Europe in the Global AI Race

The banking sector appears stronger in Europe than it does in the U.S., but some other European sectors may be at risk of lower profitability.----- Transcript -----Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues bringing you a variety of perspectives, I'll be talking about our latest thoughts on European equities. It's Thursday, May the 4th at 3 p.m. in London. Over the last couple of months, we have seen global technology stocks significantly outperform global financial stocks, aided by lower bond yields and concerns around the health of the U.S. regional banking sector. Historically, when we have seen tech outperform financials in the past, it has usually been accompanied by material underperformance from European equities. However, this time the region has proved much more resilient. Part of this reflects the benefits of lower valuation and lower investor positioning. However, we also see two broader macro supports for Europe just here. First, we see less downside risk to the European economy than that of the U.S., where many of the traditional economic leading indicators are down at recessionary levels. In contrast, similar metrics for Europe, such as consumer confidence and purchasing managers indices, have actually been rising recently. In addition, a healthier and more resilient banking sector over here in Europe suggests there is potentially less risk of a credit crunch developing here than we see in the U.S.. Second, we think Europe is also seen as an alternative way to get exposure to an economic recovery in China, given that the region has stronger economic ties and greater stock market exposure than most of its developed market peers. While this is not necessarily manifesting itself in overall aggregate inflows into European equity funds at this time, we can clearly see the theme benefiting certain sectors, such as luxury goods, which has arguably become one of the most popular ways to express a positive view on China globally. Notwithstanding these relative advantages, we do expect some near-term weakness in European stocks over the next quarter, with negative risks from the U.S. potentially outweighing positive risks from China and Asia. While first quarter results season has started strongly, we believe earnings disappointment will gradually build as we move through 2023 and our own forecasts remain close to 10% below consensus. Catalysts for this disappointment include slower economic growth, from the second quarter onwards, continued falls in profit margins and building FX headwinds given a strengthening euro. Our negative view on the outlook for corporate profitability often prompts the question as to which companies are over-earning and hence potentially most at risk from any mean reversion. To help answer this question, we ranked European sectors across five different profitability metrics where we compared their current levels to their ten year history. This analysis suggests that the European sectors who are currently over-earning, and hence most at risk of future disappointment include transport, semiconductors, construction materials, energy and autos. In contrast, sectors where profitability does not look particularly elevated at this time include retailing, diversified financials, media, chemicals, real estate and software. More broadly, we believe this analysis supports our cautious view on cyclical stocks within Europe just here, particularly for the likes of energy and autos, where profits are already falling year on year and where we see more downgrades ahead. Instead, we maintain a preference for stocks with higher quality and growth characteristics. We think these should be relative outperformers against the backdrop of economic weakness, falling bond yields and better relative earnings trends. Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

4 Touko 20233min

Congress is finally set to begin debt ceiling negotiations. What are some possible outcomes and how might the negotiations affect economic growth?----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the debt ceiling and its impact on markets. It's Wednesday, May 3rd at 9 a.m. in New York. Earlier this week, the Treasury Department informed Congress that at the start of June, it could run out of money to pay government obligations as they come due. This X-date appears much earlier than most forecasters expected, catching markets by surprise. Some investors even expressed to us disbelief, pushing the idea that the real X-date would be later, and Treasury is just trying to stir negotiations in Congress to raise the debt ceiling. Here's our take. The X-date is likely a moving target due the complex interplay of the timing of incoming tax receipts, government outlays and maturing debt securities. So, while it's possible the date ends up being sometime later this summer, the government might not be able to forecast that with a high degree of certainty. In that case, negotiations have to start now to avoid a situation where the X-date sneaks up on Congress, leaving little time to deliberate and risking default. And that seems to have prompted negotiations, with a May 9th meeting at the White House set to kick things off. But we emphasize that an early resolution remains uncertain. Both parties remain far apart on how they'd like to deal with the debt ceiling and in some ways haven't formed consensus within their own parties on the issue either. So the negotiating dynamic is likely to be tricky. That in turn means a range of policy solutions are plausible here, including a temporary suspension of the debt ceiling, unilateral measures by the administration to avoid default, a budget austerity package in exchange for raising the debt ceiling, or perhaps a clean debt ceiling raise. Of course, that level of uncertainty is generally not something markets like. Not surprisingly, we're seeing further inversion of the yield curve for Treasury bills, with notes maturing in June rising to around 5.3%. However, it does dovetail with our general preference for bonds over equities in developed markets this year. If the negotiation lingers too long, investors could become more concerned about the impact of the economic growth outlook, either because payment prioritization puts government transfer payments at risk or budget austerity reduces the trajectory of net government spending. In that case, equity markets could come under pressure, but longer maturity bonds could benefit. 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.

