End-of-Year Encore: Space Investing

As price to earnings multiples fall and inflation continues to weigh on the economy, long term earnings estimates may still be too high as the risk of a recession rises. -----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 Tuesday, June 21st at 11 a.m. in New York. So let's get after it. Coming into the year, we had a very out of consensus view that valuations would fall at least 20% due to rising interest rates and tighter monetary policy from the Fed. We also believed earnings were at risk, given payback and demand, rising costs and inventory. With price to earnings multiples falling by 28% year to date, the de-rating process is no longer much of a call, nor is it out of consensus. Having said that, many others are still assuming much higher price to earnings multiples for year end S&P 500 price targets. In contrast, we have lowered our price to earnings targets even further as 10 year U.S. Treasury yields have exceeded our expectations to the upside. In short, the price to earnings multiple should still fall towards 14x, assuming Treasury yields and earnings estimates remain stable. Of course, these are big assumptions. At this point, a recession is no longer just a tail risk given the Fed's predicament with inflation. Indeed, this is the essence of our fire and ice narrative - the Fed having to tighten into a slowdown or worse. Our bear case for this year always assumed a recessionary outcome, but the odds were just 20%. Now they're closer to 35%, according to our economists. We would probably err a bit higher given our more negative view on the consumer and corporate profitability. From a market standpoint, this is just another reason why we think the equity risk premium could far exceed our fair value estimate of 370 basis points. Of course, the 10 year Treasury yield will not be static in a recession either, and would likely fall considerably if growth expectations plunge. For example, the equity risk premium exceeded 600 basis points during the last two recessions. We appreciate that the next recession is unlikely to be accompanied by a crisis like the housing bust in 2008, or a pandemic in 2020. Therefore, we're willing to accept a lower upside target of 500 basis points should a recession come to pass. Should the risk of recession increase to the point where it becomes the market's base case, it would also come alongside a much lower earnings per share forecast. In other words, a recession would imply a much lower trough for the S&P 500 of approximately 3000 rather than our base case of 3400 we've been using lately. As of Friday's close, our negative view is not nearly as fat of a pitch, with so much of the street now in our camp on both financial conditions and growth. Having said that, the upside is quite limited as well, making the near-term a bit of a gamble. Equity markets are very oversold, but they can stay oversold until market participants feel like the risk of recession has been extinguished or at least reduced considerably. We do not see that outcome in the near term. However, we can't rule it out either and appreciate that markets can be quite fickle in the short term on both the downside and the upside. What we can say with more certainty today versus a few months ago is that earnings estimates are too high, even in the event a recession is avoided. Our base case 3400 near-term downside target accounts for the kind of earnings risk we envision in the event a soft landing is accomplished. For us, the end game remains the same. We see a poor risk reward over the next 3 to 6 months, with recession risk rising in the face of very stubborn inflation readings. Valuations are closer to fair at this point, but hardly a bargain if earnings are likely to come down or a recession is coming. While investors have suffered quite a setback this year, we can't yet get bullish for more than just a bear market rally until recession arrives or the risk of one falls materially. At the stock level, we continue to favor late cycle defensives and companies with high operational efficiency. 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.

21 Jun 20224min

With so much going on in markets, some moves that may have been hot topics against a less chaotic backdrop, such as policy shifts towards shrinking central bank balance sheets, are hitting the back burner.-----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, June 17th, at 2 p.m. in London. There is so much going on in markets that events that would usually dominate discussions find themselves relegated. You'll emerge from an investor meeting having discussed everything from Fed policy to China's COVID response, and realize there was no time for a discussion of, say, the situation in Japan where the yen has just seen one of its sharpest declines in the last 30 years. I think that applies, in a notable way, to the conversation around central bank balance sheets. For much of the last decade, the bond buying of central banks, also known as quantitative easing, was the dominant market story. That buying is now reversing with the balance sheet of central banks in the U.S., Euro area, the UK and Japan, set to shrink by about $4 trillion between now and the end of 2023. And yet, with so much else going on, this quantitative tightening really feels like it's taking a backseat. One reason is that while the size of this balance sheet reduction is large, it is, for the moment, looking like it will be quite predictable, with central banks stating that these reductions will happen in a regular manner, almost regardless of market conditions. That's in sharp contrast to the situation in interest rates, where central bank policy has been rapidly changing, much less predictable and very dependent on incoming data. We were reminded of this again on Wednesday, when the Federal Reserve decided to raise interest rates by 75 basis points, on top of the 50 basis point rise they executed last month. In the press conference that followed Chair Powell emphasized how important incoming data would be in shaping further interest rate decisions. With every data point potentially shifting the near-term interest rate outlook, the steady decline of the balance sheet all of a sudden becomes less pressing. There is also a legitimate question of how much central bank bond purchases mattered in the first place. There's a whole branch of statistics designed to test how much of the variance of one thing, like stock prices, can be explained by changes in another thing, like central bank balance sheets. When we put the data through these rigorous tests, most of the stock market moves over the last 12 years are explained by factors other than the central bank balance sheet. And one final piece of trivia; bond prices have tended to do worse when Fed bond holdings were rising, and better when bond holdings were shrinking. That might sound counterintuitive, but consider the following. Quantitative easing usually began when the economy was weak and bond prices were already high, while quantitative tightening has occurred when the economy was strong and bond prices were already lower. It's just one more example that the balance sheet is one of many factors driving cross-asset performance. 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.

