Mike Wilson: Putting the Market Correction in Context

Despite some falloff in consumer interest, anti-obesity drugs are still likely to have profound implications at both the macro and sectoral level.----- 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 give you an update on the all important obesity theme and how it's impacting a wide range of industries. It's Thursday, November the 9th at 2 p.m. in London. GLP-1s, a type of anti-obesity medicine, have been on the market since 2010, but it's taken until 2023 for this theme to really come to life. We believe that GLP-1s will clearly have profound implications over the long term, both on a macro and micro level. Obesity has far reaching implications for the global economy as it leads to lost productivity and significant health care costs. We estimate the macro impact of obesity at 3.6% of US GDP, with potentially $1.24 trillion in lost productivity indirect costs. Anti-Obesity drugs have the potential to address at least some of this economic burden and at a reasonable cost. The micro implications on businesses year-to-date have seen about a $600 billion swing in market cap. That includes, to the upside, $340 billion for the GLP-1 makers and over $260 billion lost in market value for the stocks that are potentially disrupted. For context, that compares to a total US drug market of $430 billion annually. 2023 saw an impressive surge in investor interest in anti-obesity drugs. Yet and perhaps surprising to some based on hashtag and web traffic data we track, consumer interest appears to have waned in recent weeks. We think this notable dip from the peak in activity is driven in part by supply constraints, paused geographic expansion and curtailed promotional activity. Importantly though, this fade in initial consumer excitement is occurring at the same time that company transcript mentions of obesity or GLP-1 by non-pharma companies are reaching new highs. This disconnect between sain street moderation and excitement versus Wall Street's rise in excitement, is very typical of short term hype cycle tops in equity markets, particularly given the current environment of higher interest rates. But even as the initial buzz around obesity drugs is fading back to more moderate levels in the near term, we do believe there will be wide ranging implications over the long term that are hard to deny. And our global analysts have been all over this on a sector by sector basis. First off, we believe that US alcohol beverages per capita will correct due to abnormally high consumption in recent years and longer term structural challenges such as demographic, health and wellness. For beer growing adoption of obesity medication presents an incremental risk factor to consumption, although many of these companies are already working on healthier options. Across packaged foods, patients on anti-obesity medications have been cutting back the most on foods high in sugar and fat, such as confections, baked goods, salty snacks, sugary drinks and alcohol. Companies with a weight management or better for you portfolio appear to be better positioned for here. Within US food retail, we think dollar stores which target lower end consumers with outsized exposure to high calorie foods, will be the most adversely impacted in the context of increased adoption of these drugs. Separately, insulin pump makers should be only minimally impacted, we think, by GLPs by 2027, which suggests that the share price reaction to the downside for these stocks year-to-date may be materially overdone. Obesity has a direct impact on osteoarthritis, with about twice the prevalence of arthritis in obese versus non obese patients. A much higher need for arthroplasty with higher BMIs and obese patients having higher surgical complications. GLP-1 usage could have some complex effects on these ortho stocks. We also see longer term risk for most of the US and European fast food industry. The same goes for carbonated sugary drinks and for chocolate lovers out there, the rising GLP-1 adoption could pressure chocolate consumption longer term. But the magnitude of these impacts remains uncertain, as indulgence will still remain a core consumer need even in this new GLP-1 paradigm. All in all, we remain bullish on the anti-obesity drug market, particularly given the staggering 750 million people globally living with obesity, and this continues to be a dynamic space for investors to watch closely. Thanks for listening. If you enjoyed this show, please leave a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.

