Is American Market Dominance Over?

With many investors predicting the U.S. dollar to continue to weaken, its potential for diversification and high yields may indicate otherwise.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Assets 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 Tuesday, April 25th at 2 p.m. in London. The U.S. dollar has fallen about 11% from its highs last September. We think a majority of investors expect that weakness to continue, driven by factors ranging from expensive valuations to potential slowing of the U.S. economy, to the view that a more fragmented geopolitical backdrop will lead to less trade and transactions in U.S. dollars. In contrast, our foreign exchange strategists think it's more likely that the dollar strengthens. I want to discuss the idea of dollar strength from a larger lens and what it could mean for a cross-asset portfolio. For a multi-asset investor, the greatest appeal of the U.S. dollar comes from its diversification. At present, it is one of the few positive carry diversifiers, which is another way of saying that it's one of the few assets out there that pays you while also acting as a portfolio hedge, thanks to the dollar generally moving in the opposite direction of riskier assets like stocks or high yield bonds. Importantly, that diversification from the U.S. dollar makes a lot of intuitive sense to us. We think the dollar could do well if U.S. growth is very hot, as investors are drawn to even higher U.S. rates under that scenario, or if growth is very weak as investors seek out safety and liquidity. These extremes in growth, we think, represent two of the key risks, for riskier assets. In contrast, the dollar probably does weaken if growth is down the middle and a so-called soft landing for the economy. In this case, modest Fed easing without the fear of recession would likely cause investors to seek out cheaper, more volatile currencies. But this soft landing scenario is probably the best outcome for the riskier other parts of one's portfolio, allowing the dollar to provide diversification as it zigs while other assets zag. But what about the dollar's higher valuation or the threat of geopolitical shifts? Well, on valuation, our work suggests that it tends to be a pretty weak predictor of foreign exchange returns over the next 6 to 12 months, for better or for worse. And on geopolitical shifts, the dollar remains the dominant currency of global trade. And importantly, over the last year, a year that’s contained quite a bit of geopolitical uncertainty, it's continued to show diversification benefits. In summary, many investors expect U.S. dollar weakness to continue. Thanks to its high yield and powerful potential for diversification, we think it's more likely to appreciate. 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 Apr 20232min

The drive to reduce carbon emissions could trigger the biggest transformation of the steel industry in decades. Global Head of Sustainability Research, Stephen Byrd, Head of European Metals and Mining Research, Alain Gabriel, and Head of the Americas Basic Materials Team, Carlos De Alba, discuss. ----- Transcript -----Stephen Byrd: Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research. Alain Gabriel: And I’m Alain Gabriel, Head of Europe Metals and Mining Research. Carlos De Alba: I am Carlos De Alba, Head of the Americas Basic Materials Team. Stephen Byrd: On this special episode of the podcast, we'll discuss the implications of decarbonization in the steel industry. It's Monday, April 24th at 10 a.m. in New York. Alain Gabriel: And 3 p.m. in London. Stephen Byrd: Achieving net zero is a top priority as the world moves into a new phase of climate urgency, and global decarbonization is one of the three big themes for 2023 for Morgan Stanley research. Within this broader theme, we believe that decarbonizing steelmaking has the potential to trigger the biggest transformation of the steel industry in decades. Stephen Byrd: Alain to set the stage and just give our listeners a sense of the impact of steelmaking, just how much does steel contribute to global CO2 emissions? Alain Gabriel: Thank you, Stephen. In fact, the steel industry emits around 3.6 billion tonnes of CO2 per annum. And this enormous carbon footprint puts the industry at the heart of the climate debate, and public policy is rapidly evolving towards stricter emissions reductions targets, but also shorter implementation timelines. So for instance, in Europe, which is leading this transformation by simultaneously introducing a carbon border adjustment mechanism, which is otherwise known as CBAM and gradually reducing free CO2 allowances until their full removal by 2034. Stephen Byrd: So, Alain, given the size of Steel's contributions to emissions, it should come as no surprise that decarbonizing steel would likely really reconfigure the entire supply chain, including hydrogen, renewable energy, high quality iron ore and equipment providers. So, Alain, given this impending paradigm shift, what is the potential impact on upstream resources? Alain Gabriel: Yes, the steel value chain is collectively exploring various ways to reduce carbon emissions, whether it was miners, steelmakers or even capital equipment providers. However, we think the most promising path from today's perspective appears to be via the hydrogen direct reduced iron electric arc furnaces process, which is also known as H2DRIEAF in short. Admittedly, if we were to have this conversation again in three years, this conclusion might be different. But back to the H2DRIEAF process, it promises to curb emissions by 99% by replacing carbon from coal with hydrogen to release the oxygen molecules from iron ore and convert it to pure iron. The catch is that this process is resource intensive and would face significant supply constraints and bottlenecks, which in a