What the New Tax Bill Means for Cross-Border Portfolios

Last week stocks rallied quickly but dropped just as fast as markets continue to hope for a more dovish Fed, but will this 2-way risk continue as evidence for a drop in earnings continues to accumulate?----- 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, October 10th, at 1:30 p.m. in New York. So let's get after it. Last week started with one of the biggest 2 day rallies in history, only to give most of it back by Friday's close. The culprit for this higher 2-way volatility is a combination of deteriorating fundamentals with oversold technicals. As noted last week, September was one of the worst months in what's been a difficult year, and the equity market was primed for a rally, especially with the S&P 500 closing right at its 200 week moving average on the prior Friday. Low quality stocks led the rally as further evidence the rebound was just bear market action rather than the beginning of a new bull. There is also still lingering hope for a Fed pivot, but the economic data that matters the most for such a pivot, jobs and inflation, continue to dash any hopes for a more dovish Fed. The sellout of momentum and retail, to some degree, does keep 2-way risk alive in the short term as it gets quiet for the next few weeks on the earnings front. Over the past month, there has been evidence that our call for lower earnings next year is coming to fruition. Large, important companies across a wide swath of industries have either reported or preannounced earnings and guided significantly lower for the fourth quarter. Some of these misses were as much as 30%, which is exactly what's needed for next year's estimates to finally take the step function lower, we think is necessary for the bear market to be over. The question is, will enough of this happen during third quarter earnings season, or will we need to wait for fourth quarter reporting in January and February when companies tend to formally guide for the next year? We think the evidence is already there and should be strong enough for this quarter for bottoms up consensus estimates have finally come down to reality, but we just don't know for sure. Therefore, over the next two weeks, stocks could continue to exhibit 2-way risk and defend that 200 week moving average at around 3600. One interesting development that supports our less optimistic view on 2023 earnings is in the dividend futures market. More specifically, we've noticed that dividend futures have traded materially lower, even as forward earnings per share forecasts have remained sticky to the upside. One reason this might be happening now is that cash flows are weakening. This is tied to the lower quality earnings per share we predicted earlier this year as companies struggled with the timing and costs versus revenues as the economy fully reopened. Things like inventory, labor costs and other latent expenses are wreaking havoc on cash flow. Accrual accounting earnings per share will likely follow 6 to 12 months later. In short, it's just another sign that our materially lower than consensus earnings per share forecasts next year are likely to be correct. If anything, we are now leaning more toward our bear case on S&P 500 earnings per share for next year, which is $190. The consensus is at $238. Bottom line, the valuation compression in equity markets this year is due to interest rates rising rather than concern about growth. This is evidenced by the very low equity risk premium, currently 260 basis points, that we still observe. The bear market will not be over until either earnings per share forecasts are more in line with our view, or the valuation better reflects the risk via the equity risk premium channel. Bear markets are about price and time, price takes your money, time takes your patience. Let the market wear everybody else out. When nobody is calling for the bottom, you will then know it's finally time to step in. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

10 Okt 20223min

While China’s policy objectives strive for common prosperity, the country’s strict COVID management poses risks to employment and income, so when might Chinese policymakers start to reopen and recover?----- Transcript -----Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be focusing on the expected reopening of China's economy. It's Friday, October 7th, at 8:30 a.m. in Hong Kong. When my colleagues and I discuss Asia's growth outlook with investors, one of the top questions we get is, when will China reopen and what the roadmap will look like. We believe a reopening will happen not because the rest of the world is now living with COVID, but because the effects of China's strict COVID management are now increasingly at odds with its policy objective of achieving common prosperity. The challenges of a sharp rise in youth unemployment and significantly lower income growth, especially for the low income segments of the population, have become more pronounced this year ever since the onset of Omicron. To put this in context, the youth unemployment rate is at 19% and our wage growth proxy has decelerated from around 9% pre-COVID, to just about 2.2% year on year. These issues are further exacerbated by the intensifying spillover effects from weaker exports and a continued drag from property sector. Over the next five quarters, growth in developed markets will likely remain below 2% year on year. The continued shift in DM consumer spending towards services will mean global goods demand will deflate further. And as exports weaken, manufacturing CapEx will also follow suit, which will further weigh on employment creation. As for the property market, the pace of resolution of funding issues and uncompleted projects are still relatively sluggish. With the outlook for the drivers of GDP growth weakening, we think the only meaningful policy lever is a shift in COVID management aimed at reopening, reviving consumption and allowing services sector activity to lift aggregate demand towards a sustainable recovery. As things stand, several steps are necessary for a smooth reopening. They are, number one, renewed campaign to lift booster vaccination rates, especially amongst the elderly population. Number two, shaping the public perception on COVID. And number three, ensuring adequate medical facilities, equipment and treatment methods in the next 3 to 6 months. We therefore anticipate that policymakers will, in the spring of 2023, with the peak COVID and flu season behind us, be able to proceed with a broader reopening plan. Of course, we think that reopening in China will be gradual, as policymakers will remain mindful of the potential burden on the health care system. Against this backdrop, we see the recovery strengthening from second quarter of 2023 onwards. In the next two quarters, we estimate GDP growth will be subpar at around 3%. But as China reopens from the spring of 2023, we expect GDP growth will strengthen to 5.5% in the second half of the year. Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