9 Nov 20234min

The recent treasury rally signals that perhaps the U.S. fiscal trajectory isn't as challenging as bond investors had feared.----- 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 impact of U.S. fiscal policy on markets. It's Wednesday, November 8th at 10 p.m. in New York. As Congress gets back to work on funding the government and avoiding a government shutdown, investors' attention has turned back to public finances. In particular, as bond markets sold off much of the year, a common theory posited by clients to our team was that U.S. fiscal policy was to blame. Expanding deficits meant higher supply and could also mean higher inflation, growth and ultimately a higher peak Fed funds rate. But upon closer examination, maybe the U.S. fiscal trajectory isn't as challenging as feared, and the bond market may be finally noticing. Treasuries have rallied in the past week. Which makes sense to us as our assessment is that U.S. fiscal expansion at all levels has either peaked or is near its peak. Consider that the federal deficit this year rose largely based on lower revenues driven by factors that are unlikely to repeat. For example, Fed remittances zeroed out, and there's about $85 billion of deferred collection of tax revenue due to natural disasters. Together with other factors, we think this year's nearly 1% growth in deficits as a percentage of GDP will be followed next year by a decline of about 0.2%. Further downside is possible if a spending sequester kicks in, in April. Also, consider that major deficit expansion isn't likely to be on Congress's agenda. Between now and the 2024 election, there's little reason to expect deficit expanding bills beyond the current baseline. Government control is divided, and history shows that makeup rarely does fiscal expansion unless it's responding to an economic crisis. After Election Day, Republicans and Democrats do have deficit additive policies they say they want to pursue, but the numbers are relatively modest. Republicans' plan to extend parts of prior tax cuts would add about 0.3% to deficits as a percentage of GDP in the first year, and we estimate the consensus tax and spending plans of Democrats would add about 0.1%, both manageable numbers. Also worth noting is that state and local governments seem near their peak fiscal expansion. Their recent expansion appears tied to spending of prior COVID aid, which is quickly depleting, as well as hiring, which is nearly back to pre-COVID levels. So bottom line, if you're concerned about Treasury yields resuming their upward trend, look elsewhere for a catalyst. Consumption would be the most likely culprit but at the moment, our economists are still seeing downside there in the near term. This gives us confidence that the worst of U.S. government bond returns is probably behind us for this cycle. 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.

8 Nov 20232min

AI could help video game companies boost engagement and consumer spending, but could also introduce competition by making it easier for new companies to enter the industry.----- Transcription -----Welcome to Thoughts on the Market. I'm Matt Cost from the Morgan Stanley US Internet Team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss how A.I could change the video game industry. It's Tuesday, November 7th at 10 a.m. in New York. New A.I tools are starting to transform multiple industries, and it's hardly a surprise that the game industry could see a major impact as well. As manual tasks become more automated and the user experience becomes increasingly personalized, A.I. tools are starting to change the way that games are made and operated. Building video games involves many different disciplines, including software development, art and writing, among others. Many of these processes could become more automated over time, reducing the cost and complexity of making games and likely reducing barriers to entry. And since we expect the industry to spend over $100 billion this year building and operating games, there's a significant profit opportunity for the industry to become more efficient. Automated content creation could also offer more tailored experiences and purchase options to consumers in real time, potentially boosting engagement and consumer spending. Consider, for example, a game that not only makes offers when a consumer is most likely to spend money, but also generates in-game items designed to appeal to that specific person's preferences in real time. Beyond A.I generated content, we also need to consider the impact of user generated content. Some popular titles already depend on the users to shape the game around them, and this is another core area that could be transformed by A.I.. Faster and easier to use content creation tools could make it easier for games to tap into the creativity of their users. And as we've seen with major social platforms, relying on users to create content can be a big opportunity. With all that said, these transformational opportunities create downside risk as well. Today's large game publishers rely on their scale and domain expertise to differentiate their products from competitors. But while new A.I. tools could make game development more efficient, they could also lower barriers to entry for new competitors to jump into the fray and put pressure on the incumbents. Another risk is that A.I. tools could fail to drive the hope for efficiencies and cost savings in the first place. Not all technology breakthroughs in the past have helped the industry become more profitable. In some cases, industry leaders have decided to reinvest cost savings back into their products to make sure that they deliver bigger and better games to stay ahead of the competition. With that in mind, the biggest challenge for today's industry leaders could be making sure that they find ways to differentiate their products as A.I. tools make it easier for new firms to compete. Where does all of that leave us? Although a number of A.I. tools are already being used in the game industry today, adoption is just beginning to tick up and there's a lot of room for the tools to improve. With that in mind, we think we're just on the cusp of this A.I. driven revolution, and we may have to get through a few more castles to find the princess. Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