17 Jun 20223min

With home prices hitting new highs and inventory hitting new lows, the differences between now and the last housing bubble may help ease investors' worries that the market is about to burst. Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.-----Transcript-----Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. Jay Bacow: And on this episode of the podcast, we'll be discussing the path for both housing prices, housing activity and agency mortgages through the end of the year. It's Thursday, June 16th, at noon in New York. Jay Bacow: Jim, it seems like every time we come on this podcast, there's another record in the housing market. And this time it's no different. Jim Egan: Absolutely not. Home prices just set a new record, 20.6% year over year growth. They set a new month over month growth record. Affordability, when you combine that growth in home prices with the increase we've seen in mortgage rates, we've deteriorated more in the past 12 months than any year that we have on record. And a lot of that growth can be attributed to the fact that inventory levels are at their lowest level on record. Consumer attitudes toward buying homes are worse than they've been since 1982. That's not a record, but you get my point. Jay Bacow: All right. So we're setting records for home prices. We're setting records for change in affordability. With all these broken records, investors are understandably a little worried that we might have another housing bubble. What do you think? Jim Egan: Look, given the run up in housing in the 2000s and the fact that we,ve reset the record for the pace of home price growth, investors can be permitted a little anxiety. We do not think there is a bubble forming in the U.S. housing market. There are a number of reasons for that, two things I would highlight. First, the pre GFC run up in home prices, that was fueled by lax lending standards that really elevated demand to what we think were unsustainable levels. And that ultimately led to an incredible increase in defaults, where borrowers with risky mortgages were not able to refinance and their only real option at that point was foreclosures. This time around, lending standards have remained at the tight end of historical ranges, while supply has languished at all time lows. And that demand supply mismatch is what's driving this increase in prices this time around. The second reason, we talked about affordability deteriorating more over the past 12 months than any year on record. That hit from affordability is just not as widely spread as it has been in prior mortgage markets, largely because most mortgages today are fixed rate. We're not talking about adjustable rate mortgages where current homeowners can see their payments reset higher. This time around a majority of borrowers have fixed rate mortgages with very affordable payments. And so they don't see that affordability pressure. What they're more likely to experience is being locked in at current rates, much less likely to list their home for sale and exacerbating that historically tight inventory environment that we just talked about. Jay Bacow: All right. So, you don't think we're going to have another housing bubble. Things aren't going to pop. So does that mean we're going to continue to set records? Jim Egan: I wouldn't say that we're going to continue to set records from here. I think that home prices and housing activity are going to go their separate ways. Home prices will still grow, they're just going to grow at a slower pace. Home sales is where we are really going to see decreases. Those affordability pressures that we've talked about have already made themselves manifest in existing home sales, in purchase applications, in new home sales, which have seen the biggest drops. Those kinds of decreases, we think those are going to continue. That lack of inventory, the lack of foreclosures from what we believe have been very robust underwriting standards, that keeps home prices growing, even if at a slower pace. That record level we just talked about? That was 20.6% year over year. We think that slows to 10% by December of this year, 3% by December of 2023. But we're not talking about home prices falling and we're not talking about a bubble popping. Jim Egan: But with that backdrop, Jay, you cover the agency mortgage backed securities markets, a large liquid way to invest in mortgages, how would you invest in this? Jay Bacow: So, buying a home is generally the single largest investment for individuals, but you can scale that up in the agency mortgage market. It's an $8.5 trillion market where the government has underwritten the credit risk and that agency paper provides a pretty attractive way to get exposure to the housing outlook that you've described. If housing activity is going to slow, there's less supply to the market. That's just good for investors. And the recent concern around the Fed running off their balance sheet, combined with high inflation, has meant that the spread that you get for owning these bonds looks really attractive. It's well over 100 basis points on the mortgages that are getting produced today versus treasuries. It hasn't been over 100 basis points for as long as it has since the financial crisis. Jim, just in the same way that you don't think we're having another housing bubble, we don't think mortgages are supposed to be priced for financial crisis levels. Jim Egan: Jay, thanks for taking the time to talk. Jay Bacow: Great speaking with you, Jim. Jim Egan: 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.

