Japan Summit: Consumer Resilience and Trade Uncertainty

2022 is likely to bring fresh challenges for the U.S.-China dynamic. Investors can expect an increase in non-tariff barriers and continued commitment to re- and near-shoring of supply chains in the US.----- 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, January 26th at 10:00 a.m. in New York. While the ongoing situation between the Ukraine and Russia remains an obvious geopolitical risk to pay attention to, we shouldn't lose sight of the ongoing developments in the relationship between the U.S. and China. There's plenty of reason to expect that, in 2022, the two countries’ economic relationship - perhaps the most consequential in the world - will face fresh challenges. From the US's perspective, there's unfinished business. For example, the 'phase one' trade deal, signed back in January of 2020, expired at the end of 2021, and the results fell short of the agreement. Per data from the Peterson Institute, China only purchased 62% of the manufactured products, 76% of the agricultural products and 47% of the energy products it had committed to. These stats likely won't change the perception of the American voter, where issue polls show a bipartisan consensus that the U.S. relationship with China continues to be a problematic one. And since 2022 is a midterm election year, don't expect U.S. policymakers to stand pat on the issue. So what can we expect? We've covered before how the U.S. has, and likely will continue, to raise non-tariff barriers with China - things like export controls around sensitive technologies and investment restrictions. These deployments will continue to make for a more challenging environment for U.S. companies seeking easy access to China's markets, either to sell or produce goods. But one thing you can also expect is fresh legislative action to invest in the US's capabilities in key industries and supply chains that have been declared essential for economic and national security purposes. For example, news broke this week that the U.S. House of Representatives was starting its work to advance the U.S. Innovation and Competition Act, or USICA. The bill passed the Senate last year with substantial bipartisan support and would spend over $200B on research in artificial intelligence, quantum computing and biotechnology, in addition to cultivating local supply chain sources for key tech needs, like rare earths. This dynamic underscores a trend we've been focused on for many years. The slow but steady re and near shoring of supply chains for U.S. companies. It's a key reason our colleagues in equity research continue to see an opportunity in the capital goods sector, calling for a 'generational capex cycle over the next several years, driven by supply chain investment'. So stay tuned. We'll keep tracking this trend and keep you informed. 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.