way is positive for upstream pricing.So if we were to hypothetically convert the entire industry in Europe today, we will need more than 55% of Europe's entire production of green hydrogen last year. And we'll also need more than double the global production of DRI grade pellets, which is a niche high grade iron ore product. Stephen Byrd: Alain, you believe that steel economics in Europe is really at an inflection point right now, and given that Europe will likely see the biggest disruption when it comes to the green steel transformation, I wondered if you could give us a snapshot of the current situation in Europe and of your outlook there. Alain Gabriel: Should steel mills choose to adopt the H2DRIEAF proccess, they would need to build out an entire infrastructure associated with it, and we detail each component of that chain in our note. But in aggregate, we estimate that the average capital intensity would be approximately $1,200 per ton, and this excludes the build up of renewable electricity. So on OpEx, green hydrogen and renewable electricity will constitute more than 50% of production costs and this will lead to wide disparities between regions. So the economics of this transformation will only work, in our view, under effective policy support to level the playing field. And this would include a combination of grants, subsidies and carbon border taxes. Fortunately, the EU policy is moving in that direction but is lagging the United States. Stephen Byrd: So, Carlos, as we heard from Alain, Europe is leading this green steel transformation. But at the same time, the U.S. has the greenest steel footprint and is benefiting from some relative advantages vis a vis Europe and the rest of the world. Could you walk us through these advantages and the competitive gap between the U.S. and other regions? Carlos De Alba: Yeah, I mean, definitely the U.S. is already very well positioned. And what drives this position of strength is the fact that about 70% of the steel production in the U.S. is made out of electrical furnace, and that emits roughly around half a ton of CO2 per ton of steel, which is significantly better than the average of 1.7 tons per ton of steel and the blast furnace route average of around 2 tons per ton of steel. So that is really the genesis of the better position that the U.S. has in terms of emissions. Another way of looking at it is the U.S. produces around 6% of the global crude steel and it only makes around 2% of the overall steel emissions in the world. Stephen Byrd: That's a good way of laying it out, Carlos. It's interesting, in the U.S., the cost of electricity being relatively low certainly does help with the cost of making steel as well. I wanted to shift over to China and India, which are responsible for two thirds of global steel emissions. How are they positioned for this green steel transition? Carlos De Alba: Yeah, I mean, these two countries are significant contributors to the emissions in the world. And when you take the average emission per ton of steel produced in India, it's around 2.4 tons and in China it's around 1.8 tons. And the reason being is that they have a disproportional majority of their steel made under the blast furnace route that, as I alluded to previously, emits more CO2 per ton of steel than other routes like the electrical furnaces. So it's going to take some time definitely for them to reposition their massive steel industry steel capacity and reduce their emissions. We need to keep in mind that these two countries in particular have to weigh not only the emissions that their steel sector provides, but also the economic implications of such an important sector. They contribute to jobs, they contribute to economic activity, they provide the raw material for their infrastructure and the development of their cities and their urbanization trends. So for them, it is not necessarily just straightforward a matter of reducing their emissions, but they need to weigh it and make sure that they have a balance between economic growth, urbanization, infrastructure buildup and obviously the environment. Carlos De Alba: So Stephen, given the scale of the global steel industry, what are some of the broader sustainability implications of the shift towards green steel production? How do you view this transition through the lens of your environmental, social and governance or ESG framework? Stephen Byrd: Yeah Carlos as Alain started the scope of emissions from the steel industry certainly is worthy of attention. We think a lot about the supply chain required to provide the clean energy and electrolyzers necessary to achieve this transformation that you both have laid out. Now, green hydrogen supply in particular is limited and will take some time to ramp up. So while technically feasible, there are numerous hurdles to overcome to make widespread green hydrogen use a reality. We do expect the ramp up to be gradual. A lot of capital is being deployed, but this will take time. Now, on clean energy, I think it's a bit more straightforward. The cost of clean energy has been dropping for years, just as a frame of reference in the United States from 2010 to 2020, the cost of clean energy dropped annually by about 15% per year, which is quite remarkable. Now, the levelized cost of electricity from renewables is lower in the US and China relative to Europe. So we think a lot about the growth in clean energy. We do think that the capital will be there. The cost of clean energy we believe will continue to drop. So that is a hopeful development that over time should result in a lower and lower cost for green steel. Stephen Byrd: Alain, Carlos, thanks for taking the time to talk. Alain Gabriel: Great speaking with you both.Carlos De Alba: Thank you very much. I enjoy your discussions as well. Stephen Byrd: 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.