16 Jun 20225min

With concern high over inflation and tightening Fed policy, investors looking for practical solutions may want to take another look at the municipal bond market.-----Transcript-----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, June 15th, at 10 a.m. in New York. It's been a tough few days for markets. With last week's inflation data showing yet another surprisingly high reading, both stock and bond markets have been selling off. The concern is that the Fed may have to get more aggressive in hiking rates in order to bring inflation under control. That would mean slower economic growth, which is a challenge for companies and stocks, and higher interest rates, which needs to be reflected in lower bond prices and higher bond yields. Understandably, investors are looking for practical solutions. One place we continue to favor is the muni bond market. It's been a volatile performer this year, and it's true that recently bonds haven't been a haven from broader market volatility. And that bumpy performance could go on a bit longer for munis as bond yields rise to price in a more aggressive Fed path. But that should change once the Fed's intentions are better understood. Plus, the coupons of most munis are tax exempt, something that provides extra value for investors who are keeping an eye on developments in Washington, D.C., where negotiations are gaining momentum on a package to raise taxes, to pay for investments in clean energy, health care and paying down the national debt. This means an already solid taxable equivalent yield of over 5% for investors in the top tax bracket, could improve further if D.C. acts to hike taxes. Of course, the rising recession risk from the Fed raising rates may have you concerned about muni credit quality, but in our view muni credit should be quite durable even if there is a recession. By our calculation, muni sectors got more federal aid than they needed to deal with the impacts of COVID, and the sharp economic recovery since then had mostly returned muni business activity and revenue growth to pre-COVID or better levels. And even if inflation persists, history suggests this shouldn't be a system wide credit challenge. Sure, municipalities' costs will go higher, but so would their revenues. So putting it together, bonds are probably a decent spot for investors to shelter during this volatility, and we think munis stand out among your bond options. 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.

15 Jun 20222min

As central bank policy across the globe shifts from tight fiscal policy to tight monetary policy, the rising cost of capital will have long-term consequences for investors.-----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 the rising cost of capital and its implications for European equities. It's Tuesday, June the 14th, at 2 p.m. in London. As we have discussed previously, we believe that we have witnessed a paradigm shift in the macro and market backdrops over the past couple of years, swapping the secular stagnation of the last decade with a new cycle where nominal growth is both higher and more volatile. An alternative way to think about this is that the policy dynamic has shifted from an environment of loose monetary and tight fiscal policy over the last two decades, to one of looser fiscal policy, but tighter monetary policy today. If this characterization proves to be true over the coming years, the longer term consequences for investors will be profound. While this may sound somewhat grandiose, it is worth noting that global interest rates fell to a record low in this last cycle. From such an unprecedented low, even a moderate increase in borrowing costs may feel significant, and we note that we have just witnessed the largest 2 year increase in 10 year U.S. Treasury yields since the early 1980s. The fact that we are starting a new and relatively fast rate hiking cycle, at the same time as central banks are shifting from quantitative easing to quantitative tightening, further magnifies the risk for spread products such as credit or peripheral debt, both of which have underperformed materially over the last couple of months. At this stage, we think it is this dynamic that is arguably weighing most on equity markets rather than the economic impact of higher borrowing costs. When thinking through the investment implications for European equity markets of this rise in the cost of capital, we make three points in ascending order of impact. First, the consequences of higher borrowing costs are likely to produce a relatively small hit to corporate profits. While we are concerned about a significant decline in corporate margins over the coming quarters, this is predominantly due to higher raw material prices and rising labor costs. In contrast, even a doubling of the effective interest rate on corporate debt should only take around 2.5% off of total European earnings. Second, we see a more significant impact from higher capital costs on equity valuations, as price to earnings ratios have exhibited a close negative correlation to both central bank policy rates and credit spreads over time. Hence, while European equity valuations are now beginning to look reasonably attractive after their decline this year, we think risks remain skewed to the downside over the summer, given a tricky backdrop of slowing growth, high and sticky inflation and hawkish central banks. Finally, the most significant impact from higher borrowing costs will, as ever, be felt by those entities that are most levered or require access to fresh funding. At this stage, we do not expect the ongoing increase in funding costs to generate a broader systemic shock across markets. However, we do see ample scope for idiosyncratic issues to emerge in the months ahead. Logically, identifying these issues in advance primarily requires due diligence at the stock level. However, from a top down perspective, the European sectors that are most correlated to credit spreads, and or have the weakest balance sheets, include autos, banks, consumer services, food retailing, insurance, telecoms and utilities. Ultimately, the volatility within asset markets that will accompany the largest upward shift in the cost of capital in over 30 years will create lots of opportunities for investors. However, for now, we recommend patience and await a better entry point later in the year. 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.

