Global Energy Markets and the US Election

Our head of corporate credit research dives into the question of correlation and market volatility, and explains why stock indices can remain stable despite a certain level of turmoil, as we have seen recently in Europe.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about correlations, and why they are currently so important to markets being calmer than they would otherwise be. It’s Thursday, June 20th at 2pm in London.Imagine you’re on a boat, maybe looking for sea life. People are milling around the deck, watching the vessel ripple through the waves. Suddenly someone spotsa whale, and everybody runs to port. The whale swims under the boat, and everybody now runs to starboard. The boat rocks significantly. But imagine the same scenario where marine life is popping up on both sides of the vessel. You and your fellow passengers are all now running past each other in both directions. The movements balance out. The boat is pretty stable. Believe it or not, this is how the volatility in the stock indices work. The individual passengers can be thought of as individual stocks, and how much they’re each moving around can be thought of as each stock’s volatility. The boat is the overall index – say, the S&P 500, the EuroStoxx 50, or an index of corporate bonds. When everybody on the boat moves together, what we’d call a high correlation environment, you’d get a lot of rocking, or volatility, at the index level. But when people are moving in opposite directions, moving past each other; you can still have a lot of running, or individual vol – but the market, or the boat, will appear much more calm. That is exactly what’s been happening, especially last week. Stocks within the S&P 500 are moving with unusual independence from each other, running to opposite sides of the boat, with the lowest such correlation in almost 20 years. That is a big reason why, despite all the volatile headlines out of Europe, and more stocks falling than rising in the US, the overall market has been surprisingly calm – and going up. Even in Europe, this phenomenon of low correlation has really helped. That volatility I mentioned relates to upcoming elections in France, which led the difference between French and German bond yields to jump to their highest level in more than a decade. But because this spread of France to Germany moved in the opposite direction as overall French yields, the overall result for French government bonds was not much. Last week, despite all the apparent ruckus, the yield on French government bonds was basically unchanged. Markets have been calmer than you would usually expect them to be. These correlations are a big reason why. We think they suggest a still healthy dynamic where markets are differentiating between different types of risks. To go back to our original analogy, there is still plenty of sea life out there for the market to look at. But these correlations are also worth watching, were they to rise significantly. If one thing were to dominate the focus and lead everybody to run to the same side of the boat, overall market volatility could rise surprisingly fast. It's something, you could say, that we're on the lookout for. Thanks for listening. If you enjoy the podcast, please leave us a review, wherever you listen, and share Thoughts on the Market with a friend or colleague today.

20 Juni 20243min

Investors watching for market reactions would do well to stick to their existing plans in an environment where the economic impacts of any particular US election outcome remains unclear. Our Global Head of Fixed Income and Thematic Research explains.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income and Thematic Research. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the US elections and its impacts on markets.It's Tuesday, June 18th at 10:30am in New York. We first started covering the 2024 US election in December of last year. With about five months to go until the event, it’s a good time to take stock of what we’ve learned that might be useful for investors. In short, there’s a lot of noise around this election, and recognizing that noise is a first step toward not making mistakes around the event. First, don’t make the mistake of confidently predicting an outcome. All indicators suggest it’s very unlikely that we’ll have a good sense about which candidate will win the election in the run up to the Election Day, and perhaps even in the days that follow. Neither candidate has a lead beyond a polling margin of error in sufficient states to suggest that if the election were held today that they would win the electoral college.Prediction markets and polling models also point to a race that’s a toss-up. It all suggests a tight race going into Election Day. And with the sustained popularity of voting by mail, vote counts could move slowly, as they did in 2020; meaning we may have to dig in for another election week.Second, don’t make the mistake of making big strategic changes in your portfolio just because it’s an election year. We recently studied this and there’s little pattern for how markets behave in the run up to an election, even when filtering for factors like similar outcomes and closeness of the race. Markets in the aggregate don’t seem to consistently price in US election outcomes ahead of time. There’s more evidence that they price in expected policy impacts once the outcome is known, which brings me to my third point.Don’t make the mistake of overconfidence when it comes to how post-election policies will impact the economy. Sure, if we knew one outcome was bad for growth and the other good, it might be advisable to buy risk assets on the news of the latter outcome occurring. But especially in this election it’s not that simple.For example, in scenarios where Republicans win the White House, you can expect greater tariffs, immigration curbs, and – if they also control congress – bigger deficits driven by tax cuts relative to alternative outcomes. According to our economists, these policies have different effects on growth, inflation and monetary policy depending on how they are constructed and timed; and so it defies simple conclusions of growth positive or growth negative, at least at this point.So bottom line, don’t mistake noise for signal when it comes to the election. Stick to the plan, such as the cross-asset framework recently put forward in our mid-year outlook. And maybe focus on some equity sectors, such as industrials and defense, which are well placed currently but have upside in certain election scenarios.Thanks for listening. If you enjoy the podcast, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

