't be met. And in that case, we won't get any kind of additional support at the federal level. What's fascinating in the United States, though, is frankly, we don't necessarily need to see that support in order to see tremendous growth in clean energy, we are already seeing a big shift. And as we stand today, we think that clean energy in the United States will more than triple between now and 2030. It's one of the fastest growth rates globally. That is driven mostly by economics, in some cases by state policy, but mostly by economics. 

Devin McDermott: So, Stephen, I wanted to go back to this question on the tension between energy security and the energy transition. Is it an either or? 

Stephen Byrd: You know, Devin, we get asked that question a great deal, and I strongly believe the answer is no, those two ideas are not mutually exclusive. And in fact, what we're seeing is both the policy push as well as a business push in both directions. And a good example of that would be the U.S. Utilities that I cover. They are certainly very focused on deploying more renewable energy. And as a group, for example, we see that utilities will decarbonize in the United States by about 75% by 2030 off of 2005 baseline. So very aggressive decarbonization. At the same time, those utilities are very focused on ensuring grid reliability. Now, as we deploy more renewable energy, we're learning quite a few lessons. One lesson is the importance of more energy storage, so demand has been picking up a great deal for that. Another lesson we're learning is the importance of nuclear generation, we're learning that they're critical. They provide both reliability and also zero carbon energy. And in the U.S., we've had a very strong operational track record for our nuclear fleet. So we're learning lessons along the way, but what we're seeing is a push in both directions. Now, as you know, clean energy relative to the world that you live in, oil and gas, is still fairly small. It's going to take many years before clean energy really makes a meaningful impact in terms of global energy consumption. That said, for example, coal generation in places like the United States will decline over time and be replaced with mostly renewable energy, but also with some degree of natural gas generation to ensure reliability. So we're seeing really both ideas play out, and both investment theses are very rational, and we see really good opportunities on both of those ideas. 

Devin McDermott: And let's take it one step further and talk investment opportunities and themes on the back of this. As you think about the different subsets of clean energy and clean tech, where would you be focused for opportunities here? 

Stephen Byrd: You know, it's interesting. One group of stocks that we generally like are clean energy developers. And the reason we like those stocks is essentially this spread between what we're thinking of as inflationary traditional energy like oil and gas, and this deflationary dynamic of clean energy. One example is in places like California, the traditional utility costs to customers are rising very rapidly above 10% a year. If you look in the long term, the cost of our clean energy solutions are dropping anywhere from 5% a year, to 10, 15% per year. That's a tremendous economic wedge, and we think the developers will be able to essentially capture a lot of that spread. On the manufacturers side there are still some supply chain dynamics, which can cause some near-term margin compression that concerns us, in some cases. I would say another area of really interesting growth is green hydrogen, especially in Europe. A number of our companies are focused on that market as well. So those would be a couple of the buckets of opportunity that we see. 

Devin McDermott: Great. Stephen, thanks so much for the time today. It's really a fascinating topic and one that's unfolding right before our eyes today. 

Stephen Byrd: Well, it was great speaking with you, Devin. 

Devin McDermott: And thanks for listening. If you enjoy Thoughts on the Market, please give us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

As the Fed continues down a hawkish road for 2022, investors must consider the impact of policy tightening on economic growth and equity risk premiums.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 28th at 11:00 a.m. in New York. So let's get after it. 

2022 has been a year of extraordinary hawkishness from the Fed, and it continues to surprise on the upside with both its formal guidance and informal communications. This has led to almost weekly revisions for more Fed rate hikes from just about everyone, including our economists who now expect 50 basis point interest rate hikes in both May and June, and then 25 basis points in every meeting thereafter. The bond market has definitely gotten the message, too, with one of the sharpest rises in short term interest rates ever witnessed. Longer term rates have also adjusted as the expected terminal rate for this cycle has risen to 2.9%. The questions for equity investors now is whether they believe the Fed will actually tighten this much and what will be the impact on the economy from a growth standpoint. 

We have several takeaways from these recent moves. First, the Fed appears to be very committed to reducing inflation. Friday's University of Michigan Consumer Confidence Report for March confirmed that high prices are still the key reason this metric has plummeted to levels usually reserved for recessions. 

