Can US Dollar Dominance Continue?

Investors anticipate new legislation on tech regulation, AI and defense, amid speculation about a potential government shutdown.-----Transcription -----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 Congress coming back in the session and its impact on markets. It's Wednesday, September 6th, at 10 a.m. in New York. Congress returns from summer break this week with a full agenda. Expect to see tons of headlines on various policies that markets care about. Tech regulation, artificial intelligence regulation, defense spending, disaster relief aid and the risk of a government shutdown, are just some of the issues that should be tackled. It can be a bit overwhelming, so here's our cheat sheet for September in D.C. to help cut through the noise and understand why this could be a good set up for U.S bonds. On tech regulation and A.I, don't expect any meaningful movement here. New versions of legislative proposals on data privacy and liability for spreading misinformation may come, but there's still no comprehensive bipartisan agreement that could turn proposals into law. So we continue to expect that this only becomes possible after the 2024 election delivers a new government makeup. On defense spending, we expect that aid to Ukraine will continue and the Congress will approve overall defense spending levels in excess of the cap set by the agreement put in place alongside the hike of the debt ceiling. There's bipartisan agreement here, with the exception of House Republicans. Resolving issues with those holdouts will likely take brinkmanship over a government shutdown and perhaps even an actual government shutdown, but ultimately we see a deal that should be positive for a defense sector which has benefited recently by elevated spending by Western governments. The biggest story to track, though, is that risk of a government shutdown. As we previously discussed on this podcast, a shutdown is a real risk because House Republicans are not in sync with the rest of the House of Representatives and Senate on spending levels for fiscal 2024. Further, there's the sense that both sides may rightly or wrongly perceive political value in a shutdown. So there's both motive and opportunity here. And while a shutdown on its own is not sufficient to ruin our economists' expectation of a soft landing for the U.S. economy, it does add some fresh downside risk to growth in the 4th quarter, which economists already expect would be challenged. Major entertainment events in the U.S. boosted consumption above expectations this summer, and those effects should start to wane at the same time that the student loan moratorium rolls off, meaning many households will again have to direct some level of their income away from consumption toward servicing loans come October 1st. Put it all together, and it's a strong rationale for our view that high grade bonds have value here. U.S. government bond yields should be near their peak, with the market moving beyond the notion that the Fed may have to hike substantially more this economic 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.

6 Sep 20232min

While valuations may be on the rise, fears around the resiliency of the economy could return and leave unguarded investors on uneven footing.----- 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, September 5th at 10 a.m. in New York. So let's get after it. In a world of price momentum, opinions about the fundamentals are often driven by the direction of price. Some of this is due to the view that markets are all knowing and often the best leading indicator for the fundamentals. After all, stocks are discounting machines and tell us what's likely to happen in the future rather than what is happening today. The old adage "buy the rumor and sell the news", is another way to think about this relationship. Using this philosophy, the move higher in stocks this year has provided the confidence for many to turn fundamentally bullish from what was an overly bearish consensus backdrop in the first quarter. The entire move in the major U.S. equity averages this year has been the result of higher valuations. However, with forward price earnings multiples reaching 20 times on the S&P 500 last month, not only are stocks anticipating higher earnings and growth, but they now require it. The other reason price momentum works has little to do with the fundamental outlook. Instead, price momentum often leads investors to chase or sell that momentum. It's human nature to want to go with the trend both up and down. Most were too negative on the economy at the beginning of the year, including us. The failure of a few large regional banks and negative price reaction in the stock market reinforced that view. However, when the recession didn't arrive, there was a fundamental reason to reverse that view. The price action in April and May supported that pivot, further feeding the bullish narrative. However, the move in price was very narrow, led by just a handful of Mega-cap growth stocks. In June, breadth improved, dragging investor confidence toward the optimistic fundamental outcome. But since then, breath has rolled over again and remains weak. We recommend maintaining a late cycle mindset, which means a barbell of growth stocks and defensive, not cyclicals or smaller stocks. Going into the second quarter earnings season we suggested it would be a "sell the news event", mainly because stocks had rallied in the mid-July, which was a change from the past several quarters where stocks trended weaker into results. Now that earnings season is over, we know that the price reaction post reporting was some of the weakest we've witnessed in the past decade. We think stocks may be starting to question the sustainability of the economic resiliency we experienced in the first half of the year. Defensives and growth stocks have done better than cyclicals. As an aside, the earnings results have not kept pace with the economy this year outside of a few areas which have been driven mostly by cost cutting rather than top line growth which furthers the idea we are still late cycle, not early or mid. This past week, equity prices have rebounded sharply, led once again by growth stocks. With softer economic data weighing on Treasury yields, stock market participants seem willing to bid valuations back up on the view the late cycle environment is being extended once again. With inadequate evidence to affirm or contradict that view, price continues to be the governing factor for many investors' conclusions about where we are in the cycle. Bottom line price momentum is a key driver of sentiment, especially in a late cycle environment when uncertainty about the outcome is high. We continue to recommend a more defensive growth posture in one's portfolio given that the fears of recession or financial distress could return at any moment in the late cycle environment in which we find ourselves, particularly as we enter September. 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 help's more people to find the show.