18 Juni 20243min

The AI revolution has helped fuel the tech IPO sector’s resurgence following a two-year lull. Our Co-Heads of Technology Equity Capital Markets join our Global Head of Fixed Income and Thematic Research to discuss the sustainability of this trend. ----- Transcript -----Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley.Diana Doyle: I am Diana Doyle, Managing Director and Co-Head of Technology Equity Capital Markets in the Americas.Lauren Garcia Belmonte: And I'm Lauren Garcia Belmonte, Managing Director, Co-Head of Technology Equity Capital Markets Americas.Michael Zezas: And on this episode of the podcast, we'll dive into what's ahead for the tech IPO market this year.It's Monday, June 17th, at 11 am in New York.Diana Doyle: And 8 am in San Francisco.Michael Zezas: Since 2023 only nine technology companies completed an initial public offering, which is one of the longest periods of reduced IPO activity in history. For context, compare that with the all-time record of 124 technology IPOs in 2021. But with the first quarter of 2024 behind us, we're starting to see that picture improve. With tech and AI in focus right now, on today's episode, I want to speak with Diana and Lauren from our global capital markets team to get their take on where the tech IPO environment might be headed and what investors may want to watch for.Lauren, maybe to start -- what's contributing to this resurgence in IPO activity this year?Lauren Garcia Belmonte: Well, the market backdrop has been constructive. We've had the SMP and NASDAQ trading up 10 -- 11 per cent this year and multiples have been stable for technology businesses. And against this backdrop, we've seen some IPO issuers recognize that this is a good environment in which to move forward with their IPO event. There are several benefits to becoming a public company, not just the opportunity to raise capital -- but to give liquidity to employees and to early investors in the business, and to set the company up to be a real industry leader as a public company.So, issuers are seeing the opportunity; and meanwhile, the demand side from investors has been encouraging as well. Investors in the public equities recognize that there's limited opportunity, in some instances, to underwrite growth. Right now, 55 per cent of publicly traded technology businesses are growing top line 10 per cent or less. So, the IPO opportunity, where companies generally have an attractive growth profile, is a way for these investors to get access to an opportunity to underwrite exciting growth profiles -- even when that opportunity isn't so prevalent in the public markets right now.Michael Zezas: And Diana, do you see the rebound in IPO activity as a durable trend? Maybe take us into 2025.Diana Doyle: Well, 2024 is definitely going to be better than 2022 and 2023. Now, it'll be a long time before we get back to that 124 tech IPOs in 2021 that you mentioned, Michael. But in an average year, we have about 35 to 40 IPOs, and we expect 2025 to approach more of an average. So, as Lauren said, we're encouraged by the breadth of investor demand for IPOs that we've done this year, and investors’ appetite to take risk. And all that lays the foundation for a healthy IPO market in 12 to 18 months.But it will be a slow build because IPOs are not a quick turnaround financing. It takes about six months on average to get through an IPO process. So, if you're not already underway, you're likely looking at 2025. In the meantime, we're seeing many late-stage private companies. They have plenty of cash. They're doing secondary raises to provide liquidity to employees and early investors, and they're waiting for growth rates to be more predictable -- for profitability to improve and to get more scale.So, we're excited for 2025, and the IPO market is wide open for companies that have growth and scale, profitability and that offer investors something different than what's available in the public market today.Michael Zezas: Got it. And what about macro conditions, Lauren? So perhaps the Fed's pivoting to cutting rates, the overall economic backdrop, geopolitical considerations. How do those things impact the tech IPO market?Lauren Garcia Belmonte: Yeah, absolutely. The tech IPO market is influenced by these macro considerations -- and it's in a few different ways.First, of course, and importantly, the valuation impact is real for technology businesses that have a lot of their growth on the come and a higher rate environment. Of course, that future growth needs to be discounted more significantly. The second key impact is around just how these management teams are able to manage, predict, and model out their business.In a more uncertain environment, it can be more challenging to articulate and defend