7 Nov 20232min

Last week’s uptick in stock prices, driven by a pullback in bond yields and the Fed’s decision to hold rates steady, is likely to fizzle over the coming weeks.----- 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 6th, at 10 a.m. in New York. So let's get after it. With many stocks down more than 20% from the July highs, a dynamic punctuated by tax loss selling from institutional managers at the end of October, equity markets were primed for some kind of a bounce. However, last week's rally in equities was the largest that we've seen all year, and it was led by many of the year-to-date laggards. Furthermore, both market cap and equal weight versions of the S&P 500 index were up 5.9%, as breadth showed its first signs of life since June. In our view, this move in equities was more about the strong rally in bonds than anything else. After an historic rise this past quarter, ten year Treasury yields reached an attractive level of 5% near the end of last month. Perhaps even more attractive for investors to ignore was that real ten year yields were at 2.5%. One factor driving bond yields lower last week was the Treasury's announcement of its planned longer term securities issuance that was below expectations. We also attribute the move to the weaker than expected economic data releases last week, more specifically, manufacturing and services purchasing manager surveys fell by much more than expected. The labor market data also showed further signs of cooling. Specifically, continuing jobless claims are now up more than 35% from the cycle trough, and the unemployment rate is now up 0.5% from the lows, both of these are important thresholds in past labor cycles. Finally, revisions to prior non-farm payroll data have consistently been negative this year, while the Household Labor survey indicated we lost 348,000 jobs last month. Given the absolute level of yields in a slowing growth and inflation backdrop, bonds may finally be attracting larger asset owners and allocators. Meanwhile, earnings revision breadth remains well into negative territory, with the big growth stocks earnings results providing only modest stability to this important leading indicator. This year's earnings recession continues to play out, particularly at the stock level. This is one reason why broader indices and the average stock's performance within the S&P 500 have been so much weaker than the very concentrated market cap weighted S&P 500 index this year. From a tactical perspective, the underlying performance breadth remains weak, while several broader and equal weighted indices remain flat on the year, with elevated volatility. A challenging risk reward set up in the context of 5% plus risk free yields that are currently available in money markets and T-bills. Yet the number one question we continue to get is whether there will be a rally into year end. For equity only asset managers, that's an important question and debate, but for asset owners and allocators, the prospect of adding additional equity risk at current levels seems unattractive given these other alternatives. The bottom line, we think the strong rally in rates drove stocks higher last week. Bulls have interpreted this move as a signal the Fed is done hiking rates and is likely to cut next year without any material deterioration to the labor market or some other negative event for growth. In contrast, we believe that the rate decline was mainly a function of less than expected, longer dated bond issuance guidance from the Treasury combined with some signs that the economy is slowing from the torrid pace of the third quarter. This is in line with our economists' tepid forecast for the fourth quarter and 2024 GDP growth and supports our view that the earnings recession is not yet over. Such an outcome suggests last week's rally should fizzle out over the coming week or two as it becomes clear the growth picture does not support either Fed cuts or a significant acceleration in EPS growth in the near term. 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.

