Vishy Tirupattur: U.S. and China on Divergent Paths

Economic growth data from the summer has bolstered belief in a possible soft landing in the U.S., while China has experienced a faster-than-expected deterioration in the macro environment.

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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 our views on the markets as we head into the fall. It's Tuesday, September 12th at 10 a.m. in New York.

As many of us head back to school, Morgan Stanley Global economics and strategy teams look back on how the economy and the markets have evolved over the summer and look ahead to what changing narratives mean for the economic outlook and asset markets. Our debate centered on two key issues. One, the outperformance of the U.S. economy and the underperformance of China economy. And two, the recent spike in government bond yields at the longer end of the curve.

The U.S. economy has been outperforming our expectations and has led markets over the summer to push out the first expected cut into 2024. The concern is that a still hot economy means that the Fed can keep policy restrictive for longer. Acknowledging the strong incoming data, our economists have revised their 2023 growth expectations significantly higher for the U.S. from 0.4% to 1.7%, even as they maintain that the Fed is done hiking and will be on hold until first quarter of 2024.

On the other hand, in China, the trajectory of economic growth has been different. Over the summer, data have been pointing to a faster than expected deterioration in the macro environment. We have seen successive and incremental property and infrastructure easing measures, but market confidence has not returned and debates around earnings, spillover effects on global growth and the impact on commodities are growing. Noting the macro and policy challenges since the mid-year outlook, our China economists have revised their 2023 growth expectations lower for China from 5.7% to 4.7% for 2023. And our emerging market equity strategists have moved to equal weight on China and revise down their MSCI Emerging Market Index target.

What about our call to be long duration? Ten year Treasury yields have sold off by about 65 basis points since our mid-year outlook on better than expected U.S. growth data, among other factors. Can this continue? Our strategists make modest changes to their rates forecast, but still see a path for low yields, countering the market narrative of growth reacceleration or a higher treasury supply technical. Thus, we reaffirm our conviction to be long duration, despite the rates market moving away from us.

Overall, our conviction on a U.S. soft landing has strengthened. But with monetary policy remaining restrictive, late cycle risks, growth, earnings and defaults remain. We maintain a defensive stance. We prefer bonds over equities and equal-weight stocks, overweight fixed income, underweight commodities, and equal weight cash. Combined with rich valuations, this makes us stay equal-weight equities, with a preference for rest of the world stocks over US stocks. In all, high carry and late cycle environment favor an overweight in fixed income.

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