7 Okt 20223min

As month over month data begins to show a downturn in home prices, will overall price growth and sales begin to fall steeper than expected? Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.----- 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 why home prices could turn negative in 2023. It's Thursday, October 6th, at 3 p.m. in New York. Jay Bacow: Jim, it seems like every month the housing data is getting worse when we look at the sales activity. But, now I think I just saw something about home prices falling? What's going on there? I thought we call it home price appreciation, now we're seeing home price depreciation? Jim Egan: There is a lot going on out there. There's a lot of volatility, things are moving fast, and yes, there are home price indices that are showing negative numbers. I would caveat that a lot of those negative numbers are month over month, not the year over year that we've typically talked about here. But that doesn't mean it isn't important. Jay Bacow: In the past we've talked about this bifurcation narrative where we were going to get a big drop in home sales and housing starts, which we've seen, but home prices were more protected. Do you still believe that? Jim Egan: We do still believe in the bifurcation narrative, but the levels of the forecasts have changed, and they've changed for a couple of reasons. I think one reason is that there have been a number of forecast changes, expectations for 2023 are different. Our U.S. economics team has raised their hiking forecast 25 basis points in each of the next three meetings, and our interest rate team on the back of that forecast change has moved up their expectations for the 10 year Treasury. What that move means for us is that the incredible affordability deterioration that we've seen, probably isn't going to get a whole lot better next year. And that's happening in a world in which you mentioned some home prices turning negative. The home price deceleration that we were calling for, from plus 20% all the way down to plus 3% at the end of next year, that relied upon or I can say we expected home prices to fall month over month, but we thought that was going to start in September. It started in July. Sales volumes have been coming in weaker than we thought they would. When we take that weaker than expected housing data, we marry that with different expectations for affordability next year, the forecasts have to change. Jay Bacow: And so what exactly are we forecasting for this year and next year? Jim Egan: So in this world, we do think that sales are going to fall steeper than we thought. We think that starts are going to fall steeper than we thought, and that next year a single unit starts are going to be lower in 2023 than they were in 2022. We had originally been forecasting a return to growth in 2023, but the change to the forecast that's getting the most attention is that we went from plus 3% year over year growth in December of 2023 to -3% year over year growth by the end of next year. Jay Bacow: So if I buy a house today, it might be lower a year from now? That seems worrisome. Jim Egan: Yes. And I think there is a positive and a negative headline to that, right. The negative headline, the worrisome, if you will, that you mentioned is that not only is it down 3% next year, but that's down 7% from where we are right now. The positive headline is that even with that decrease in home prices from today, that only brings us back to January of 2022. That's 32% above where they were in March of 2020. Jay Bacow: All right, that doesn't seem so bad, given that stocks are a lot lower than where they were in January of 2022. So it's more stalling out than a real correction in home prices. But, why wouldn't home prices fall further from there? Jim Egan: We haven't seen anything in the data that changes kind of the underlying narrative that we've been discussing on this podcast in the past. In particular, two things. The first is how robust credit standards have been. If anything, lending standards, which were pretty tight to begin with in the first quarter of 2020, have tightened substantially since then. What that means, again, it constrains sales volumes. We think sales are going to fall more than home prices, but it also means that the likelihood of defaults and foreclosures is limited. And it is those distressed transactions, those forced sellers that we would need to see a leg down in prices. The other point is, away from defaults and foreclosures, actual inventory is still incredibly low. And because current homeowners sit on 30 year fixed rate mortgages, well below the current mortgage rate, when we talk about affordability deteriorating, we're not talking about it deteriorating for current homeowners. They're much more likely to stay in their home, much less likely to list their home for sale, they're not going to be selling into depressed bids. So that credit availability and those tight lending standards, we think that keeps home prices supported. Jay Bacow: So home prices are protected because we're not going to get the forced sellers that we saw during the financial crisis and the fundamentals of the housing market are in much stronger footing. What would actually get you, though, to forecast more of a real correction than just the stalling out? Jim Egan: I'm going to make this really complicated and say the supply and demand. If demand were to be weaker than we already think it is, and that could happen because the historic deterioration we've seen in affordability has a bigger impact than we think it will. Maybe because the unemployment rate picks up faster than we're expecting it to next year. If you have a much weaker demand environment than we're already envisioning, and you combine that with more supply, perhaps people who'd be a little bit more willing to part with their home at slightly lower prices than we expect them to, people who've owned their home for 10, 15, 20 years and might be looking to downsize. That's where you might have a little bit more of a marriage between uneconomic sellers and depressed demand that could bring home prices lower than we expect. Now, how does all of that, if we think about the implications to investors, what does all that mean for the MBS market? Jay Bacow: I'm going to make this really complicated, too. A lot of it comes down to supply and demand. The lack of housing activity and the lower home prices means that there's going to be less supply for mortgage investors to buy. That's good for the mortgage market. The rapid increase in unaffordability has been because of the rapid increase in implied volatility, which is bad for mortgage investors. This has brought nominal spread to the Treasury curve for agency mortgages to levels that are basically at the post GFC wides. And we think that move is a little bit overdone. And so for institutional investors we think this is an opportunity to own agency mortgages versus treasuries as a way to fade some of these moves, and take advantage of some of the more forward looking supply projections that we think will be coming as supply slows down. Jay Bacow: But Jim, it's always great talking to you. Jim Egan: Great talking to you too, Jay. Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.

