Is American Market Dominance Over?

As India enters a new era of growth, investors will want to know what’s driving this growth and how it may create once-in-a-generation opportunities. Head of Global Thematic and Public Policy Research Michael Zezas and Chief India Equity Strategist Ridham Desai discuss.----- Transcript -----Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Head of Global Thematic and Public Policy Research. Ridham Desai: And I'm Ridham Desai, Morgan Stanley's Chief India Equity Strategist. Michael Zezas: And on this special episode of Thoughts on the Market, we'll discuss India's growth story over the next decade and some key investment themes that global investors should pay attention to. It's Wednesday, December 7th, at 7 a.m. in New York. Michael Zezas: Our listeners are likely well aware that over the past 25 years or so, India's growth has lagged only China's among the world's largest economies. And here at Morgan Stanley, we believe India will continue to outperform. In fact, India is now entering a new era of growth, which creates a once in a generation shift in opportunities for investors. We estimate that India's GDP is poised to more than doubled to $7.5 trillion by 2031, and its market capitalization could grow 11% annually to reach $10 trillion. Essentially, we expect India to drive about a fifth of global growth in the coming decade. So Ridham, what in your view are the main drivers behind India's growth story? Ridham Desai: Mike, the full global trends of demographics, digitalization, decarbonization and deglobalization that we keep discussing about in our research files are favoring this new India. The new India, we argue, is benefiting from three idiosyncratic factors. The first one is India is likely to increase its share of global exports thanks to a surge in offshoring. Second, India is pursuing a distinct model for digitalization of its economy, supported by a public utility called India Stack. Operating at population scale India stack is a transaction led, low cost, high volume, small ticket size system with embedded lending. The digital revolution has already changed the way India handles documents, the way it invests and makes payments and it is now set to transform the way it lends, spends and ensures. With private credit to GDP at just 57%, a credit boom is in the offing, in our view. The third driver is India's energy consumption and energy sources, which are changing in a disruptive fashion with broad economic benefits. On the back of greater access to energy, we estimate per capita energy consumption is likely to rise by 60% to 1450 watts per day over the next decade. And with two thirds of this incremental supply coming from renewable sources, well in short, with this self-help story in play as you said, India could continue to outperform the world on GDP growth in the coming decade. Michael Zezas: So let's dig into some of the specifics here. You mentioned the big surge in offshoring, which has resulted in India's becoming "the office of the world". Will this continue long term? Ridham Desai: Yes, Mike. In the post-COVID environment, global CEOs appear more comfortable with work from home and also work from India. So the emergence of distributed delivery models, along with tighter labor markets globally, has accelerated outsourcing to India. In fact, the number of global in-house captive centers that opened in India over the past two years was double of that in the prior four years. During the pandemic years, the number of people employed in this industry in India rose by almost 800,000 to 5.1 million. And India's share in global services trade rose by 60 basis points to 4.3%. In the coming decade we think the number of people employed in India for jobs outside the country is likely to at least double to 11 million. And we think that global spending on outsourcing could rise from its current level of U.S. dollar 180 billion per year to about 1/2 trillion U.S. dollars by 2030. Michael Zezas: In addition to being "the office of the world", you see India as a "factory to the world" with manufacturing going up. What evidence are we seeing of India benefiting from China moving away from the global supply chain and shifting business activity away from China? Ridham Desai: We are anticipating a wave of manufacturing CapEx owing to government policies aimed at lifting corporate profits share and GDP via tax cuts, and some hard dollars on the table for investing in specific sectors. Multinationals are more optimistic than ever before about investing in India, and that's evident in the all-time high that our MNC sentiment index shows, and the government is encouraging investments by building both infrastructure as well as supplying land for factories. The trends outlined in Morgan Stanley's Multipolar World Thesis, a document that you have co authored, Mike, and the cheap labor that India is now able to offer relative to, say, China are adding to the mix. Indeed, the fact is that India is likely to also be a big consumption market, a hard thing for a lot of multinational corporations to ignore. We are forecasting India's per capita GDP to rise from $2,300 USD to about $5,200 USD in the next ten years. This implies that India's income pyramid offers a wide breadth of consumption, with the number of rich households likely to quintuple from 5 million to 25 million, and the middle class households more than doubling to 165 million. So all these are essentially aiding the story on India becoming a factory to the world. And the evidence is in the sharp jump in FDI that we are already seeing, the daily news flows of how companies are ramping up manufacturing in India, to both gain access to its market and to export to other countries. Michael Zezas: So given all these macro trends we've been discussing, what sectors within India's economy do you think are particularly well-positioned to benefit both short term and longer term? Ridham Desai: Three sectors are worth highlighting here. The coming credit boom favors financial services firms. The rise in per capita income and discretionary income implies that consumer discretionary companies should do well. And finally, a large CapEx cycle could lead to a boom for industrial businesses. So financials, consumer discretionary and industrials. Michael Zezas: Finally, what are the biggest potential impediments and risks to India's success? Ridham Desai: Of course, things could always go wrong. We would include a prolonged global recession or sluggish growth, adverse outcomes in geopolitics and/or domestic politics. India goes to the polls in 2024, so another election for the country to decide upon. Policy errors, shortages of skilled labor, I would note that as a key risk. And steep rises in energy and commodity prices in the interim as India tries to change its energy sources. So all these are risk factors that investors should pay attention to. That said, we think that the pieces are in place to make this India's decade.Michael Zezas: Ridham, thanks for taking the time to talk. Ridham Desai: Great speaking with you, Mike. Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.

