Japan Summit: Consumer Resilience and Trade Uncertainty

As we head towards the final weeks of winter, we are predicting a period of continued slow growth. As evidence we look not to our shadow but at earnings estimates and inventories.----- 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 colleague bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, February 7th at 11:30 a.m. in New York. So let's get after it.In the United States, February 2nd is known as Groundhog Day. A 135-year-old tradition of taking a groundhog out of his cage to determine if he can see his shadow. In short, a sunny February 2nd means six more weeks of winter, while a cloudy day suggests an early spring. Well, last week the most famous groundhog, who lives in Pennsylvania, saw his shadow informing us to expect more cold weather for six more weeks. While this tradition lives on, its track record is pretty spotty with a 50% hit rate. Flipping a coin sounds a lot easier. However, it does jive with our market forecast for at least six more weeks of winter, and ice, as growth slows further into the spring. Signs of weakness are starting to appear, and we think they go beyond Omicron. While we remain optimistic that this could be the final major wave of the pandemic, we're not so sure growth will rebound and accelerate as many others are suggesting.First, fourth quarter earnings beat rates are back to 5%, which is the long-term average. However, this is well below the beat rates of 15-20% observed over the past 18 months, a period of over earning in our view. The key question now is whether we are going to return to normal, or will we experience a period of under earning first, or payback? We've long held the view that payback was coming in the first half of 2022 as the extraordinary fiscal stimulus faded, monetary policy tightened, and supply caught up with demand in many end markets. Over the past few weeks several leading companies that weren't supposed to see this payback have disappointed with weaker than expected guidance on earnings. These stocks sold off sharply, and we think there are likely more disappointments to come as consumption falls short of expectations. Consumer confidence remains very soft due to higher prices, with our recent proprietary surveys suggesting consumers are expecting to spend more on staples categories over the next six months, versus the last six months. Spending on durables, consumer electronics and travel/leisure is expected to decline for lower income cohorts in particular.Second, inventories are now building fast and driving strong economic growth. However, the timing of this couldn't be worse if demand is fading more than expected. As noted in prior research, we think it could also reveal the high amounts of double ordering across many different industries. If that's correct, we are likely to see order cancelations, and that will only exacerbate the already weakening demand. In short, this supports a period of under-earning by companies as a mirror image to the past 18 months when inventories were lean and pricing power was rampant.Of course, the good news is that this likely means inflation pressures will ebb as companies lose pricing power. Eventually, this will lead to a more sustainable situation for the consumer and the economy. However, we think this could take several quarters before it's finally reflected in either earnings growth forecasts, valuations, or both. What this means for the broader market is probably six more weeks of downward bias. We continue to target sub-4000 on the S&P 500 before we would get more interested in trying to call an end to this ongoing correction. In the meantime, favor a defensive positioning. We've taken a more defensive posture in our recommendation since publishing our year ahead outlook in mid-November. Since then, it's paid off, although it hasn't been consistent. With last week's modest rally in cyclicals relative to defensives, we think it's a good time to fade the former and by the latter, since we still feel confident in our forecast for slowing growth even if the groundhog's track record isn't great.Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