5 Sep 20233min

Although back-to-school spending appears to be trending higher than in 2022, there are signs that U.S. consumers could feel pinched before the holiday season.----- Transcript -----Sarah Wolfe: Welcome to Thoughts on the Market. I'm Sarah Wolfe from Morgan Stanley's U.S. Economics Team. Simeon Gutman: And I'm Simeon Gutman, an Equity Analyst covering the U.S. Hard Lines, Broad Lines and Food Retail Industries. Sarah Wolfe: And on this special episode of the podcast, we'll focus on back to school shopping trends and what they suggest for the U.S. consumer outlook for the rest of the year. It's Friday, September 1st at 10 a.m. in New York. Simeon Gutman: Sarah, back to school shopping is in full swing as we go into the Labor Day weekend and end of the summer. As an economist who focuses on the U.S. consumer. I know you track it closely. Why is back to school shopping such an important indicator in general, and what is it suggesting about the overall health of the U.S. consumer? Sarah Wolfe: Back to school is a large shopping event across July and August each year, which is an event that is only as strong as the strength of the U.S. household. If households feel good about job prospects and inflation is not eating away at their buying power, you should see that reflected in back to school sales. If we go back to summer 2022, headline inflation was 8% going into back to school shopping, and there were lingering concerns about COVID disrupting school. In 2023, certain headwinds to the consumer are risks to spend, these include higher debt service costs, tighter lending standards and a student loan moratorium expiring in October, but a still strong labor market and abating inflationary pressures that have supported a recovery in real wages should outweigh the downside risk and lead to a moderate back to school spending year. So what does this all mean for what we're seeing in the data? Our early read on July back to school shopping and in-store sales is that they're going to be weaker than the historical average, however, August matters most. If we see August sales in line with the historical average, then back to school sales for 2023 on a year-over-year basis would be quite a bit stronger than 2022 still, but roughly in line with the historical run rate from 2011 to 2019. This jives with our early readings from our AlphaWise Consumer Poll survey that this year back to school shopping is looking stronger than last year, but it is not a blowout. Simeon Gutman: And how about end of year holiday spending? Is back to school a predictor of holiday spending trends? Sarah Wolfe: Back to school shopping is indeed a predictor of holiday shopping trends. However, the early read through to holiday shopping points to a holiday season that's actually weaker than 2022, but in line with the historical run rate as well. Total retail sales on a non seasonally adjusted basis across November and December have been 8% year-over-year from 2011 to 2019 in 2021, the growth was 33% and 2022 was 12%. This was due to stronger than usual demand for goods as a result of COVID and stimulus. So while the consumer remains relatively healthy and is spending more on back to school shopping than last year, it'll be tough to beat 2022 holiday shopping growth. The preliminary forecast for holiday shopping is to see growth in line with the historical run rate, but weaker than next year. We still get a couple more retail sales reports that are going to help us fine tune our holiday shopping forecast. Simeon, turning it over to you, what specific trends are you observing during this back to school shopping season? Simeon Gutman: So far, it's mixed. On the surface, it looks like the consumer is healthy. If we look at durable goods spending the last couple of months, we have June and now July, low 2% range. That's decent. But under the surface, it's a bit of a different story. If you look at the Q2 comps across the coverage universe, they were roughly flat. That's not a great indicator of spending. And we see a shift towards consumables and supplies and must haves. Consumers are not prioritizing discretionary items. Big ticket items are under pressure. The companies that are growing and doing well, they look like they're taking market share, there's a shift towards value, so discount stores, dollar stores, off price stores, and it looks like it's a story of product categories, beauty and auto parts. What we've seen specifically for back to school, July was a strong month, but there was potentially some pull forward from earlier in the season. August seems to be good, but may have slowed a little and we'll see about September. But consumers are definitely shopping more on occasion and it's been a little bit choppy. Sarah Wolfe: These are great insights, Simeon, on how consumer behavior is slowly evolving as the macro backdrop becomes a little bit tougher. You've also highlighted electronics as one particular area that appears most at risk. What exactly does that mean and what's driving it? Simeon Gutman: So we conducted an AlphaWise survey, that Morgan Stanley did about a month ago, that suggests electronics have the most risk. We had a net neutral spending intention from consumers year-over-year. In contrast to other categories, we asked about clothing and apparel had a 21% net positive spending intention while school supplies was also positive 12%. The largest public company in the electronics space, they posted a -6% same store sales number in their recent quarter on top of a pretty big negative number the prior year. So it underscores the survey. The only caveat, and maybe a silver lining is, there is chatter about units in electronics beginning to bottom, so there could be some silver lining. Sarah Wolfe: Finally, Simeon, if we were to widen the lens a bit, how have back to school shopping trends evolved over the last 5 to 10 years? And what is your longer term outlook for what lies ahead in terms of potential future trends? Simeon Gutman: Drum roll, please. Not much. It doesn't seem that we've gotten a big shift in spending. So we looked back over the last ten years at the percentage of spend that consumers have made over the July, August and September timeframe, which captures the back to school season. As a percentage of retail sales, it's surprisingly consistent in the 24 to 25% range. In this kind of COVID post-COVID era, we've seen it tick up a bit, but this makes sense because the consumer has shifted spend from services to goods. So it's run rating around 25%, but as we've seen reversion in other categories, we think this will moderate as well. So our future prediction would be consistent with the prior trend line; it doesn't seem to be trading off sales with other periods, including the holiday. The one trend we have seen is e-commerce penetration is rising, in this timeframe for both non store retailers and for physical retailers who have seen a higher mix of online sales. But as far as the future goes, we don't expect a big change. Sarah Wolfe: Simeon, thanks for taking the time to talk. Simeon Gutman: Great speaking with you, Sarah. Sarah Wolfe: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