6 Nov 20234min

As the majority of the stress from higher rates falls on weaker borrowers, investors should consider moving up in quality.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research 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 3rd at 2 p.m. in London. Downgrades in the loan market are moderating after a spike in 2022. That's good news overall, but still suggests an environment that will reward a higher quality bias in high yield investing. After rising throughout last year, net downgrade activity for U.S. leveraged loans, which represent corporate loans to below investment grade borrowers, have declined about 50%. The most extreme downgrades where issuers fall to a triple C rating, have moderated the most, while triple C upgrades have become more frequent, as companies have successfully refinanced upcoming debt. Fewer net downgrades, and especially less movement into this riskiest triple C cohort, is good news. And we think it's consistent with the idea that despite a near doubling of borrowing costs over the last two years, default rates will only rise to about average levels and not something higher and more alarming. But within this activity, we think there's also a message, the majority of the stress from those higher rates is falling on weaker borrowers. Investors should look to move up in quality. Why do we think this? When interest rates rise, the impact on borrowers happens gradually, rather than all at once, since borrowers are still likely to have some debt outstanding that was taken out when rates were lower. That means that today's financial metrics and ratings may still not fully reflect the impact of the unusually fast rise in borrowing costs. That still to come impact, could fall most heavily on loan issuers rated B3/B-, the last step above the lowest triple C tier. My colleagues Vishwas Patkar and Joyce Jiang of the U.S. Credit Strategy team estimate that by the end of this year, over 1/3 of these issuers could have an interest coverage ratio, which represents the ratio of your cash flow to your borrowing costs, below 1.3x, even if their earnings are flat. In a scenario where growth is even weaker this year, that share would be even higher. And despite these low single B's facing the most risk from higher borrowing costs, in our view, markets aren't charging a particularly large premium to avoid them. The extra spread that an investor gets from moving down to a B- credit from the notches above, is near the lowest of the last ten years. And our up and quality bias isn't just about playing defense, as higher rated issuers are generally seeing better ratings transition trends. Double B rated credits are posting more upgrades than downgrades and outperforming lower rated single B's or triple C's. And even higher rated triple B credits are posting an even larger volume of upgrades relative to downgrades over the last 12 months. Ratings actions are stabilizing and suggest extreme outcomes for default rates are likely to be avoided. But given fundamentals and pricing, moving up in quality still makes sense. 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.