Second, 10 year yields are now at a level that takes the equity risk premium to its lowest level since the Great Financial Crisis. As a reminder, equity risk premium is the return and investor receives above and beyond the yield on a Treasury bond. The higher the risk, the greater the equity risk premium. In our view, it makes little sense for the equity risk premium to be so low right now, given the heightened risks to earnings growth from a rise in cost pressures, payback in demand, and a war that has structurally increased the price of food and energy. While stocks are a good hedge from higher inflation, keep in mind that inflation from food and energy is bad for most companies as it acts as a tax on consumers. Only energy and materials companies really benefit from this kind of inflation but they make up a very small slice of the index. Some may argue technology companies are less affected, but we're skeptical as they will feel it too in lower revenues if the consumer spending fades. 

Third, the risk from further exogenous shocks to growth are also elevated given the war in Ukraine, China's real estate stress, and ongoing battle with COVID, to name a few. This is one reason why market volatility remains so high. Importantly for investors, our work suggests the equity risk premium is also understated relative to this high market volatility. In short, equity investors are not being properly compensated for taking equity like risk at current prices. 

Finally, these high valuations are not isolated to just a few sectors. The lower equity risk premium is present across all sectors except energy and materials, and these are the two biggest beneficiaries of high commodity inflation. In some ways, the low equity risk premium for these sectors is simply saying the market does not believe the recent boost to earnings and cash flow is sustainable, due to either demand destruction or the eventual supply response. 

The bottom line is that we remain bearish on the S&P 500 index from a risk reward standpoint, particularly after the recent rally. Our year end base case target of 4400 is 4% below current levels. At the stock level, we continue to recommend investors look for stable cash flow generating companies in defensive sectors like utilities, health care, REITs and consumer staples. 

Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show. 

The new Fed hiking cycle has begun and with it comes expectations for faster rate hikes and quantitative tightening to address inflation, as well as questions around how and when the U.S. economy will be affected. Chief U.S. Economist Ellen Zentner and Senior U.S. Economist Robert Rosener discuss.

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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research. 

Robert Rosener: And I'm Robert Rosner, Morgan Stanley's Senior U.S. Economist. 

Ellen Zentner: On this episode of the podcast, we'll be talking about the outlook for the U.S. economy as the Fed begins a new rate hike cycle. It's Friday, March 25th at 9:00 a.m. in New York. 

Ellen Zentner: So Robert, last week the U.S. Federal Reserve raised the federal funds rate a quarter of a percentage point, which is notable because it's the first interest rate hike in more than two years, and it's likely to be the first of many. Chair Powell has told us that it's unlikely to be like any prior hiking cycle, so maybe you could share our view on the pace of hikes and where and when it might peak for the cycle. 

Robert Rosener: Well, it certainly is starting off unlike any recent policy tightening cycle, and recent remarks from Fed policymakers have really doubled down on the message that policy tightening is likely to be front loaded. And we're now forecasting that we're likely to see an even steeper path for Fed policy tightening this year, and we think that as soon as the May meeting, we could see the Fed pick up the pace and hike interest rates by 50 basis points and follow that in June with yet another 50 basis point increase. We're expecting they'll revert back to a 25 basis point per meeting pace after that, but still that marks 225 basis points of policy tightening that we're expecting this year in our baseline outlook. 

Ellen Zentner: So how does Jay Powell, the chair of the FOMC, fit into this? Do you think he's about in line with this view as well? 

Robert Rosener: He does seem to be generally in line with this view, but he is negotiating the outlook among a committee that has a diversity of views, and we've been hearing from policy makers, a wide range of policy makers, over the last week. What's been notable is that more and more policymakers are starting to get on board the train that a faster pace of policy tightening is likely to be warranted. And that may very well include rate hikes that come in larger increments, such as 50 basis point increments, over the course of the year as policymakers seek to get monetary policy into more of a neutral setting. 

Ellen Zentner: So this is all because of inflation. Inflation's broad based, it's rising. I think it felt like there was a very big shift on the FOMC January/February, when the inflation data was really rocketing to new heights. So in order to bring inflation down when the Fed is hiking, how long does it take for those hikes to flow through into the economy to bring inflation down? 