1 Sep 20236min

While recent news of a potential debt deflation loop in China’s equity market is causing concern for investors, Japan’s equity market resilience may bring optimism.----- Transcript -----Welcome to Thoughts on the Market. I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the Japanese equity market vis-a-vis China. It's Thursday, August 31st at 9 a.m. in Singapore. We recently did a three part series on this show focusing on our economic and market outlook for Japan. We discussed a bullish view on Japan equities, which is driven by three powerful drivers of outperformance coming together, namely macro, micro and the transition to a multipolar world. Recently, however, there's been investor concern about the potential impact on Japan from a Chinese debt-deflation loop, that is a scenario where prices fall, debt rises and economic growth stagnates, and this is the risk that I will discuss today. As a reminder, our economists came into 2023 flagging Japan as a standout developed market for growth momentum. In contrast to a U.S and European slowdown, as Japan continues to benefit from COVID reopening, ongoing stimulatory policy and a competitive currency. Since then, we have seen upside surprises, such as in wages and capital investments amid what we see as confirmation of a move into a structurally higher nominal GDP growth path. Indeed, Japan's recent second quarter GDP figures confirmed that trend, with a surge in real and nominal GDP to 6% and 12% annualized respectively. Following this result, our economists have doubled their 2023 GDP forecast to 2.2%, and this stands in contrast to China's GDP growth trend, where our economists have been reducing forecasts and will see nominal GDP growth slow below that of Japan to 4.8% over the last year. So the key exception to a generally bullish picture for Japan has been its linkages to China. While this may appear to be a legitimate investor concern for the market as a whole, it's important to note that Japanese revenues are driven much more by the U.S and Europe, which together make up a quarter of total sales. Instead, China makes up just 5% less than many assume, and far lower than that of Singapore, Taiwan, Australia or South Korea. However, there are some pockets of China exposure that we note, including in semis and semi-cap equipment, electronic components and factory automation. Another reason for our optimism about Japan's equity market resilience amid the slowdown in China is that China exposed Stocks in Japan have almost fully unwound the outperformance seen during the early COVID zero and post-COVID reopening phases. In contrast, Asia-Pacific ex-Japan companies with high exposures to China, many of them in the technology or resources sector, stand close to their relative highs. So while we do see from here less upside to the aggregate MSCI Emerging Markets Index and the Tokyo Stock Price Index, known as TOPIX, after the post October rally, we do see good reason for Japanese equities to continue to outperform. Valuations on a 12 month forward basis are in line or slightly below their ten year historical averages, and we expect 10% earnings growth in 2023 and 2024 as that nominal GDP growth recovery and corporate reform rolls through the market. The key downside risk will, of course, be not just the Chinese debt deflation loop, but adding on top a US recession, which ironically would be similar to what happened in the 1990s, when in Japan, imbalances, excess leverage and insufficient policy stimulus tipped the economy into structural deflation and stagnation. So while that risk is more relevant for China and Japan is in a completely different situation now, we are closely monitoring the risks of this bear case scenario and what that would mean for parts of the Asia and emerging markets universe. So 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.