6 Okt 20226min

As globalization slows and companies begin to nearshore their supply chains, investors may be wondering what the costs and benefits are of bringing manufacturing back home.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.----- Transcript -----Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research 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, October 5th, at 10 a.m. in New York. We speak often here about the themes of slowing globalization, or slowbalization, and the shift to a multipolar world. It's important to understand these megatrends, as they will likely impact global commerce for decades to come and in many ways we cannot yet anticipate. But one impact we have anticipated is multinational companies spending money to shift their supply chains. Whereas globalization meant companies could focus on lowering their labor and transportation costs through 'just in time' logistics, 'just in case' logistics are the watchword of the multipolar world. Companies will have to invest money to nearshore or friend shore to protect their supply chains from seizing up due to geopolitical conflicts, be it war, such as Russia invading Ukraine leading to sanctions, or the proliferation of policies by Western governments, preventing companies from producing and/or sourcing sensitive technologies overseas. Now, we're increasingly seeing evidence that this dynamic is already at play. Take Apple, for example, which, according to the Wall Street Journal, recently released a supplier list showing that in September of 2021, 48 of its suppliers had manufacturing sites in the U.S., up from 25 just a year before. The article goes on to cite several semiconductor chip makers who have recently opened US based sites. One company recently agreed to invest as much as $100 billion in a semiconductor manufacturing facility in upstate New York. Another announced plans to invest $20 billion for chip factories in Ohio. So it's clear that companies are starting to respond to geopolitical incentives. The long term public policy benefits of these moves could prove to be quite sound, but in the short term they're a challenge to markets. These investments cost money and represent elevated costs relative to what these companies would have enjoyed had the geopolitical environment not become more challenging. That means investors have to price in yet another margin pressure on top of the ones our colleague Mike Wilson continues to highlight in U.S. equities, from labor costs and the fed hiking rates to engineer slower economic growth. So bottom line for investors, shifting to a new geopolitical world order may be necessary, but it will cost something along the way. And for the moment, that means extra pressure on a U.S. equity market that's already got its fair share. 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 Okt 20222min

