Is American Market Dominance Over?

While the cost of shelter has risen quickly, the measure of housing inflation has been slow to catch up, creating challenges for renters, homeowners and the Fed.-----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 Tuesday, March 22nd at 2:00 p.m. in London. Our base case at Morgan Stanley is that the U.S. economy sees solid growth over the next two years, with inflation moderating but still being somewhat higher than the Federal Reserve would like. We think this means the Fed raises interest rates modestly more than the market expects, flattening the US yield curve. But what are the risks to this view? Specifically, what could cause inflation to be much higher, for much longer, putting the Federal Reserve in a more pressing bind? I want to focus here on core inflation as central banks have more leeway to look through volatile food or energy prices. This is a story about shelter. The cost of shelter represents about 1/3 of U.S. core consumer price inflation. That makes sense. For most Americans, where you live is your largest expense, whether you rent or pay a mortgage. The CPI measure of inflation assumes that the cost of renting has risen 4.5% in the last year. Now, if that sounds low, you're not alone. At the publicly traded apartment companies covered by my colleague Richard Hill, a Morgan Stanley real estate analyst, rents have risen 10% or more year-over-year. There are reasons that the official CPI number is lower. For one, not everyone renews their lease at the same time. But with a strong labor market and limited supply, the case for higher rents going forward looks strong. Owner occupied housing is even more interesting. Since 2016, U.S. home prices have risen about 56%. But the cost of a house that goes into the CPI inflation calculation, known as "owners’ equivalent rent", has risen only 21%. That's a 35% gap between actual home prices and where the inflation calculation sits. This is a potential problem. Even if home prices stop going up, the official measure of housing inflation could keep rising at a healthy clip to simply catch up to where home prices already are. And given high demand, low supply, and still low interest rates, home prices may keep going up, meaning there's even more catching up to do from the official inflation measure. Higher shelter costs are also a challenge because they're very hard for the Federal Reserve to address. Raising interest rates, which is the usual strategy to combat inflation, makes buying a house less attractive relative to renting. Which means even more upward pressure on rental demand and even higher rents. And higher interest rates make building homes more costly to finance, further restricting housing supply and raising home prices.Housing has long been a very important sector for the economy and financial markets. Over the next 12 months, expect it to be central to the inflation debate as well. 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.

22 Mars 20223min

This year is validating our call for a shorter but hotter economic cycle. As the indicators begin to point to a late-cycle environment, here’s how investors can navigate the change.-----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, March 21st at 1:00 p.m. in New York. So let's get after it. A year ago, we published a joint note with our Economics and Cross Asset Strategy teams arguing this cycle would run hotter but shorter than the prior three. Our view was based on the speed and strength of the rebound from the 2020 recession, the return of inflation after a multi-decade absence and an earlier than expected pivot to a more hawkish Fed policy. Developments over the past year support this call - US GDP and earnings have surged past prior cycle peaks and are now decelerating sharply, inflation is running at a 40-year high and the Fed has executed the sharpest pivot in policy we've ever witnessed. Meanwhile, just 22 months after the end of the last recession, our Cross Asset team's 'U.S. Cycle' model is already approaching prior peaks. This indicator aggregates key cyclical data to help signal where we are in the economic cycle and where headwinds or tailwinds exist for different parts of the market.With regard to factors that affect U.S. equities the most, earnings, sales and margins have also surged past prior cycle highs. In fact, earnings recovered to the prior cycle peak in just 16 months, the fastest rebound going back 40 years. The early to mid-cycle benefits of positive operating leverage have come and gone, and U.S. corporates now face decelerating sales growth coupled with higher costs. As such, our leading earnings model is pointing to a steep deceleration in earnings growth over the coming months. These negative earnings revisions are being driven by cyclicals and economically sensitive sectors - a setup that looks increasingly late cycle. Another key input to the shorter cycle view was our analysis of the 1940s as a good historical parallel. Specifically, excess household savings unleashed on an economy constrained by supply set the stage for breakout inflation both then and now. Developments since we published our report in March of last year continue to support this historical analog. Inflation has surged, forcing the Fed to raise interest rates aggressively in a credible effort to restore price stability. Assuming the comparison holds, the next move would be a slowdown and ultimately a much shorter cycle.Further analysis of the postwar evolution of the cycle reveals another compelling similarity to the current post-COVID phase - unintended inventory build from over ordering to meet an excessive pull forward of demand. In short, we think the risk of an inventory glut is growing this year in many consumer goods, particularly in areas of the economy that experienced well above trend demand. Consumer discretionary and technology goods stand out in our view. Now, with the Fed raising rates this past week and communicating a very hawkish tightening path over the next year, our rate strategists are looking for an inversion of the yield curve in the second quarter. While curve inversion does not guarantee a recession, it does support our view for decelerating earnings growth and would be one more piece of evidence that says it's late cycle. In terms of our U.S. strategy recommendations, we continue to lean defensive and focus on companies with operational efficiency with high cash flow generation. This leads us to more defensive names with more durable earnings profiles that are also attractively priced. 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.

