Europe in the Global AI Race

With the Fed continuing to focus on inflation and the upcoming midterm elections suggesting market volatility, investors may be wondering, is the U.S. equity market rally really over?----- Transcript -----Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, November 7th, at 11 a.m. in New York. So let's get after it. Last week's pullback in major U.S. stock indices was not a surprise as the Fed remained committed to its mandate of getting inflation under control. However, if our tactical rally in U.S. stocks is going to have legs, 10 year U.S. Treasury yields will need to come down from current levels. Otherwise, it will be difficult to see higher prices for the S&P 500, given how sensitive this large cap growth index is to interest rates. Furthermore, we remain of the view that 2023 earnings forecasts are as much as 20% too high, so it will be difficult for stocks to move higher without valuations expanding. Does this mean the U.S. equity rally is over? We don't think so, but it's going to remain very noisy in the near term. First, we have two more important events this week to contend with: the Consumer Price Index release on Thursday and the midterm elections on Tuesday. On the former, we aren't that focused on it because it tells us little about the trajectory of inflation going forward. Nevertheless, we appreciate that the bond market remains fixated on such data points and will trade it. Therefore, it's likely to keep interest rate volatility high through Thursday. If interest rate volatility falls with the passing of these data, equity valuations can then expand further. In terms of interest rate levels, we think next week's midterms could play a bigger role. Should the polls prove correct, the Republicans are likely to win at least one chamber of Congress. This should throw a wrench into the aggressive fiscal spending plans the Democrats would still like to get done. Furthermore, Republican leadership has talked about freezing spending via the debt ceiling, much like they did with the Budget Control Act in 2011. This would be a sharp reversal from the past few years when budget deficits reached levels not seen since World War II. In our view, a clean sweep by the Republicans on Tuesday could greatly raise the odds of such an outcome. Such a decisive win should invoke the kind of rally and 10 year Treasury bonds to keep the equity market moving higher. One caveat to consider is that the election results may not be clear on Tuesday night, given the delay in counting mail in ballots. That means we can expect price volatility in equity markets will remain high and provide fodder for bears and bulls alike. Bottom line, we remain tactically bullish on U.S. equities, assuming longer term interest rate levels begin to fall. This week's midterm elections provide a potential catalyst in that regard. If the Republicans win decisive control of both the House and Senate, as some polls and betting markets are suggesting. Because this is purely a tactical trading view and not in line with our core fundamental view which remains bearish, we will remain disciplined on how much leash to give it. Last week we said that 3700 on the S&P 500 is our stop loss level for this rally, and markets traded exactly to that level after Friday's strong labor report before recovering nicely. For this week, we think that level could be challenged again given the uncertainty around election results. Anxiety around the Consumer Price Index Thursday morning is another reason to think both interest rate and equity volatility will remain high. Therefore, we are willing to give a bit more wiggle room to our stop loss level for next week, something like 3625 to 3650, assuming the 10 year Treasury yields don't make a new high. Conversely, if 10 year Treasury yields do trade about 4.35% and the S&P 500 tests 3625, we would suggest clients to exit bullish trades at that point. In short, the bear market rally is likely to hang around for longer than most expect if it can survive this week's test. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

7 Marras 20223min

As prices for bonds go down and yields go up, investors may be asking why the price is so low, and what this shift may do to the broader market and asset allocation.----- 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, November 4th, at 2 p.m. in London. The market is a funny thing. Relative to January 1st of this year, the U.S. 30 year Treasury bond is set to pay out all of the same coupons, and return the exact same amount of principal when it matures in 2052. But the market has decided that that same bond today is worth 36% less than at the start of the year. So what happened? Well, yields rose. That 30 year U.S. bond might be the exact same entity, but investors now need all of those future payments to yield 4.2% per year, not the 1.9% they needed on January 1st. It's another way of saying that there's been a major change in what's considered the minimal accepted return on safe assets. And that large jump in yields has led to the largest drop in bond prices that we've seen in recorded history. But the implications are broader. Many assets have bond-like characteristics, where you pay money today for a string of payments in the future. Whether it's an office building, a rental unit or a company with a future set of earnings, you can get very different current values for the exact same asset today by varying what sort of yield it's required to produce. And so if bonds are now priced lower to generate higher returns in the future, so should many other assets that have similar bond-like characteristics. For markets, we see a couple of implications. First, these rising yields have made bonds increasingly competitive relative to stocks. Currently, $100 of the S&P 500 is expected to yield about $6.25 of earnings next year. $100 of U.S. 1 to 5 year corporate bonds yields about $6 of interest, despite having just one sixth the volatility of the stock market. It's been 14 years since the earnings yield on stocks and the yield on corporate bonds has been so similar. Higher yields on safe assets may also shift broader asset allocation decisions. At this time last year, 30 year BBB- rated investment grade bonds yielded just 3.3%. Given such low returns, it's no wonder that many asset allocators, especially those with longer time horizons, pushed into alternative asset classes and private markets in an effort to generate higher returns. But that calculus now looks different. Yields on those same investment grade bonds have risen from that 3.3% to 6.3%. With public markets now offering many more opportunities for a safe, reliable, long run return, we'd expect asset allocators to start to swing back in this direction, especially favoring various forms of investment grade debt. Thanks for listening. Subscribe to Thoughts on the market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