the forward model that is a part of all IPO processes where you're explaining to the research analysts and investors how your business will perform, as a public company. And, of course, management teams want to set their companies up for success as public companies -- and set up for a beat and raise cadence -- which can be difficult to do when you're dealing with an uncertain macro backdrop.I think one encouraging signal -- as much as we haven't seen the Fed cut as much as people had anticipated as would have happened at the start of this year -- is that the rate of change has slowed.So, the rate increase environment was one of the quickest that we've seen; and although we haven't seen the cuts as people had anticipated, I think it's encouraging that that rate of change has adjusted and that will allow for, hopefully, more predictability in businesses going forwardMichael Zezas: Got it. That connection between predictability and rates makes a lot of sense. And it seems that the market's particularly hungry for AI names. Diana, what AI related trends are you seeing?Diana Doyle: Well, AI is this black hole right now that's drawing all the energy and attention in the private markets. There's this huge enthusiasm because the technology is improving so quickly, and there's an uncertainty how long that rapid pace of advancement will continue. This cycle, in fact, is an exaggerated version of what we've seen in prior cycles, where the monetization typically accrues first to the semiconductors and hardware, then eventually to software. So right now, a lot of the investment is going into the semiconductors and hardware, the picks and shovels, and the fundamental model of research.But in software, there's still a lot to play out in private companies to create the type of profitable, proven business models that public market investors are looking for. There are big unknowns in how enterprises are going to reallocate spend in a world of AI, what happens with all the efficiency these new tools create, how a lower barrier to entry for software creation impacts margins.Michael Zezas: And aside from AI, Lauren, what other areas within tech are seeing more activity?Lauren Garcia Belmonte: I would say that these businesses aren't in a particular spot within the tech landscape, but rather have certain characteristics in that they share -- namely that they are in attractive markets.Additionally, being a market leader is of critical importance today. No longer do people want to back the third, fourth, fifth player in a market. I think people are really focused on market leadership. So that one or two spot is going to be really important. And investors are looking for businesses that are already scaled. That market leadership typically comes along with a certain scale qualifier. But that is absolutely going to be an important feature of the businesses that are successful transitioning from the private to public markets.These companies are in the software space and the internet side. So, there's a diversity of companies that have this in common, and that could be great IPO candidates on that timeline that Diana was mentioning.Michael Zezas: And finally, I'm curious how the political election cycle might have an impact on IPO activity during the rest of this year. Diana, what's your read?Diana Doyle: Well, we do expect to see some volatility in the pre-election window in the fall, like we do in every presidential election cycle. But what's different this time is that we have a pretty good sense, not only of who the candidates will be -- but also what their presidency is likely to look like and what policies they're likely to prioritize.So that de-risks the election as a market event materially versus prior cycles. And for the IPO market, any company that's been looking at an IPO in the second half of 2024 has already evaluated pulling it forward to hit the September-October time frame and get ahead of that likely market event.But there's a narrow window for anyone who hasn't yet pulled the trigger to accelerate. Before the holidays, post-election -- where some IPOs will be able to squeeze in. In practice, most of the companies that aren't already in the pipeline now -- have their eye on 2025.Michael Zezas: Okay, so, putting it all together, seems you're both pretty confident that there's going to be a durable pickup in IPO activity.Lauren Garcia Belmonte: That's right.Diana Doyle: Yes.Michael Zezas: Okay, great. So, our audience should stay tuned. Well, Diana, Lauren, thanks for taking the time to talk.Diana Doyle: Great speaking with you, Michael.Lauren Garcia Belmonte: Yes. Thank you for having us.Michael Zezas: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen, and share the podcast with a friend or colleague today.