7 Feb 20223min

For only the second time in the last decade, commodities outperformed equities in 2021. Looking ahead at 2022, what challenges and opportunities are on the horizon for this asset class?----- Transcript -----Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset. Strategist.Martijn Rats And I'm Martijn Rats, Morgan Stanley's Global Commodity Strategist.Andrew Sheets And today in the podcast we'll be talking about tailwinds driving commodities broadly, as well as the path ahead for global energy markets. It's Friday, February 4th at 3p.m. in London. Andrew Sheets So, Martijn, there were a number of reasons why I wanted to talk to you today, but one of them was that, for only the second time in the last decade, commodities outperformed equities in 2021. There are a number of drivers behind this, and you and your team have done some good work recently talking about those drivers and how they might continue. But one of them has certainly been the focus on inflation, which has been a major investment topic at the end of last year and continues to be a major topic into this year. Why are commodities and the inflation debate so interlinked and why do you think they're important for commodity performance?Martijn Rats Well, look, commodities tend to maintain their value in real terms. So when there is broad inflation, the cost of producing commodities tends to go up. And when that happens, then the price of commodities tends to follow that. So at the same time, if you have a rising inflation, then also ends up in having an impact on interest rates. Interest rates start to rise. That tends to be a headwind for a lot of financial assets. So when inflation expectations all of a sudden pick up, then then all of a sudden it weighs on the valuation of an awful lot of other things, whilst actually commodities are often somewhat insulated of that. There aren't that many sectors that that really benefit from inflation. So all of a sudden then from an investment perspective, investment demand for commodities goes up. The allocation to commodities is still small, and when you put those things together, that explains why in the past and again over the last 12, 18 months, commodities really come into their own in these periods where inflation expectations are picking up and are high, commodities tend to do well in those environments.Andrew Sheets So another thing about commodities is that you can't ignore is that this is a really diverse set of things. You know, we're talking about everything from, you know, wheat, to coffee, to aluminum, to crude oil. So it's hard to generalize what's driving commodities as a whole, but something I think is quite interesting in your research is that one theme that actually strikes out across a lot of different commodities from aluminum to oil, is the energy transition, which is affecting both demand for certain commodities and the supply of certain commodities. Could you go into that in a little bit more detail how you see the energy transition impacting this space? You know, really over the next decade?Martijn Rats Yeah, it broadly splits in two and there are a range of commodities for which the energy transition is basically demand positive. So if you look at a lot of renewable projects, you know, wind power or solar power or hydrogen projects, electric vehicles, all of those types of assets require tremendous demand amounts of, basically of metals, copper, lithium, cobalt, nickel, aluminum. In those areas, it simply demands positive. But then there are other areas where the energy transition creates a lot of uncertainty about the long-term outlook for demand. This is particularly true, of course, for the fossil fuels, for oil and gas. And what is currently going on is that the energy transition is starting to become such a red flag not to invest in new productive capacity in those areas, that it's that it's already weighing on capex, and that there is an element of it constraining the supply of those fossil fuels even before demand is materially impacted. And we're seeing that at play at the moment. Oil and gas demand continues to recover quite strongly coming out of COVID, and there are actually very little signs that demand for those fossil fuels is rolling over anytime soon. But the energy transition makes the demand outlook over the long run into the 2030s very uncertain. And the way that we read the market at the moment is that the demand uncertainty is already impacting investment now. If you don't invest for the 2030s, there's a certain amount of oil and gas you also don't have over the next couple of years. So whether it's through the supply side or through the demand side, our conclusion would be that on the whole the energy transition contributes to the tightness of commodity markets in a relatively broad sense.Andrew Sheets So Martijn, drilling down a little bit further into the oil story. You know, you and your team have identified what you call a triple deficit in oil markets that would drive a triple digit oil price estimate. You and your team think oil could hit $100 a barrel this year. Now what is that triple deficit and what's driving it?Martijn Rats The triple deficit refers to the idea or the expectation that three things will be low in the oil markets simultaneously, broadly around the middle of this year as we go into the second half. The first one is inventories, the second one is spare capacity, and a third one is investment levels. Already read last year we have seen very strong draws in global oil inventories. The oil market was under supplied by about two million barrels a day last year, which is historically very high. The way that we model supply demands, that rate of inventory draws that does slow down in 2022, but we end up with inventory draws nonetheless, and we will end 2022 on our balances