3 Touko 20232min

With the trend toward a multipolar world accelerating, companies are finding that investing in productivity may help protect margins. Ravi Shanker and Diego Anzoategui discuss.----- Transcript -----Ravi Shanker: Welcome to Thoughts on the Market. I'm Ravi Shanker, Morgan Stanley's North American Freight Transportation Analyst. Diego Anzoategui: And I'm Diego Anzoategui from the U.S. Economics Team. Ravi Shanker: And on this special episode of the podcast, we discuss what we see as The Great Productivity Race, that's poised to accelerate. It's Tuesday, May 2nd at 10 a.m. in New York. Ravi Shanker: The transition away from globalization to a decentralized multipolar world means companies' ability to source labor globally is contracting. This narrowing of geographical options for companies is making cheap labor, particularly for skilled manufacturing, harder to find. But there is a potential positive, a rebound in productivity which has been anemic for more than a decade. Ravi Shanker: So Diego, what's the connection that you see between the slowing or even reversal of globalization and productivity trends? Diego Anzoategui: If you think about it, the decision to upgrade technologies and increase productivity is like any other type of capital investment. Firms decide to improve their production technologies, either to deal with scarce factors of production or to meet increasing demand. COVID 19 was a negative shock to the labor supply in the U.S., and there is still a long road ahead to reach pre-pandemic levels. On top of that, we think that slowing globalization trends will likely limit labor supply further, causing real wages to increase, and keeping firms under pressure to improve productivity to protect margins. But we think firms will boost productivity investment in the medium term once business sentiment picks up again. And we are past the slowdown in economic activity that we expect in 2023 and into 2024. Expectations are key because the decision to innovate is forward looking, adopting new technologies takes time and the benefits of innovation come with a lag. Diego Anzoategui: Ravi, as a result of COVID and the geopolitical uncertainties from the war in Ukraine, companies have been dealing with a number of significant challenges recently, from supply chain disruptions to worker shortages and energy security. How are companies addressing these hurdles and what kinds of investments do they need to make in order to boost productivity? Ravi Shanker: Look, it's a good question and certainly a focus area for virtually every company anywhere in the world. The last five years have been very challenging and a lot of those challenges have revolved around labor availability and labor cost in particular. So I think companies are approaching this with two broad buckets or two broad focus areas. One is, I think they are trying to reinvest in their labor force. I think for too long companies' labor force was viewed as sort of a source of free money, if you will, an area to cut costs and gain efficiency. But I think companies have realized that, hey, we need to reinvest in our workforce, we need to raise their wages, improve their benefits, give them better working conditions, and make them a true resource that will obviously contribute to the success of the company over time. And the second bucket they're looking at is just broader long term investments in things like automation and productivity technologies, because many of these labor trends are structural, that are demographic issues, that are geopolitical issues, that are not going to reverse anytime soon. So you do need to look for an alternative, particularly in areas where, you know, jobs that people don't want to take on or where the value added from a labor is not as good as automating it. That's where companies are highly focused on the next generation of tools, whether that's automation or A.I. and machine learning. Diego Anzoategui: It seems that A.I. technology holds great promise when it comes to raising productivity growth. In fact, our analysts here at Morgan Stanley believe that A.I. focused productivity revolution could be more global than the PC revolution. What is your thinking around this? Ravi Shanker: Look, I think it's still too early to tell what impact A.I. will have on labor productivity as a whole and the impact of labor at corporations around the world. Take, for example, my sector of freight transportation. We don't make anything, but we move everybody else's stuff. And so by nature of freight transportation, is a very process driven industry and process driven industries by nature kind of iterate to find more efficiency and better ways of doing things, and that's where a lot of these new productivity tools can be very helpful. At the same time, it is also a very labor intensive industry that has some significant demographic challenges, whether it's a truck driver shortage, the inability to find rail workers, warehouse workers on the airline side of the house, the inability to find pilots and so the training and the desire of people to do this job over time may be changing. And that's where something like, you know, automation or A.I. tools can be very, very helpful going forward. However, I think this is still very early innings and we will see how this evolves in the coming years. Ravi Shanker: So finally, Diego, what is your outlook for the US labor market and wages over the next 5 to 10 years and how persistent do you think this productivity race is going to be? Diego Anzoategui: We think that a persistently lower labor supply should gradually boost wages. So far nominal wages have increased less than inflation, but we believe the modest increase in nominal wages is simply evidence of typically sluggish response of wages to price shocks. We expect real wages to pick up ahead and regain lost ground, and without this catch up in wages we leave firms to raise prices rather than upgrade their technologies. Evidence of strong price passthrough in the U.S. is limited and structural changes have made wage price spirals less relevant. Ravi Shanker: Diego, thanks so much for taking the time to talk. Diego Anzoategui: Great speaking with you Ravi.