24 Apr 20238min

With equity markets showing strength in the face of slowing growth, investors are left wondering how, or if, they can remain resilient.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Assets 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, April 21st at 2 p.m. in London. Meeting with investors over the last several weeks, there's one question above all others that seems to be on people's mind. In the face of slowing growth, tightening policy, banking sector stresses and uninspiring valuations, why are markets, especially equity markets, so resilient? Like many things in the market, there is no one reason, and it's also impossible to know for sure. But we have some suspicions about what is and isn't behind the strength and what that means going forward. One trio of factors rolled out to explain this resiliency, is the idea that growth and earnings are holding up well, the Fed is once again injecting liquidity into the system, given recent banking sector challenges and investors are already so negative that the risks are well known. Yet each of these explanations seems to come up a little short. Global growth in the first quarter was better than expected, but markets should care more about the forward looking outlook, which looks set for deceleration, while estimates for corporate earnings have generally been falling throughout the year. While the Fed did provide extra liquidity given recent banking sector challenges, this looks very different from traditional quantitative easing, especially as the banks continue to tighten their lending activity. And while sentiment feels cautious, perhaps as evidenced by the popularity of this question, measures that try to quantify that fear have generally normalized quite a bit and look a lot closer to average than extreme. So what do we believe is going on? First, the stock market is often seen as a broad proxy for the economy or risk appetite, but in 2023 it's been unusually swayed by a small number of very large stocks in the U.S. and Europe. That still counts, of course, but it makes drawing broad conclusions about what the stock market is doing or saying a lot more difficult. Second, recent banking issues created an odd dynamic where markets could celebrate the possibility of easier central bank policy almost immediately, while the real economic impact of tighter lending standards arrives at some uncertain point in the future. That provides an immediate boost for markets, but the fundamental challenges of that tighter bank lending are still to come. Third, and just as important, the market tends to take a view that the end of central bank interest rate increases will be a positive. That is what the data says if you look across all hiking cycles since, say, 1980. But if you only look at times when the yield curve is inverted and the Fed has stopped hiking, like it is today, the picture looks a lot less rosy. Market resilience has likely had several drivers. But with measures of sentiment starting to look more balanced, growth still set to slow and markets already expecting easier central bank policy than our economists expect, we think the outlook remains challenging as we look beyond April. 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 Apr 20233min

"Smart chemotherapy" could change the way that cancer is treated, potentially opening up a $140 billion market over the next 15 years.----- Transcript -----Welcome to Thoughts on the Market. I'm Mark Purcell, Head of Morgan Stanley's European Pharmaceuticals Team. Along with my colleagues bringing you a variety of perspectives, today I'll talk about the concept of Smart Chemotherapy. It's Thursday, the 20th of April at 2 p.m. in London. Cancer is still the second leading cause of death globally, accounting for approximately 10 million deaths worldwide in 2020. Despite recent advances in areas like immuno-oncology, we still rely heavily on chemotherapy as the mainstay in the treatment of many cancers. Chemotherapy originated in the early 1900s when German chemist Paul Ehrlich attempted to develop "Magic Bullets", these are chemicals that would kill cancer cells while sparing healthy tissues. The 1960s saw the development of chemotherapy based on Ehrlich's work, and this approach, now known as traditional chemotherapy, has been in wide use since then. Nowadays, it accounts for more than 37% of cancer prescriptions and more than half of patients with colorectal, pancreatic, ovarian and stomach cancers are still treated with traditional chemo. But traditional chemo has many drawbacks and some significant limitations. So here's where "Smart Chemotherapy" comes in. Targeted therapies including antibodies to treat cancer were first developed in the late 1990s. These innovative approaches offer a safer, more effective