31 Aug 20233min

Although Europe has been the global leader when it comes to greening its economy, recent challenges may be a cause for concern.----- Transcript -----Rob Pulleyn: Welcome to Thoughts on the Market. I'm Rob Pulleyn, Morgan Stanley's Head of Utilities of Clean Energy Research in Europe. Jens Eisenschmidt: And I'm Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist. Rob Pulleyn: On this special episode of this podcast, we'll be discussing the future of Europe's energy transition, including whether its clean energy goals are realistic and the implications for investors and Europe's broader economy. It's the 30th of August, 10 a.m. in London. Rob Pulleyn: Europe has long been a global leader when it comes to greening its economy. Strong societal and political support has bolstered the region's transition to clean sources of energy, with a European Green Deal and climate target plan aiming to reduce CO2 emissions by at least 55% by 2030 and achieve net zero by 2050. While substantial progress has been made over the previous decades, the region is now facing several challenges. Jens, can you give us the backdrop to Europe's energy transition and some of what's changed recently? Jens Eisenschmidt: Yes Rob, I mean, you have explained it already. There are big change targets, climate change related targets to the energy transition that Europe has subscribed to. These targets were in place already before the 24th of February in 22, when we saw the Russian invasion in Ukraine that changed the European energy set up profoundly. Now, why is this important? It's important because these targets were done in sort of a plan that relied on a certain energy source that is no longer existing. So let me give you an example. Let's take Germany, which was anyway already quite progressed in its journey onto increasing the share of renewables in electricity production. If you take Germany, they have been turning their back on nuclear power generation, which is another source of emission free power generation, and have embraced as a flex load provider, so as a provider of electricity when renewables are unavailable to natural gas. Now this natural gas supply from Russia is no longer available, as we all know, and of course, that implies that the Germans and other member states of the European Union as well have to change the plan by which they transit to a carbon free economy. And, you know, this is very complicated because it's not only switching one energy source for the other or exchanging one for the other. You also have to look about the infrastructure, you have to see what is essentially giving your energy mix the stability, as I said before, when we don't have sun shining and wind blowing, you need to have a source that's about the question about storage technologies, that's not entirely independent of the energy sources that you have available. And so the last year provided a profound challenge to the way Europe had planned its energy transition, so they have to replan it, and the complexity of that is huge. Essentially, it's something you want to ideally plan at the European level in order to harness all the comparative advantages all the countries have, given example, you have a lot of sun hours in Spain, less so in Germany, so ideally you want to put solar for Europe somewhere south and not so much somewhere north. But that of course means something for the grid, you have to deploy around it. So all that complexity is huge, all the coordination needs are huge and so this is the new situation we are in. Rob Pulleyn: Yeah, that new situation clearly puts increased pressure on Europe, if electricity prices remain elevated, Europe's large industrial base and you mentioned Germany would continue to shoulder this burden. You know margins, pricing, competitiveness would all suffer and the region's place in the global value chain might be at risk. Now, renewables are increasingly cost competitive, but even when the solar power is still very intermittent and that requires either a stable baseload or at least flexible generation. And as you mentioned, this previously was facilitated partly by Russian gas. Now, with all that in mind Jens, how much investment is needed to fund the transition and is there economic risk associated with this? Jens Eisenschmidt: So the numbers are huge. We have said that number could be around $5 trillion, other sources estimate this to be slightly higher, but more or less the ballpark is the same. We also know that already $1.4 trillion is earmarked from public funds, so EU budget, meaning that $3.6 are left for the private sector to deploy or for member states to come up from national budgets. So the figure itself boiling down to somewhere between $5 to $600 billion a year until at least 2030 and maybe beyond, these figures are not in itself the problem. The problem is how do you, according to which plan, do you deploy this and what is the sort of economic backdrop in which this investment happens? So ideally, from an economist perspective, this is a productivity increasing undertaking, and if it's done in that way, it won't be necessarily inflationary, it would be mildly growth enhancing. But of course there is a risk