27 Jan 20222min

With inflation on the minds of consumers and the Fed reacting with a sharp turn towards tightening, 2022 may be a year for investors to focus on incorporating tax-efficient strategies into their portfolios. Morgan Stanley Wealth Management’s Chief Investment Officer Lisa Shalett and Chief Cross-Asset Strategist Andrew Sheets discuss.----- Transcript -----Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.Lisa Shalett And I'm Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.Andrew Sheets And today on the podcast, we'll be discussing the importance of tax efficiency as a pillar of portfolio construction. It's Tuesday, January 25th at three p.m. in London.Lisa Shalett And it's 10:00 a.m. here in New York.Andrew Sheets Lisa, welcome back to the podcast! Now, as members of Morgan Stanley Wealth Management's Global Investment Committee, we both agree that the current portfolio construction backdrop is increasingly complicated and constrained. But tax considerations are also important, and this is something you and your team have written a lot on recently. So I'd really like to talk to you about both of these issues, both the challenges of portfolio construction and some of the unique considerations around tax that can really make a difference to the bottom line of investment returns. So Lisa, let's start with that current environment. Can you highlight why we believe that standard stock bond portfolios face a number of challenges going forward?Lisa Shalett We've been through an extraordinary period over the last 13 years where both stocks and bonds have benefited profoundly from Federal Reserve policy, just to put it bluntly, and, you know, the direction of overall interest rates. And so, our observation has been that, you know, over the last 13 years, U.S. stocks have compounded at close to 15% per year, U.S. bonds have compounded at 9% per year. Both of those are well above long run averages. And so we're now at a point where both stocks and bonds are quite expensive. They are both correlated to each other, and they are both correlated to a large extent with Federal Reserve policy. And as we know, Federal Reserve policy by dint of what appears to be inflation that is not as transitory as the Fed originally thought is causing the Fed to have to accelerate their shift in policy. And I think, as we noted over the last three to six weeks, you know, the Fed's position has gone from, you know, we're going to taper and have three hikes to we're going to taper be done by March. We may have as many as four or five hikes and we're going to consider a balance sheet runoff. That's an awful lot for both stocks and bonds to digest at the same time, especially when they're correlated with one another.Andrew Sheets And Lisa, you know, if I can just dive into this a little bit more, how do you think about portfolio diversification in that environment you just described, where both stocks and bonds seem increasingly linked to a single common factor, this this direction of Federal Reserve policy?Lisa Shalett One of the things that we've been emphasizing is to take a step back and to recognize that diversification can happen beyond the simple passive betas of stocks and bonds, which we would, you know, typically represent by, you know, exposures to things like the S&P 500 or a Barclays aggregate. And so what we're saying is, within stocks, you've got to really make an effort to move away from the indexes to higher active managers who tend to take a diversified approach by sector, by style, by market cap. And within fixed income, you know, we're encouraging, clients to hire what we've described as non-core managers. These are managers who may have the ability to navigate the yield curve and navigate the credit environment by using, perhaps what are nontraditional type products. They may employ strategies that include things like preferred shares or covered call strategies, or own asset backed securities. These are all more esoteric instruments that that hiring a manager can give our clients sources of income. And last, you know, we're obviously thinking about generating income and diversification using real assets and alternatives as well.Andrew Sheets And so, Lisa, one other thing you know, related to that portfolio construction challenge, I also just want to ask you about was how you think about inflation protection. I mean, obviously, I think a lot of investors are trying to achieve the highest return relative to the overall level of prices relative to inflation. You know, how do you think from a portfolio context, investors can try to add some inflation protection here in a smart, you know, intelligent way?Lisa Shalett So you know what we've tried to say is let's take a step back and think about, you know, our forecast for, you know, whether inflation is going to accelerate from here or decelerate. And you know, I think our position has broadly been that that we do think we're probably at a rate of change turning point for inflation, that we're not headed for a 1970s style level of inflation and that, you know, current readings are probably, you know, closer to peak than not and that we're probably going to mean revert to something closer to the, you know, two and a half to three and a half percent range sooner rather than later. And so in the short term, you know, we've tried to take an approach that says, not only do you want to think about real assets, these are things like real estate, like commodities like gold, like energy infrastructure linked assets that have historically provided some protection to inflation but really go back to those tried and true quality oriented stocks where there is pricing power. Because, you know, 2.5-3.5% Inflation is the type of inflation environment where companies who do have very strong brands who do have very moored competitive positions tend to be able to navigate, you know, better than others and pass some of that the cost increases on to consumers.Andrew Sheets So, Lisa, that takes me to the next thing I want to talk to you about. You know, investors also care about their return after the effects of tax, and the effects of tax can be quite complex and quite varied. So, you know, as you think about that challenge from a portfolio construction standpoint, why do you think it's critical that investors incorporate tax efficient investing strategies into their portfolios?Lisa Shalett Well, look, you know, managing, tax and what we call tax drag is always important. And the reason is it's that invisible levy, if you will, on performance. Most of our clients are savvy enough to suss out, you know, the fees that they're paying and understand how the returns are, you know, gross returns are diluted by high fees. But what is less obvious is that some of the investment structures that clients routinely use-- things like mutual funds, things like limited partnership stakes-- very often in both public and private settings, are highly tax inefficient where, you know, taxable gain pass throughs are highly unpredictable, and clients tend to get hit with them. And so that's, you know, part of what we try to do year in, year out is be attentive to making sure that the clients are in tax efficient strategies. That having been said, what we also want to do is minimize tax drag over time. But in a year like 2022, where you know, we're potentially looking at low single digit or even negative returns for some of these asset classes, saving money in taxes can make the difference between, you know, an account that that is at a loss for the full year or at a gain. So there's work to be done. There's this unique window of opportunity right now in the beginning of 2022 to do it. And happily, we have, you know, some of these tools to speed the implementation of that type of an approach.Andrew Sheets So Lisa, let's wrap this up with how investors can implement this advice with their investments. You know, what strategies could they consider? And I'm also just wondering, you know, if there's any way to just kind of put some numbers around, you know, what are kind of the upper limits of how much these kind of tax drags, you know, can have on performance?Lisa Shalett Yeah. So that's a great question. So over time, through the studies that we've done, we believe that tax optimization in any given year can add, you know, somewhere between 200 and 300 full basis points to portfolio performance, literally by reducing that tax bill through intelligent tax loss harvesting, intelligent product selection, you know, choosing products that are more tax efficient, et cetera.Andrew Sheets Well, Lisa, I think that's a great place to end it. Thanks for taking the time to talk. We hope to have you back soon.Lisa Shalett Absolutely, Andrew. Happy New Year!Andrew Sheets As a reminder, 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 find the show.