solution that can be used earlier in treatment and in combination with other cancer medicines. "Smart Chemo" uses antibodies as the guidance system to find the cancer, and once the target is reached, releases chemotherapy inside the cancer cells. Think of it as a marriage of biology and chemistry called an antibody drug conjugate, an ADC. It's essentially a biological missile that hones in on the cancer and avoids collateral damage to the healthy tissues. The first ADC drug was approved for a form of leukemia in the year 2000, but it's taken about 20 years to perfect this "biological missile" to target solid tumors, which are far more complex and harder to infiltrate into. We're now at a major inflection point with 87 new ADC drugs entering development in the past two years alone. We believe smart chemotherapy could open up a $140 billion market over the next 15 years or so, up from a $5 billion sales base in 2022. This would make ADCs one of the biggest growth areas across Global Biopharma, led by colorectal, lung and breast cancer. Large biopharma companies are increasingly aware of the enormous potential of ADC drugs and are more actively deploying capital towards smart chemotherapy. It's important to note, though, that while a smart chemotherapy revolution is well underway in breast and bladder cancer, the focus is now shifting to earlier lines of treatment and combination approaches. The potential to replace traditional chemotherapy in other solid tumors is completely untapped. A year from now, we expect ADC drugs to deliver major advances in the treatment of lung cancer and bladder cancer, as well as really important proof of concept data for colorectal cancer, which is arguably one of the biggest unmet needs out there. Given vastly improved outcomes for cancer patients, we believe that "Smart Chemotherapy" is well on the way to replacing traditional chemotherapy, and we expect the market to start pricing this in over the coming months. Thanks for listening. If you enjoy this show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

20 Apr 20233min

Recent interactions between China and Europe signal a continuing reorganization of global commerce around multiple power bases, bringing new and familiar challenges for companies.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the U.S.-China relationship and the shift to a multipolar world. It's Wednesday, April 19th, at 9 p.m. in New York. As listeners here already know, one of the big secular themes we've been tracking in recent years is the shift to a multipolar world, one where instead of having one major power base, the United States, you now have multiple power bases to organize global commerce around, including China and Europe. And recent interactions between China and Europe underscore this trend. For example, President Macron of France recently noted following a trip to China that Europe need not precisely follow the U.S. in how it approaches its relationship with China. While those comments have received pushback in other European capitals, it's fair to say that Europe, with its relatively more interconnected and trade-based economy, may have a more nuanced approach to China than its traditional ally in the U.S.. In any case, multiple power bases mean multiple challenges for companies doing business on a global scale. This trend is most noticeable to U.S. investors in large cap stocks, where multinationals continue to announce shifts in the geographic mix of their supply chains. While incremental, some of these changes seemed unfathomable just a few years ago. Take a recent Bloomberg News report about a major tech company that continues to shift, again incrementally, new production of some products out of China and into places like India. While the news report doesn't draw an explicit link between those moves and U.S. policy choices, we think such a story speaks to the influence of the non-tariff barriers that the U.S. has raised in recent years as it seeks to protect new and emerging tech industries in its jurisdiction that it deems important for national and economic security. This includes existing export restrictions and the potential for outbound investment restrictions, which could hamper companies seeking to build production facilities in countries like China, where sensitive technologies would either be produced or be part of the production process. To keep it simple, the multipolar world comes with new costs for many types of companies, and it's becoming clearer and clearer who will bear those costs and who will benefit from that spend. We've previously highlighted potential geographical beneficiaries like Mexico and India and will continue to check in with new work on specific sector impacts to 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.