2 Touko 20236min

As the banking sector is in the news again, investors wonder about an increase in borrowing from the Fed and possible restrictions on the horizon.----- Transcript -----Welcome to Thoughts on the Market. I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the ongoing tensions in the regional banking sector. It's Monday, May 1st at 2 p.m. in New York. At the outset, I would note that the news we woke up to this morning about JP Morgan's acquisition of First Republic is an important development. As Betsy Graseck, our large cap banks equity analyst noted, as part of this transaction JP Morgan will assume all $92 billion remaining deposits at First Republic, including the $30 billion of large bank deposits which will be repaid in full post consolidation. We believe that this is credit positive for the large cap bank group, as investors have been concerned that large banks would have to take losses against their $30 billion in deposits in the event First Republic was put into FDIC receivership. That said, we will be watching closely a key metric of demand for liquidity in the system, the borrowings from the Fed by the banks. The last two weeks saw consecutive increases in the borrowings from the Fed facilities by the banks, the discount window and the Bank Term Funding Program. That the banking system needed to continue to borrow at such high and increasing levels suggested that liquidity pressures remained and may have actually been increasing over the past two weeks. In light of the developments over the weekend, it will be useful to see how these borrowings from the Fed change when this week's data are released on Thursday. Last Friday, the Federal Reserve Board announced the results from the review of the supervision and regulation of the Silicon Valley Bank, led by Vice Chair for Supervision Michael Barr. The regulatory changes proposed are broadly in line with our expectations. The most important highlights from a macro perspective include the emphasis on banks management of interest rate risk and liquidity risk. Further, the report calls for a review of stress testing requirements. The Fed is now proposing to extend the rules that already apply to large banks now to smaller banks, banks with $100 billion to $700 billion in assets. These changes will be proposed, debated, reviewed and these changes will not be effective for a few years because of the standard notice and common periods in the rulemaking process. What are the market implications? We think that the recent events in the regional banking sector will cause banks to shorten assumptions on deposit durations, while potential regulatory changes would likely impact the amount of duration banks can take on their asset side. This is a steepener for rates, negative for longer duration securities such as agency mortgage backed securities and a dampener for the bank demand for senior tranches of securitized credit. While the implementation of these rules will take time, markets would be proactive. In the near-term, the challenges in the regional banks sector will likely result in lower credit formation and raise the risk of a sharper economic contraction. 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.