3 Nov 20233min

Generative AI could transform the nature of work and boost productivity, but companies and governments will need to invest in reskilling.----- Transcript -----Stephen Byrd: Welcome to Thoughts in the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research. Seth Carpenter: And I'm Seth Carpenter, the Global Chief Economist. Stephen Byrd: And on the special episode of the podcast, we'll discuss how generative A.I. could reshape the US economy and the labor market. It's Thursday, November 2nd at 10 a.m. in New York. Stephen Byrd: If we think back to the early 90's, few could have predicted just how revolutionary the Internet would become. Creating entirely new professions and industries with a wide ranging impact on labor and global economies. And yet with generative A.I. here we are again on the cusp of a revolution. So, Seth, as our global chief economist, you've been assessing the overarching macro implications of the Gen A.I. phenomenon. And while it's still early days, I know you've been thinking about the range of impacts Gen A.I could have on the global economy. I wondered if you could walk us through the broad parameters of your thinking around macro impacts and maybe starting with the productivity and the labor market side of things? Seth Carpenter: Absolutely, Stephen. And I agree with you, the possibilities here are immense. The hardest part of all of this is trying to gauge just how big the effects might be, when they might happen and how soon anyone is going to be able to pick up on the true changes and things. But let's talk a little bit about those two components, productivity and the labor market. They are very closely connected to each other. So one of the key things about generative A.I is it could make lots of types of processes, lots of types of jobs, things that are very knowledge base intensive. You could do the same amount of work with fewer people or, and I think this is an important thing to keep in mind, you could do lots more work with the same number of people. And I think that distinction is really critical, lots of people and I'm sure you've heard this before, lots of people have a fear that generative A.I is going to come in and destroy lots of jobs and so we'll just have lots of people who are out of work. And I guess I'm at the margin a lot more optimistic than that. I really do think what we're going to end up seeing is more output with the same amount of workers, and indeed, as you alluded to before, more types of jobs than we've seen before. That doesn't exactly answer your question so let's jump into those broad parameters. If productivity goes up, what that means is we should see faster growth in the economy than we're used to seeing and I think that means things like GDP should be growing faster and that should have implications for equities. In addition, because more can get done with the same inputs, we should see some of the inflationary pressures that we're seeing now dissipate even more quickly. And what does that mean? Well, that means that at least in the short run, the central bank, the Fed in the U.S., can allow the economy to run a little bit hotter than you would have thought otherwise, because the inflationary pressures aren't there after all. Those are the two for me, the key things one, faster growth in the economy with the same amount of inputs and some lower inflationary pressures, which makes the central bank's job a little bit easier. Stephen Byrd: And Seth, as you think about specific sectors and regions of the global economy that might be most impacted by the adoption of Gen A.I., does anything stand out to you? Seth Carpenter: I mean, I really do think if we're focusing just on generative A.I, it really comes down, I think a lot to what can generative A.I do better. It's a lot of these large language models, a lot of that sort of knowledge based side of things. So the services sector of the economy seems more ripe for turnover than, say, the plain old fashion manufacturing sector. Now, I don't want to push that too far because there are clearly going to be lots of ways that people in all sectors will learn how to apply these technology. But I think the first place we see adoption is in some of the knowledge based sectors. So some of the prime candidates people like to point to are things like the legal profession where review of documents can be done much more quickly and efficiently with Gen A.I. In our industry, Stephen in the financial services industry, I have spoken with clients who are working to find ways to consume lots more information on lots of different types of firms so that as they're assessing equity market investments, they have better information, faster information and can invest in a broader set of firms than they had before. I really look to the knowledge based sectors of the economy as the first target. You know, so that Stephen is mostly how I'm thinking about it, but one of the things I love about these conversations with you is that I get to start asking questions and so here it is right back at you. I said that I thought generative A.I is not going to leave large swaths of the population unemployed, but I've heard you say that generative A.I is really going to set the stage for an unprecedented demand in reskilling workers. What kind of private sector support from corporations and what sort of public sector support from governments do you expect to see? Stephen Byrd: Yeah Seth, I mean, that point about reskilling, I think, is one of the most important elements of the work that we've been doing together. This could be the biggest reskilling initiative that we'll ever see, given how broad generative A.I really is and how many different professions generative A.I could impact. Now, when we think about the job impacts, we do see potential benefits from private public partnerships. They would be really focused on reskilling and upskilling workers and respond to the changes to the very nature of work that's going to be driven by Gen A.I. And an example of some real promising efforts in that regard was the White House industry joint efforts in this regard to think about ways to reskill the workforce. That said, there really are multiple unknowns with respect to the pace and the depth of the employment impacts from A.I. So it's very challenging to really scope out the magnitude and cadence a nd that makes joint planning for reskilling and upskilling highly challenging. Seth Carpenter: I hear what you're saying, Stephen, and it is always hard looking into the future to try to suss out what's going on but when we think about the future of work, you talked about the possibility that Gen A.I could change the nature of work. Speculate here a little bit for me. What do you think? What could be those changes in terms of the actual nature of work? Stephen Byrd: Yeah, you know, that's what's really fascinating about Gen A.I and also potentially in terms of the nature of work and the need to be flexible. You know, I think job gains and losses will heavily depend on whether skills can be really transferred, whether new skills can be picked up. For those with skills that are easy to transfer to other tasks in occupations, you know, disruptions could be short lived. To this point the tech sector recently experienced heavy layoffs, but employees were quickly absorbed by the rest of the economy because of overall tight labor market, something you've written a lot about Seth. And in fact, the number of tech layoffs was around 170,000 in the first quarter of 2023. That's a 17 fold increase over the previous year. While most of these folks did find a new job within three months of being laid off, so we do see this potential for movements, reskilling, etc., to be significant. But it certainly depends a lot on the skill set and how transferable that skill set really is. Seth Carpenter: How do you start to hire people at the beginning of this sort of revolution? And so when you think about those changes in the labor market, do you think there are going to be changes in the way people hire folks? Once Gen A.I becomes more widespread. Do you think workers end up getting hired based on the skill set that they can demonstrate on some sort of credentials? Are we going to see somehow in either diplomas or other sorts of certificates, things that are labeled A.I? Stephen Byrd: You know, I think there is going to be a big shift away from credentials and more heavily towards skills, specific skill sets. Especially skills that involve creativity and also skills involving just complex human interactions, human negotiations as well. And it's going to be critical to prioritize skills over credentials going forward as, especially as we think about reskilling and retraining a number of workers, that's going to be such a broad effort. I think the future work will require hiring managers to prioritize these skills, especially these soft skills that I think are going to be more difficult for A.I models to replace. We highlight a number of skills that really will be more challenging to automate versus those that are less challenging. And I think that essentially is a guidepost to think about where reskilling should really be focused. Seth Carpenter: Well, Stephen, I have to say I'd be able to talk with you about these sorts of things all day long, but I think we've run out of time. So let me just say, thank you for taking some time to talk to me today. Stephen Byrd: It was great speaking with you, Seth. Seth Carpenter: And thanks to the listeners for listening. If you enjoyed Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