4 Marras 20223min

As developed markets heal from the pandemic, labor force participation has recovered in some areas faster than others, so how will a return to work impact the broader economy in places like the U.K. and the U.S.? U.S. Economist Julian Richers and European Economist Markus Guetschow discuss.----- Transcript -----Julian Richers: Welcome to Thoughts on the Market. I'm Julian Richers from the Morgan Stanley U.S. Economics Team. Markus Guetschow: And I'm Markus Guetschow from the European Economics Team. Julian Richers: On this special episode of the podcast, we'll focus on the issue of labor force participation across developed markets and its broader economic implications. It's Thursday, November 3rd, at 10 a.m. in New York. Markus Guetschow: And 3 p.m. in London. Markus Guetschow: It's no secret that the COVID pandemic profoundly disrupted labor markets across the globe. Labor shortages, rather than unemployment, have now become the key challenge to economies everywhere, and the 'great resignation' has become a catchphrase. In the U.K. and U.S. in particular, are experiencing a slow recovery in labor participation post-COVID, which is adding to an already complex set of policy trade offs by the Fed and the Bank of England. At the same time, Europe looks like a bright spot. So Julian, 'nobody wants to work anymore' has become a punchline. What kind of picture do the data on labor supply really paint in the U.S.? Julian Richers: In the U.S. at least we have seen a massive decline in labor force participation at the onset of the pandemic and really an incomplete recovery so far. Less immigration and more retirements have been major contributors to that drop initially, but since then it also is that prime age workers, so workers age 25 to 54, have been slow to come back. Now in contrast to the U.S., I think your analysis shows that labor supply in the euro area has already fully recovered to pre-pandemic levels. What drove that faster rebound and what's your outlook for the euro area from here? Can we learn something about what this may mean for other countries? Markus Guetschow: We've seen a remarkably quick bounce back in the labor market in the euro area after the pandemic recession, with participation already one percentage point above pre-pandemic levels by mid 22, and also about the level implied by pre-crisis trends. We think that furlough schemes that kept workers in the jobs during COVID were a key supporting factor here. We don't expect to return to pre-crisis labor supply growth, however, with increasing headwinds from immigration and demographics increasingly a factor in the euro area. The U.K. had a similarly generous furlough scheme, but dynamics are in many ways more similar to the U.S., with participation almost one percentage point below 4Q 19 levels in the middle of 2022. Post-Brexit migration flows are one obvious reasons, but we also point to a record number of workers out of the labor force due to health reasons. But let me turn back to the U.S. What makes the US labor market so challenging right now, and how would a potential rise in labor supply affect the economic growth outlook and the Fed's monetary policy? Julian Richers: Well, really, the U.S. labor market has just remained extremely resilient, even though the overall economy has clearly slowed. The U.S. economy is also now producing a lot more output with about the same amount of workers as we did before the pandemic. So structurally, labor demand is still high. At the same time, a lot of the losses in participation among older workers will not reverse. But prime age workers have been coming back and there is still more room for them to go. So prime age, labor force participation should be increasing and that will be key for some relaxation in the labor market. For the Fed that's key, right? Removing pressure from the labor market is very important to feel more confident about the inflation outlook. Wage growth has been extremely high because there still is a pretty significant shortage of workers, and workers are quitting at high rates to go to higher paying jobs. Now, as the economy slows more and labor demand begins to cool, that should lessen. But really, getting more people into the labor force is just going to be key to see wage growth moderate and the unemployment rate go up for good reasons and not for job cuts. So an expansion in labor supply in particular, if it's coming from more primary workers, is really key to manage a soft landing the Fed is looking for. Marcus, how about the ECB in the Bank of England? Maybe walk us through the thinking there and give us a sense of the outlook for the U.K. and the euro area into 2023. Markus Guetschow: So the ECB is facing a different set of issues altogether. Labor market supply is closely monitored, but with rates growth really rather modest to date, despite record low unemployment, much less of a focus for monetary policy. Instead, with rates still arguably in stimulating territory, the near-term focus continues to be on policy normalization, eventually also QT, while fending off concerns about fragmentation. The picture for the Bank of England is somewhat more similar to the one faced by the Fed. The more labor supply bounces back, the less the Bank of England has to lean against demand. With recession ahead and a bearish outlook on participation, most of the slackening will likely be done via the demand channel, however. Julian Richers: Marcus, thanks for taking the time to talk. Markus Guetschow: Great speaking to you, Julian. Julian Richers: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts, and share the podcast with a friend or colleague today.