21 Mars 20223min

The U.S. Federal Reserve recently enacted its first interest rate hike in two years, but there is still more work to be done to counteract rising inflation and markets are watching closely.-----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 Friday, March 18th at 2:00 p.m. in London. On Wednesday, the U.S. Federal Reserve raised interest rates for the first time in two years. This is notable because of how much time has passed since the Fed last took action. It's notable because of how low interest rates still are, relative to inflation. And it's notable because rate increases, and decreases, by the Fed tend to lump together. Once the Fed starts raising or lowering rates, history says that it tends to keep doing so. Now, one question looming over the Fed's action this week could be paraphrased as, "what took you so long?" Since the Fed cut rates to zero in March of 2020, the U.S. stock market is 77% higher, U.S. home prices are 35% higher, and the U.S. economy has added over 5.7 million new jobs. Core consumer price inflation, excluding volatile food and energy prices, has risen 6.4% in the last year, indicative of demand for goods outpacing the ability of the economy to supply them at current prices, exactly what a hot economy implies. The reason the Fed waited was the genuine uncertainty around the impact of COVID on the economy, and the risk that new variants would evade vaccines or dash consumer confidence. But every decision has tradeoffs. Easy Fed policy has helped the U.S. economy recover unusually quickly, but that quick recovery now means the Fed has a lot more to do to catch up. Specifically, we think the Fed will need to raise the upper band of its policy rate, currently at 0.5%, to about 2.75% by the end of next year. This is more than the market currently expects, and we think outcomes here are skewed to the upside, with it more likely that rates end up higher than lower. My colleagues in U.S. interest rate strategy believe that this should cause U.S. rates to rise further, with 2 year bond yields rising most and ultimately moving higher than 10 year bond yields. It's rare for 2 year bonds to yield more than their 10 year counterpart, a so-called curve inversion. Nevertheless, this is what we expect. Now, one counter to this Fed outlook is that the U.S. economy simply can't handle higher rates, and that will force the Fed to stop hiking earlier. But we disagree. With a large share of household debt in the U.S. in the form of 30 year fixed rate mortgages, the impact of higher rates may actually be more muted than in the past, as the cost of servicing this debt won't change even as the Fed raises rates. Higher short-term interest rates and an inverted yield curve are one specific implication of these expectations. More broadly, inverted yield curves have historically been key signposts for increased risk of recession. While we think a recession is unlikely, the market could still worry about it, supporting U.S. defensive equities and investment grade over high yield credit. 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.