With investors becoming pervasively bearish on stocks and bonds in the face of a worsening growth outlook, can the U.S. investment grade credit market provide shelter from the storm?----- Transcript -----Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Global Director of Fixed Income Research. Along with my colleagues, bringing you a variety of perspectives, today I'll share why corporate credit markets may be a sheltering opportunity amid current turbulence. It's Tuesday, October 4th, at 11 a.m. in New York. At a September meeting, the Federal Open Market Committee delivered a third consecutive 75 basis point rate hike, just as consensus had expected. The markets took this to mean a higher peak and a longer hiking cycle, resulting in sharp spikes in bond yields and a sell off in equities. At the moment, both 2 and 10 year Treasury yields stand at decade highs, thanks to pervasively bearish sentiment among investors across both stocks and bonds. As regular listeners may have heard on this podcast, Morgan Stanley's Chief Global Economist, Seth Carpenter, has said that the worst of the global slowdown is still likely ahead. And our Chief U.S. Equity Strategist, Mike Wilson, recently revised down his earnings expectations for U.S. equities. Navigating this choppy waters is a challenge in both risk free and risky assets due to duration risk in the former, and growth or earnings risks in the latter. Against this backdrop, we think the U.S. investment grade corporate bonds, IG, particularly at the front end of the curve, which is to say 1 to 5 year segment, could provide a safer alternative with lower downside for investors looking for income, especially on the back of much higher yields. But investors may wonder, wont credit fundamentals deteriorate if economy slows, or worse, enters the recession and company earnings decline. Here is where the starting point matters. After inching higher in Q1, median investment grade leverage improved modestly in the second quarter and is well below its post-COVID peak in the second quarter of 2020. Gross leverage is roughly in line with pre-COVID levels. Notably, while median leverage is back to pre-COVID levels, the percentage of debt in the leverage tail has declined meaningfully. But if earnings were to decline, as our equity strategists expect, leverage ratios may pick back up. That said, interest coverage is the offsetting consideration. Given the amount of debt that investment grade companies have raised at very low coupons over the years, their ability to cover interest has been a bright spot for some time. Despite sharply higher rates, median interest coverage improved in the second quarter and is around the highest levels since early 1990. This modest improvement in interest coverage comes down to the fact that even though yields on new debt are higher than the average of all outstanding debt, the bonds that are maturing have relatively high coupons. Therefore, most companies have not had to refinance at substantially higher funding levels. In fact, absolute dollar level of interest expense paid out by IG companies actually declined in the quarter and is now well below the peaks of 2021. With limited near-term financing needs, higher rates are unlikely to dent these very healthy interest coverage ratios. The combination of strong in-place investment grade fundamentals, relatively low duration for the 1 to 5 year segment and yields at decade highs, suggests that this part of the credit market offers a relatively safe haven to weather the storms that are coming for the markets. History provides some validation as well. Looking back to the stagflationary periods of 1970s and 80's, while we saw multiple decisions and volatility in equity markets, IG credit was relatively stable with very modest defaults. And while history doesn't repeat, it does sometimes rhyme, so we look to the relative safety of IG credit once again in the current environment. 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.