17 Juni 20249min

Our Head of India Research and Chief India Equity Strategist lays out his bullish post-election view on India, explaining why the market is likely to drive a fifth of global growth in the coming decade.----- Transcript -----Welcome to Thoughts on the Market. I’m Ridham Desai, Morgan Stanley’s Head of India Research and Chief India Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss our take on India’s election results and why we still believe this is India’s decade. It’s Friday, June 14th, at 2pm in Mumbai.India’s general election results are in, and the world is paying close attention. The most important aspect of the BJP led NDA retaining its majority is policy predictability – something equities tend to thrive on. We believe the market can look forward to further structural reforms. This gives us more confidence in our forecast of a 20 per cent annual earnings growth over the next five years. Macro stability with rising GDP growth relative to real rates should extend India's outperformance over Emerging Market equities. We’ve been bullish on India since April 2020, and we still believe that India is likely to drive a fifth of global growth in the coming decade. This will be underpinned by increased offshoring of both services and manufacturing, as well as the energy transition and the country's advanced digital infrastructure. India's stock market has been making new highs. The big investor debate now is what could take the India market even higher from here. We believe share prices have yet to bake in a number of positives, such as India's newfound macro stability, a likely fall in its primary deficit moving into a primary balance, and a fast-evolving deep tech sector, to name just a few.We expect critical reforms to be made in Modi’s third term. Here are three more important ones. Number one, further consolidation of India’s fiscal deficit. From a market perspective this lends itself to sustained credit growth, which we think is going to be good for India’s private banks. Number two, a continuing buildout of both physical and social infrastructure. The physical infrastructure will likely focus on railways. Social infrastructure may include more low-income housing as well as water and electricity security. These reforms make us bullish on industrial stocks. Number three, further growth in India’s manufacturing prowess. The government will likely focus on improving competitiveness via fiscal incentives and by building infrastructure within such industries as defense, electronics, aerospace, food processing and renewables. We expect India’s energy consumption to rise by around 50 per cent over the next five years with increasing contribution from renewables. From an equities perspective, we think consumer stocks are well-positioned as nearly 100 million families could move into the middle-income bracket in the next decade. At the top end of the income pyramid, India’s affluent households could quintuple to 25 million over the coming decade, which should support a surge in luxury consumption. Of course, there are plenty of risks, even with the elections behind us – from various capacity constraints to geopolitics, the impact of AI and climate change. But even with all these in mind, we still believe this is set to be India's longest and strongest bull market ever. Stay invested. Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

14 Juni 20243min

A strong economy and global stock market surge may suggest market euphoria. However, our Head of Corporate Credit Research explains why the corporate sector caution is, in fact, a good sign.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the surprising lack of confidence in corporate boardrooms, and why it could extend the cycle. It's Thursday, June 13th at 2pm in London. “Buy low, sell high.” That age-old advice is rooted in the idea that investors should try to buy when others are fearful and sell when others are euphoric. The high in prices, after all, should occur when people are as positive, and things are as good as they can possibly be. At the moment, there is plenty of focus on this idea that the market pendulum may have swung too far towards excessive positivity. The economy is strong, with US growth tracking above 2 per cent, inflation moderating and the unemployment rate still near a 60 year low. US and global stock markets are near all-time highs. And many quantitative measures of investor optimism are elevated, whether it's the low levels of expected volatility, polls of investor outlooks or ownership of equity futures. But we think there is one missing piece of this story, with relevance for credit and beyond. While investors are optimistic, corporate boardrooms remain much more restrained. And that caution could help extend the cycle. One way to measure corporate optimism is whether or not companies are adding debt; a company is more likely to borrow when it feels better about the future. Well, as of the first quarter of 2024, the growth in US non-financial corporate borrowing was at a 10-year low. And among lower rated borrowers, the issuance of high yield bonds and loans remains dominated by borrowing to repay or refinance existing debt – the most conservative type of issuance that you can get. Another way to measure corporate optimism is Mergers & Acquisitions, or M&A, as it really takes confidence in the future to acquire another company. Well, global M&A volumes in 2023 were the lowest, adjusted for the size of the economy in over 30 years. While this has picked up a bit, and we do think M&A recovers significantly over the next two years, it’s currently still very low. On the surface, there are plenty of signs that investors are entering the summer optimistic. But the corporate sector remains surprisingly restrained, especially given that solid economic data, record profits and record highs in the stock market. We’d further note that the Tech sector, where there is more optimism and much more investment spending, generally isn’t borrowing to fund this, and also enjoys unusually strong balance sheets. All of this matters because it’s been high levels of corporate optimism that have often been very bad for credit, as it’s excessive optimism that often leads to excessive risk taking, hubris, and an eventual payback that is bad for lenders. The lack of optimism, at the moment, is a good sign, and one of several reasons why we think spreads can remain tight, and the credit cycle has further to run. Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