18 Mars 20223min

The U.S. and its allies have frozen the Central Bank of Russia’s foreign currency reserves, leading to questions about the safety of FX assets more broadly and the centrality of the U.S. dollar to the international financial system.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----Welcome to Thoughts on the Market. I'm James Lord, Head of FX and EM 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 currency markets. It's Thursday, March 17th at 3:00 p.m. in London. Ever since the U.S. and its allies announced their intention to freeze the Central Bank of Russia's foreign exchange, or FX, reserves, market practitioners have been quick to argue that this would likely accelerate a shift away from a U.S. dollar based international financial system. It is easy to understand why. Other central banks may now worry that their FX reserves are not as safe as they once thought, and start to diversify away from the dollar. Yet, despite frequent calls for the end of the dollar based international financial system over the last couple of decades, the dollar remains overwhelmingly the world's dominant reserve currency and preeminent safe haven asset. But could sanctioning the currency reserves of a central bank the size of Russia's be a tipping point? Well, let's dig into that. The willingness of U.S. authorities to freeze the supposedly liquid, safe and accessible deposits and securities of a foreign state certainly raises many questions for reserve managers, sovereign wealth funds and perhaps even some private investors. One is likely to be: Could my assets be frozen too? It's an important question, but we need to remember that the U.S. is not acting alone with these actions. Europe, Canada, the UK and Japan have all joined in freezing the central bank of Russia's reserve assets. So, an equally valid question is: Could any foreign authority potentially freeze my assets? If the answer is yes, that likely calls into question the idea of a risk free asset that underpins central bank FX reserves in general, and not just specifically for the dollar and U.S. government backed securities. If that's the case, what could be the implications? Let me walk you through three. First would be identifying the safest asset. Reserve managers and sovereign wealth fund investors will need to take a view on where they can find the safest assets and not just safe assets, as the concept of the latter may have been seriously impaired. And in fact, the dollar and U.S. Government backed securities may still be the safest assets since the latest sanctions against the central Bank of Russia involve a broad range of government authorities acting in concert. A second implication is that political alliances could be key. These sanctions demonstrate that international relations between different states may play an important role in the safety of reserve assets. While the dollar might be a safe asset for strong allies of the U.S., its adversaries could see things differently. To put the dollar's dominance in the international financial system at serious risk, would-be challenges of the system would need to build strategic alliances with other large economies. Finally, is the on shoring of foreign exchange assets. Recent sanctions have crystallized the fact that there is a big difference between an FX deposit under the jurisdiction of a foreign government and one that you own on your home ground. While both might be considered cash, they are not equivalent in terms of accessibility or safety. So another upshot might be that reserve managers bring their foreign exchange assets onshore. One way of doing this is to buy physical gold and store it safely within the home jurisdiction. The same could be said of other FX assets, as reserve managers will certainly have access to printed U.S. dollars, Euros or Chinese Yuan banknotes if they are stored in vaults at home, though there could be practical challenges in making large transactions in that scenario. Bottom line, though, while these are all important notions to consider, in our view recent actions do not undermine the dollar as the safest global reserve asset, and it's likely to remain the dominant global currency for the foreseeable future. Thanks for listening! As a reminder, 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.

17 Mars 20224min

As oil prices rise across the globe, investors wonder if governments will continue to incentivize clean energy development or pivot to greater investment in traditional fossil fuels.-----Transcript-----Welcome to 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, March 16th, at 10:00 a.m. in New York. With the conflict in Ukraine ongoing, many investors continue to ask questions about the U.S. and European policy response to the rising price of oil. In particular, many ask if governments will continue down the path of incentivizing clean energy development, or pivot to greater exploration of traditional fossil fuels. But as my colleague Stephen Byrd, who heads North America Power Utilities and Clean Energy Research, pointed out in a recent report, this is a false choice, and it's one that many policymakers are likely to reject in favor of embracing an "all of the above" strategy. It's important to understand that focusing only on traditional energy sources wouldn't solve the problem in the near term. For example, switching on any dormant U.S. oil production facilities would only replace a fraction of the oil that Russia produces, so fresh explorations ramp up production would be needed, and that could take a few years. The same could be said about natural gas. The U.S. Has the spare capacity to backfill with Europe imports from Russia, but Europe mostly doesn't have the facilities to accept liquefied natural gas shipped overseas from America. Germany has announced plans to build two liquefied natural gas terminals, but that could take years to complete. The point is, focusing on traditional energy sources alone is no quick fix for high energy prices and energy independence, and therefore there's little opportunity cost in also focusing on renewable energy development. For that reason, we think western governments are likely to include both clean energy and traditional investments in their strategy going forward. You see this echoed in the statements of policymakers, such as U.S. Climate Envoy John Kerry's recent comments that the US is committed to an "all of the above" energy policy. So what does it mean for investors? In short, expect energy companies of all types to have business to do with governments in the coming years. That includes traditional oil exploration companies, but also clean tech companies, as market beneficiaries. 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.