that all that investment in particularly being driven by the public sector, crowds out other productive investment. And in that case, it would be less productivity enhancing and more inflationary, which we think is the more realistic case here for Europe. We don't think that this is the end of the world in terms of inflation, but we do estimate a sizable impact of around 20 basis points per year that inflation could turn out to be higher. That all being said, if electricity prices can be reliably and durably lowered, that would have the potential to generate more innovation. Rob, you have your finger on the pulse of new technology, what do you see emerging that may advance the progress of Europe's transition? Rob Pulleyn: Yeah, thanks Jens. So historically, we've been positively surprised by the pace of levelized cost of energy coming down, particularly in renewables. And we've also been positively surprised by technological developments elsewhere. As we think about the key challenge of this new wind and solar capacity ambitions, the key is intermittency, and therefore industrial scale batteries are going to be key, fuel cells should also be, green gas, which is also needed for industrial abatement, could also be part of that solution. I also think we need to talk about behind the meter, which is really rooftop solar, whether it's solar panels but more crucially one of the parts of the value chain is the inverters. More efficient inverters are one of the most key components for reducing the cost of solar. As we think about electrification of the home in terms of heat pumps, you know, there's another technology which will develop and also passenger vehicles moving to electric, this behind the meter rooftop solar generation will be important combined with batteries and as I said, the inverters are a key part of that. Also will be software, how to manage all of this demand side response, I think is something you're going to hear much more from many of the retail companies we cover and innovating in the space. Now, as we think about the sequence and the steps of decarbonization here, step one, decarbonize the existing power system, step two electrify as much as possible, step three move to green gasses. We will eventually reach an area whereby we cannot decarbonize any further, and that's where carbon capture and storage comes in, for which we're already seeing significant improvement. So, there's many technologies which I think will play a significant role in this. And I suspect despite the current pressures we're seeing at the moment, we will continue to see significant positive surprises over the coming decade and thereafter, notwithstanding that the cost of capital is, of course, higher than it was over the last decade. Jens Eisenschmidt: So which sectors are likely to benefit the near-term and in the longer term? Rob Pulleyn: So the obvious answer, and somewhat self-serving, is utilities. To that number you mentioned earlier of $5 billion spent, we also think that the utilities could probably contribute around a European utility in Europe around $1.5 to $2 trillion of this. That still leaves a sizable gap versus what you were talking and perhaps there is upside risk to these investment spends. But within utilities, the obvious route is renewables. Having a tough time, I would say in 2023, trapped within higher costs and capital costs, but also, you know, policy impasse. But if we separate the wood for the trees under the vast majority of scenarios out to 2030 and 2050, the increase in green electricity is going to be substantial and utilities are the natural developers of those assets as they migrate away from coal and some degree gas, into clean energy. But it's not the only area. There's also networks. We need to invest in distribution and transmission, in electricity to actually accommodate these renewables and connect the new areas of upstream electricity generation to the areas of demand, which is primarily the cities and industry. Speaking about industry, there's also a need for green gas, and I actually think other sectors are going to contribute here, most notably oil and gas, which has the technical expertise and of course the industrial plant for industrial gasses. As we look into the supply chains, another area that's been in focus this year, both the OEMs in terms of turbines and solar manufacturers, the cabling, the software, the heat pumps, I think there are many aspects within equity stories which are ancillary to utilities but could create different risk rewards and different opportunities to what you may find in my sector. I think we can both agree that while significant progress has been made, Europe still has a long way to go for the next step of this journey. Jens Eisenschmidt: I fully agree. I would say that not all hope is lost that current targets will be met, but there are headwinds that cannot be denied. Rob Pulleyn: Jens, thank you very much for taking the time to talk today. Jens Eisenschmidt: Thanks, Rob. It was great to speak with you. Rob Pulleyn: And thank you all for listening. Subscribe to Thoughts on the Market, on Apple Podcasts or wherever you listen, and please leave us a review. We'd love to hear from you.