4 Okt 20223min

With rates and currency markets experiencing increasing volatility, the state of global U.S. dollar supply has begun to force central bank moves, leaving the question of when and how the Fed may react up for debate.----- 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, October 3rd, at 11 a.m. in New York. So let's get after it. The month of September followed its typical seasonal pattern as the worst month of the year, and given how bad this year has been, I don't say that lightly. But as bad as stocks have been, rates and currency markets have been even more volatile. With volatility this severe, some of the cavalry has been called in. The Bank of England's surprise move last week was arguably necessary to protect against a sharp fall in U.K. bonds. Some may argue the U.K. is in a unique situation, and so this doesn't portend other central banks doing the same thing. However, this is how it starts. In other words, investors can't be as adamant the Fed will choose or be able to follow through on its tough talk. Like it or not, the world is still dependent on U.S. dollars, which provide the oxygen for global economies and markets. Former U.S. Treasury Secretary John Connolly's famous quote that "the dollar is our currency, but it's your problem" continues to ring true. It's also one of the primary reasons why several countries have been working so hard to de-dollarise over the past decade. The U.S. dollar is very important for the direction of global financial markets, and this is why we track the growth of global dollar supply so closely. In fact, the primary reason for our mid-cycle transition call in March of 2021 was our observation that U.S. dollar money supply growth had peaked. Indeed, this is exactly when the most speculative assets in the marketplace peaked and began to suffer. Things like cryptocurrencies, SPACs, recent IPOs and profitless growth stocks trading at excessive valuations. Now we find global U.S. dollar money supply growth negative on a year over year basis, a level where financial and economic accidents have occurred historically. In many ways, that's exactly what happened in the U.K. bond market last week, forcing the Bank of England's hand. There are many reasons why a U.S. dollar liquidity is so tight; central banks raising rates and shrinking balance sheets, higher oil prices and inflation in many goods bought and sold in dollars, incremental regulatory tightening and lower velocity of money in the real economy as activity dries up in critical areas like housing. In short, U.S. dollar supply is tight for many reasons beyond Fed policy, but only the Fed can print the dollars necessary to fix the problem quickly. We looked at the four largest economies in the world, the U.S., China, the Eurozone and Japan, to gauge how much U.S. dollar liquidity is tightening. More specifically, money supply in U.S. dollars for the Big Four is down approximately $4 trillion from the peak in March. As already mentioned, the year over year growth rate is now in negative territory for the first time since March of 2015, a period that immediately preceded a global manufacturing recession. In our view, such tightness is unsustainable because it will lead to intolerable economic and financial stress, and the problem can be fixed very easily by the Fed if it so chooses. The first question to ask is, when does the U.S. dollar become a U.S. problem? Nobody knows, but more price action of the kind we've been experiencing should eventually get the Fed to back off. The second question to ask is, will slowing or ending quantitative tightening be enough? Or will the Fed need to restart quantitative easing? In our opinion, the answer may be the latter if one is looking for stocks to rebound sustainably. Which leads us to the final point of this podcast - a Fed pivot is likely at some point given the trajectory of global U.S. dollar money supply. However, the timing is uncertain and won't change the downward trajectory of earnings, our primary concern for stocks at this point. Bottom line, in the absence of a Fed pivot, risk assets are likely headed lower. Conversely, a Fed pivot, or the anticipation of one, can still lead to sharp rallies like we are experiencing this morning. Just keep in mind that the light at the end of the tunnel you might see if that happens, is actually the train of the oncoming earnings recession that even the Fed can't stop. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