13 Juni 20243min

Our US Thematic Strategist explains the premium that consumers will pay for convenience, and what that means for sectors including online retail, dining and package delivery.----- Transcript -----Welcome to Thoughts on the Market. I’m Michelle Weaver, Morgan Stanley’s US Thematic Strategist. Along with my colleagues bringing you a variety of perspectives, today I’ll talk about convenience and why it’s such an important factor for a number of industries. It’s Wednesday, June 12, at 11am in New York. The consumer has been weakening around the edges, and this is flowing through to companies' bottom line. Our Consumer Economist thinks that consumption is likely to continue to slow this year and even into 2025 as the labor market cools and that weighs on real disposable income, elevated rates continue to pressure debt service costs, and tighter lending standards limit credit availability. And given this setup, companies have been focusing on their value offerings, and we saw a lot of commentary around this during first quarter earnings calls. Mentions of just the word value itself were elevated. But value isn't the whole story, and consumers aren’t always just choosing the cheapest option. You and I are consumers. We are all consumers. Think about the last time you bought something. Did you pick one retailer over another because buying the item was easier? Did the company have a better website or a better mobile app? Did they offer faster shipping options or free shipping? Would the product itself save you time? And how much more were you willing to pay to make the more convenient choice? Convenience is a valuable product and a key factor in consumer choice. In fact, our survey shows that 77 percent of US consumers rate it as important and base purchasing decisions on it. Our work suggests three key conclusions. On average, consumers would be willing to pay about a 5 percent price premium for convenience. And there are two groups that place a particular emphasis on it - those who are younger and those who are more affluent. Second, consumers are willing to choose one company's product or service over another's because of convenience. Staples products and food away from home are the industries where consumers are especially likely to pick one option over another. And third, shipping features like free shipping or fast shipping are the most important convenience-related criteria when shopping online. Several industries stand to benefit from providing convenience. And convenience has been a long-term, persistent driver of eCommerce. Consumers love the combination of an ever-expanding assortment of goods and services and shrinking delivery times – and this is convenience really at its best. Convenience is easier to deliver for categories with standardized, durable products with lower purchase frequency that are easier to deliver like electronics or travel. But even within an already winning industry there is still a lot of opportunity, especially within the least penetrated categories, grocery and household and personal care. In Restaurants, fast casual is likely to continue to take share given the combination of quality and convenience. Restaurants that have led digital access -- like mobile and online orders as well as online reservations – have posted impressive growth over time. Some fast-food chains have also invested in a digital approach and will likely to continue to build on this in the future. Now unlike internet and restaurants, the parcels industry is facing a large threat from convenience, specifically fast and free shipping and easy returns. Their networks were not built to handle the quick delivery required of ecommerce volumes today, and the business-to-consumer shipping that is offered by the largest online vendors. We think convenience is an important factor for companies and one they can use to differentiate themselves in customers minds. Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