Robert Rosener: Well, that's a really good question, and certainly that broadening that you mentioned is key. We saw a run up in inflation in the later part of last year that was driven by a few segments, particularly on the goods side. But as we moved into the end of 2021 and early 2022, what we really started to see was a broadening out of inflationary pressures and particularly a broadening into the service sectors of the economy where price pressures began to pick up more notably and began to lead the inflation data higher. Now, as we think about how monetary policy interacts with that, tighter monetary policy needs to slow growth in order to slow inflation. And typically, you would look at monetary policy and not expect it to be really materially affecting the economy for, say, a year out. Something that Chair Powell has stressed is that monetary policy transmits through financial conditions, and financial markets moved to price in a more hawkish Fed outlook as soon as the latter part of last year. Now, as those rate hikes got priced into the market, that acted to tighten financial conditions. So as Chair Powell noted in his press conference, the clock for when rate hikes start to impact the economy doesn't necessarily start on the delivery of those rate hikes. It starts when they affect financial conditions. And so we may start to see that a backdrop of tighter financial conditions begins to reduce some of the steam in the economy and reduce some of the steam in inflation as we move through the course of the year. But with headline CPI currently at around 8%, likely to march higher in the upcoming data, there's a lot of room to bring that down. So we might have to wait some time before we see material relief on inflation. 

Ellen Zentner: So let's talk about the balance sheet because they're not just hiking rates, right? They're going to reduce the size of their balance sheet, what we call quantitative tightening or Q.T. And so run us through our view and how the Fed's thinking about that quantitative tightening process when they're unwinding much of that four and a half trillion in asset purchases that they made during the pandemic. 

Robert Rosener: So the Fed has made it clear they're on track to begin winding down the size of their balance sheet, and that's a decision that we're expecting will come at the May meeting, that in very short order the Fed would begin to reduce the size of its balance sheet with caps on reinvestment and total at about $80 billion per month. And that would set roughly the monthly pace by which the balance sheet would decline, and Chair Powell has indicated that that process may take around three years to bring the balance sheet down to a size that would be consistent with a neutral balance sheet. It's going to act to tighten financial conditions in the same way or similar ways that rate hikes do, but it's a little bit less clear how those effects happen, over what time horizons they happen. So there's some uncertainty there, but it's something that the Fed wants to have running in the background, while they pursue rate hikes. 

Ellen Zentner: So in terms of, you know, if the balance sheet is going to be doing additional tightening, what do we think the Fed funds equivalent of that is, has Chair Powell discussed that?

Robert Rosener: So when we looked at this, we looked at the effects through financial conditions. And in our estimates, the tightening of financial conditions that we would see on the back of the balance sheet reduction that we're expecting, was about the equivalent this year of one additional 25 basis point hike. Now, perhaps coincidentally, Chair Powell in his most recent remarks, also noted that the tightening of the balance sheet or the shrinking of the balance sheet this year would be about the equivalent of one rate hike. So there's some consolidation of views there that it does act to tighten. Again, there's uncertainty bands around that, but it's about the equivalent of one additional hike this year. 

Robert Rosener: So Ellen, we can't really talk about the Fed raising rates without thinking about the broader implications for the yield curve, and more recently the applications for yield curve inversion. For listeners who might not be familiar, that's when shorter term investments in U.S. treasuries, such as the 2-year yield, pay more than longer term treasuries, such as the 10-year yield. Historically, when we've seen that spread inverting, it's been a signal that a recession might be coming. What are you thinking about the risks that the yield curve is telling us now? And does that tell us anything about the risk of a future recession? 

Ellen Zentner: Well, Robert, I think it is clear that the yield curve, if we're talking about just the spread between 2-year treasuries and 10-year treasuries, is going to continue to flatten and invert. And policymakers have made it clear that because of special factors, they shouldn't be concerned this time. And when I look at factors in the economy that are typically what you would look at for signals of recession, you know, jobs, we are still creating jobs, it’s been a very steady run of about 500,000 jobs a month. We are expecting another strong print in the upcoming payroll report, that does not speak to approaching recession. When I look at retail and wholesale sales still growing, industrial production still growing, real disposable income of households still growing. Even though we're dealing with the fading of fiscal stimulus, that labor income has been very strong. So all of those traditional measures would tell you that an inverted yield curve today is not providing you a signal of approaching recession, and I think overall inversion of the yield curve has become less of a recession indicator since we have been trapped so near the zero lower bound over the last cycle and this cycle. 