30 Aug 20239min

If China economic woes become a true debt deflation cycle, it could export some of that disinflation to the global economy.----- Transcript -----Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today, I'll be talking about the global implications of China's economic slowdown. It's Tuesday, August 29th, at 10 a.m. in New York. China's economic woes continue to be center stage. Our Asia team has outlined the risks of a debt deflation cycle there and how policy is needed to avert the possibility of a lost decade. As always, big economic news from China will get global attention. That said, when we turned bullish on China's economic growth last year, we flagged that the typical positive spillovers from China were likely to be smaller this cycle than in the past. We expected growth to be heavily skewed towards domestic consumption, especially of services, and thus the pull into China from the rest of the world would be smaller than usual. We also published empirical analysis on the importance of the manufacturing sector to these global spillovers, and the very strong Chinese growth and yet modest global effects that we saw in the first quarter of this year vindicated that view. Now the world has changed and Chinese growth has slumped, with no recovery apparent so far. The global implications, however, are somewhat asymmetric here. Because we are seeing the weakness now show through to the industrial sector and especially CapEx spending, we cannot assume that the rest of the world will be as insulated as it was in the first quarter. Although we have recently marked down our view for Chinese economic growth, we still think a lost decade can be avoided. Nevertheless, with Chinese inflation turning negative, the prospect of China exporting disinflation is now getting discussed in markets. Much of the discussion about China exporting this inflation started when China's CPI went into deflation in the past couple of months. Although the connection is intuitive, it is not obvious that domestic consumer price numbers translate into the pricing that, say, U.S. consumers will eventually see. Indeed, even before China's prices turned negative, U.S. goods inflation had already turned to deflation because supply chains had healed and consumer spending patterns were starting to normalize. For China to export meaningful disinflation, they will likely have to come through one of three channels. Reduced Chinese demand for commodities that leads to a retreat in global commodities prices, currency depreciation or exporters cutting their prices. On the first, oil prices are actually at the same levels roughly that they were in the first quarter after Chinese goods surged. And they're well off the lows for this year. And despite the slump in economic activity, transportation metrics for China remain healthy, so to date, that first channel is far from clear. The renminbi is much weaker than it was at the beginning of the year. But recent policy announcements from the People's Bank of China imply that they are not eager to see a substantial further depreciation from here, limiting the extent of further disinflation through that channel. So that leaves exporters cutting prices, which could happen, but again, it need not be directly connected to the broader domestic prices within China coming down. So all of that said, the direction of the effect on the rest of the world is clear. Even if the magnitude is not huge, there is a disinflationary force from China to the rest of the world. For the Fed and ECB, other developed market central bankers, such an impulse may be almost welcome. Central banks have tightened policy intentionally to slow their economies and pulled down inflation. Despite progress to date, we are nowhere near done with this hiking cycle. If we're wrong about China, however, should we start to worry about a global slump? Probably not. The Fed is currently trying to restrain growth in the US with high interest rates. If the drag comes more from China, well then the Fed will make less of the drag come from monetary policy. Thanks for listening and 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.