7 Dec 20227min

As bond markets appear to have already priced in what central banks will likely do in 2023, how will this path impact inflation and currencies around the world?----- Transcript -----Welcome to Thoughts on the Market. I'm Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy. Along with my colleagues, bringing you a variety of perspectives, today I'll talk about our 2023 outlook and how investors should view some key macro trends. It's Tuesday, December 6th, at 10 a.m. in New York. During the pandemic in 2020 and 2021, central banks provided the global economy a safety net with uber-accommodative interest rate and balance sheet policies. In 2022, central banks started to aggressively pull away that safety net. In 2023, we expect central banks to finish the job. And in 2024, central banks will likely start to roll out that safety net again, namely by lowering interest rates. Bond markets, which are forward looking discounting machines, are already pricing in the final stages of what central banks will likely do in 2023. The prospect of easier central bank policies should bring with it newfound demand for long term government bonds, just at a time when supply of these bonds is falling from decade long highs seen in 2021 and 2022. Central bank balance sheets will continue to shrink in 2023, meaning central banks are not aggressively buying bonds - but investors shouldn't be intimidated. These expected reductions in central bank purchases are already well understood by market participants and largely in the price already. In addition, for the largest central bank balance sheets, the reductions we forecast simply take them back to the pre-pandemic trend. Of course, for central bank policies and macro markets alike, the path of inflation and associated expectations will exert the most influence. We think inflation will fall faster than investors expect, even if it doesn't stabilize at or below pre-pandemic run rates. Lower inflation around the world should allow central banks to stop their policy tightening cycles. As lower U.S. inflation brings a less hawkish Fed to bear, the markets should price lower policy rates and a weaker U.S. dollar. Lower inflation in Europe and the U.K. should encourage a less hawkish ECB and Bank of England. This should help growth expectations rebound in those vicinities as rates fall, which will result in euro and sterling currency strength. We do think the U.S. dollar has already peaked and will decline through 2023. A fall in the U.S. dollar is usually something that reflects, and also contributes to, positive outcomes in the global economy. Typically, the U.S. dollar falls during periods of rising global growth and rising global growth expectations. As we anticipate the dollar's decline through 2023, it's worth noting that in emerging markets, U.S. dollar weakness and EM currency strength actually tend to loosen financial conditions within emerging market economies, not tighten them. Emerging markets that have U.S. dollar debt will also see their debt to GDP ratios fall as their currencies rise, further helping to lower borrowing costs and, in turn, boosting growth. In a nutshell, we see the negative feedback loops that were in place in 2022 reversing, at least somewhat in 2023 via virtuous cycles led by lower U.S. inflation, lower U.S. interest rates, and a weaker U.S. dollar. 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.