12 Juni 20244min

Our Global Chief Economist takes stock of recent elections in India, Mexico and South Africa -- and what they suggest about the market implications of the upcoming UK and US elections.----- Transcript -----Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about recent elections and upcoming elections and what they mean for the economy.It's Tuesday, June 11th at 10am in New York.Markets usually prefer simple narratives, but this week it's shown us that simplicity can be elusive. In particular, for elections, legislative outcomes can be more complicated but are consequential. Here in the US, clients often ask about the economic implications of a Trump vs. Biden presidency -- but we immediately have to flag that the congressional outcome has to be a big part of the conversation.Indeed, three important elections in the past weeks have emphasized the importance of a legislative focus. But the surprise was not in who won -- rather, in how big the legislative decisions were. In India, Prime Minister Modi was re-elected, but his BJP party lost its outright majority. Exit polls on June 1st had predicted a resounding victory for the BJP, prompting a rally in the lead up to the final results.The results surprised markets and caused a reversal. Markets have since recovered to roughly where they were before the exit polls,We expect policy predictability with the continued focus on macro stability. This focus implies moderate inflation, smaller primary deficits, along with support for domestic manufacturing and infrastructure in upcoming years. Those have been the core of our view that the Indian economy is set for continued expansion.The Mexican election was almost the reverse, where the winning candidate's party won far more votes than was expected. In response to the news, equity markets sold off and the Mexican peso depreciated. Scheinbaum was largely expected to win after the endorsement of Obrador; but by winning a supermajority, the market focus turned to Mexican fiscal discipline based on a view that there may be less restraint on government spending.Fiscal policy has been in focus for us because for the first time in recent years the government there ran a fiscal deficit. While the party has sought to reassure markets, concern has mounted regarding the risks of fiscal slippage without a more balanced legislature.Compared to India and Mexico, The South African market reaction to the election was modest, though not for a lack of surprise in the legislature. The ANC lost more of its majority than polls had predicted, which narrows the options for a coalition. The market now expects a more reform-oriented coalition to take power and support a continued improvement in the economy. For example, frequent power outages had impeded the economy for a long time, but the energy sector now appears to be more stable, and those sorts of reforms can help catalyze an improved economic outlook.Examples of India, Mexico, and South Africa have reinforced why we've remained focused on the upcoming general elections in the UK, and also the congressional outcomes in the US. In the UK, a change in government is predicted by the polls, and fiscal considerations will be in focus.So back here in the US, the fiscal outcome will largely be determined by the congressional results. To meaningfully change federal tax or spending requires legislation. And our colleagues in public policy research have flagged that under a Republican sweep, they expect lower taxes and higher spending; contrasted with a Democratic sweep that might bring somewhat higher spending, but also higher taxes leading to a narrower deficit.A split government, where the party in the White House not the same as the party controlling each of the Houses of Congress, however, probably implies more muted outcomes. While we should focus on the legislative outcomes, there are important authorities, of course, that the President can exercise independently of the Congress.So, when we highlight the importance of the legislative outcomes, we are not denying the criticality of the presidency.Thanks for listening. If you enjoy the show, please leave us a review wherever you listen to podcasts and share Thoughts on the Market with a friend or colleague.

11 Juni 20244min

Our CIO and Chief U.S. Equity Strategist explains why economic fluctuations have made it more difficult to project a possible soft or no landing outcome, and how investors can navigate this continuing market volatility.----- Transcript -----Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the continued uncertainty in economic data and its impact on markets. It's Monday, June 10th at 11:30am in New York. So let’s get after it. Over the past few months, the economic growth data has surprised to the downside with more data releases coming in below expectations than usual. Meanwhile, inflation surprises have skewed more to the upside. This is a challenging combination because it means the Fed can't cut rates yet even though it may make sense to keep the economic expansion going. As we have been discussing for months, aggressive fiscal spending is keeping the headline economy looking good on the surface. The bad news is that inflation remains too high for the Fed which has to keep interest rate policy too tight for many economic participants. Some may disagree with that statement, but we think it's hard to argue with the yield curve which remains significantly inverted and a valid indicator of interest rate policy. When combined with high price levels for many goods and services, the end result is a crowding out of many parts of the economy and consumers. From our perspective, this is most evident in the persistent underperformance of small cap stocks. In fact, this past week, small cap equities relative performance fell to new cycle lows. Even more concerning is that while small caps are showing greater interest rate sensitivity than large caps, it’s also asymmetric. While higher rates are an obvious headwind for small caps, we're skeptical that lower rates offer a comparable benefit. Last week was a good example of this dynamic when small caps underperformed early in the week when rates rose and later in the week when rates fell. All of this argues for what we have been recommending — in an uncertain macro world, we think investors should stay up the quality curve with a barbell of both growth and cyclicals to participate in both the soft and no landing outcomes. We also think it makes sense to have some defensive exposure as a hedge against the above average risk of a recession that still looms. Given the more negative skew in the economic surprise data as noted, we think the defensive part of the portfolio should outweigh cyclicals at this point. We favor staples and utilities specifically in this regard. With markets sensitive to unpredictable inflation and labor data, it's very difficult to have an edge going into these releases, particularly on the labor front where the data itself has been subject to significant and ongoing revisions. While many market participants focus on the non-farm payroll data, these data have been subject to some of the larger revisions we’ve seen in recent history. Meanwhile, the household survey has been weaker than the non-farm payroll data and job openings have fallen persistently over the last 18 months. These diverging labor dynamics are classic late cycle phenomena based on our experience. For investors, it's just another reason to stay up the quality curve and to avoid positioning for a broadening out to lower quality areas. In our view, such a broadening is unlikely in any kind of sustainable way until the Fed cuts meaningfully — and by that we mean several hundred basis points rather than the one-to-two cuts that are now priced into the markets for this year. Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

10 Juni 20243min