End-of-Year Encore: Space Investing

As earnings season kicks off, market valuations continue to trend high based on major growth expectations. However, investors may want to keep an eye on liquidity.----- 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, July 10th at 11 a.m. in New York. So let's get after it. With year to date U.S. equity returns driven nearly 100% by higher valuations, the market either doesn't care about earnings or it expects a major reacceleration in growth both later this year and next. One might argue that the higher valuations are anticipating the end of the Fed's rate hiking campaign, even though the bond market doesn't seem to agree with that conclusion, given the recent rise in yields. In short, the price earnings ratio for the S&P 500 is up approximately 15%, and with interest rates up this year, the equity risk premium has collapsed by 100 basis points to its lowest level since the tech bubble era. With second quarter earnings season beginning this week, 'better than feared' likely isn't going to cut it anymore. While earnings results so far this year remain right on track for the sharp earnings recession we forecast, we don't expect second quarter earnings to disappoint expectations in aggregate, given second quarter estimates have now been revised lower by 7.5% since the beginning of the year. Instead, we would point out that the consensus bottom-up second quarter EPS forecast for the S&P 500 is -7% year over year, hardly exciting. Furthermore, the consensus pushed out the trough earnings per share growth quarter from the first quarter to the second quarter over the last three months. We expect this trend to continue through the balance of the year, which would also be in line with our forecast. In other words, no big second half recovery as the consensus and valuations now expect. More specifically, third quarter is when our forecast starts to meaningfully diverge from the consensus. This means the key driver for stocks during this earnings season will come via company guidance for the out quarter rather than the second quarter results. We suspect some companies will begin to walk down the estimates, while others will continue to tell a more optimistic story. In short, this earnings season should matter more than the prior two, and should provide significant alpha opportunities for investors in terms of both longs and shorts. In our view, the year to date multiple expansion has occurred for a couple of reasons beyond earnings growth optimism. One, excess liquidity provided by global central banks amid a weaker U.S. dollar and the FDIC bail out of depositors. And two, excitement around artificial intelligence’s potential impact on productivity and earnings growth. On the liquidity front we think that support is starting to fade. One way of measuring liquidity is global money supply in U.S. dollars. One of the reasons we turned tactically bullish last October was due to our view that the U.S. dollar was topping. This, along with the China reopening and the Bank of Japan's monetary policy actions, added close to $7 trillion to global money supply over the following six months. We've pointed out previously that the rate of change on global money supply is correlated to the rate of change on global equities, as well as the S&P 500. Over the past few months, global money supply in U.S. dollars has begun to shrink again, just as the Treasury begins to issue over a trillion dollars of supply to restock its coffers post a debt ceiling resolution last month. As an early indicator that market liquidity is fading, nominal ten-year yields broke out last week above the psychologically important 4% level, and real rates are making new cycle highs. Interest rate volatility also picked up as uncertainty about the Fed's next moves increased. Neither higher interest rate levels nor volatility are generally conducive to higher equity valuations. Bottom line, with earnings season upon us, we aren't expecting any fireworks from the earnings reports directly. However, with expectations for growth now much higher than six months ago, we suspect it will be a 'sell the news' event for many stocks, no matter what the companies post, as the market begins to look ahead to what is likely going to disappoint lofty expectations. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