26 Jan 20228min

All eyes are on the Fed as they implement a sharp pivot to account for higher inflation being felt by consumers and businesses alike. With these shifts we turn our attention to the ‘Ice’ portion of our ‘Fire & Ice’ narrative: slowing growth.----- 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, January 24th at 11:30 a.m. in New York. So let's get after it. Investors have recently become fixated on the Fed's every move. That makes sense, with the Fed pivoting so aggressively on policy over the past few months. It also fits nicely with the first part of our well-established "Fire and Ice" narrative and our view that equity valuations are vulnerable. The reason for the Fed's sharp pivot is obvious, as inflation has overshot its goals - leading to problems for the real economy, not to mention the White House. When the Fed first announced its inflation targeting policy in the summer of 2020, it was appropriate given the deflationary effects of the pandemic. Therefore, it's now just as appropriate for the Fed to tighten at an accelerated pace to fight the inflation overshoot. However, this is a big change for a Fed that has been fighting the risk of deflation for 20+ years, and it has market implications. Importantly, consumers are truly starting to feel the impacts of inflation, with the University of Michigan Confidence Survey currently at levels typically observed only in recessions. Small businesses are also feeling the pain, as demonstrated by their difficulty finding employees and the prices that they are paying for supply and logistics. In short, the Fed is serious about fighting inflation, and it's unlikely they will be turning dovish anytime soon, given the seriousness of these economic threats and the political cover to take action. The good news is that markets have been digesting this tightening for months. Despite the fact that major U.S. large cap equity indices are only down 10-15% from their highs, the damage under the surface has been much worse for many individual stocks. Expensive, unprofitable companies are down 30-50%. This is appropriate, in our view, not just because the Fed is pivoting, but because these kinds of valuations don't make sense in any kind of investment environment. In short, the froth is coming out of an equity market that simply got too extended on valuation - the key part of our 2022 outlook published in November. But attention should now turn to the Ice part of our narrative - slowing growth. As we've been writing for months, we view the current deceleration in growth as more about the natural ebbing of the cycle than the latest variant of COVID. In fact, there are reasons to believe that we are closer to the end than the beginning of this pandemic. However, that also means the end of extraordinary stimulus, both monetary and fiscal. It also means looser supply chains as restrictions ease and people fully return back to work. Better supply is good for fighting inflation, but it may also reveal the degree to which demand has been supported and overstated by double ordering. This would fit nicely with the 1940s analogy that we have also detailed in our 2022 outlook. In brief, the end of the Second World War freed pent up savings and unleashed demand into an economy unable to supply it. Double digit inflation ensued, which led to the first Fed rate hike in over a decade and the beginning of the end of financial repression. Sound familiar? Shortly thereafter, inflation plummeted as demand normalized, but the Fed never returned to the zero bound on interest rates. Instead, we began a new era of shorter booms and busts as the world adjusted to the higher levels of demand, as well as cost of capital and labor. The end of secular stagnation and financial repression has arrived, in our view, but it won't be a smooth ride. In the near term, hunker down for a few more months of winter as slowing growth overtakes the Fed as the primary concern for markets. In such a world, we continue to favor value over growth, but with a defensive rather than cyclical bias. 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.