16 Mars 20222min

As global markets face a rise in commodity prices due to geopolitical conflict, investors in Asia and EM equities will want to keep an eye on the divergence between commodity exporters and importers.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about geopolitical risk, commodity exposure, and how they affect our views on Asia and EM Equities. It's Tuesday, March the 15th at 8:00 p.m. in Hong Kong. The Russia Ukraine conflict is having a profound impact on the investment world in multiple dimensions. In this episode we focus on just two, commodity prices and geopolitical alignment, and what they mean for investors in Asia and emerging market equities. The major sanctions imposed by the U.S., U.K., European Union and their allies are focused not only on isolating Russia financially but depriving it, in some instances overnight and in others more gradually, of the ability to export its commodities. And Russia is a major producer of oil, natural gas, food and precious metals and rare minerals. Ukraine is also a major food exporter. In our coverage there's a sharp divergence between economies which are major commodity importers, and are therefore suffering a negative terms of trade shock as commodity prices rise, and those which are exporters and hence benefit. Major importers include Korea, Taiwan, China and India, all with more than a 5% of GDP commodity trade deficit. Meanwhile, Australia, Mexico, Brazil, Saudi Arabia, UAE and South Africa are all significant commodity exporters and stand to benefit. Australia's overall commodity trade surplus is the largest at 12% of GDP, and that is before the recent gains in price for almost everything which Australia produces and exports. Meanwhile, on the geopolitical risk front, we've been monitoring the pattern of voting on Russia's actions at the United Nations, where there have been both UN Security Council and General Assembly votes. Although none of the countries we cover actually voted with Russia on either occasion, two major countries, China and India, did abstain twice. South Africa abstained at the General Assembly. The UAE abstained in the Security Council, but then voted with the US and Europe in the General Assembly vote. This pattern of voting, in our mind, may have an impact in raising the equity risk premium, i.e. lowering the valuation, for China and to a lesser extent India in the current environment. All taken together, we are shifting exposure further towards commodity exporting markets and in particular those such as Australia, which are also geopolitically aligned with the major sources of global investor flows. We lowered our bear-case scenario values for China further recently and are turning incrementally more cautious on India. 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.

15 Mars 20223min

This week the market turns to the Federal Reserve as it eyes challenges to growth while remaining committed to combating high inflation with its first rate hike of the tightening cycle.-----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, March 14th at 11:00 a.m. in New York. So let's get after it. With all eyes on the Russian invasion of Ukraine, markets are likely to turn back towards the Fed this week as it embarks upon the first tightening of the cycle and the first rate hike since 2018. This follows a period of perhaps the most accommodative monetary support ever provided by the Federal Reserve, an extraordinary statement unto itself given the Fed's actions over the past few decades. When it comes to measuring how accommodative Fed policy is at the moment, we look at the Fed funds rate minus inflation, or the real short-term borrowing rate. Using this measure tells us that fed accommodation has been in a steady downtrend since the early 1980s. In fact, the real Fed funds rate has been in a remarkably well-defined channel for this entire period. Second, after reaching the low end of the channel in record time during the COVID recession, the real Fed funds rate has turned higher- albeit barely. That low was in November of last year, when Fed Chair Jerome Powell was renominated by President Biden, and he made it clear that the Fed was going to pivot hard on policy. It was no coincidence that this is exactly when expensive growth stocks topped and began what has been one of the largest and most persistent drawdowns in growth stocks ever witnessed. Finally, based on how low the Fed funds rate remains, the Fed has a lot of wood to chop to get this rate back to a more normal level. Furthermore, if Powell is truly committed to making monetary policy restrictive to fight inflation, expensive growth stocks remain vulnerable, in our view. Currently, the bond market is pricing in eight 25 basis point hikes over the next 12 months. If the Fed is successful in executing this expected path, it will have achieved the soft landing it seeks. Inflation will come down as the economy remains in expansion. However, we think that's a big if at this point. First, growth is already at risk as we enter 2022 due to the payback in demand lapsing government transfers, generationally high inflation and rising inventories at the wrong time. Now, the conflict in Ukraine is leading to even higher commodity prices, while the growth outlook deteriorates further. While we are likely to avoid an economic recession in the U.S., we can't say the same for earnings. We think the Fed will keep a watchful eye on the data, but air on the side of hawkishness given the state of inflation. This likely means a collision with equity markets this spring, with valuations overshooting to the downside. While short-term interest rates are still at zero, longer term treasury yields are now approaching a level that may offer some value for asset owners, even if they are unattractive on a standalone basis. This is especially true if one is now more concerned about growth like we are. Let's assume we're wrong about growth slowing, under such a view it's unlikely the Fed hikes faster than what is already priced into the bond market. Therefore, longer term rates are unlikely to raise much more by the time we know the answer to this growth question. Conversely, if we're right about growth slowing more than expected, longer term rates likely have room to fall and provide a cushion to equity portfolios. High quality investment grade credit may also offer some ballast given the significant correction in both rates and spreads. For equity investments, we continue to favor defensive quality stocks as well as companies with high operational efficiency. Yes, boring is still beautiful. 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.