3 Marras 20224min

This coming Tuesday is the midterm election in the U.S., so what should investors watch out for as the results roll in? And which outcomes might influence market moves?----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, November 2nd at 10 a.m. in New York. On Tuesday, Americans will cast their ballots for members of Congress. Well, most Americans will. Many will have already voted by mail. And that's important to know, because it means that, like in 2020, investors may have to wait days to reliably know who will control Congress. And that uncertainty could spell volatility in the bond markets, under the right conditions. Allow me to explain. Like in 2020, the increased use of vote by mail means that early vote counts reported may not be a good indicator of who's winning a particular race, especially in races expected to be close. Mailin ballots are typically cast more often by Democrats than Republicans, and in many jurisdictions are counted after in-person voting. That means that early reported results may look favorable to Republicans, but like in 2020, leads can vanish over time. And so we'll need to reserve judgment on which party seems poised to control Congress. While that uncertainty is playing out, it helps to know which outcomes would be market movers and which ones might have no immediate impact. For example, let's consider what it would mean if Republicans take back control of one or both houses of Congress, which polls and prediction markets are pointing to as the most likely outcome. We wouldn't anticipate this 'divided government' outcome being a market mover, at least not in the near term. That's because the most we can take away from this are some hypothetical concerns. A divided government tends to deliver a weaker fiscal response to a recession. And Republicans have publicly touted their intent to use the debt ceiling and government funding deadlines as negotiating points to reduce government spending in 2023 and 2024. But in recent years, markets have dismissed those types of negotiations as political theater. So perhaps these events would only matter in the moment if the economy and or markets were already showing substantial weakness. But what if instead Democrats do what the polling data suggests they're very unlikely to do, not only keep control of Congress, but expand their majorities. If the early vote counting makes this seem like a real possibility, perhaps because Democrats outperform in early tallies in places like Pennsylvania, then expect market gyrations, particularly in the bond market. That's because if Democrats were to pull off such an outcome, bond markets could come to see a risk that fiscal policy will be pulling in a different direction than monetary policy, meaning the Fed could have to hike rates even more than currently expected to bring inflation down to target. Expanded Democratic majorities could be a signal that inflation was not the electoral challenge many feared. Without that political constraint, investors could equate these expanded majorities with an increased chance that Democrats would revisit many of their previously abandoned spending plans. So bottom line, be prepared. The polls are showing Democrats are unlikely to expand majorities, but the history of markets is rife with examples of unexpected outcomes creating market volatility. Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us for a view on Apple Podcasts. It helps more people find the show.