1 Touko 20233min

With the world moving towards a more complex and decentralized multipolar structure, how will technology and infrastructure markets fare going forward?----- Transcript -----Welcome to Thoughts on the Market. I'm Ed Stanley, Morgan Stanley's Head of Thematic Research in Europe. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the complex issue of security in the multipolar world. For some time, the world has been trending away from a globalized, unipolar structure characterized by stability and mutual cooperation. And in its place, we've been moving towards a multipolar structure, more complex, more decentralized. And this theme is one that Morgan Stanley's Global Research Department has been exploring deeply over the last three years. And the time is right to revisit that theme now because it's accelerating. And we see two plausible outcomes from here, a de-risking or a decoupling, lie ahead for companies. Our base case is still for a gradual phased de-risking between regions and companies are already in the process of facing up to that new reality, by diversifying their highly concentrated supply chains. But the possibility of a full and disorderly decoupling scenario now warrants more serious consideration. It's no longer the tail risk it was when we first addressed the theme three years ago. What has acted as a more recent accelerant to this trend is the extent of top down policy measures we've witnessed over recent years. The number of such policies designed to restrict trade have increased fivefold in the last five years, as measured by the UN. And these restrictions have covered everything from rare earth battery minerals, to grain exports and solar panel imports, to specialist machinery for microchip production. Add to this the ever greater incentives to reshore supply chains and critical components back to the U.S. and Europe, in the form of the CHIPS Act, the U.S. IRA and Europe's response to it, and it becomes clearer why this multipolar world and de-risking theme continue to gather pace. After all, Europe's market share of critical inputs and technologies stand at about 6% versus China's at over 50%. And that scale of imbalance will take time and substantial resources to even partially reverse. And while this is a complex theme with many moving parts, there is one relatively simple conclusion. Whether the world continues to gradually de-risk or more abruptly decouple, greater spending on security and critical infrastructure will be essential. Consequently, the industrial and tech sectors will likely need to allocate the most capital to achieve this de-risking process. But we also see promise for more than 80 companies exposed to the critical infrastructure buildout, which should see higher demand and should be able to generate strong return on capital in the process. These are the types of companies that should be well-placed, as this theme evolves. Our new security framework suggests that space infrastructure, artificial intelligence and batteries may be areas of greatest focus for the markets going forward. Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts, and share Thoughts on the Market with a friend or a colleague today.

28 Huhti 20233min

While government bonds have been less than desirable investments for the past two years, the tide may be turning on bond returns.----- Transcript -----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, April 27th at 2 p.m. in New York. Over the past 2 years, government bonds have been less than desirable investments. This year, the inflation phenomena came out of hibernation and appears unwilling to go away anytime soon. In 2022, one of the worst years on record, U.S. Treasuries delivered a total return of -12.5%. Securities that offer fixed interest payments like government bonds tend to lose value when inflation rises, because the future purchasing power of those cash flows declines. But that doesn't always happen, of course, and certainly not to this degree. For most of the past 20 years, government bonds dealt reasonably well with positive inflation rates, even if those rates were rising. But last year was different, for two reasons primarily. First, inflation rose at a rate we haven't seen since the late 1970s. And second, central banks responded aggressively by tightening monetary policies. How have these factors changed so far this year? Well, inflation has started to moderate both in terms of consumer prices and wages. And in response, central banks have become less aggressive in their recent policy maneuvering. Investors have also benefited from the clarity on the speed with which central banks have moved and how fast they may move in the future. This would seem like good news for government bond returns, and so far it has been. However, at the same time, investor nerves remain frayed, even if less so than last year. But why? First, investors remain worried about inflation, but for different reasons than last year. Throughout 2022 concern focused on the speed with which inflation was rising and just how high it would go. This year, however, concerns remain around how far inflation will fall, a process known as disinflation. The consensus view amongst investors is that inflation will remain above the Fed's 2% goal unless the Fed engineers a deep recession. And to do so, the Fed will either have to tighten monetary policy even further or keep monetary policy tight for an extended period of time. Neither scenario seems particularly supportive of government bond returns. Second, investors are worried about the upcoming debt ceiling negotiations. The concern isn't so much that the government will default on its debt obligations, although that is a possibility. Rather, it's more about whether the government will have to delay paying other obligations, such as federal employee salaries or Social Security. A cessation of those payments, even if temporary, could slow economic activity in the United States. And even if the debt ceiling is raised in time, material risks to regional banking institutions still remain. Putting it all together, the higher yields available in the government bond markets and the increasing risk to economic activity, including those from the lagged effects of monetary policy tightening, leave us hopeful on the future returns of the asset class. 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.