19 Apr 20232min

As the U.S. banking sector faces oncoming regulatory changes, how will the smaller banks react to these new requirements and what will the impact be on markets?----- 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 impact of potential regulatory changes on bank assets. It's Tuesday, April 18th at 11a.m in New York. In the wake of the tumult in the banking sector since early March, and the significant intervention by the authorities, it is likely that a regulatory response will follow, particularly focused on the regulation of regional banks. President Biden has already called on the federal banking agencies in consultation with the Treasury Department, to consider a set of reforms that will reduce the risk of future banking crises. A review led by Michael Barr, the Vice Chair for Supervision at the Federal Reserve Board, is set to be released by May 1st and will likely offer some indication as to where future bank regulation might be headed. In this context, it is worthwhile to examine potential changes to regional bank regulation, reflect on how banks would respond to such changes and consider their impact on markets. Across all banks, there are approximately 4.7 trillion of non-interest bearing deposits with the duration of about seven years. Banks will likely need to either review and re-justify or shorten such deposits. Our bank equity analysts expect two key regulatory changes TLAC, total loss absorbing capacity and LCR, liquidity coverage ratio, to be extended to smaller banks, about $100 billion in assets, though this process will likely not get fully implemented until 2027. From the perspective of rates markets, these changes make the case for steepening of the curve. Our rate strategists see bank demand for treasuries increasing relative to other assets with greater LCR requirements. Both shortening deposit duration and implementing LCR suggest that banks would favor shorter dated Treasuries over longer dated Treasuries. More longer term issuance due to TLAC, drives higher long term yields and fixed income, with support curve steepeners for Treasuries over the medium term. For agency mortgage backed securities, these changes will result in less demand from banks and consequently wider mortgage spreads. For munis, these changes would likely imply a lower footprint from banks with available for sale securities favored or held to maturity securities. For securitized credit markets, we see downside in demand ahead. Longer term outlook for securitized credit depends on the specifics of regulatory reform, but is likely to remain tepid for some time to come. The expansion of TLAC to smaller banks could intensify supply headwinds in the medium term. Our credit strategists believe that supply risks in bank credit are now skewed to the upside. The emphasis on funding diversity and shift away from deposits to wholesale funding, is likely to keep regional bank issuance elevated for longer. An important lesson from recent events in the banking sector, is that the risks to the asset banks hold, extend beyond credit risk into other risks, most notably interest rate risk. While interest rate and convexity risks are reflected in Comprehensive Capital Analysis Review, CCAR and Horizontal Liquidity Review, HLR test, arguably not having an interest rate component to risk weights enable banks, and regional banks in particular, to seek term premia to support their earnings. It is not our base case that this will change. However, it is possible that regulators would at least consider enacting some type of a charge for owning longer-duration securities. At a minimum, we expect the regulators could require all banks to flow marked-to-market hits from available-for-sale securities through their regulatory capital ratios, something that the big banks have been doing already. Ultimately, new regulations for regional banks will take time for formulation and implementation. We'll be watching developments in this space closely. 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 Apr 20234min

While some investors may be cheering due to softer than expected inflation data, revenues may begin to disappoint in the face of a credit crunch brought on by recent banking stress.----- 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, April 17th, at 11:30 a.m. in New York. So let's get after it. A month ago, when the banking stress first surfaced, my primary takeaway for U.S. equity markets was that it would lead to a credit crunch. Given our already well below consensus outlook for corporate earnings, it simply gave us more confidence in that view. Fast forward to today and the data suggests a credit crunch has started. More specifically, they show the biggest two week decline in lending by banks on record as they simultaneously sell mortgages and treasuries at a record pace to offset deposit flight. In fact, since the Fed began raising rates a year ago, almost $1 trillion in deposits have left the banking system. Throw in the already tight lending standards and it's no surprise credit growth is shrinking. If that isn't enough, last week, the latest small business survey showed that credit availability had its biggest drop in 20 years, while interest costs are at a 15-year high. There's a passage in Ernest Hemingway's The Sun Also Rises, in which a character is asked how he went bankrupt. "Two ways", he answers. "Gradually, then suddenly". This is a good description of recent bank failures. The losses from long duration Treasury holdings and concentrated deposit risk built up gradually over the past year and then suddenly accelerated, leading to the surprising failures of two large and seemingly safe banks. In hindsight, these failures seem predictable given the speed and magnitude of the Federal Reserve's rate hikes, some regrettable regulatory treatment of bank assets and concentrated deposits from corporates. Nevertheless, most did not see the