2 Nov 20238min

Investors are questioning whether a new U.S. Speaker in the House of Representatives will push for fresh legislation, and whether a potential government shutdown is on the horizon.----- 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 impact to markets from Congress's agenda. It's Wednesday, November 1st at 10 a.m. in New York. Last week in D.C., following a few weeks of Republicans failing to coalesce around a nominee, the House of Representatives chose a speaker, Republican Mike Johnson. So, with a new speaker in place, does that mean investors need to rethink their expectations about legislation that could impact markets? Not exactly. At least not before the next presidential election. Here's three takeaways from us to keep in mind. First, a new speaker doesn't mean new momentum for most of the legislation that investors tell us they care about. For example, fresh regulations for social media or cryptocurrency are no closer as a result of having a new speaker. Those are issues both parties are keen to tackle but are still working out exactly how they'd like to tackle them. Second, a government shutdown still remains a possibility. Speaker Johnson has said avoiding a shutdown is a priority for him, stating he would allow a vote on another stopgap spending measure to give Congress more time to agree on longer term funding levels. But such a stopgap measure could also reflect that House Republicans haven't yet solved for their own internal disagreement on key funding measures, such as aid for Ukraine. If that's the case, then a shutdown later this year or early next year remains a possibility. And, while on its own, a brief shutdown wouldn’t meaningfully affect the economy, markets will reflect a higher probability of weaker growth on the horizon, particularly as failure to agree on longer term funding would put in play an automatic government spending cut under current law. Third and finally, military aid and funding is likely to be a source of intense debate in Congress but we still expect defense spending to rise, supporting the aerospace and defense sectors in the equity market. Two factors give us comfort here. First, the Fiscal Responsibility Act, which was the bill that was passed to raise the debt ceiling, also laid out multi-year government spending targets that include an increase in defense spending. Being already passed by Congress, we expect this is the template they'll work within. Second, while a sufficient minority of the House Republican caucus is skeptical of further aid to Ukraine, such aid enjoys broader bipartisan support across all of Congress. So we expect any spending bill that makes its way through Congress is likely to have that aid. 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.