with inventories that are still lower than at the end of last year. So, the first point low and falling levels of inventory. The second point relates to spare capacity. The world's spare capacity to produce oil in emergency situations when it's needed completely sits within OPEC. There is no spare capacity outside of OPEC now. OPEC is growing production this year, but they're not adding an awful lot of capacity. Our reading of the situation is that by the middle of the year OPEC's spare capacity, which at the moment stands probably somewhere around three and a half million barrels a day, will fall below two million barrels a day. And typically, when spare capacity falls to such low levels, it becomes supportive for prices. So that's the second of the triple deficit that we talk about, low and falling levels of spare capacity. And finally, there is investment. Investment has been on a sliding trend already since 2014, took an enormous nosedive in 2020, did not rebound in 2021, and is only modestly creeping higher this year. Investment levels relative to current consumption we would characterize as very low. And that is not changing anytime soon. So if you add these three things up low inventories, low spare capacity, low levels of investment, you're really looking at the oil market that is very tight. And ultimately, we think that that will support this $100 oil price forecast. Andrew Sheets So Martijn, the last thing I want to ask you about was this question of geopolitical uncertainty. When I talked to investors, there are some who think that the only reason that the oil price has gone up a lot this year is because of increasing geopolitical tension. There are others who say, no, it's gone up mostly because of the supply and demand imbalance that you just highlighted how do you how do you as a commodities analyst in your team try to address questions of how much of a driver is fundamental and how much of it is risk premium around event uncertainty? Martijn Rats It depends a little bit market by market, but in most markets we have price indicators other than simply the spot price of the commodity that will tell us something about the underlying dynamics of the market. In particular, price forward curves tell us a lot, and particularly the slope of the forward curve tells us a lot. So if a market is fundamentally tight, quite often that is associated with downward sloping forward curves. Downward sloping forward curves, incentivize holders of inventory to release commodities from inventory, and the market only creates those structures when extra supply from inventory is needed. So at the moment, particularly in the oil markets, that is exactly that what we're seeing. We're seeing very steeply downward sloping forward curves. And that would be consistent with a scenario in which oil prices simply rise because of the tightness in supply demand, not because of speculative reasons. If you have purely speculative reasons, geopolitical risk building, the price can still rise, but the forward curve would not be so steeply downward sloping. And for that reason, we would be of the school of thought that actually says that particularly the rise in the price of oil recently is not related to geopolitical risk at this stage. Maybe at some point that will become more important, but that is not what's going on. So far, the price of oil is mostly supported by simply the fundamentals of supply and demand. Martijn Rats That's typically how we go about it, but Andrew perhaps let me ask you. We look at commodities from a pure fundamentals perspective, supply and demand, inventories, those factors, but you often put it in a broader cross asset context. From a cross asset perspective, how do you look at the asset class?Andrew Sheets So there are two factors here that I think are really important. The first is that I think commodities are really unique in that they are maybe the asset class where buying the index, kind of quote unquote, has actually potentially the most problematic. Some of the broadest, most widely recognized commodity indices have not performed particularly well over time, and some of that's due to the nature of the commodity markets you just highlighted. These markets can be inefficient, they can have structural inefficiencies. That's one thing I think investors should keep in mind is that the performance of commodities relative to some of the indices one might see can be quite different. The second element is around the inflation debate. I think that's really important. As we've discussed on this program before, I'm kind of skeptical that gold will be a particularly good inflation hedge in this environment. Whereas I'm a lot more optimistic that oil can work in that manner that energy related commodities can and I think there are some interesting dynamics there related not just to the to your team's fundamental views, your team has a much more bullish forecast for oil than it does for gold, as well as some of the more quantitative tools that we run that that oil yields a lot more to hold it than gold does, that oil has much better momentum, price momentum, than gold does. And generally speaking, in commodities, investors have been rewarded for going with the momentum. It tends to be a very cycle-based trending asset class. So, you know, I think that the case for commodities overall is strong in our cross asset allocation. We're running a modest overweight to commodities. That was a view we went out with in our 2022 outlook back in November. But you know, these nuances are really important, both between different commodities and then how one implements them going forward.Andrew Sheets So with that, Martijn, thanks for taking the time to talk.Martijn Rats My pleasure. Thank you, Andrew.Andrew Sheets 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.