3 Okt 20224min

Amidst increased volatility across credit, equity and FX markets, many investors this week are wondering, what is the path ahead for Fed intervention? Chief Cross Asset Strategist Andrew Sheets, Global Chief Economist Seth Carpenter and Head of Thematic and Public Policy Research Michael Zezas discuss.----- Transcript -----Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Seth Carpenter: And I'm Seth Carpenter. Morgan Stanley's Global Chief Economist. Michael Zezas: And I'm Michael Zezas, Head of Global Thematic and Public Policy Research. Andrew Sheets: And on this special edition of the podcast, we'll be talking about intervention, inflation and what's ahead for markets. It's Friday, September 30th at 9 a.m. in San Francisco. Michael Zezas: So, Andrew, Seth, we've been on the road all week seeing clients and that's come amidst some very unusual moves in the markets and interventions by a couple of central banks. Andrew, can you put in a context for us what's happened and maybe why it's happened? Andrew Sheets: Thanks, Mike. So I think you have the intersection of three pretty interesting stories that have been happening over the last couple of weeks. The first, and probably most important, is that core inflation in the U.S. remains higher than the Federal Reserve would like, which has kept Fed policy hawkish, which has kept the dollar strong and U.S. yields moving higher. Now, one of the currencies that the dollar has been strongest against is the Japanese yen, which has fallen sharply in value this year. Now we saw Japan finally intervene into the currency markets to a limited extent to try to support the yen but that support was short lived and we saw the dollar continue to strengthen. The other story that we saw occurred in the U.K., a country we discussed on this podcast recently about some of its unique economic challenges. The U.K. has also seen a weak currency against the dollar. But in addition to that, because of the market's reaction to recent fiscal policy proposals, we saw a very large rise in U.K. bond yields, which caused market dislocations and pushed the Bank of England to intervene in bond markets in a way that drove some of the largest moves in U.K. interest rates, really in recorded history. So a lot's been going on, Mike, it's been a very busy couple of weeks, but it's a story at its core about inflation leading to intervention, but ultimately not really changing a core backdrop of higher U.S. yields and a stronger U.S. dollar. Seth Carpenter: I completely agree with you on that, Andrew. And I think it brings up some of the questions that you and I have got in our client meetings this week, which is, 'where can this end?' Any trend that's not sustainable won't last forever, as the saying goes. So what would cause sort of an end to the dollar's run? And I think a natural place to look is, what would cause the Fed to stop hiking? I think the first thing that's worth strongly emphasizing is, from the Fed's perspective, a narrow monetary policy mandate, the rising dollar is actually a good thing. A stronger dollar means lower imported inflation. A stronger dollar means less demand for U.S. exports from the rest of the world. The Fed is fighting inflation by hiking interest rates, trying to slow the economy and thereby reduce inflationary pressures. Right now, this run in the dollar is doing their job for them. Michael Zezas: I would add to that that we've been getting a lot of questions about, 'when would the Fed or the Treasury see this weakness and want to intervene on behalf of markets?' And I think the answer is it's unlikely to happen anytime soon. And there's really kind of two reasons for that. One, doing so would contradict the Fed and the Treasury's own stated goals of fighting inflation right now. I think there are heavy political and policy incentives that haven't changed that support that being the policy direction for those institutions. And then the second is, even if you intervened right now, our FX research team has pointed out it's probably unlikely to work. At the moment, there aren't a tremendous amount of FX reserves in the system with which to intervene. And so any intervention would probably deliver short term results. So long story short, if the intervention is against your goals and wouldn't likely work anyway, it's probably not going to happen. So, Andrew, I think this kind of brings the conversation back around to you. If there really isn't going to be any net change in the Federal Reserve's stance towards monetary policy, then what should investors expect going forward? Andrew Sheets: So at the risk of sounding simplistic, if we're not going to see a change in policy response from the Fed, then we shouldn't expect a major change in market dynamics. Core inflation remains higher than we think the Fed is comfortable with. That will keep pressure on the Fed to keep making hawkish noises that should keep upward pressure on the front end of the curve and keep the curve quite inverted. We think that helps support the dollar because while the dollar might be expensive in many measures of foreign exchange valuation, the dollar is still paying investors much more than currencies like the yen or the UK pound in real interest rates. And that differential is powerful, that differential is important. And I think that differential will keep investors looking for the safety and stability and higher yields of the U.S. dollar. Look, taking a step back, I think markets are adjusting to this dynamic where the Fed is not your friend as an investor. Which is the pattern that we saw through most of financial market history, but was different in the post global financial crisis era, when the level of stress on the markets was so severe that the level of policy support had to be extraordinary. And so that is a dynamic that's shifting now that we're facing a stronger economy, now that we're facing much stronger consumer and corporate demand, we're facing the more normal tradeoff where strong labor markets, strong consumer demand leads to a Federal Reserve that's really trying to tighten the reins and slow the economy down, slow financial market activity down. So, you know, investors are still sailing into that headwind. We think that presents a headwind to risky assets. We think that presents a headwind to the S&P 500. And we think, with the Fed still sounding quite serious on inflation, still erring on the side of caution, that will lead investors to continue to think more rate hikes are possible and support the U.S. dollar against many other currencies in the developed market, which still have lower yields, especially on an inflation adjusted basis. Seth Carpenter: So, Andrew, I think I want to jump in on that because I think what you're saying is, for now, nothing's changing and so we should expect the same market dynamics. Which brings up the question that you and I have got this week as we've been seeing clients, which is, 'what would cause the Fed to pivot? What would cause the Fed to change its policies?' And I think there, I would break it into two parts. Going back to my first point about what the rising interest rates and the rising dollar have been doing, they've been doing exactly what the Fed wants, limiting demand in the United States, slowing growth in the United States, and, as a result, putting downward pressure on inflation. If we get to the point where the US economy is clearly slowing enough, if we get data that is convincing that inflation is on a downward trajectory, that's what the Fed is looking for to pause their hiking cycle. So I think that's the first answer. The other version, though, is the market volatility that we're seeing is being driven by some of this policy action. We could get feedback loops, we could get increasing bouts of volatility where markets start to break, we could get credit markets breaking, we could get more volatility and interest rate markets like we saw in the U.K.. I think at some point we can see where there's a feedback loop from financial market disruptions globally that threatens the United States. And at some point, that kind of feedback could be enough to cause the Fed to take a pause. Andrew Sheets: So Seth, that's a great point. And actually, I want to push you on specifics here. How do you and the economics team think about a scenario where, let's say inflation is 3/10 lower than expected next month, or where we go from a very strong level of reading in the labor market? What would be an indication of the type of market stress that the Fed would care about relative to something it would see as more the normal course of business? Seth Carpenter: I don't think one month's worth of data coming in softer than forecast would be enough to completely change the Fed's mind, but it would be enough to change the Fed's tone. I think in those circumstances, if both nonfarm payrolls and CPI came in substantially below expectations, you would hear Chair Powell at the November meeting saying things like, 'We got some data that came in softer and for now, we're going to monitor the data to see if this same downward trajectory continues.' I think that kind of language from Powell would be a signal that a pivot is probably closer than you might have thought otherwise. Conversely, when it comes to financial markets, I think the key takeaway is that it has to be the type of financial market disruptions that the Fed thinks could spill back to the U.S. and hurt overall growth enough to slow the economy, to bring inflation down. Credit market disruptions are a key issue there. Sometimes we've seen global risk markets and global funding markets get disrupted. I think it's very hard to say ex-ante what it would take. But the key is that it would have to be severe enough that it would start to affect U.S. domestic markets. Andrew Sheets: So, Seth, Mike, it's been great to talk to you. So just to wrap this up, we face a backdrop where inflation still remains higher than the Federal Reserve would like it. We think that keeps policy hawkish, which keeps the dollar strong. And even though we've seen some market interventions to a limited degree, we don't see much larger interventions reversing the direction of the dollar. And we don't think such interventions, at the moment, would be particularly effective. We think that keeps the dollar strong and we think that means headwinds for markets, which leaves us cautious on risky assets in the near term. As always, this is a fast evolving story and we'll do our best to keep you up to date on it. Andrew Sheets: 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 find the show.