Robert Rosener: So we talked about the Fed, we talked about the yield curve and financial conditions, but of course, there's a lot of things that the Fed has to take into account as it thinks about the outlook. And of course, we're all watching the terrible events unfolding in Ukraine. And as we think about the ripple effects on the world economy, particularly in Europe, as well as more broadly on energy security and supply and so much more. Clearly, this is an impact that's going to be affecting regions differently. But how should we think about how that's going to be felt here in the U.S. economy? And what does that mean for the Fed? 

Ellen Zentner: So I think first and foremost, it plays back into the inflation story. I think what we've heard from the chair is that typically they do look through food and energy price fluctuations. But in this case, where inflation is already broad based and high, they do have to act and it just puts more fuel behind the need to have a more aggressive tightening cycle. When we look at our own analysis and impact analysis that you've done for us on the team, the impact on inflation from increases in energy prices is four times that of the impact on GDP growth. In the U.S. we're just about energy independent. And so it's become more ambiguous as whether higher energy prices are really a negative for the U.S. economy. But the way I would look at this is, it will slow activity in parts of the economy, we've taken our own growth forecasts down to reflect that forecast for GDP, and it will disproportionately affect lower income households. Where food prices, energy prices and just general inflation impacts them to a much greater degree than upper income households. So overall, aggregate spending will look quite strong in the U.S. economy, but for the lower income groups, I think it's going to be lagging behind. But certainly you mentioned Europe, you know, Europe is facing possible recession if gas supplies are cut off, which is a very real risk. But it's just not going to be as big of an impact to the U.S. economy, where we'll feel it is if other parts of the globe are deteriorating it can hamper financial conditions here, and that's something that the Fed will be watching closely. And so, Robert, you and I will be watching these developments closely as well. We've made it clear and the Fed has made it clear that it's on the path higher for interest rates, but the outlook always comes with risks and we'll be reporting back on those risks in future podcasts. So, thanks for taking the time to talk, Robert. 

Robert Rosener: Great talking with you, Ellen. 

Ellen Zentner: And thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

While the possibility of a yield curve inversion in the U.S. has news outlets and investors wondering if a recession is on the way, there’s more to the story that should put minds at ease.

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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, March 24th at noon in New York. 

For most investors, most of the time, the general level of U.S. Treasury yields is more important than the differences between yields on shorter maturity bonds and those on longer maturity bonds. The most widely quoted Treasury yield is usually the one investors earn by lending their money to the government for 10 years. 

But there are times when the difference between yields on, say, treasuries that mature in 2 years and those that mature in 10 years make the news. And this is one of those times. These yields are tracked over time on a visual representation we call the yield curve. And at some point soon, we expect the yields on 2 year treasuries to be higher than those on 10 year treasuries. This is what we call a 2s10s yield curve inversion. 

The reason why yield curve inversion makes the news is because, in the past, yield curve inversion has preceded recessions in the U.S. economy. 

Still, there are two points to make about the relationship between the yield curve and recessions, both of which should put investors' minds at ease. First, using history as a guide, inverted 2s10s yield curves preceded recessions by almost two years on average. While time flies, two years is plenty of time for people to prepare for harder times ahead. 

Second, despite popular belief, yield curve inversions don't necessarily cause recessions, and neither does significantly tighter fed monetary policy - which also can cause yield curves to invert. In his recent speech, Fed Chair Powell highlighted 1965, 1984, and 1994 as times when the Fed raised the federal funds rate significantly without causing a recession. 

Another important point is that the yield curve can flatten for reasons unrelated to tighter Fed policy. For example, between 2004 and 2006, the yield curve flattened by much more than Fed policy alone would have suggested. The curve flattening during this period baffled the Fed and investors alike. Former Fed Chair Greenspan labeled the episode "a conundrum" at the time. 

So what caused the yield curve to flatten so much during that period? Former Fed Chair Bernanke suggested it was a global savings glut. Overseas investors purchased an increasingly larger share of the Treasury market than they had ever bought before. 

Fast forward to today and the demand from overseas investors has been replaced by demand from the Fed. In fact, the Fed owns almost 30% of outstanding Treasury notes and bonds, which goes some way to explaining how flat the yield curve is today. And, to be clear, fed ownership of those bonds also isn't a reason to think recession is right around the corner. 

Another common concern about a flat yield curve is that it will cause banks to stop lending. And without banks lending into the real economy, recession might loom large. But our U.S. Bank Equity Research Team is less concerned. 