failures coming, which begs the question of what other surprises may be coming from the Fed's abrupt monetary policy adjustment? In contrast to what we expected, the S&P 500 and Nasdaq have traded well since these bank stresses appeared. However, small caps, banks and other highly leveraged stocks have traded poorly as the market leadership turned more defensive and in line with our sector and style recommendations. Our contention is that the major averages are hanging around current levels due mostly to their defensive and high quality characteristics. However, that should not necessarily be viewed as a signal that all is well. On the contrary, the gradual deterioration in the growth outlook continues, which means even these large cap indices are at risk of a sudden fall like those that we have witnessed in the regional banking and small cap indices. The analogy with Hemingway's poetic description of bankruptcy can extend to the earnings growth deterioration observed over the past year. Until now, the decline in earnings estimates for the S&P 500 has been steady and gradual. Since peaking in June of last year, the forward 12 month bottoms up consensus earnings per share forecast for the S&P 500 has fallen at a rate of approximately 9% per annum, which is not severe enough for equity investors to demand the higher equity risk premium we think they should. Further comforting investors is the consensus earnings forecast that implies first quarter will be the trough rate of change for S&P 500 earnings per share. This is a key buy signal that we would normally embrace, if we believed it. Instead, if we are right on our well below consensus earnings forecast, the rate of decline in these estimates should increase materially over the next few months as revenue growth begins to disappoint. To date, most of the disappointment in earnings has been a result of lower profitability, particularly in the technology, consumer goods and communication services sectors. To those investors cheering the softer than expected inflation data last week, we would say, be careful what you wish for. Falling inflation last week, especially for goods, is a sign of waning demand, and inflation is the one thing holding up revenue growth for many businesses. The gradually eroding margins to date have been mostly a function of bloated cost structures. If and when revenues begin to disappoint, that margin degradation can be much more sudden, and that's when the market can suddenly get in front of the earnings decline we are forecasting, too. Bottom line, continue to favor companies with stable earnings that are defendable in the deteriorating growth environment we project. 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.

17 Apr 20234min

Artificial Intelligence is clearly a powerful tool that could help a number of sustainability objectives, but are there risks attached to these potential benefits? Global Head of Sustainability Research Stephen Byrd and Global Sustainability Analyst Brenda Duverce discuss.----- Transcript -----Stephen Byrd: Welcome to Thoughts on the Market. I'm Stephen Bryd, Morgan Stanley's Global Head of Sustainability Research. Brenda Duverce: And I'm Brenda Duverce from the Global Sustainability Team. Stephen Byrd: On the special episode of the podcast, we'll discuss some key A.I. related opportunities and risks through the lens of sustainability. It's Friday, April 14th at 10 a.m. in New York. Stephen Byrd: Recent developments in A.I. make it clear it's a very powerful tool that can help achieve a great number of sustainability objectives. So, Brenda, can you maybe start by walking us through some of the potential benefits and opportunities from A.I. that can drive improved financial performance for companies? Brenda Duverce: Sure, we think A.I. can have tremendous benefits to our society and we are excited about the potential A.I. can have in reducing the harm to our environment and enhancing people's lives. To share a couple of examples from our research, we are excited on what A.I. can do in improving biodiversity protection and conservation. Specifically on how A.I. can improve the accuracy and efficiency of monitoring, helping us better understand biodiversity loss and support decision making and policy design. Overall, we think A.I. can help us more efficiently identify areas for urgent conservation and provide us with the tools to make more informed decisions. Another example is what we see A.I. can do in improving education outcomes, particularly in under-resourced areas. We think A.I. can help enhance teaching and learning outcomes, improve assessment practices, increase accessibility and make institutions more operationally efficient. Which then goes into financial implications A.I. can have in improving margins and reducing costs for organizations. Essentially, we view A.I. as a deflationary technology for many organizations. So Stephen, the Morgan Stanley's Sustainability Team has also done some recent work around the future of food. What role will A.I. play in agriculture in particular? Stephen Byrd: Yeah, we're especially excited about what A.I could do in the agriculture sector. So we think about A.I. enabled tools that will help farmers improve efficiencies while also improving the quantity and quality of crop production. For example, there's technology that annotates camera images to differentiate between weeds and crops at the pixel level and then uses that information to administer pesticides only to weed infested areas. The result is the farmer saves money on pesticides, while also improving agricultural production and enhancing biodiversity by reducing damage to the ecosystem. Brenda Duverce: But there are also risks and negative implications that ESG investors need to consider in exploring A.I. driven opportunities. How should investors think about these? Stephen Byrd: You know, we've been getting a lot of questions from ESG investors