30 Sep 202210min

Asia and EM equities are on the verge of the longest bear market in their history, so what is the likelihood that a sharp fall in prices follows soon after?----- Transcript -----Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing the ongoing bear market in Asia and Emerging Market equities. It's Thursday, September the 29th at 8 a.m. in Singapore. We have repeatedly emphasized that patience may be rewarded during what will likely, by the end of this month, become the longest bear market in the history of Asia and Emerging Market equities. Indeed, we argued that the August Jackson Hole speech by Fed Chair Powell, and the mid-September upside surprise in U.S. CPI inflation likely accelerated a downward move towards our bear case targets near term. And in recent weeks, the MSCI Emerging Markets Index has indeed given back almost all of the gains it had recorded from the COVID recession lows. To our mind, this raises the likelihood that a classic capitulation trough, a sudden sharp fall in prices and high trading volumes, could be forming in a matter of weeks. Now, all cycles are not made alike, and this one is unusual in a number of key regards. Most notably, the dislocations in the supply side of the global economy caused by COVID and geopolitics. Moreover, China is not easing policy to the same extent as helped generate troughs in late 2008 and early 2016. Thus, caution is warranted in drawing too firm a set of conclusions from relationships that have held in the past. That said, by the end of this month, the current bear market will likely become the longest in the history of the asset class, overtaking in days duration that triggered by the dot com bust in the early 2000's. And after a more than 35% drawdown, the MSCI Emerging Markets Index is now trading close to prior trough valuations at only 10x price to consensus forward earnings. Our experience covering all previous bear markets back to 1997/1998 suggests to us ten sets of indicators to monitor. We've recently undertaken an exercise to score each indicator from 1, which equates to a trough indicator not enforced at all to 5, which indicates a compelling trough indicator already in place. Currently, the sum of the scores across the factors is 32 out of a maximum of 50, which we view as suggesting that a trough is approaching but not yet fully conclusive at this stage. In our view, the U.S. dollar, which continues to rise, including after the most recent FOMC meeting, gives the least sign of an impending trough in EM equities. Whilst the underperformance of the Korean equity market and the semiconductor sector, the recent sharp fall in oil price and the fall in the oil price relative to the gold price give the strongest signs. In this regard, we would note that within our coverage we recently downgraded the energy sector to neutral, upgrading defensive sectors, including telecoms and utilities. We intend to update the evolution of these indicators as appropriate as we attempt to help clients move through the trough of this unusually long Asia and Emerging Markets equity bear market. Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.

29 Sep 20223min