5 Feb 202210min

Yields on Treasury Inflation-Protected Securities, or TIPS, are set to rise but, beyond inflation, what other factors will drive moves in real yields for these bonds in the coming year?----- Transcript -----Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, February 3rd at noon in New York. Last week, I talked about our expectation for the yields on Treasury Inflation-Protected Securities to keep rising. Those bonds are known as TIPS, and their yields are called real yields. Today, I want to tell you about what I think moves real yields up and down, and how the current macro environment influences our view on their next move. First, let's suppose demand for TIPS increases because investors think inflation is going to rise. If nothing else changes in the market, then TIPS prices will rise and the real yields they offer will fall. But, more often than not, something else changes. For example, the monetary policies of the Federal Reserve. An important part of the Fed's mandate is to stabilize prices. The Fed has defined this to be an average inflation rate of 2% over time. So, when inflation is above 2% and on the rise, like today, the Fed's approach to monetary policy becomes more hawkish. That means the Fed is looking to tighten monetary conditions and, more broadly, financial conditions. This tends to put upward pressure on real yields. So, even if inflation is high and rising, the effect of a hawkish Fed tends to dominate. But what if inflation is rising from a rate below 2%? In this case, the Fed might favor a more dovish policy stance because it wants to encourage inflation to return to its goal from below. Therefore, we would expect downward pressure on real yields. Another important factor driving inflation is aggregate demand in the economy. When investors expect demand to strengthen, that puts upward pressure on real yields. Said differently, when economic activity accelerates and real GDP is set to grow more quickly, real yields tend to rise. The opposite also holds true. If investors expect a deceleration in economic activity or, in the worst case, a recession, then real yields tend to fall. But what do these relationships mean for the direction of real yields in 2022? Bottom line, our economists expect the Fed to be more hawkish this year, tightening monetary policy in light of improved economic growth. Both of these factors should push real yields higher, even as inflation eventually cools later this year. 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.

3 Feb 20222min

The Federal Reserve continues to face a host of uncertainties, leading to volatility in the Treasuries market. This trend may lead some investors to reconsider the municipal bond market.----- Transcript -----Welcome the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, February 2nd at 10 a.m. in New York. A couple weeks back, we focused on the tough job ahead for the Federal Reserve. It's grappling with an uncertain inflation outlook driven by unprecedented circumstances, including the trajectory of the pandemic, and the still unanswered questions about whether supply chain bottlenecks and swelling demand by U.S. consumers for goods over services have become a persistent economic challenge. Against that backdrop, it's understandable that keeping open the possibility of continued revisions to monetary policy is part of the Fed's strategy. Not surprisingly, that uncertainty has translated to volatility in the Treasury market and, as expected, some fresh opportunity for bond investors.For that, we looked in the market for municipal bonds, which are issued by state and local governments, as well as nonprofits. Credit quality is good for munis as the combination of substantial COVID aid to municipal entities and a strong economic recovery have likely locked in credit stability for 2022. But until recently, the price of munis was quite rich, in part reflecting this credit outlook, an expectation of higher taxes that would improve the benefit of munis tax exempt coupon, and a recent track record of low market volatility. But the bond market's reaction to the Fed undermined that last pillar, resulting in muni mutual fund outflows and, as a result, a move lower in relative prices for muni versus other types of bonds.While this adjustment in valuations doesn't exactly make munis cheap, for individuals in higher tax brackets, they're now looking more reasonably priced. And, as a general rule of thumb, when the fundamentals of an investment remain good, but prices adjust for purely technical reasons, that's a good signal to pay attention.So what does this mean for investors? Well, that fed driven volatility isn't going away, so munis could certainly still underperform some more from here. But for a certain type of investor, we wouldn't let the perfect be the enemy of the good. If you're in a higher tax bracket and need to replenish the fixed income portion of your portfolio, it could be time to curb your caution and start adding back some muni exposure.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.