10 Jul 20233min

Though the debate around the global strength of the dollar in currency markets continues, the dollar’s current high yield in a world of weak global growth could help it appreciate----- Transcript -----Welcome to Thoughts on the Market. I'm James Lord, Morgan Stanley's Head of Foreign Exchange and Emerging Market Strategy. Along with my colleagues bringing you a variety of perspectives, today, I'll be discussing the status of the U.S dollar within global foreign exchange or FX reserves. It's Friday, July 7th, 3 p.m. in London. The debate about the dollar's status as the world's dominant currency usually resurfaces during every business cycle, and as our world increasingly transitions from globalized toward a multipolar model, this debate appears more relevant. Indeed, some economic actors are already de-risking their currency reserves away from the dollar, promoting the use of local currencies as an alternative in international trade and trying to reduce the dollar's global role through other means. Yet, this debate is usually a distraction from determining where the dollar is headed. In contrast to the popular narrative, we believe the dollar can appreciate, even if its use as a reserve currency or invoicing currency in international trade declines. Let's first address the dollar's status as the world's dominant central bank reserve currency. The purpose of FX reserves is to bolster the external stability of an economy and enable central banks to act as lenders of last resort to those in demand of foreign currency. It's intuitive to think that reserve choices might therefore be correlated with the value of currencies themselves, yet relying on that intuition would not have served you well in recent history. Case in point, while the dollar remains the world's dominant reserve currency, its share has dropped by around 20% over the last 20 years, most rapidly over the last ten. Nevertheless, over the last decade, the dollar has been one of the world's strongest currencies, with the Fed's real broad dollar index reaching a near 20 year high in October 2022. The dollar's declining share of global FX reserves has not been relevant in figuring out where the dollar is heading, in part because FX reserve managers are less influential in currency markets today, but more importantly, because other investors have favored U.S. assets. To be clear, this does not mean that watching trends in FX reserves is not important. A sudden, sharp decline in the market share of a reserve currency could well be driven by a sudden loss of confidence in the macroeconomic stability of an economy, diminishing its attraction as an investment destination. If so, the currency of that economy would likely decline. This concern has not driven the decline of the dollar's share of global FX reserves in recent years, as evidenced by its continued strength. Moreover, U.S. assets retain unique appeal for global capital, as the recent boom in U.S. tech stocks and rising optimism about the productivity enhancing implications of A.I show.Meanwhile, the dollar provides one of the highest yields of the world's major currencies, thanks to the Fed's hiking cycle. In a world of weak global growth, this yield will also likely help the dollar to appreciate. For clues about the future direction of exchange rates, we would be watching for signs that investment opportunities in different economies are improving. For now, the dollar offers attractive yields and remains a safe harbor during the current period of slow global economic growth. 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.

7 Jul 20233min

Artificial intelligence could help biopharmaceutical companies reduce costs as well as improve their chances of developing successful new drugs.----- Transcript -----Welcome to Thoughts on the Market. I'm Terence Flynn, Morgan Stanley's Head of U.S. BioPharma Research. Along with my colleagues bringing you a variety of perspectives, today, I'll focus on how artificial intelligence and machine learning can reshape the health care sector. It's Thursday, July 6th at 10 a.m. in New York. As we've discussed on this podcast, Tech Diffusion is one of the big three themes we at Morgan Stanley Research are following this year. The other two being the Multipolar World and Decarbonization. As a quick reminder, by tech diffusion, we mean the process by which any transformative technology is adopted widely by consumers and industries. When it comes to the healthcare sector, it's still early but we believe artificial intelligence and machine learning adoption is poised to accelerate significantly. The biopharma industry specifically is moving to unlock the potential of A.I across multiple areas, including drug discovery, clinical development, manufacturing and physician patient engagement. We see two broad areas where A.I enabled investments in drug development could drive significant value in the biopharma space. One is direct cost savings, so think of improved R&D margins, for example. And two is increased probability of success of pipeline programs. Here we estimate that even small improvements in the probability of success could drive significant value. Now, let me put some numbers around this. Over the past ten years, the FDA has granted 430 new drug approvals or about 43 per year. We estimate that every two and a half percentage point improvement in early stage development success rates could lead to an additional 30 new drug approvals over the course of ten years, or nearly a 10% boost. Assuming that each incremental approved drug generates over 600 million in peak sales, we estimate that 60 additional therapies approved over a ten year period would translate into an additional 70 billion in drug development and PV for the biopharma industry. However, biopharma is not the only health care subsector that's poised to benefit from A.I.. Looking at health care services and technology, A.I represents an opportunity to drive meaningful change in efficiency in how care is delivered. A.I tools have predictive capabilities that could be used for early diagnosis and detection of disease, which could lead to improved clinical outcomes and patient experience and reduce the cost of care over time. Many health systems have already begun to migrate data from on premises to the cloud, an important step for capturing the full benefits of A.I. We will continue to monitor further developments in health care, both near-term and long term, and will provide you with our latest analysis and insights. 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.