14 Mars 20223min

With multiple countries now imposing sanctions, investors in Russian government bonds and currencies will need to consider their options as the risk of default rises.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----James Lord: Welcome to Thoughts on the Market. I'm James Lord, Head of FX and EM strategy. Simon Waever: And I'm Simon Waever, Global Head of Sovereign Credit Strategy. James Lord: And on this special episode of Thoughts on the Market, we'll be discussing the impact of recent sanctions on Russia for bonds and currency markets. It's Friday, March 11th at 1:00 p.m. in London. Simon Waever: and 8:00 a.m. in New York. James Lord: So, Simon, we've all been watching the recent events in Ukraine, which are truly tragic, and I think we've all been very saddened by everything that's happened. And it certainly feels a bit trite to be talking about the market implications of everything. But at the same time, there are huge economic and financial consequences from this invasion, and it has big implications for the whole world. So today, I think it would be great if we can provide a little bit of clarity on the impact for emerging markets. Simon, I want to start with Russia itself. The strong sanctions put in place have really had a big impact and increasing the likelihood that Russia could default on its debt. Can you walk us through where we stand on that debate and what the implications are? Simon Waever: That's right, it's had a huge impact already. So Russia's sovereign ratings have been downgraded all the way to Triple C and below, which is only just above default, and that's them having been investment grade just two weeks ago. If you look at the dollar denominated sovereign bonds, they're trading at around 20 cents on the dollar or below. But I think it all makes sense. The economic resilience needed to support an investment grade rating goes away when you remove a large part of the effect reserves, have sanctions on 80% of the banking sector, and with the economy likely to enter into a bigger recession, higher oil prices help, but just not enough. For now, the question is whether upcoming payments on the sovereign dollar bonds will be made. And I think it really comes down to two things. One, whether Russia wants to make the payments, so what we tend to call the willingness. And two whether US sanctions allow it, so the ability. Clarifications from the US Treasury suggests that beyond May 25th, payments cannot be made. So, either a missed payment happens on the first bond repayment after this, which is May 27th or Russia may also decide not to pay as soon as the next payment, which is on March 16th. And of course, the reason for Russia potentially not paying would be that they would want to conserve their foreign exchange. And actually, we've already had some issues on the local currency government bonds, so the ones denominated in Russian ruble. James, do you want to go over what those issues have been? James Lord: That's absolutely right. Already, foreigners do not appear to have received interest payments on their holdings of local currency government bonds. There was one due at the beginning of March, and it looks as though, although the Russian government has paid the interest on that bond, the institutions that are then supposed to transfer the interest payments onto the funds of the various bondholders haven't done so for at least the foreign holders of that bond. Does that count as default? Well, I mean, on the one hand, the government can claim to have paid, but at the same time, some bondholders clearly haven't received any money. There's also another interest payment due in the last week of March, so we'll see if anything changes with that payment. But in the end, there isn't a huge amount that bondholders can really do about it, since these are local currency bonds and they're governed under local law. There isn't really much in the way of legal recourse, and there isn't really much insurance that investors can take out to protect themselves. The situation is a bit different for Russian government bonds that are denominated in US dollars, though. So I'd like to dig a little bit more into what happens if Russia defaults on those bonds. For listeners that are unfamiliar, investors will sometimes take out insurance policies called CDSs or credit default swaps just for this type of situation, and they've been quite a lot of headlines around this. So, Simon, I'd be curious if you could walk us through the implications of default there. Simon Waever: So it's like two different