24 Jan 20223min

Higher levels of inflation have made it a hot topic among investors. While inflation’s effects cannot be avoided completely, there are some strategies that can help protect against the worst of them.----- 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, January 21st at 2:00 p.m. in London. One question we get a lot at the moment is “how can I protect my investments against inflation?”. While Morgan Stanley's economists do expect inflation to moderate this year - actually starting this quarter - the high current readings on inflation have made it a hot topic. One of the biggest investing challenges with inflation is that when it's truly high and persistent - the kind of inflation that we saw in, say, the 1970s - it's simply bad for everything. That decade saw stocks, bonds and real estate all perform poorly. There was simply nowhere to hide. Still, investors do look at specific strategies to try to hedge inflation. Unfortunately, some of these, we think, have challenges. One place that investors look to protect against the effects of inflation is precious metals, like gold. But while gold has a very impressive track record of maintaining value throughout thousands of years of human history, its day to day and month to month relationship with inflation is kind of shaky. Gold can actually do worse when interest rates rise because gold, which doesn't provide any income, starts to look worse relative to bonds, which do. And note that over the last six months, when inflation has been elevated, gold hasn't performed particularly well. Another popular strategy is owning treasury inflation protected securities, or TIPS, which have a payout linked to inflation. I mean, the inflation protection is in the name. Yet if you look at the actual performance of these securities, that inflation protection isn't always so simple. TIPS performed well in 2020, a year when inflation was low, and they performed poorly in 2018 and over the last three months, when inflation was higher. The reason for this is that TIPS are also sensitive to the overall level of interest rates - and if those are going up, they can see their performance suffer. These two examples are part of the reason that, when we think about protecting portfolios against elevated inflation, what we're often trying to do is to avoid sensitivity to real interest rates, which, at the moment, we think will continue to rise. We think this favors keeping lighter exposure overall, favoring energy over metals and commodities, favoring stocks in Europe and Japan over those in the U.S. and emerging markets, and being underweight real interest rates directly in government bonds. 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.