6 Jul 20232min

With the U.S. possibly imposing tighter trade policies towards China, investors may want to look into diversifying their investments.----- Transcript -----Welcome to the 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 U.S., China relationship and its impact on markets. It's Wednesday, July 5th at noon in New York. In recent weeks, the Biden administration has focused on the U.S. relationship with China. Treasury Secretary Yellen is headed to Beijing this week for meetings with senior officials in China, following on Secretary of State Blinken's recent visit. Whenever these diplomatic efforts pick up, investors tend to ask if it's a sign that there could be a softening or even a reversal in policy choices by the U.S. in recent years to create more rules and barriers to trade in certain higher tech industries. The interest is because these moves drove concern among many investors that multinational companies would have a harder time doing business in China in the future. But in our view, these policies are not going to reverse, but rather will likely become tighter. Consider that the stated goal of these meetings was to open regular communication channels on economic and security issues. It's obviously important for countries to have regular communication to avoid misunderstandings spiraling into conflict. But this appears to be where the ambition for these meetings ends. There's no more talk of reaching comprehensive free trade agreements, for example. Given that context, it makes sense that we're continuing to see news reports that the Biden administration is preparing fresh non-tariff barriers which would impact China. This includes further tightening export controls on semiconductors in an attempt by the U.S. to protect its technical advantage in an industry that's critical to both its economic and national security. It also includes long awaited outbound investment restrictions, which could crimp foreign direct investment into China. To be clear though, none of this is the same as a hard decoupling of the U.S. and China economies, nor would it have the related shock effect on global markets. The effects here are likely to be incremental adjustments by companies over time to deal with these policies. This is why, for example, we've seen many multinationals announce their diversifying they’re supply chains by investing in new geographies like Mexico and Turkey. But for the most part, they're not pulling existing resources out of China. Given all of that, investors may want to react to this nuanced situation by incrementally shifting international equity allocations to countries whose stock markets have solid valuations and may also benefit from companies' new supply chain investments. Japan in particular stands out to our colleagues in equity strategy, and Mexico and India also appear to be solid options longer term. 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.

5 Jul 20232min

Original Release on June, 15th 2023: With more Asian economies on pace to join the recovery path set by China, confidence in economic outperformance versus the rest of the world is rising. ----- Transcript -----Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist at Morgan Stanley. Along with my colleagues bringing your variety of perspectives, today I'll be discussing our mid-year outlook for Asia's economy. It's Thursday, June 15 at 9 a.m. in Hong Kong. Asia's recovery is for real. We believe its growth outperformance has just started. We expect a full fledged recovery to build up over the next two quarters across two dimensions. First, we think more economies in the region will join the recovery path. Second, the recovery will broaden from services consumption to goods consumption and in the next six months to capital investments, or CapEx. We see Asia's growth accelerating to 5.1% by fourth quarter of this year. There are three main reasons why we expect this growth outperformance for Asia. First, Asia did not experience the interest rate shock that the U.S. and Europe did. Asian central banks did not have to take rates through restrictive territory because inflation in Asia has not been as intense. Plus, Asia's inflation has already declined and we expect 80% of region’s inflation will get back into central bank's comfort zone in the next 2 to 3 months. The second reason is China. While China's consumption recovery is largely on track, we have seen downside in the last two months, in investment spending and the manufacturing sector. We believe policy easing is imminent as policymakers are keen on preventing a deterioration in labor market conditions and on minimizing social stability risks. Easing should help stabilize investment spending and broaden out the recovery in back half of 2023. Beyond China, India, Indonesia and Japan will also contribute significantly to region's growth recovery. India is benefiting from cyclical and structural factors. Cyclically beating healthy corporate and banking system balance sheets mean India can have an independent business cycle driven by domestic demand, and we are seeing that appetite for expansion translating into stronger CapEx and loan growth. As for Japan, it is in a sweet spot, having decisively left the deflation environment behind, but not facing runaway inflation. Accommodative real interest rates are helping catalyze private CapEx growth, which has already risen to a seven year high. And, in another momentous shift, Japan's nominal GDP growth is now rising at a healthy pace after a long period of flatlining. Finally, we believe Indonesia will be able to sustain a 5% pace of growth. Indonesia runs the most prudent macro policy mix amongst emerging markets. In particular, the fiscal deficit has been maintained below 3%, since the adoption of the fiscal rule and has only exceeded that in 2020 during the worst of the pandemic. This has resulted in a consistent improvement in macro stability indicators and led to a structural decline in the cost of capital supporting private domestic demand. The risks to our next 12 month Asia outlook are hard landing in the U.S., which Morgan Stanley's U.S. economists think it's unlikely and a deeper slowdown in China. But we believe China's recovery will only broaden out in the second half of 2023. And given this, we feel confident about our outlook for Asia's outperformance in 2023 vis-à-vis rest of the world. 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.