products, right? So you have the bonds there, it can take a long time to recover some of the lost value. I mean, either you actually get the economic recovery and there's no default or you then go to a debt restructuring or litigation. But then on the other hand, you have the CDS contracts, they're going to pay out within a few weeks of the missed bond payment. But it's not unusual to find disagreement on exactly what that payment will look like. And that payment is, we call it, the recovery value perhaps is a bit like the uncertainty that sometimes happens when standard insurance needs to pay out. But if we start with the facts, if there is a missed payment on any of the upcoming dollar or euro denominated bonds, then CDS will trigger. Local currency bonds do not count and the sovereign rating does not matter either. So far I think it's clear, the uncertainty has been around what bonds can actually be delivered into the contract, as that's what determines the recovery value. As it stands, sanctions do allow secondary trading of the bonds. There have been some issues around settlement, but hopefully that can be resolved by the time an auction comes around. The main question is then where that recovery rate will end up, and I would say that given the amount of selling I think is yet to come I wouldn't be surprised if it ends up being among the lower recovery rates we've seen in E.M sovereign CDS. James Lord: Yeah, that makes sense on the recovery rates and the CDs. But I mean, clearly, if Russia defaults, there could be some big implications for the rest of emerging markets as well. And even if they don't default, I mean, there's been a lot of spill over into other asset classes and other emerging markets. How do you think about that? Simon Waever: So I try to think of it in two ways, and I would expect both to continue if we do not see a de-escalation in Ukraine. So first, it really impacts those countries physically close to Russia and Ukraine and those then with trade linkages, which mainly comes with agriculture, energy, tourism and remittances. And that points you towards Eastern Europe, Turkey and Egypt, for instance. Secondly, if we also then see this continued weaker risk backdrop, it would then impact those countries where investor positioning is heavier. But enough on sovereign credit, I wanted to cover currencies, too. The Russian central bank was sanctioned. What do you think that means for EM currencies? James Lord: Absolutely. The sanctions against the central Bank of Russia were really quite dramatic and have understandably had a very big impact on the Russian exchange rate. The ruble’s really depreciated in value quite significantly in the last couple of weeks. I mean, during periods of market uncertainty, the central Bank of Russia would ordinarily sell its foreign exchange assets to buy Ruble to keep the currency under control. But now that's not really possible. It's led to a whole range of countermeasures from Russia to try and protect the currency, such as lifting interest rates from just under 10% to 20%. There have also been significant restrictions on the ability of local residents to move capital abroad or buy dollars, and on the ability of foreigners that hold assets in Russia to actually sell and take their money home. All of that's designed to protect the exchange rate and keep foreign exchange reserves on home soil. I think the willingness of the US to go down that road, as well as the authorities in Europe and Canada and other jurisdictions, it does raise some important questions about whether or not investors will continue to want to hold dollars and US government bonds as part of their FX reserves. Many reserve asset holders may wonder whether or not similar action could be taken against them. This has become a big debate in the market. Some investors believe that this turn of events could ultimately lead to some long-term weakness in the dollar. But I think it's also important to remember that yes the U.S. is not the only country that has done this, and it's probably the case that actually any country could potentially freeze the foreign assets of another central bank. And if that's the case, then I don't see having a materially negative impact on the dollar over the long term, as many now seem to be suggesting. But I think that's all we have time for today. So let's leave it there. Simon, thanks very much for taking the time to talk. Simon Waever: Great speaking with you, James. James Lord: As a reminder, 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.

11 Mars 20228min