14 Jun 20223min

With consumer sentiment hitting an all time low due to inflation concerns, the question investors should be asking is, are these risks to the economy properly priced into the market?-----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, June 13th, at 11 a.m. in New York. So let's get after it. Over time, the lion's share of stock returns is determined by earnings growth if one assumes that valuations are relatively stable. However, valuations are not stable and often hard to predict. In our experience, most investors don't spend nearly as much time trying to predict multiples as they do earnings. This is probably because it's hard to do consistently, and there are so many methodologies it's often difficult to know if you are using the right one. For equity strategists, predicting valuations is core to the job, so we spend a lot of time on it. Our methodology is fairly simple. There are just two components to our method; 10 year Treasury yields and the equity risk premium. At the end of last year, we argued the P/E at 21x was too high. From our vantage point, both ten year Treasury yields and the equity risk premium appeared to be mispriced. Treasury yields are more levered to inflation expectations and Fed policy. At year end 10 year Treasuries did not properly reflect the risk of higher inflation or the Fed's reaction to it. Today, we would argue it's not the case. In fact, 10 year Treasury yields may be pricing too much Fed tightening if growth continues to erode and recession risks increase further. In contrast to Treasury yields, the equity risk premium is largely a reflection of growth expectations. When growth is accelerating, the equity risk premium tends to be lower and vice versa. At year end, the equity risk premium is 315 basis points, well below the average of 375 basis points over the past 15 years. In short, the equity risk remaining was not reflecting the rising risks to growth that we expected coming into this year. Fast forward to today and the equity risk premium is even lower at just 300 basis points. Given the rising risk of slowing growth in earnings, this part of the price earnings ratio seems more mispriced today than 6 months ago. At the end of the day, we think 3400 represents a much better level of support for the S&P 500 and an area we would consider getting bullish. Last Friday, consumer sentiment in the U.S. hit an all time low due largely to concerns inflation is here to stay. This has been one of our greatest concerns this year with respect to demand and one of the areas we received the most pushback. We continually hear from many clients that the consumer is in such great shape due to the excess savings still available in checking accounts. However, this view does not take into account savings in stocks, bonds, cryptocurrencies and other assets, which are down significantly this year. Furthermore, while most consumers have more cash on hand than pre-COVID, that cash just isn't going as far as it used to, and that is likely to restrain discretionary spending. Finally, we think it's important to point out that the latest reading is the lowest on record, and 45% lower than during the last time the Fed embarked on such an aggressive tightening campaign, and was able to orchestrate a soft landing. In other words, the consumer was in much better shape back then, and that probably helped the economy to stabilize and avoid a recession. Let's also keep in mind that inflation was dormant in 1994 relative to today and allowed the Fed to pause, a luxury they clearly do not have now given Friday's red hot Consumer Price Index report. Bottom line, the drop in sentiment not only poses a risk to the economy and market from a demand standpoint, but coupled with Friday's CPI print keeps the Fed on a hawkish path to fight inflation. In such an environment, we continue to recommend equity investors keep a defensive bias with overweighting utilities, health care and REITs until the price or earnings expectations come down further. 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.