3 Jul 20233min

Original Release on June, 6th 2023: Consumers in the U.S. are largely returning to pre-COVID spending levels, but new behaviors related to travel, credit availability and inflation have emerged.----- Transcript -----Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley U.S. Equity Strategy Team. Sarah Wolfe: And I'm Sarah Wolfe from the U.S. Economics Team. Michelle Weaver: On this special episode of the podcast, we're taking a look at the state of the U.S. consumer as we approach the midyear mark. It's Tuesday, June 6th at 10 a.m. in New York. Michelle Weaver: In order to talk about where the consumer is right now, let's take it back two and a half years. It's January 2021, and households are slowly emerging from their COVID hibernations, but we're still months away from the broad distribution of the vaccine. Consumers are allocating 5% more of their wallet share to goods than before COVID, driving record consumption of electronics, home furnishings, sporting goods and recreational vehicles. All the things you needed to make staying at home a little bit better. Our U.S. economists at Morgan Stanley made a high conviction call in early 2021 that vaccine distribution would flip the script and drive a surge in services spending and a payback in goods spending. Sara, to what extent has this reversion played out and where do you think the U.S. consumer is now? Sarah Wolfe: The reversion is definitely played out, but there's been some big surprises. Basically, the spending pie has just been greater overall than expected, and that's thanks to unprecedented fiscal stimulus, excess savings and significant supply shortages. So we've not only seen a shift away from goods and toward services, but a much larger spending pie overall. The result has been a 13% surge in goods inflation over nearly three years, an acceleration in services inflation, and a return to pre-COVID spending habits that's much greater in real spending terms than in nominal terms. So if we look in the details, where has the payback been the largest? We've seen the biggest payback in home furnishing, home equipment, jewelry, watches, recreational vehicles, but we've seen the most robust recovery in discretionary services like dining out, going to a hotel, public transportation and recreational services. Michelle Weaver: Sara, has the recent turmoil in the banking sector affected the U.S. consumer and do you think there's a credit crunch going on right now? Sarah Wolfe: Bank funding costs have risen meaningfully and are expected to rise further, leading to tighter lending standards, slower loan growth and wider loan spreads. But let me be clear, this is not a credit crunch, nor do we expect it to be. We think about the pass through from tighter lending standards to the consumer to ways directly and indirectly. The direct channel is tighter lending standards for loans on consumer products, including credit cards and autos, and indirectly through tighter lending standards for businesses, which has knock-on effects for job growth. We've already seen the direct channel of consumer spending in the past year, as interest rates on new consumer loan products hit 20 to 30-year highs, raising overall debt service costs and forcing consumers to reduce purchases of interest sensitive goods. Dwindling supply of credit as banks tighten lending standards is also dampening consumption. Michelle Weaver: Great. And given that credit is getting a little bit tougher to come by, can you tell us what's happening with savings and what's happening with the labor market and labor income? Sarah Wolfe: This is very timely. Just a few days ago, we got a very strong jobs report for May. I think that this really supports our call for a soft landing, and even though consumers are increasingly worried about the economic outlook, about financial prospects, it's clear that we still have momentum in the economy and that the Fed can achieve its 2% inflation target without driving the unemployment rate significantly higher. We are seeing under the details that consumer spending is slowing, there's a pullback in discretionary happening, there's a bit of trade down behavior. But with the labor market remaining robust, it's going to keep spending afloat and prevent this hard landing scenario. Michelle, let me turn it to you now, let's drill down into some specifics. What are the latest spending trends around spending plans you're seeing in your consumer survey? Michelle Weaver: Sure. So consumers expect to pull back on spending for most categories that we asked them about over the next six months. And the only categories where they expect to spend more are necessities like groceries and household products. We also added two new questions to this round of the survey to figure out which discretionary categories are most at risk of a pullback in spending. We asked consumers to order categories based on spending priority and identify categories where they would pull back on spending if forced to reduce household expenses. We found that travel and live entertainment were most at risk of a pull back, and this isn't just a case of income groups having different attitudes towards spending, we saw similar prioritization across income cohorts. Sarah Wolfe: So you mentioned travel, travel's been in a boom state in the post-COVID world. But you're saying now that households are reporting that they would pull back if they needed to. Are we seeing that already? What do we expect for summer travel? What do we expect for the remainder of the year? Michelle Weaver: So the data I was just referencing was if you had to reduce your household expenses, how would you do it? And travel was identified there. So that's not a plan that's currently in place. But summer travel may be a bit softer this year versus last year. In our survey, we asked consumers if they're planning to travel more, the same amount or less than last summer, and we found that a greater proportion of consumers are planning to travel less this year. Budgets are also smaller for summer travel this year, with more than a third of consumers expecting to spend less. We're seeing a mixed picture from the company side. Airlines are seeing very strong results still, and Memorial Day weekend proved to be very strong.. But the data around hotels has started to weaken and the revenue per available room that hotels have been able to generate has been pretty choppy and forward bookings that hotels are seeing have actually been flat to down for the summer. Demand for resorts and economy hotels has fallen but demand for urban market hotels still remained very strong. Sarah, how does this deceleration, both services and goods growth play into your team's long standing argument for a soft landing for the economy? Sarah Wolfe: It's really the key to inflation coming down and avoiding a hard landing. With less pent up demand left for services spending and a strong labor market recovery, supply demand imbalances in the services sector are slowly resolving themselves. We estimate that there's a point three percentage point pass through from services wages to core core services inflation throughout any given year. Core core services, is services excluding housing inflation. So with compensation for services providing industries already decelerating for the past five quarters, we do expect the largest impact of core services inflation to occur in the back half of this year. So that's going to see a more meaningful step down in inflationary pressures later this year. This combined with a rising savings rate, so a shrinking spending pie, means that there's just going to be less demand for goods and services together this year. Altogether, it will enable the Fed to make progress towards its 2% inflation target without driving the economy into a recession. Michelle Weaver: Sarah, thank you for taking the time to talk. Sarah Wolfe: It was great speaking with you, Michelle. Michelle Weaver: 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.