1 Nov 20232min

With mortgage rates at their highest level in 20 years, housing affordability may deteriorate to levels not seen in decades.----- Transcript -----Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of Securitized Products Research here at Morgan Stanley. Jay Bacow: And I'm Jay Bacow, the other Co-Head of Securitized Products Research. Jim Egan: And on this episode of the podcast, we'll be discussing U.S. home prices. It's Tuesday, October 31st at 11 a.m. in New York. Happy Halloween. Jay Bacow: Jim. Mortgage rates are close to 8%. They haven't been this high since the year 2000. Now, you've pointed out in this podcast before, home prices have been incredibly resilient. So what is this combination of mortgage rates being at the highs over the last 20 years versus resilient home prices mean for housing affordability? Jim Egan: Well, not good. Now, one of the statements that you and I have made on prior episodes of this podcast is that affordability remains incredibly challenged. But at least throughout the first half of 2023, it really wasn't getting any worse. If mortgage rates stay at these levels, we can no longer make the second half of that statement. In fact, affordability deterioration would return to the most severe that we've seen in decades, 2022 experience notwithstanding. Jay Bacow: Okay. But what does that mean for the housing market? You know, at first blush, it doesn't sound great, but we've done a lot of these podcasts, and the story that you're talking about sounds kind of similar to what we saw last year in 2022. Home sales and housing starts could fall, but home prices would remain protected as homeowners are effectively locked in to their current low mortgage rate and there's not a lot of for sellers. Jim Egan: Those dynamics certainly continue to play a role in our thinking. But in our view, with mortgage rates at these levels, that requires us to think about both the short term impacts but also the longer term impacts if we were to stay here. Jay Bacow: All right, Jim, you said shorter term first. So what do we think happens in the near future? Jim Egan: Basically, what you just described, look, the immediate reaction to the recent climb in mortgage rates has been on the supply side. Existing listings have begun falling again, as of August we can now say that we have the fewest listings on record, controlling for time of year, the housing market is very seasonal and homebuilder confidence has also retreated. Now it increased in every single month of 2023 from January through July. In the past three months, it's down over 30% from that peak, and the NAHB attributes a lot of this u-turn to higher mortgage rates. At least when it comes to home prices, we think that the impact from these renewed decreases in the supply of homes is going to have a greater impact on prices than any decrease in demand. In fact, that did cause us to move our home price forecast a couple of months ago. We were flat at the end of this year and again, we're saying short term, this is October, the end of this year is pretty close. Our bull case was plus five. We're not moving all the way to that plus five, but we're moving towards that plus five from our 0% base case. Jay Bacow: All right. So over the next few months, you're a little bit more constructive on home prices, but people own homes for many years. So longer term, what do you expect the outlook to be? Jim Egan: Well, the answer there is, you know, more predicated on how long mortgage rates stay at these levels. We do think that a higher for a longer environment requires a different outlook today than it did in late 2021 and early 2022, and there are a number of reasons for that, but I think one of the bigger ones, Jay, is kind of the distribution of outstanding mortgage rates today. What does that look like? Jay Bacow: The average outstanding mortgage rate today is roughly three and 5/8%. But if you look at the distribution of homeowners, because we spent basically all of 2020 and 2021 at really low mortgage rates and many homeowners were stuck in their house, they spent a lot of time refinancing. And so there isn't that many mortgages that have a much higher rate than that. And so if we look at, for instance, the universe of mortgages between 7% and 8%, that's less than 2% of the outstanding mortgages. Jim Egan: And this is an important point, because not that many borrowers are falling out of the money with this move, we don't think that supply is going to see the sharp, sharp drops that we experienced throughout 2022. There's also some level of transaction volumes that need to take place regardless of economic incentive. If we look at home sales versus the stock of own homes is one example here. We're already at the lows from the great financial crisis. So instead of sharp declines in home sales moving forward, we think it's more accurate to describe a higher for a longer rate environment as more preventing sales from increasing going forward. Jay Bacow: All right. So the sales outlook, I guess, feels a little better than the sharp drops that we saw last year. But what about home prices? Jim Egan: If home sales were to remain at these levels, then we become even more reliant on the supply of for sale housing, staying at historic lows, or at least the lowest levels we have on record going back over 40 years, to prevent home prices from falling. As a scenario analysis, let's just say that inventory were to grow just 5% next year. For context, inventory was growing for May of 2022 through the middle of this year. If we just get 5% growth and that comes alongside zero increase in sales because of the affordability challenge, our model says that would lead to a drop in home prices by the end of 2024, that rounds to about 5%. But Jay, that's all predicated on where mortgage rates go from here. So are we staying at these levels? Jay Bacow: The biggest driver of where mortgage rates go is where treasury rates are going to be. However, there's certainly a secondary component which has to do with the spread between where Treasury rates are and the spread where the originators can sell their mortgage exposure to investors. And that spread looks way too wide to us over the longer term. Now, you talked about short term versus long term. Short term, we're not really sure what happens to spread, longer term we do think that spreads will compress, which would bring mortgage rates lower. Jim Egan: Surely at some point these levels become attractive? Jay Bacow: Absolutely. And we think longer term, that point is now we're talking about owning a government guaranteed asset at about 6.75% yield that picks roughly 180 basis points the Treasury curve. That's not a level that things normally trade at. We think next year as the Fed cuts rates, vol comes down, the curve steepened and mortgages would tighten under that scenario. But near-term over the next couple of months, as you're talking through the end of the year, it's hard to have much conviction and there's risks certainly to further liquidity pressures and spread widening. Jay Bacow: All right, Jim, it's always great talking to you. Jim Egan: Great talking to you, too, Jay. Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.

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