2 Marras 20223min

Over the last decade private markets have outperformed versus public markets, but given the recent public market volatility, will private markets continue to attract investors? Head of Brokers, Asset Managers, and the Exchanges Team Mike Cyprys and Head of European Asset Managers, Exchanges, and Diversified Financials Research Bruce Hamilton discuss.----- Transcript -----Mike Cyprys: Welcome to Thoughts on the Market. I'm Mike Cyprys, Morgan Stanley's Head of Brokers, Asset Managers and Exchanges Team. Bruce Hamilton: And I'm Bruce Hamilton, Head of European Asset Managers, the exchanges and Diversified Financials Research. Mike Cyprys: And on this special episode of the podcast, we'll talk about our outlook on the private markets industry against an uncertain macro backdrop and market upheaval. It's Tuesday, November 1st at noon in New York. Bruce Hamilton: And 4 p.m. in London. Mike Cyprys: We spend most of our time on this podcast talking about public markets, which are stocks and bonds traded on public exchanges like Nasdaq and Euronext. But today, we're going to talk a little bit about the private markets, which are equity and debt of privately owned companies. You probably know it as private equity, venture capital and private credit, but it also encompasses private real estate and infrastructure investments, all of this largely held in funds owned by institutions such as pension funds and endowments and increasingly high net worth investors. Today, there is nearly 10 trillion of assets held across these funds globally. But despite the different structure, private markets have been faced with the same macro challenges facing public markets here in 2022. So Bruce, before we get into some of the specifics, let's maybe set the context for our listeners. How have private markets fared vis a vis public markets over the last decade? Bruce Hamilton: So the industry has grown at around 12% per annum on average over the past decade in terms of asset growth and a faster 17% over the past three years, driven by increasing allocations from institutional investors attracted to the historic outperformance of private markets versus public markets, a smoother ride on valuations given that assets are not mark to market, unlike public markets, and an ability to source a more diversified set of exposures, including the faster growth in earlier stage companies. Mike Cyprys: And what are some of the near-term specific risks facing private markets right now amidst this challenging market backdrop? Bruce Hamilton: The near-term concerns really focus around the implications of a tougher economic environment, impacting corporate earnings growth at the same time that increasing central bank interest rates across the globe are feeding into increased borrowing costs for these companies. This raises questions on how this will impact the profitability and investment returns from these companies and whether investors will continue to view the private markets as an attractive place to allocate capital. The uncertain economic outlook has dramatically reduced the appetite to finance new private market deals. However, there are factors that mitigate the risks forced to refinance in the short term. Secondly, corporate balance sheets are in relatively good health in terms of profits to cover interest payments or interest cover. Moreover, flexibility built into financing structures such as hedging to lock in lower interest rates should reduce the impact of rising rates. Importantly, the private market industry also has significant dry powder, or available capital, to invest in new opportunities or protect existing investments. For players active in the private markets. We think that there are undoubtedly risks in the near term, linked to congested fundraising with many private market firms seeking to raise capital from clients against a decline in public markets, which has left clients with less money in their pockets. From the performance of existing portfolio companies, given the more difficult market and economic environment and from subdued company disposal and investment activity linked to the more difficult financing markets. This has kept us pretty cautious on the sector this year. Bruce Hamilton: But Mike, despite these near-term risks and concerns, you remain convicted in your bullish outlook on the next five years. In a recent work, you've outlined five key themes that you see lifting private markets to your 17 trillion assets under management forecast. What are these themes and how do you see them playing out over time? Mike Cyprys: Look, clearly, I would echo your concerns in the short term. And I do think growth moderates after an exceptional period here. But we do see a number of growth drivers that we feel are more enduring. Specifically, five key engines of growth, if you will. First is democratization of private markets that we think can spur retail growth and unlock a $17 trillion addressable market or TAM. This is the single largest growth contributor to our outlook. Product development, investor education and technological innovation are all helping unlock access here as retail investors look to the private markets for income and capital appreciation in addition to a smooth ride with lower volatility versus the public markets. The second growth zone is private credit that we think is poised to penetrate a $23 trillion TAM as traditional bank lenders retrench, providing an opportunity for private lenders to step in. For corporate issuers, private credit offers greater flexibility on structure and terms, and provides greater certainty of execution. For investors, it can provide higher yields and diversification from public credit. The third growth zone is infrastructure investing, which we think can help solve for decades-long underinvestment and addresses a $15 trillion funding gap over the next 20 years. This is underpinned by structural tailwinds for the 3 Ds of digitization, decarbonization and deglobalization. The fourth growth zone is around liquidity solutions. As you know, the private markets are illiquid. And so as the asset class grows, we do expect some investors will want to find ways to access some degree of liquidity over time. And that's where solutions such as secondaries and NAV based lending can be helpful. The fifth and final growth zone is around impact in ESG investing. In public markets, we've seen significant asset flows into ESG and impact investing strategies as investors look to have a positive impact on society. And we expect that this will also play a role in the private markets, though it's a bit earlier days. Today we estimate about 200 billion invested in private market impact strategies, and we think that can reach about 850 billion in five years time. Mike Cyprys: So for investors, this does boil down to an impact on publicly traded companies. Given the specific challenges of the current environment, Bruce, which business models do you think are best positioned to succeed both near-term and longer term? And what should investors be looking at? Bruce Hamilton: Well, Mike, whilst we think the challenging macro conditions could continue to weigh on the sector near-term, we think that investors may want to look at companies with the best exposure to the five growth themes that you mentioned, who are building out global multi-asset investment franchises with diverse earnings streams, a high proportion of durable management fee related earnings—rather than heavy reliance or more volatile carry or performance fees—and deployment skewed to inflation protected sectors like infrastructure or real estate. Mike Cyprys: Bruce, thanks for taking the time to talk. Bruce Hamilton: Great speaking with you, Mike. Mike Cyprys: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