21 Jan 20222min

The foundation for the housing market remains healthy in 2022, with responsible lending standards and a tight supply environment, but, as the year continues, affordability challenges and a more hawkish Fed will likely slow appreciation and dampen housing activity.----- Transcript -----James Egan Welcome to Thoughts on the Market. I'm James 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. James Egan And on this edition of the podcast, we'll be talking about the 2022 outlook for the U.S. housing market. It's Thursday, January 20th at 10:00 a.m. in New York. James Egan All right, Jay. Now, since we published the outlook for 2022, the market has already priced in a much more hawkish Fed and Fed board members really haven't been pushing back. We've now priced in 100 basis points of hikes in 2022 in addition to quantitative tightening. How does this change how you're thinking about the mortgage market? Jay Bacow When we went into the year, we thought that mortgage spreads looked pretty tight and thought they were going to go wider, and that was in a world where we just thought the Fed was going to be tapering and stop buying mortgages, but still reinvesting. Now that they're pricing in that the Fed is going to be hiking rates and normalizing their balance sheet, mortgage spreads have widened about 20 basis points this year, but we think they have further room to go. This is because a normalizing Fed is going to mean that the supply to the market in conjunction with the net issuance is going to be the highest that the private market has ever had to digest. So, we think that could push spreads about 10 or 15 basis points wider, which is going to weigh on mortgage rates, but mortgage rates have already been going up. They are about 3/8 of a point higher just over the last month. And when we forecast mortgage spreads and interest rates to go higher over the next year, we think this could end up with about a full point rise in mortgage rates this year. Jay Bacow So, Jim, a point move higher in mortgage rates. What does that do to affordability? James Egan The short answer is they don't help affordability. For people who've been listening to our podcast before, affordability largely has three main components: home prices, mortgage rates and incomes. And so, if we're talking about mortgage rates, a full 100 basis points higher, that's going to be bad for affordability. But look, this just reinforces what we're thinking about affordability with respect to the housing market as we look ahead to 2022. In our outlook, we described affordability as the chief headwind to home prices and housing activity this year. Looking back to the end of 2021, home prices were climbing at a record pace of growth. And one of the good things about this climb is we think it's been healthier than the prior times that HPA even approached these levels. We got to almost 20% year over year growth because of the fact that we had an historically tight supply environment, and we had a lot of demand, and that demand was not being stimulated by easing lending standards. Lending standards themselves remained very responsible. James Egan But just because the foundation of the housing market today is healthy, and we believe it is, that doesn't mean it can't be too expensive. As home prices were climbing, mortgage rates continued to fall to record lows, and that really acted as a release valve with respect to affordability in the market. That release valve has already been turned off. Mortgage rates climbed throughout 2021. We expected them to climb in 2022. Yes, we now see them climbing faster than we anticipated, but that release Valve, as I mentioned, was already turned off. Affordability was already a substantial headwind in our call. Jay Bacow All right, Jim. So, we've talked about affordability. Can you remind us where do home prices currently stand? Haven't they started to come down a little bit? James Egan Yes. Home prices have been slowing for two months now. And it's becoming more pervasive geographically. James Egan As recently as July, 100 of the top 100 metro areas in the country, were not only seeing home prices grow year over year, but that pace of growth was accelerating. Five months later, the most recent data we have there is November, it's fallen from 100 out of 100 to 38 out of 100 metro areas, still seeing acceleration. The other 62? They're still climbing. But the pace of that growth has slowed. Jay Bacow All right, so home price growth is slowing. Does this mean that it just continues to slow and home prices actually go negative this year? James Egan We do think that home price growth will continue to slow, but we definitively think it will remain positive. We do not see home price growth going negative on a year over year basis. One of the biggest reasons there: healthy lending standards that we mentioned earlier. That kind of responsible underwriting we think keeps distressed transactions, so delinquencies - really foreclosures. It keeps those distressed transactions limited, and you really need an increase in the concentration of distressed transactions to see home price growth turn negative, or to see home prices turn negative. James Egan One of the other things we talked about affordability that we do think is playing a role in the housing market is supply. The supply market is at historical tights right now. That contributes to the healthy foundation that we see the housing market sitting on. We do think we are going to start to see a supply increase on the margins next year. Existing inventories continue to fall, but new inventories have been up over 30% year over year each of the past four months. While single unit starts might not be climbing at the same pace today as they were early in 2021, if we look at the number of single unit homes under construction today, that's surpassed the number of multi-unit homes under construction for the first time since 2013. We do think that will mean more supply coming on the market next year. James Egan The overall environment will be tight. But we will no longer be able to say historically tight. We will see positive year over year changes. That also weighs on the pace of home price growth, which is why we see it slowing to 5% by 2022. Jay Bacow OK, but Jim, you talked about supply and how that's been picking up recently, but that was based off of a period when mortgage rates are lower than they are today. What is this forecasted rise in mortgage rates mean for your expectations for housing activity going forward for the rest of 2022? James Egan So I think there's a few ways that this rise in mortgage rates can impact housing activity. The I think most straightforward way to think about it is on the affordability spectrum that we've been talking about. It's going to make the carrying cost, the debt service of housing those mortgage payments more expensive for households. And that affordability problem is going to weigh on purchase decisions that, as I mentioned earlier, reinforces what we were already thinking about the housing market this year. It also contributes to a lock in effect - borrowers that have homes at lower mortgage rates, it now increases their opportunity costs to move. They'd have to take on a larger mortgage if they were to move their home, and so it weighs on supply as well. James Egan We see it leading to a decrease in existing home sales. So home prices will slow, but they'll remain positive. We do think that home sales are going to fall. Throughout the totality of 2022 we see existing home sales coming in about 5% below where they'll finish 2021. Jay Bacow All right. So basically, a more hawkish Fed has meant that mortgage spreads have widened out and mortgage rates are heading higher. This has led to reduced affordability, which is also going to cause a bit of a slowdown in home sale activity and a slowdown in home price appreciation. But home prices will still near higher than where they are now. I got that right? James Egan Absolutely. James Egan Jay, thanks for taking the time to chat. Jay Bacow Always a pleasure, Jim. James Egan As a reminder, 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 find the show.