around some of the risks related to A.I., and there certainly are quite a few to consider. One big category of risk would be bias, and in the note, we lay out a series of different types of bias risks that we see with A.I. One example would be data selection bias, another would be algorithmic bias, and then lastly, human bias. Just as an example on human bias, this bias would occur when the people developing and training the algorithm introduce their own biases into the data or the algorithm itself. So this is a broad category that's gathered a lot of concern, and that's quite understandable. Another area would be data privacy and security. An example in the utility sector from a research entity focused on the power sector, they highlight that the data collected for A.I. technologies while being meant to train models for a good purpose, could be used in ways that violate the privacy of the data owners. For instance, energy usage data can be collected and used to help residential customers be more energy efficient and lower their bills, but at the same time, the same data could also be used to derive personal information such as the occupation and religion of the residents. Stephen Byrd: So Brenda, keeping in mind the potential benefits and risks for me that we just touched on, where do you think A.I's impact is likely to be the greatest and the most immediate? Brenda Duverce: Beyond the improvements A.I. can have on our society, in our ESG space in particular, we are excited to see how A.I. can improve the data landscape, specifically thinking about corporate disclosures. We think A.I. can help companies better predict their scope through emissions, which tend to be the largest component of a company's total greenhouse gas emissions, but the most difficult to quantify. We think machine learning in particular can be useful in estimating these emissions by using statistical learning techniques to develop more accurate models. Stephen Byrd: But it's ironic that when we talk about A.I., within the context of ESG, one of the drawbacks to consider around A.I. is its potential carbon footprint and emissions. So is this a big concern? Brenda Duverce: Yes, we do think this is a big concern, particularly as we think about our path towards net zero. Since 2010, emissions at data centers and transmission networks that underpin our digital environment have only grown modestly, despite rapid demand for digital services. This is largely thanks to energy efficiency improvements, renewable energy purchases and a broader decarbonization of our grids. However, we are concerned that these efficiencies in place won't be enough to withstand the high compute intensity required as more A.I. models come online. This is a risk we hope to continue to explore and monitor, especially as it relates to our climate goals. Stephen Byrd: In terms of the latest developments around risk from A.I, there's been a call to pause giant A.I. experiments. Can you give us some context around this? Brenda Duverce: Sure. In a recent open letter led by the Future of Life Institute, several A.I. researchers called for a pause for at least six months on the training of A.I. systems more powerful than GPT-4. The letter highlighted the risk these systems can have on society and humanity. In our view, we think that a pause is highly unlikely. However, we do think that this continues to bring to light why it is important to also consider the risk of A.I. and why A.I. researchers must follow responsible ethical principles. Brenda Duverce: So, Stephen, in the United States, there's currently no comprehensive federal regulation specifically dedicated to A.I.. What is your outlook for legislative action and policies around A.I., both here in the U.S. and abroad? Stephen Byrd: Yeah, Brenda, I'd say broadly it does look like the pace of A.I. development is more rapid than the pace of regulatory and legislative developments, and I'll walk through some developments around the world. There have been several calls across stakeholder groups for effective regulation, the US Chamber of Commerce being one of them. And last year we did see some state level regulation focused on A.I. use cases and the risks associated with A.I. and unequal practices. But broadly, in our opinion, we think that the likelihood of legislation being enacted in the near term is low, and that in the U.S. in particular, we expect to see more involvement from regulatory bodies and other industry leaders advocating for a national standard. The European approach to A.I. is focused on trust and excellence, aiming to increase research and industrial capacity while ensuring safety and fundamental rights. The A.I. ACT is a proposed European law assigning A.I. to three risk categories. Unacceptable risk, high risk and applications that don’t fall in either of those categories which would be unregulated. This proposed law has faced significant delays and its future is still unclear. Proponents of the legislation expect it to lead the way for other global governing bodies to follow while others are disappointed by its vagueness, the potential for it to stifle innovation and concerns that it does not do enough to explicitly protect against A.I. systems used for weapons, finance and health care. Stephen Byrd: Finally, Brenda, what are some A.I. related catalysts that investors should pay attention to? Brenda Duverce: In terms of catalysts, we'll continue to see innovation updates from our core A.I. enablers, which shouldn't be a surprise to our listeners. But we plan to continue to monitor the ever evolving regulatory landscape on this topic and the discourse from influential organizations helping to push for A.I. safety around the world. Stephen Byrd: Brenda, thanks for taking the time to talk. Brenda Duverce: Great speaking with you, Stephen. Stephen Byrd: And thanks for listening. 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14 Apr 20238min