30 Jun 20237min

A surprising increase in the sale of new homes doesn’t mean that overall demand for housing is on the rise. Find out what to expect for the rest of the year.----- Transcript -----Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. Jay Bacow: And I'm Jay Bacow, the other Co-Head of U.S. Securitized Products Research. Jim Egan: And on this episode of the podcast, we'll be discussing the U.S. housing market. It's Thursday, June 29th at 11am in New York. Jay Bacow: All right, Jim. We put out our mid-year outlook about a month ago, and since we put out that outlook, we've had a breadth of housing data and it feels like you can pick any portion of that housing data, sales, starts, home prices and it's telling a different story. Which one are we supposed to read? Jim Egan: I think that's a really important point. The U.S. housing market right now is not a monolith, and there are different fundamental drivers going on with each of these characteristics, each of these statistics that are pushing them in different directions. Let's start with new home sales. I think that was the most positive, we could say the strongest print from the past month. The consensus expectation, just to put this in context, was a month over month decrease of 1.2%, instead, we got an increase of 12.2%. To put it succinctly, new home sales are basically the only game in town. Existing listings remain incredibly low. We've talked about affordability deterioration on this podcast. We've talked about the lock in effect, the fact that the effective mortgage rate for existing homeowners right now is over three points below the prevailing mortgage rate. That just means there's no inventory. If you want to buy a home right now, there's a much greater likelihood that it's a new home sale than at any point in the past 10 to 15 years. And new home sales were the only housing statistic in our mid-year forecast where we projected a year over year increase in 2023 versus 2022 because of these dynamics. Jay Bacow: All right. So that's the new home sales story. Does that mean that we're just, broadly speaking, supposed to expect more housing activity? Jim Egan: This is the single most frequent question that we've been getting the past two weeks because of this data that's come in. And what we want to be careful to do here is not conflate this growth in new home sales with a swelling in demand for housing. As we stated in the outlook, we expect the recovery in housing activity to be more L-shaped. This behavior is apparent in more higher frequency data points, purchase applications for instance. 2023 remains far weaker than 2022. Average weekly volumes are down 35% year-to-date versus last year, and they're really not showing much sign of inflecting higher. In fact, if we look at just May and June versus 2019 prior to the pandemic, purchase applications are down almost 40%. Now, comps will get easier in the second half of the year. Year-over-year decreases will come down, but total activity is not inflecting higher. This is also showing through existing home sales, which are not showing the same improvement as new home sales. Existing home sales are down 24% year to date versus 2022. Also pending home sales, which missed a little bit to the downside just this morning. Jay Bacow: Okay. So when I think about the process of housing activity at the end, you've got a home sale, existing home sale, a new home sale. At the beginning, you've got either people applying to buy a home or starting to build a home. And the housing start data, that was pretty strong relative expectations as well, right? Jim Egan: It was. And the dynamics that we're discussing here, fewer existing home sales and climbing new home sales, that's leading to new home sales making up a larger share of that total number. And subsequently, homebuilder confidence is growing as a result. We think you can view this large number as perhaps a manifestation of that confidence, but we also want to stress that you need to think about that starch number in terms of single unit starts versus multi-unit starts. And yes, single unit starts were stronger than we anticipated, but they were still down year-over-year and through the first five months of this year, they're down 23%. Again, as with most housing activity data, the year over year comps are going to get easier in the back half of this year. That year over year percent will fall. We think they'll only finish the year down about 12%. But that's still a starch number that looks more L-shaped than a strong recovery. On the other hand, five plus unit starts in May were higher than in any single month since 1986. Multi-unit starts are still really driving the bus here. Jay Bacow: Okay. So with that homebuilder confidence, what are homeowners supposed to be thinking? They just saw the first negative year-on-year print in home prices since 2012. Are we in a repeat of previous things or are things going to get better? Jim Egan: Look, we just actually, in the mid-year outlook process, upgraded our year end home price forecast from -4% in December of 2023 to flat in December of 2023 versus December of 2022. That being said, while making that upgrade, we maintained that home prices were going to turn negative this month for the first time since 2012. We believe it's going to be short lived, largely because of the dynamics that we've already been discussing on this podcast. Current homeowners are not incentivized to list their home for sale. Existing listings continue to be incredibly low. The past few months, they've actually resumed falling year-over-year. When you look at affordability it’s still challenged, but it's not getting worse. When you look at overall inventories, they're still close to multi-decade lows, but we're not setting new historic lows each month. All of that leads to even more support for home prices on a go forward basis. We're still confident in our 0% for the end of the year. We might spend a couple more months here in negative territory before we kind of rebound back towards that flat by the end of 2023. Jay Bacow: All right. So new home sales, surprised to the upside, but we shouldn't conflate that with swelling demand for housing. Home prices just trended negative, but we think that was expected and they're going to end the year flat versus 2022. Jim, 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.