20 Jan 20227min

In 2021, many expected the US dollar to face significant challenges yet the year ended with strong levels coming off a mid-year rally. As we look out at 2022, how much more can the dollar rise and where do other currency opportunities lie?----- Transcript -----Welcome to Thoughts on the Market. I'm James Lord, Global Head of Foreign Exchange and Emerging Market Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for the US dollar and global currency markets. It's Wednesday, January 19th at 2:00 p.m. in London. This time last year, many strategists on Wall Street were expecting 2021 to turn out badly for the US dollar. But as we now know, the dollar ended the year much differently. The dollar troughed on January 6th, spent the first half of the year moving sideways, then began a pretty strong rally mid-year and finished the year around the strongest levels since July of 2020. And the question we've all been asking ourselves recently is - how much more can the dollar rise in 2022? Well, this year, most analysts and investors expect the dollar to continue to rise. But if last year's track record of prediction is anything to go by, this probably means that the dollar could instead head lower over the next 12 months. Our team at Morgan Stanley believes that the US dollar could be close to peaking. In fact, we've just changed our dollar call to neutral, which means we think it will just go sideways from here - after being bullish the dollar since June last year. Here's why: the Federal Reserve has indicated it may be close to raising interest rates, and we think that the Fed starting an interest rate hiking cycle could be a signal that the dollar's rise is close to finished. This may seem counterintuitive, since rising interest rates tend to strengthen currencies. But the US dollar has actually already gone up on the back of rising interest rates. A year ago, the market wasn't expecting any rate hikes for the year ahead. Now, the market is expecting nearly four hikes and for lift off to potentially begin as soon as March. If we look back at the last five cycles where the Fed has hiked interest rates, we can see the same pattern every time. The US dollar tends to rise in the months before liftoff, but fall in the months afterwards. This is a great example of buying the rumor and selling the fact. And if the market is right and the Fed hikes rates as soon as March, the peak of the US dollar for this cycle may not be too far away. We also need to remember that the dollar doesn't stand in isolation. Currencies are always a relative game and are valued against the currencies of other economies. Because of that, what happens in other parts of the world also affects the value of the US dollar. And what we've seen recently is that other central banks are also starting to think about tightening policy and raising interest rates, which will, to some extent, offset Fed hikes - reducing their impact on the dollar. We think this may be a good time for investors to start to reduce their dollar long positions, not add to them. What does the future hold for emerging market currencies? The consensus view is very negative on emerging markets, and that is the polar opposite of this time last year when everybody loved them. Like last year, though, we suspect the consensus view will probably be wrong by the time we close the year. Valuations on emerging market currencies and local currency bonds are cheap. If inflation peaks over the next few months, as Morgan Stanley economists expect, then investors may well take another look at emerging market bonds and any inflows would strengthen their currencies. Bottom line: the dollar has probably peaked for the year, but the future for emerging market currencies is brighter than most people think. As ever, the trick is in the timing. Stay tuned. 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.