1 Marras 20226min

Despite companies beginning to report earnings misses and poor stock performance, the S&P 500 is on the rise, leading many to wonder how the Fed will react to this new data in their coming meeting.----- 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, October 31st at 11 a.m. in New York. So let's get after it. Two weeks ago, we turned tactically bullish on U.S. equities. Some clients felt this call came out of left field, given our well-established bearish view on the fundamentals. To be clear, this call is based almost entirely on technicals rather than the fundamentals which remain unsupportive of most equity prices and the S&P 500. Today, we will put some meat around the fundamental drivers for why this call can work for longer than most expect. Last week was the biggest one for third quarter earnings season in terms of market cap reporting. More specifically it included all of the mega-cap tech stocks that make up much of the S&P 500. On one hand, these companies did not disappoint the fundamental bears like us who've been expecting weaker earnings to finally emerge. In fact, several of these large tech stocks reported third quarter results that were even worse than we were expecting. Furthermore, the primary driver of the downside was due to negative operating leverage, which is a core part of our thesis on earnings as described in the fire and ice narrative. However, these large earnings misses and poor stock performance did not translate into negative price performance for the S&P 500 or even the NASDAQ 100. This price action is very much in line with our tactical bullish call a few weeks ago. In addition to the supportive tactical picture we discussed in prior notes, we fully expected third quarter results to be weak. However, we also expected most companies would punt on providing any material guidance for 2023, leaving the consensus forward 12 month earnings per share estimates relatively unchanged. This is why the primary index didn't go down in our view, and actually rose 4%. The other driver for why the S&P 500 rose, in our view, is tied to the upcoming Fed meeting this week. While the Fed has hawkishly surprised most investors this year, we've now reached a point where both bond and stock markets may be pricing in too much hawkishness. First, other central banks are starting to slow their rate of tightening. Second, there are growing signs the labor market is finally at risk of a downturn as earnings disappoint and job openings continue to fall. Third, the 3 month 10 year yield curve is finally inverted, and that is one item Fed Chair Jay Powell has said he's watching closely as a sign the Fed has gone far enough. However, the best evidence the Fed has already done enough to beat inflation comes from the simple fact that money supply growth has collapsed over the past year. Money supply is now growing just 2.5% year over year. This is down from a peak of 27% year over year back in March of 2021. A monetarist which suggests inflation is likely to fall just as rapidly as it tends to lag money supply growth by 16 months. This means longer term interest rates are likely to follow, which can serve as a driver of higher valuations until the forward earnings per share estimates fall more meaningfully. What this all means for equity markets is that we have a window where stocks can rally on the expectation inflation is coming down, which allows the Fed to pause its rate hikes at some point in the near future, if not this week. Moreover, this pause must occur while earnings forecasts remain high. The bottom line is that we continue to think there's further upside toward 4000 - 4150 from the current 3900 level. However, for that to happen, longer term interest rates will need to come down, and that will likely require a less hawkish message from the Fed. That puts a lot of pressure on this week's Fed meeting for our tactical call to keep working. If the Fed comes in hawkish and squashes any hopes for a pause before it's too late, the rally could very well be over. More practically, anyone who jumped on board this tactical trade should use 3700 on the S&P 500 as a stop loss for remaining bullish. Conversely, should longer term interest rates fall after Wednesday's meeting, we would gain more confidence in our 4150 upside target for the trade and even consider further upside depending on the message from the Fed. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