27 Huhti 20233min

As multinational companies look towards a future of higher innovation costs and a shrinking labor pool, some corporate sectors may fare better than others in the multipolar world.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the great productivity race and the multipolar world. It's Wednesday, April 26th at 9 a.m. in New York. Client questions this week have focused on the U.S. debt ceiling, as Republicans in the House of Representatives work to pass their version of a debt ceiling raise. But we think this bill is just one step in a longer process, so we'll return to this topic when there's something more concrete to say about the ultimate resolution and its market implications. Stepping away from that topic gives us the opportunity to focus on a longer term trend impacting the markets, something our research team is calling the Great Productivity Race. It's the idea that U.S. multinational companies in particular will have to spend to develop and integrate new technologies, including artificial intelligence , into their production in order to keep up output. Why is that? In part, it has to do with one of our big three themes for 2023, the transition to a multipolar world. In a multipolar world, where the U.S. is looking to safeguard advantages and technologies and key areas of production, the labor pool for U.S. multinationals is contracting. Efforts to re-friend, and near-shore critical industries have strong political support. But this narrows the geographical options for companies making cheap labor, particularly for skilled manufacturing, harder to find. And that exacerbates a U.S. economic challenge already present for several reasons. That means companies are likely to invest in improving their own productivity through technology. And as our economists point out, there's historical precedent for this. For one academic study, the great Mississippi Flood of 1927 led many people to emigrate from some adjacent counties. Those areas modernized agricultural production much faster than others. Another academic study shows that conversely, metro areas that had a significant inflow of low skilled workers in the eighties and nineties were slow to adopt automated production processes. So investors need to know that some corporate sectors will be able to handle this well and others will be challenged. Those best positioned are ones less reliant on labor and with ample resources to invest in productivity. Those more challenged rely heavily on labor and have less resources on their balance sheets. Our colleagues in equity research are digging into which sectors fit into which category, and in a future podcast we’ll share with you what they're learning.

26 Huhti 20232min

With many investors predicting the U.S. dollar to continue to weaken, its potential for diversification and high yields may indicate otherwise.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Assets 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, April 25th at 2 p.m. in London. The U.S. dollar has fallen about 11% from its highs last September. We think a majority of investors expect that weakness to continue, driven by factors ranging from expensive valuations to potential slowing of the U.S. economy, to the view that a more fragmented geopolitical backdrop will lead to less trade and transactions in U.S. dollars. In contrast, our foreign exchange strategists think it's more likely that the dollar strengthens. I want to discuss the idea of dollar strength from a larger lens and what it could mean for a cross-asset portfolio. For a multi-asset investor, the greatest appeal of the U.S. dollar comes from its diversification. At present, it is one of the few positive carry diversifiers, which is another way of saying that it's one of the few assets out there that pays you while also acting as a portfolio hedge, thanks to the dollar generally moving in the opposite direction of riskier assets like stocks or high yield bonds. Importantly, that diversification from the U.S. dollar makes a lot of intuitive sense to us. We think the dollar could do well if U.S. growth is very hot, as investors are drawn to even higher U.S. rates under that scenario, or if growth is very weak as investors seek out safety and liquidity. These extremes in growth, we think, represent two of the key risks, for riskier assets. In contrast, the dollar probably does weaken if growth is down the middle and a so-called soft landing for the economy. In this case, modest Fed easing without the fear of recession would likely cause investors to seek out cheaper, more volatile currencies. But this soft landing scenario is probably the best outcome for the riskier other parts of one's portfolio, allowing the dollar to provide diversification as it zigs while other assets zag. But what about the dollar's higher valuation or the threat of geopolitical shifts? Well, on valuation, our work suggests that it tends to be a pretty weak predictor of foreign exchange returns over the next 6 to 12 months, for better or for worse. And on geopolitical shifts, the dollar remains the dominant currency of global trade. And importantly, over the last year, a year that’s contained quite a bit of geopolitical uncertainty, it's continued to show diversification benefits. In summary, many investors expect U.S. dollar weakness to continue. Thanks to its high yield and powerful potential for diversification, we think it's more likely to appreciate. 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.

25 Huhti 20232min