2 Feb 20222min

The European Central Bank has indicated it would not raise rates this year, but markets are not fully convinced as shifts in inflation, gas prices and labor could force the ECB to reconsider.----- Transcript -----Welcome to Thoughts on the Market. I am Reza Moghadam, Morgan Stanley's chief economic adviser. Along with my colleagues, we bring you a variety of market perspectives. Today I'll be talking about the European Central Bank and whether it is likely to follow the Federal Reserve and the Bank of England in raising interest rates this year. It is Tuesday, February 1st at 2:00 p.m. in London. The European Central Bank, or the ECB, has long said it would not raise interest rates until it has concluded its bond purchase program. Since the ECB only recently announced that its taper would take at least till the end of this year to complete, this in theory rules out rate increases in 2022. The ECB president, Madame Lagarde, has reiterated that rate increases this year are "highly unlikely." However, the market is not fully convinced and is pricing some modest rate hikes. Many investors are also concerned that inflation could prove higher and more persistent than the ECB is projecting and could force it to follow the Fed and the Bank of England in tightening policy. We should start by recognizing that euro area inflation is nowhere near as high as in the United States, and expectations of longer-term inflation are below 2% - unlike in the US. Labor market conditions are easier, with low and stable wage growth. But even if the case for tightening is not as clear cut, this does not preclude a preemptive move by the ECB. Whether it does so will hinge on the continued viability of the ECB's inflation projections, which see inflation falling below its 2% target by the end of the year. It is too early to conclude that this inflation path has become too optimistic. Certainly, the second-round effects of recent high inflation outcomes - on wages and long-term inflation expectations - has so far been moderate. But this could change, and we would keep an eye on three triggers that might force a reconsideration. First, long-term inflation expectations. If perceptions start to drift up in the face of chronic supply shortages and higher gas prices, the process risks becoming a self-fulfilling prophecy, and un-anchoring inflation expectations. The ECB will want to nip this in the bud. Second, gas prices have jumped in the face of supply shortages and geopolitical tensions in Ukraine. Normally, the ECB looks through energy prices - not only because they are usually temporary, but also because, even when permanent, they imply a higher price level - not permanently higher inflation. But evidence of energy prices finding their way into long term inflation expectations could force action. Third, the current benign labor market situation could tighten. In that case, the ECB would want to react before the process goes too far. So if the ECB decides to tighten policy, what would that look like, and when could we expect it? A faster taper is the most likely vehicle for tightening monetary policy. Still, if inflation proves more resilient than currently projected, rate hikes while tapering cannot be definitively ruled out. We see limited risk of a policy shift at the ECB meeting later this week. There could be some action in March, but we expect this to be more likely in June, when there will be a fresh forecast and some hard data to base decisions on. So stay tuned. Thank you for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on Apple Podcasts. It helps more people find the show.

2 Feb 20224min

Investing strategies can be categorized into two broad categories: subjective and systematic. While some prefer one over the other, the best outcomes are realized when they are used together.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross-asset strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Monday, January 31st at 2:00 p.m. in London.There are as many different approaches to investing as there are investors. These can generally be divided into two camps. In one, which I'll call ‘subjective,’ the investor ultimately uses their own judgment and expertise to decide what inputs to look at, and what those inputs mean.Reasonable people often disagree, what variables matter and what they're telling us, which is why at this very moment you can find plenty of very smart, very experienced investors in complete disagreement over practically any investment debate you can think of.A lot of the research that myself and my colleagues at Morgan Stanley do fall into this more subjective camp. We're constantly in the process of trying to decide which variables matter and what we think these mean. But there's another approach which I'll call ‘systematic.’ Systematic investing is about writing down very strict rules and then following them over and over again, no matter what, with no leeway. Think of it a bit like computer code, if A happens - I will do B.The advantage of this systematic approach is that it isn't swayed by fear, or greed, or any other weaknesses in human psychology. The drawbacks are that very strict rules may not be flexible enough to adjust for genuine changes in the economy, in markets, or large, unforeseen shocks like a global pandemic. Think about it this way: Autopilot has been a great technological innovation in commercial aviation, but we all still feel much better knowing that there is a human at the controls that can take over if needed.I mention all this because alongside our normal subjective research, we also run a systematic approach called our Cross Assets Systematic Trading Strategy, or CAST. CAST looks at what data has historically been most meaningful to market returns, and then makes rule-based recommendations on where that data sits today.For example, if the key to investing in commodities historically has been favoring those with lower valuations, higher yields, and stronger recent price performance, CAST will look at current commodities and favor those with lower valuations, higher yields, and stronger recent price performance. And it will dislike commodities with the opposite characteristics. CAST then applies this thinking across lots of different asset classes and lots of different characteristics of those asset classes. It looks at equities, currencies, interest rates, credit and, of course, commodities.At the moment there are a number of areas where our systematic approach CAST and are more subjective strategy work, are in agreement. Both approaches see US assets underperforming those in the rest of the world. Both expect European stocks to outperform European bonds to a large degree. Both see higher energy prices, and both see underperformance in mortgages and investment grade credit spreads.When thinking about systematic versus subjective investment strategy, there's no right answer. But like our pilot analogy, we think things can work best when human and automated approaches can complement each other and work with each other.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.