29 Aug 20233min

Proposed regulations for smaller banks show that turmoil in the banking sector may still have an impact on the broader economy.----- 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 links between regulations and the real economy. It's Monday, August 28, at 11 a.m. in New York. In the euphoria of buoyant equity markets over the last few months, the many challenges facing regional banks have receded into the background. While it certainly has not been our view, a narrative has clearly emerged that the issues in the sector that erupted in March are largely behind us. The ratings downgrades by both Moody's and Standard & Poor's of multiple U.S. banks in the last few weeks provide a reminder that the headwinds of increasing capital requirements, higher cost of funding and rising loan losses continue to challenge the business models of the regional banking sector. The rating agency actions come on the heels of proposed rules to modify capital requirements for banks with total assets of 100 billion or more. Separately, the Fed has proposed a capital rule on implementing capital surcharge for the eight U.S. global systemically important banks. Further proposed regulations on new long term debt requirements for banks with assets of $100-700 billion are due to be announced tomorrow. It is early in the rulemaking process for all of these proposals. They may change after the comment period and the rules will be phased in over several years once they are finalized. Nevertheless, they outline the framework of the regulatory regime ahead of us. While we won't go into the detailed discussion of thousands of pages of proposals here, suffice to say that the documents envisage significantly higher capital requirement for much of the U.S. banking sector, and extends several large bank requirements to much smaller banks. One such requirement pertains to the impact on capital of unrealized losses in available for sale securities. Currently, this provision applies only to Category one and Category two banks, that is banks with greater than $700 billion in total assets. But the proposal now expands it to Category three and Category four banks, that is banks with greater than $100 billion in total assets. A recent paper from the San Francisco Fed shows how the regulatory framework of the banking system affects the real economy. Specifically, the paper demonstrates that banks, which experienced larger market value losses on their securities during the 2022 monetary tightening cycle extended less credit to firms. Given the experience of the last 18 months across fixed income markets, extending the impact of such mark-to-market losses to smaller banks, as is being proposed now, would exasperate the potential challenges to credit formation. Against this background, we look at the near term prospects for bank lending. In the latest Senior Loan Officer Opinion survey, reflecting 2Q23 lending conditions, lending standards tightened across nearly all categories for the fourth consecutive quarter. Banks expect to tighten lending standards further across all categories through the year end, with the most tightening coming in commercial real estate, followed by credit card and commercial and industrial loans to small firms. The survey also asked banks to describe current lending standards relative to the midpoint of the standards since 2005. Most banks indicated the lending standards are tighter than the historical midpoint for all categories of commercial real estate and commercial and industrial loans to small firms. The bottom line is that more tightening lies ahead for the broader economy. This survey shows how the evolution of regulatory policy can weigh on credit formation and overall economic growth. Given the disproportionate exposure of the regional banks to commercial real estate debt that needs to be refinanced, commercial real estate is likely to be the arena where pressure has become most evident, another reason why we are skeptical that the turmoil in the regional banking sector is behind us. While the proposed regulatory changes can open doors for non-bank lenders, such as private credit, it is important to note that such lending will likely come at higher cost. 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 Aug 20234min

As the Fed meets this weekend for their annual summit at Jackson Hole, investors are most focused on whether rate hikes will continue and the state of the neutral interest rate.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research at 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, August 25th at 2 p.m. in London. The eyes of the market will be on Wyoming this weekend, where the Federal Reserve is holding its annual summit at Jackson Hole. While many topics will be discussed, investors are particularly focused on two: is the Fed done raising interest rates? And is the so-called neutral rate of interest higher than initially thought? The Federal Reserve has been raising interest rates at the fastest pace in 40 years to try to get rates to a level where economic activity starts to slow, easing inflationary pressure. But the level of interest rate that achieves this is genuinely uncertain, even to the experts at the Fed. We believe that they'll feel increasingly comfortable that rates have now hit this level. And in turn, Morgan Stanley's economists do not expect further rate hikes in this cycle. A few things drive our thinking. First, those inflationary pressures are easing. Two key measures of underlying inflation, core PCE and core CPI, slowed sharply in the most recent reading. Leading indicators for car prices and rental costs, which have been big drivers of high inflation last year, now point in the opposite direction. Bank loan growth is slowing and the torrid pace of U.S. job growth is also moderating, two other signs that interest rates are already restrictive. Historically, the Fed being done raising interest rates has been supportive for markets. But the relationship with high grade bonds is especially notable. Since 1984, there have been five times where the Fed has ended interest rate hiking cycles after multiple increases. Each time the yield on the U.S. aggregate bond index peaked within a month of this last hike. In short, the Fed being done has been good for the U.S. Agg Bond Index. And we can see the logic to this. If the Fed has stopped raising interest rates, one of two things may very well be true. First, it stopped at the correct level to support growth while also reducing inflation, and that stability with less inflation is liked by the bond market. Or it has stopped because rates are actually too high and set to slow growth and inflation much more sharply. In the second scenario, investors like the safety of bonds. But behind this question of whether the Fed will pause is another, larger issue. What is the so-called neutral rate of interest that neither slows nor boosts the U.S. economy? During the decade of stagnation that followed the global financial crisis, weak growth led people to believe that this balancing interest rate was extremely low. There are signs this thinking persists, when the Fed surveys its members about where they see the Fed funds rate over the long run, which is a proxy for where this neutral interest rate might be, the median is just 2.5%. In 2012, the Fed thought this same rate was over 4%. So that will be another focus at Jackson Hole, and beyond. The strength of the U.S. economy in the face of higher rates has been a surprising story. Does that mean that the balancing interest rate is much higher, and will the Fed raise their long run estimates of this rate to reflect this? Or is recent U.S. strength still temporary and not yet fully reflecting the effect of higher interest rates? Expect this debate to continue in the months ahead. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

25 Aug 20233min