29 Jun 20236min

How will corporate credit markets fare as the Fed keeps rates higher for longer? Look for wider spreads, further decompression and muted excess returns. ----- Transcript -----Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed-Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the outlook for corporate credit markets. It's Wednesday, June 28th at 11 a.m. in New York. Our economists are calling for one more 25 basis point rate hike in the upcoming Fed meeting in July and pause thereafter until the end of first quarter of next year. They're also calling for continued growth slowdown because of the policy tightening that we have seen over the last 15 months or so. A restrictive pause, which means rates staying higher for longer, and muted growth will weigh more on the performance of the corporate credit markets, especially as refinancing needs pick up. So our call is for wider spreads, further decompression and muted excess returns for corporate grade markets. Within credit we favor higher quality, which means investment grade credit over leveraged credit, both in bonds and in loans. Let's dig into some details. Industrial grade credit looks attractive from a duration lens, and we expect 7% plus total returns over the next 12 months. From a spread perspective, our base case target, a 150 basis point, calls for modest widening. Although risks are skewed to the downside in the recession bear case scenario to 200 basis points. We think the banking space looks cheap versus the market, especially money center banks. We favor single A's or triple B's and shortening of portfolio duration. Our preference is to own the front end of the curve within the investment graded space. Higher for longer puts more pressure on lower quality borrowers. While the macro outlook is not acutely challenging for credit, it progressively erodes debt affordability. For larger and higher quality borrowers, we expect the net impact to be gradual decline in interest coverage ratios and a voluntary focus on right sizing balance sheets. For smaller and lower quality companies, this adjustment could well be disruptive as 2025 maturity walls come into view. So even in leverage credit, we would look to stay up in quality. The layering of leverage and rate sensitivity in loans informs our preference for bonds in general relative to loans. We expect loan only structures to underperform mixed capital structures. We also expect sponsor commitment will be put to test. That said, higher quality names within the loan market are a way to benefit from the shape of the rates curve and generate better near-term carry. In all, we forecast wider spreads and higher default rates in the lower quality segments of the credit markets. Relative to the modest widening in the investment grade space within high yield and leveraged loans, we expect more significant widening in the range of 120 basis points of widening. This will result in marginally negative excess returns for these segments and will screen even worse when adjusted for volatility and downside risk. We forecast default rates pushing above long-run averages with loan defaults outpacing bond defaults, especially after accounting for distressed exchanges. 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.

28 Jun 20233min