31 Jan 20223min

Consumer prices reached an all-time high this past December, and a new year brings new challenges across inflation, wage growth and interest rates.----- Transcript -----Ellen Zentner Welcome to Thoughts on the Market. I'm Ellen Zentner, Chief U.S. Economist for Morgan Stanley Research. Sarah Wolfe And I'm Sarah Wolfe, also on Morgan Stanley's U.S. Economics team. Ellen Zentner And on this episode of the podcast, we'll be talking about the outlook for consumer spending in the face of inflation, Omicron, rising interest rates and other headwinds. It's Friday, January 28th at 10:00 a.m. in New York. Ellen Zentner So Sarah, as most listeners have observed since the Fall, inflation is on everyone's mind, with consumer prices reaching a 39-year high in December, and we're forecasting inflation to recede throughout this year from about 7% now down to 2.9% by the fourth quarter. But let's talk about right now. Ellen Zentner So, you've got your finger on the pulse of the consumer. You're a consumer specialist on the team. And so, I want to ask, how quickly have consumers adjusted their spending over the past few months because of inflation? What evidence have we seen? Sarah Wolfe The consumer buying power has been very resilient in the face of high inflation. This week we got the fourth quarter GDP data and we saw the real PCE expanded by 3.3%. So that is another very strong quarter for consumer spending. And that brings spending to nearly 8% year over year in 2021, so very elevated. However, we are beginning to see that consumers may be reaching the upper echelon of their price tolerance in December. We got the retail sales report a couple of weeks ago for December, and we saw a very large contraction in consumer spending declined by more than 3%, and the decline was pretty broad based across all categories that have seen very high inflation, and this is largely reflective of goods spending. So, this is a pretty clear signal to us that while Omicron may be weighing on spending, inflation is largely at play here. And we still expect inflation to be peaking in January and February, so we likely will see some deterioration in consumer spending as we enter the first quarter of 2022. Ellen Zentner How weak could consumer spending be this quarter? Sarah Wolfe Right now, we just started our tracking for the first quarter of 2022 at 1.5% GDP growth, but within that, we have 1-2% contraction in real PCE. I will note that inflation's high so nominal PCE is still tracking positive, but it's not looking very good as we enter the first quarter. Ellen Zentner Yeah, it seems clear that inflation is taking a bite. And remind me, we have this great consumer pulse survey that we've been putting out, and I think it was back in November, right? That the people were actually saying, "Look, I'm more worried about inflation than Omicron or than COVID 19". And that's incredible. I mean, that's a pandemic that's been weighing on people's minds and yet inflation usurped. Sarah Wolfe We're also seeing it in the consumer sentiment surveys. The University of Michigan surveys inflation expectations each month. Near term inflation expectations have reached all-time highs. They're at 4.9%, and we're starting to see longer term expectations also start to tick up. In January, they hit 3.1%, which is a high since 2011. So, it's definitely being felt by consumers and causing a lot of uncertainty among them as well. Ellen Zentner But now, because we have this forecast that inflation is going to peak in February, which is data we have in hand in March, if we're right on that, can that give us a lot of confidence that at least households can see that there's light at the end of the tunnel and start to breathe a sigh of relief? Sarah Wolfe Yeah. As you mentioned, there are few headwinds facing the consumer right now. We think most of them are going to recede by the end of the first quarter. Ellen Zentner Another big change for the consumer versus last year, that you've been writing about is the roll off of government stimulus for a lot of Americans. That had really helped bolster consumer spending, getting us to that big growth rate in 2021 that you mentioned. But now that that's rolling off, what impact might it have on spending this year? Sarah Wolfe So, the big impact to spending is going to be felt this quarter in the beginning of 2022. And that's for two reasons. The first is that the child tax credits have come to an end. That did not get extended because the Build Back Better plan was not passed in time. and the child tax credits were boosting income for lower, middle-income households by $15B a month. And that included $300-360 payments per child per month. A lot of that was going straight into spending, food, other essential items, school supplies. So, we're going to get a level shift down in income and spending in January alone just because of the expiration. So, the other reason that first quarter is going to be hard for consumers is because a lot of the stimulus came through one year ago in 1Q21. That's when we got the $600 checks per person, then the $1400 checks and then also the supplemental $300 unemployment insurance benefit. So, when you're looking at income and spending year over year, especially for lower middle-income households, this is going to be a tough quarter. Ellen Zentner All right. So that's a lot of stimulus that came in, not just over 2020, but all the way into early 2021. So, does that mean that they spent all of that money that they