31 Loka 20224min

As the U.K. grapples with structural, political, and economic issues, how are markets affected across assets, and what stories may look better for investors than others? Chief Cross-Asset Strategist Andrew Sheets and U.K. Economist Bruna Skarica discuss.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan stanley's Chief Cross-Asset Strategist. Bruna Skarica: And I'm Bruna Skarica, Morgan Stanley's U.K. Economist. Andrew Sheets: And on part two of this special two part edition of the podcast, we'll be talking about the market implications of the latest political, economic and market developments in the U.K. It's Friday, October. 28th at 2 p.m. in London. Bruna Skarica: So Andrew, we already discussed the economic outlook for the U.K., and today I'd like to turn our conversation to you and your cross asset views. Obviously the current economic and political situation in the U.K. has a very significant impact on both macro and micro markets. Let's start with one of the number one investor questions around the U.K., which is the mortgage market. Roughly one in four mortgages has a variable rate and current estimates suggest that more than a third of UK mortgage holders will see their rates rise from under two to over 6% over the next year. What is your outlook for the mortgage market and its impact on the U.K. consumer, especially amid what is already severe cost of living crisis? Andrew Sheets: Like the U.S. most household debt in the U.K. is held in the form of mortgages. Unlike t,vhe U.S., though, those mortgages tend to have a quite short period where the rate is fixed. The typical U.K. mortgage, the rate is only fixed for 2 to 5 years. Which means that if you bought a house in 2020 or 2021, a lot of those mortgages are coming due for a reset very soon. And that reset is large. The mortgage, when it was taken out in 2020, might have had a rate of 2%. The current rate that it will reset to is closer to 6%. So that's a tripling of the interest rate that these homeowners face. So this is a very severe consumer shock, especially if you layer it on top of higher utility bills. This is, I think, a big challenge that, as you correctly identified in our conversation yesterday, that the Bank of England is worried about. And, you know, this is one reason why we think the pound will weaken. I'm sure we'll talk about the pound more, but if rate rises in the U.K. work their way into the household much faster because the mortgage fixed period is much shorter, maybe that means the Bank of England can't hike as much as markets expect. Whereas the Fed can because the dynamics in the mortgage market are so much different. Bruna Skarica: Indeed. Now, aside from that, U.K. rates have also seen a historical level of volatility this year. The pound as well has been weak all year, even though it has rallied a bit recently. Perhaps let's focus on the currency first. How do you see the pound from here? Do you think the downside risks have subsided or the structural risks still remain? Andrew Sheets: So the pound is a very inexpensive currency. It's inexpensive on a number of the different valuation measures that we look at, purchasing power parity, a real effective exchange rate and it's certainly fallen a lot. But our view is that the pound will fall further and that this temporary bounce that the pound has enjoyed in the aftermath of another new leadership team in the country is ultimately going to be short lived. A lot of the economic challenges that were there before the mini budget are still there. Weak economic growth, a large current account deficit, trade friction coming out of Brexit. And also I think this part about the Bank of England maybe not raising rates as much as the market expects, there's that much less interest income for investors for holding the pound. We forecast a medium term level for the pound relative to the dollar, about 1.05, so still lower from here. And we do think the pound will be the underperformer across U.K. assets. Bruna Skarica: Now aside from the pound I've mentioned, investors have been very focused on the UK rates market where we have indeed seen a lot of volatility in recent weeks. Now what do valuations look like here after all the fiscal U-turns? And is Morgan Stanley still bearish on gilts? Andrew Sheets: It's common to talk about historic moves in the global market and sometimes you realize you're talking about a market that's been around for 10 years or 20 years. The U.K. bond market's been around for hundreds of years. And we saw some of the largest moves in that history over the last 2 months. So these have been really extreme moves, both up and down, as a result of the fallout from that mini budget. But going forward we think U.K. rates will rise further from here, we think bonds will underperform and there are a couple of reasons for that. One is that the