13 Jun 20223min

As inflation continues to rise beyond expectations, the Fed is set to meet next week, leaving markets to wonder if an acceleration in rate hikes might be in store this summer.-----Transcript-----Welcome to Thoughts on the Market. I'm Robert Rosner, Senior U.S. Economist for Morgan Stanley Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about this morning's inflation data and how that may impact Fed discussions at next week's FOMC meeting. It's Friday, June 10th, at 2 p.m. in New York. This morning, we received the Consumer Price Index data for May that showed a faster than anticipated increase in both headline and core inflation. Inflation continues to be lifted by high food and energy prices, and the combination of the two have pushed inflation up to a new high on a year over year basis, to. 8.6%. That rise in inflation reflects not just gains in food and energy prices, but extremely broad based increases under the surface, with core goods prices continuing to reaccelerate and core services prices also remaining strong, reflecting continued upside in travel related airfares and hotels. While other factors like rents and owners' equivalent rents both jumped. Rents in particular posted their fastest sequential month on month pace of increase since 1987. That's really impo the Fed next week because this sets a tone of inflation that remains very elevated as the Fed sits down to discuss its policy. Moreover, many, including ourselves, had been expecting that the peak for inflation on a year over year basis would have been registered back in March. But today's data showed that CPI has reached a new high on a year over year basis. That raises uncertainty about the outlook for inflation. And Fed policymakers have expressed some concern about the possibility for some underlying reacceleration in inflation. We also saw at the same time that data from the University of Michigan Survey of Consumer Sentiment showed that both short and longer term household expectations for inflation have been on the rise. So the risks around inflation remain high, and as the Fed sits down next week policymakers are likely to see inflation as remaining a top of mind topic. We have been expecting the Fed to pursue a series of 50 basis point rate hikes as the FOMC seeks to tighten financial conditions in order to slow demand and eventually slow inflation. And markets after the inflation data moved very quickly to price in an even more hawkish path for Fed policy, with some risk that a 50 basis point rate hike might not be enough and that there might be some chance that the Fed could deliver a 75 basis point rate hike at some point over the summer. We'll hear from policymakers next week as to whether or not an acceleration in the pace of rate hikes is something that they see as an attractive option. But the bottom line here is the Fed's work is far from done. Inflation remains high, incoming data suggests that growth has moderated, but has not slowed enough to feel confident that inflation is likely to follow. It's going to be a tricky summer for Fed policymakers, and a tricky summer for data watchers as well, because each incremental inflation data point is likely to inform how Fed policymakers are likely to react and what that path for rate hikes is likely to look like over the summer and into the fall. Thank you 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.

10 Jun 20223min

While many investors may be curious to know what other investors are thinking about current and future market trends, there’s a lot more to the calculation of investor sentiment than one might think.-----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 Thursday, June 9th, at 6 p.m. in London. I've found that investors are almost always interested in what other types of investors are doing. Some of this is curiosity, but a lot of it is interest in sentiment and a desire to try to quantify market emotion to give a better indicator of when to buy or sell. One can find a variety of metrics that portend to reflect this investor mood. Many of them move in nice, big, oscillating waves between fear and greed. But as anyone trying to use them as encountered, investing based on sentiment is harder in theory than practice. The first challenge, of course, is that there is little agreement in professional circles on exactly the best way to capture market emotion. Is it different responses to a regular investor survey? Is it the level of implied volatility in the market? Is it the flow of money in and out of different funds? The potential list goes on. Next, once you have an indicator, what's the right threshold to establish if it's telling you something is extreme? If you poll a thousand investors every week, maybe 70% of those investors being negative tells you the mood is sufficiently sour. But maybe the magic number is 80%, or maybe it's 60%. Defining positive or negative sentiment isn't always straightforward. Finally, there's the simple but important point that sometimes the crowd is right. Think of a long bull market like the 1990s. People were often optimistic about the stock market and correct to think so as prices kept rising. Meanwhile, people are often bearish in a bear market. We remember the dour mood that persisted throughout 2008. It certainly didn't stop stocks from going down. With all of this in mind, our research is focused on finding some ways to use sentiment measures more effectively. We think it makes sense to use a composite of different indicators, as true extremes are likely to show up across multiple approaches to measurement. Valuing both the level and direction of sentiment can be helpful. Rather than trying to catch an absolute extreme or market bottom, the best risk reward is often when sentiment is negative but improving. And sentiment is more useful to identify market lows than market peaks, as negativity and despair tend to be stronger, sharper emotions. Identifying peak optimism, at least in our work, is much harder. So don't beat yourself up if you can't find a signal that consistently flags market tops. Those ideas underlie the tools that we've built to try to turn market sentiment into signals as the age old debate around the true state of fear and greed continues throughout this year. 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.

9 Jun 20223min