got? Because you've been writing a lot about this idea of an excess savings. So, what do you mean by that? How do we define excess savings? Who's holding that excess savings, and can it make its way into the economy? Sarah Wolfe So, to define what excess savings is, it's basically cumulative savings above the pre-COVID savings trend. And how does that compare to the savings rate? The savings rate is just a monthly snapshot of income and spending, but excess savings is looking at how much is building up over time. And so excess savings, as many have heard this number, was over $2T throughout 2020 and 2021. We have data that shows that some of it was held all the way across the income distribution, but 80% of that was held among the top 20%. And so, a lot of that excess savings is still sitting with the wealthiest people. Sarah Wolfe What about the excess savings for lower income people? It's a smaller dollar amount, and for that reason, it just does not go as far. We have been dealing with, I mentioned, with six to eight months of high inflation. We've seen consumer spending throughout all of this high inflation. And part of that was likely driven by the drawdown in excess savings for lower income households. And so, when I think about spending for 2022, excess savings is not the main driver. Ellen Zentner So in this battle that households have with inflation, right? You got excess savings. There's a lot of uncertainty around how and when that might filter into the economy. And so, it seems that in the face of higher inflation then it makes labor income all that much more important. So, when you're looking at income or prices, how do you weigh that tug of war? Sarah Wolfe So it's OK if prices are going up as long as wages are going up by more. And so, people continue to spend. What we're seeing in the data right now is that, on net, real wages are negative. I mean, we're dealing with 7% inflation. However, and this is very important, real wages for the lowest income group are actually positive. They're the group that's seen the strongest wage growth and it actually is outpacing inflation. I say this is really important because of all we have discussed. The rolling off of fiscal stimulus - this is a group that gets hurt the most by that. Inflation - this is also the group that gets hurt the most by that. When we think about the spending bucket of lower middle-income households, most of their spending goes to essential items like food, energy and shelter. Energy prices alone have increased by over 8% in the last three months. Sarah Wolfe So, seeing real wage growth is very important, and we expect real wages to enter a positive territory for middle- and higher-income households as well as we enter mid 2022, and inflation comes down to about 4% or so. Ellen Zentner Yeah, so for those of you not able to see us, Sarah rolls her eyeballs when she says "come down to 4%" because that's still such a high rate of inflation. But it is quite a few percentage points lower than where we've peaked. So, it's really about the direction. Households can start to breathe a sigh of relief that indeed this is not some sort of permanently higher inflation and ultimately just that labor market improvement, remains the most important piece of the consumer spending outlook. Would you agree? Sarah Wolfe I would agree. Fundamentally, income is what drives spending and a large chunk of income is labor compensation. So as long as we're seeing job gains and wage growth outpacing inflation, we should continue to see spending as we move through a tough first quarter. Ellen Zentner But importantly, we've got to be right on those inflation forecasts. You know, finally, let me just say a couple of things about the Fed's meeting here. So, we do believe that the Fed has laid the groundwork to start raising rates in March, and so higher interest rates are meant to slow activity and specifically through the credit channel, right? They're going to raise the cost of access to credit this year. But in terms of, sort of what contributes most to, say, downturns when the Fed is tightening is the interest expense on the household balance sheet, right? All that debt we carry, which is a tremendous amount, that interest expense rises. So, should we be worried about household balance sheets in this environment because the Fed is going to be raising rates? Sarah Wolfe Yeah, I mean, households are carrying over $14T in debt, but things are not as bad as they sound. 70% of household debt is in mortgages and another 10% is in auto debt. And luckily, those are largely locked in at fixed rates. 90% of mortgages are at fixed rates, so that alone is 68% of the household balance sheet. Sarah Wolfe So, the picture looks better on net for households. Obviously, you need to be a homeowner for it to be in that fixed rate. So, there are non-homeowners that are more susceptible to changing rates. So, people that are holding more credit card debt, that's more lower income people. So that is the group that's going to be the most affected by a raising rates environment. Ellen Zentner Right. Good point. And so, it's even more important that we keep the labor market strong and wage growth strong for those lower income cohorts. Ellen Zentner So we've talked a lot about the consumer, Sarah, but I could do this all day long. So, thanks for taking the time today. Sarah Wolfe It was great talking with you, Ellen. Thanks for having me on. Ellen Zentner And 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.