real interest rate on U.K. gilts, the yield above expected inflation, it's not very high, it's about zero actually. Whereas if I invest in a U.S. inflation protected security, I get about 1.5% more than the inflation rate. And then I think you add on this challenge of it's a smaller market, you add on the challenge of there's more political uncertainty, and then you add in the the risk that inflation stays higher than the Bank of England expects, that core inflation remains more persistent. And I think all of these are reasons why the market could inject a little bit more risk premium into the gilt market. One other thing that's been highlighted by our colleagues in interest rate strategy, is just simply there's a lot of supply gilts. There's supply of gilts not just because the governments running a deficit, but there's supply because the Bank of England was a major buyer and a major holder of gilts during the year of quantitative easing and it's shifting towards quantitative tightening. So heavy supply, low real rates, and I think a potential for kind of a higher risk premium are all reasons why we think gilts underperform both bonds and treasuries. Bruna Skarica: Now that you mentioned quantitative tightening, of course, the Bank of England is planning to sell its credit holdings as well. What is the situation in the sterling credit market? Can you walk us through the challenges and opportunities there right now for both domestic and foreign investors? Andrew Sheets: Yeah. So I think the credit market in the U.K. is actually one of the better stories in this market. Now it's not particularly liquid. But I think where sterling credit has some advantages is, one, it's actually a relatively international market. Only about half of it references U.K. companies, the other half of it is global companies, including a lot of U.S. issuers. So the credit market is not a particularly domestically focused index to the extent people are worried about the U.K. domestic situation. It's a market that trades at a spread discount to the U.S., both because of some of the recent volatility and the fact it's a little bit less liquid. this is a market that yields around 6.5% - 6.75% on investment grade credit. That's, I think, a pretty good return relative to expected inflation, relative to where we think credit risk is in that market. So, you know, amidst some other more difficult stories, we think the credit market might end up being a relatively better one. Bruna Skarica: Finally, let's take a step back perhaps, and take a look at some of the U.K.'s structural vulnerabilities. The U.K. has a very weak net international investment position, it's reliant on foreign money to fund some of its deficit and despite the recent fiscal U-turns, the U.K.'s fiscal deficit is still relatively large. In the context of these vulnerabilities, can you maybe discuss how recent events have affected foreign investors' confidence, and how do you see things going forward? Andrew Sheets: Yes, so I think this is a really important issue and maybe a good one to close on. The U.K., as you just mentioned, runs a very large current account deficit. It imports much more than it exports, and when you do that you need to attract foreign capital to make up that difference. Now the U.S. also imports more than it exports, the U.S. also runs a large current account deficit, but because the U.S. is this large deep capital market, it's seen as a relative winner in the global economy in terms of both the makeup of its companies and its longer term growth it tends to have an easier time attracting that foreign capital. The U.K. has more challenges there. It's a much smaller market, it doesn't have the same sort of tech leadership that you see in the U.S. and in terms of attracting the foreign capital into the equity market, well, that's been more difficult because you've had some uncertainty over what U.K. corporate tax policy will be. The U.K. equity market also tends to be quite energy and commodity focused. So in an ESG focused world, it's more complicated to attract inward investment. And then on the bond market side, the U.K.'s bonds don't yield more than U.K. inflation at the moment. So again, that's probably worked against attracting foreign investment. So maybe one other factor there that is important and we've touched this in a glancing way throughout this conversation, is brexit. That the U.K.'s exit from the European union does still present a number of big uncertainties around how U.K. companies and the U.K. economy will operate relative to its largest trading partner. And so, again, we can see a scenario where just simply higher risk premiums or lower valuations are ultimately needed to clear the market. Andrew Sheets: So Bruna, thanks for taking the time to talk. Bruna Skarica: Thanks, Andrew. Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