19 Jan 20223min

While our outlook for 2022 already called for a hawkish Fed, recent signals from the central bank of more aggressive tightening have given cause to reexamine some of our calls while remaining steadfast in key aspects of our narrative for the year.----- 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, January 18th at 11:30 a.m. in New York. So, let's get after it. Last week, our economics team adjusted its forecast on Fed policy, given the more hawkish tone in the most recent Fed minutes and commentary from Chair Powell and other governors. We now expect the Fed to fully exit its asset purchase program known as quantitative easing by April. We also expect the Fed to increase rates by 25 basis points 4 times this year and begin balance sheet normalization by July. That's a lot of tightening, and fits with our general outlook for 2022 that we published back in November. To recall, our Fire and Ice narrative assumed the Fed was behind the curve and would need to catch up in a hurry, given the dramatic move in inflation that we've experienced during this pandemic. Public outcry and consumer confidence measures suggest inflation is the number one concern right now - making this a political issue as much as an economic one. Expect the Fed to keep pushing until financial conditions tighten. What that means for equity markets is that valuations should come down this year via a combination of higher long term interest rates and higher equity risk premiums. The changes to our Fed forecast simply mean it's likely to happen faster now, making the hand-off between lower valuations and higher earnings more challenging. This is the classic finishing move to the mid-cycle transition we've been anticipating for months, and it appears we've finally arrived. Our outlook for 2022 incorporated a fairly hawkish Fed, and while that hawkishness has increased since we published in mid-November, it doesn't change our year-end targets, which are already well below the consensus. Specifically, our base case year-end target for the S&P 500 is 4400. This compares to the median forecast of approximately 4900. Our target assumes a meaningfully lower Price Earnings multiple of 18x the forward 12-month earnings. This would be a 15% drop from the current Price Earnings multiple of 21x. Our EPS forecast is largely in line with consensus. In short, our view differs with consensus mainly on valuation rather than growth. The faster ending to QE and more aggressive rate hikes simply brings this valuation risk forward to the first half of the year. Furthermore, given the Fed's new guidance it will try to shrink its balance sheet, means valuations could even overshoot to the downside of what we think is fair value. Bottom line, the bringing forward of tapering and rate hikes is likely to lead to a 10-20% correction in the first half of this year for the S&P 500, in our view. The good news is that markets have been adjusting for months to this new reality, with 40% of the Nasdaq having corrected by 50% or more. As we've noted many times, the breadth of the market remains poor as it goes through the classic rolling correction under the surface as the index grinds higher. This phenomenon is largely due to the relentless inflows from retail investors into equities. On one hand, this rotation from bonds to stocks by asset owners makes perfect sense in a world of rising prices. After all, stocks are a decent hedge against inflation, unlike bonds. However, certain stocks fit that billing better than others. In its simplest form, it means value over growth stocks or short duration over long - think dividend growth stocks. In addition, we would favor defensively oriented value stocks relative to cyclicals, given our view growth may slow a bit more in the near term before re-accelerating in the second half. Bottom line, don't fight the Fed and be patient with new capital deployments until later this Spring. 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.

18 Jan 20223min

After two years of support and accommodation from the Fed, 2022 is seeing a shift in tone towards the strength of the economy and risks of inflation, meaning investors may need to reassess expectations for the year.------ 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, January 14th at 2:00 p.m. in London. Sometimes in investing, if you're lucky, you make a forecast that holds up for a long time. Other times, the facts change, and your assumptions need to change with them. We've just made some significant shifts to our assumptions for what the Federal Reserve will do this year. I want to discuss these new expectations and how we got there. The U.S. Federal Reserve influences interest rates through two main policy tools. First, it sets a target rate of interest for very short-term borrowing, which influences a lot of other interest rates. And second, it can buy government bonds and mortgages directly - influencing the rate that these bonds offer. When COVID struck, the Federal Reserve pulled hard on both of these levers, cutting its target interest rate to its lowest ever level of zero and buying trillions of government bonds and mortgages to support these markets. But now, almost two years removed from those actions, the tone from the Fed is changing, and quickly. For much of 2021, its message focused on erring on the side of caution and continuing to provide extraordinary support, even as the U.S. economy was clearly recovering. But now, that improvement is clear. The U.S. unemployment rate has fallen all the way to 3.9%, lower than where it was in January of 2018. The number of Americans claiming unemployment benefits is the lowest since 1973. And meanwhile, inflation has been elevated - with the U.S. consumer prices up 7% over the last year. All of this helps explain the sharp shift we've seen recently in the Fed's tone, which is now focusing much more on the strength of the economy, the risks of inflation and the need to dial back some of its policy support. It's this change of rhetoric, as well as that underlying data that's driven our economists to change their forecasts for the Federal Reserve. We now expect the Fed to raise interest rates 4 times this year, by a total of 1%. Just as important, we think they not only stop buying bonds in March, but start reducing their bond holdings later in the year - moving from quantitative easing, or QE, to so-called quantitative tightening, or QT. The result should help push U.S. 10-year yields higher up to 2.2%, in our view, by the middle of the year. For markets, we think this should continue to drive a bumpy first quarter for U.S. and emerging market assets. We think European stocks and financial stocks, which are both less sensitive to changes in interest rates, should outperform. 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.

14 Jan 20222min