28 Jan 202210min

Despite two good years for Treasury Inflation-Protected Securities, or TIPS, a dramatic rise in real yields may be cause for investors to reexamine their potential for 2022.----- Transcript -----Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, January 27th at noon in New York. Today, I want to talk about the Treasury market, and I want to get real. Yields on Treasury notes and bonds have risen dramatically to start the year, but real yields have risen more. What are "real yields"? Let me start by assuring you that yields on regular Treasury notes and bonds aren't fake. They are very real, but not in the same way as yields on Treasury inflation-protected securities. Those inflation-protected bonds, known as TIPS, offer investors an inflation-adjusted yield. You can think about an inflation-adjusted yield as having two parts. The first part is a yield without an inflation adjustment. That's what we call the real yield. And the second part is a yield that adjusts for inflation. So, if the rate of inflation is positive, you get more than just the real yield. Last year, a lot of investors bought TIPS because inflation was high and rising. The news media covered the topic of inflation like never before in my career. So, buying a security that offered inflation protection would have made sense last year. Consumer prices rose 7% over the year, and the TIPS index returned almost 6%. So that investment strategy worked out. But, did you know that TIPS returned almost 11% in 2020, when consumer prices only rose 1.4%? That's right. TIPS were a much better investment in 2020, when there was less inflation than there was in 2021. How could that be? Well, remember the real yield that TIPS offer investors? That yield can be a very important contributor to the total return of TIPS. And, at times, it can be even more important than the yield that adjusts for inflation. Over the past couple of years, the real yields that TIPS have offered investors have been negative. So, imagine if there hadn't been any inflation over these past two years. An investment in TIPS might have been a bad one because investors would have been left with nothing but a negative yielding bond. Of course, the yield on a bond is just one factor in driving the total return that investors receive. The other is capital gain - or loss. And the change in yields over time drive capital gains or losses. If bond yields fall, bond prices rise and that improves total returns. But if bond yields rise, well, falling prices hurt total returns. And the same applies to the real yield on TIPS. Rising real yields hurts the total return of TIPS and can do so even during periods of high inflation, like today. The period since last Thanksgiving is a perfect example: inflation continued to surprise to the upside, but the real yield on 10-year maturity TIPS rose by over half a percentage point. As a result, TIPS delivered a negative total return of 3.5% during this period. This should be a valuable lesson for TIPS investors. TIPS aren't just about inflation protection, although they do offer more inflation protection than most other bonds. TIPS perform best when inflation is high and rising, and real yields are stable or they're falling. We saw that environment in 2020 and through most of 2021. But things have started to change. We expect real yields to keep rising this year and our economists expect inflation to fall. That means investors should get less yield that adjusts for inflation while having to cope with capital losses from rising real yields. It would be the worst combination for TIPS performance and stand in quite a contrast to the past two years. So our advice is to stop thinking about TIPS as just protecting against inflation. Instead, investors should think about how TIPS performance could be impacted by higher real yields. And as the Fed raises interest rates this year, real yields should rise and hurt the performance of TIPS. Thanks for listening. And 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.

27 Jan 20224min