28 Loka 20229min

As the U.K. deals with a bout of market volatility, political transitions, and sticky inflation, how will policy makers and the Bank of England respond, and where might the U.K. economy be headed from here? Chief Cross-Asset Strategist Andrew Sheets and U.K. Economist Bruna Skarica discuss.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist. Bruna Skarica: And I'm Bruna Skarica, Morgan Stanley's U.K. Economist. Andrew Sheets: And on this special two part edition of the podcast, we'll be focused on the latest political, economic and market developments in the United Kingdom and how investors should think about the situation now and going forward. It's Thursday, October 27th at 2 p.m. in London. Andrew Sheets: So Bruna, the world's eyes have been on the U.K. over the last couple of months, not only because it's the world's sixth largest economy, but because it's been experiencing an unprecedented level of market volatility, and it also has had an unusually large amount of political volatility. So I think a good place to start this discussion is just taking a step back. How would you currently frame the economic challenges facing the U.K.? Bruna Skarica: Indeed, the level of volatility has truly been historic, both in the macro space, in the market and in politics. Now, in terms of what Prime Minister Sunak has on his tray coming into number 10, first let me mention the fiscal challenges. Chancellor Hunt, who's currently in number 11, has already reversed nearly all the measures from the mini budget, which was the catalyst of all this turbulence. Still, there is more to come. We think another £30 billion of fiscal tightening will be needed to stabilize debt to GDP ratio in the medium term. So more austerity, which of course, will be negative for growth. Now, this fiscal tightening, of course, comes in order to facilitate Bank of England's monetary tightening and help return inflation to the 2% target. The Bank of England has already hiked the bank rate to 2.25%, and we expect further hikes to come. So a lot of monetary tightening weighing on growth, too. And all of this is coming in the context of a very large external shock, that is the energy price move that has led to a spike in utility bills that the state is helping to counter, but that is weighing on UK's disposable income.Andrew Sheets: Given all of these challenges, how do you think the Bank of England is going to react? They have an upcoming meeting on November 3rd, and they’re facing a backdrop where on the one hand the U.K. has some of the highest core inflation in the developed world, and on the other hand it has a number of these risks to growth which you just outlined. How do you think they try to thread that needle and what do you think they ultimately do? Bruna Skarica: Indeed, the Bank of England has this year had a really complicated task at its hand. What started as the energy shock to inflation first impacting headline inflation, then spread on to pretty much every part of the consumer basket. The Bank of England we think has no choice but to tighten further from here. Chief Economist Pearl, in the aftermath of the mini budget, said that there will be a significant monetary response to the fiscal news and financial market volatility. As I mentioned, the mini budget was almost entirely scrapped, volatility subsided and so we think this significant response on November 3rd will come in the form of a 75 basis point hike. And we also see clear messaging from the Bank of England next week that this should be perceived as a one off level shift and that the pace of tightening will slow from December, as a lot of monetary tightening has already been delivered. We're expecting a 50 basis point move from the bank then and then two more 25 basis points hikes in the first quarter of next year, leaving the terminal rate at 4%. Andrew Sheets: In the Bank of England's thinking, how does inflation come down? You know, because you still have imported inflation from a weak currency, you still have some of the higher friction cost to trade coming through from Brexit, you still have quite high core inflation. What do you think the Bank of England is looking at that gives it conviction? Alternatively, what do you think is the most likely way those predictions could be wrong? Bruna Skarica: Well, the first thing to mention is the energy price inflation. It is true that our in-house Morgan Stanley view is that energy prices, for example natural gas prices, will not meaningfully correct from here. However, even if they stay at their current levels, inflation itself is going to slow and that's going to be a big drag on headline inflation over the course of next year and more so into 2024 and 2025. Additionally, the U.K. has seen a very sharp increase in traded goods inflation and our Morgan Stanley in-house view is that some of this is going to come off next year in the U.S. and the DM space more broadly, which we think will help lower U.K.'s headline and core inflation over the course of next year too. We do think services inflation will remain stickier. We think it's going to average around 5% next year actually, because our labor market's very tight and wage growth will remain at levels that are not consistent with meeting the 2% inflation target. However, the traded goods and energy prices we think should help with lowering headline inflation, and that is what the Bank of England is reflecting in its forecasts.Andrew Sheets: So Bruna you mentioned the strength of the U.K. labor market holding up despite, you know, a number of these macroeconomic challenges. What's going on there? What do you think explains the strength and how big of a problem do you think that is for the Bank of England's policy challenges? Bruna Skarica: That's a great question because our employment levels are actually not yet back to where they were pre-COVID. So a question arises as to why is our labor market this tight? And it's all about supply, really. The U.K.'s participation rate has been very subdued in the aftermath of the COVID shock. Some of it has to do with Brexit, a slowdown in migration flows from the EU from 2020 onwards because of course we've seen COVID and the Brexit shock coincide. However, much of it is to do with the drop in participation of U.K. born labor. For example, we now have a record high number of potential workers out with the labor force due to self-reported health issues. The health care backlog and NHS waiting lists are at an all time high and we now seem to have very limited fiscal space to address this. So we actually took down our own labor supply growth forecasts recently. This means that we do expect the slowdown in employment growth and when the recession comes shedding of employees over the course of next year, and that to be the main factor driving the rise in the unemployment rate. Andrew Sheets: So you have been calling for a recession around the end of the year in the U.K. and weak growth really through the middle of 2023. Is that still your forecast and what are the most likely factors that could change it? Bruna Skarica: Yes, that is still the case. We are looking for a 1% contraction in 2023 and for a recession to kick off in the second half of 2022. In terms of positive catalysts, I would say if natural gas prices fall further, the government will have more fiscal space to support the economy as opposed to using the funds to counter the external energy price hit. It would, of course, help with keeping the inflation somewhat lower. More resilient consumer spending, perhaps as some of those pandemic excess savings are spent, is another upside risk. But we see a very low probability of this happening. And finally, a more aggressive global disinflation, something I've mentioned when it comes to global traded goods inflation, leading to a faster return to positive real income growth, that's another factor to think about, and that would be beneficial for consumers and of course for overall U.K. GDP growth. So those are the main positive factors, I would say. Andrew Sheets: Bruna, thanks for taking the time to talk. Bruna Skarica: Great speaking with you, Andrew. Andrew Sheets: And thanks for listening. Be sure to tune in for the upcoming Part two of our conversation about the U.K. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

27 Loka 20228min