Their work shows that bank loans grew during the prior 11 periods of yield curve inversion since 1969. While they found some moderation in loan growth, it was modest. And this year, despite our forecast for an inverted yield curve. The project loans to grow 7% over the year, after loans shrank last year, when the yield curve was actually much steeper. 

So in the end, while we think the yield curve will invert this year, we don't think investors should worry too much about a looming recession - even if the news does. 

Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

While the demand for Environmental, Social, and Governance investing has been growing primarily in Europe, a potential new regulatory policy may drive new interest and opportunity for U.S. investors.

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Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 23rd at 10 a.m. in New York. 

Taking a break from specific market impacts for the moment, we want to focus on the growth of a new market for investors - the market for ESG investing, which a new regulatory policy may help nudge into the mainstream in the U.S. 

As you may already know, ESG stands for Environmental, Social and Governance, three factors that represent a measurement of how socially conscious the investment is. The demand for this style of investing has grown substantially in recent years. For example, per our sustainability research team, there are about 2 trillion dollars of dedicated ESG assets under management globally. But about 85% of that is in Europe, showing how U.S. investors have been relatively slower to adopt such strategies. 

Yet earlier this week, the SEC proposed a new rule that could create new incentives for U.S. investors to adopt ESG strategies. This rule would require companies to provide disclosures about their emissions, as well as governance and strategy for dealing with climate related risks. As our sustainability research team noted in a report this week, having a standard for disclosure can help build the ESG market by giving investors a common template for understanding ESG impacts. That differs from the current state of play, where many companies do disclose on climate related issues, but to different levels and by differing standards, making analytical comparisons difficult. 

We should note, though, that this is just a first step toward a regulation that could boost the size of the ESG market. Regulatory rules tend to take a long time to finalize and implement. According to Government Accountability Office case studies, it can take anywhere from six months to five years, as proposed rules navigate a series of comment periods, judicial challenges and revisions. So we'll track the process here and report back when there's more to know. 

Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

While the cost of shelter has risen quickly, the measure of housing inflation has been slow to catch up, creating challenges for renters, homeowners and the Fed.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Tuesday, March 22nd at 2:00 p.m. in London. 

Our base case at Morgan Stanley is that the U.S. economy sees solid growth over the next two years, with inflation moderating but still being somewhat higher than the Federal Reserve would like. We think this means the Fed raises interest rates modestly more than the market expects, flattening the US yield curve. 

But what are the risks to this view? Specifically, what could cause inflation to be much higher, for much longer, putting the Federal Reserve in a more pressing bind? I want to focus here on core inflation as central banks have more leeway to look through volatile food or energy prices. This is a story about shelter. 

The cost of shelter represents about 1/3 of U.S. core consumer price inflation. That makes sense. For most Americans, where you live is your largest expense, whether you rent or pay a mortgage. 

The CPI measure of inflation assumes that the cost of renting has risen 4.5% in the last year. Now, if that sounds low, you're not alone. At the publicly traded apartment companies covered by my colleague Richard Hill, a Morgan Stanley real estate analyst, rents have risen 10% or more year-over-year. There are reasons that the official CPI number is lower. For one, not everyone renews their lease at the same time. But with a strong labor market and limited supply, the case for higher rents going forward looks strong. 

Owner occupied housing is even more interesting. Since 2016, U.S. home prices have risen about 56%. But the cost of a house that goes into the CPI inflation calculation, known as "owners’ equivalent rent", has risen only 21%. That's a 35% gap between actual home prices and where the inflation calculation sits. 

This is a potential problem. Even if home prices stop going up, the official measure of housing inflation could keep rising at a healthy clip to simply catch up to where home prices already are. And given high demand, low supply, and still low interest rates, home prices may keep going up, meaning there's even more catching up to do from the official inflation measure. 

Higher shelter costs are also a challenge because they're very hard for the Federal Reserve to address. Raising interest rates, which is the usual strategy to combat inflation, makes buying a house less attractive relative to renting. Which means even more upward pressure on rental demand and even higher rents. And higher interest rates make building homes more costly to finance, further restricting housing supply and raising home prices.

Housing has long been a very important sector for the economy and financial markets. Over the next 12 months, expect it to be central to the inflation debate as well. 

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.