6 Dec 20223min

The tactical rally in stocks has continued and treasury bonds have experienced their own rally, leaving investors to wonder when this bear market might run out of steam.----- 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, December 5th, at 11 a.m. in New York. So let's get after it. Last week, the tactical rally in stocks took another step forward after Fed Chair Jay Powell's speech at the Brookings Institution. After his comments and interview, long term Treasury yields came down sharply and continued into the end of the week. This sparked a similar boost higher in equities, led by the most interest rate sensitive and heavily shorted stocks. This fits nicely with our view from a few weeks ago, which suggests that any further rally would require lower long term interest rates. It also makes sense in the context of what we think has been driving this tactical rally in the first place - the growing hope for a Fed pivot that kick saves the economic cycle from a recession. So maybe the biggest question is why did Treasury bonds rally so much? First, we think it mostly had to do with Powell now pushing back on the recent loosening of financial conditions. Many investors we spoke with early last week thought Powell would try to cool some of the recent excitement, to help the Fed get inflation under control. Furthermore, investors seem positioned for that kind of hawkish rhetoric, so when that didn't happen we were off to the races in both bonds and stocks. Second, the jobs data on Friday were stronger than expected, which sparked a quick sell off in bonds and stocks on Friday, but neither seemed to gain any momentum to the downside. Instead, bonds rallied back sharply, with longer term bonds ending up on the day. Meanwhile, the S&P 500 held its 200 day moving average after briefly looking like a failed breakout on Friday morning. In short, the surprising strength in the labor market did not scare away the newly minted bond bulls, which is more focused on growth slowing next year and the Fed pausing its rate hikes. A few weeks ago, we highlighted how breadth in the equity market has improved significantly since the rally began in October. In fact, breath for all the major averages is now well above the levels reached during the summer rally. This is a net positive that cannot be ignored. It's also consistent with our view that even if the S&P 500 makes a new low next year as we expect, the average stock likely will not. This is typically how bear markets end with the darlings of the last bull finally underperforming to the degree that is commensurate with their outperformance during the prior bull market. Third quarter earnings season was just the beginning of that process, in our view. In other words, improving breadth isn't unusual at the end of a bear market. Given our negative outlook for earnings next year, even if we skirt an economic recession, the risk reward of playing for any further upside in U.S. equities is poor. This is especially true when considering we are now right into the original resistance levels of 4000 to 4150 we projected when we made the tactically bullish call seven weeks ago. Bottom line, the bear market rally we called for seven weeks ago is running out of steam. While there could be some final vestiges of strength in the year end, the risk reward of trying to play forward is deteriorating materially given our confidence in our well below consensus earnings forecast for next year. From a very short term perspective, we think 4150 is the upside this rally can achieve and we would not rule that out over the next week or so. Conversely, a break of last week's low, which coincides with the 150 day moving average around 3940, would provide some confirmation that the bear market is ready to reassert the downtrend in earnest. Defensively oriented stocks should continue to outperform until more realistic earnings expectations for next year are better discounted. We expect that to occur during the first quarter and possibly into the spring. At that point, we will likely pivot more bullish structurally. Until then, bonds and defensively oriented bond proxies like defensive stocks should prove to be the best harbor for this storm. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

5 Dec 20223min

While 2022 saw the fastest pace of policy tightening on record, has the Fed’s hiking cycle properly set the U.S. economy up for a soft landing in 2023?----- Transcript -----Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief U.S. Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss our 2023 outlook for the U.S. economy. It's Friday, December 2nd, at 10 a.m. in New York. Let's start with the Fed and the role higher interest rates play in the overall growth outlook. The Fed has delivered the fastest pace of policy tightening on record and now feels comfortable to begin slowing the pace of interest rate increases. We expect it to step down the pace to 50 basis points at its meeting later this month and then deliver a final hike in January to a peak rate of between 4.5 and 4.75%. But in order to keep inflation on a downward trajectory, the Fed will likely keep rates at that peak level for most of next year. This shift to a more cautious stance from the Fed we think will help the U.S. economy narrowly miss recession in 2023. And we think only in the back half of 2024 will the pace of growth pick back up as the Fed gradually reduces the policy rate back toward neutral, which is around 2.5%. Altogether, we forecast 2023 GDP growth of just 0.3% before rebounding modestly to 1.4% in 2024. One bright spot in the outlook is that inflation seems to have reached a turning point. Mounting evidence points to a slowing in housing prices and rents, though they continue to drive above target inflation. Core goods inflation should turn to disinflation as supply chains normalize and demand shifts to services and away from goods. Used vehicle prices are a big contributor to lower overall inflation in our forecast, as our motor vehicle analysts believe that used car prices could be down as much as 10 to 20% next year. So overall, we expect core PCE - or personal consumption expenditures inflation - to slow from 5% this year, to 2.9% in 2023, and further to 2.4% in 2024. Throughout 2022, rising interest rates have raised borrowing costs, which has weighed on consumption. And we expect that to continue into 2023 as the cumulative effects of past policy hikes continue to flow through to households. On the income side, we expect a rebound in real disposable income growth in 23, because inflation pressures abate while job growth continues to be positive. So if I put those together, slower consumption and rising incomes should lift the savings rate from 3.2% this year, to 5.1% in 2023, and 6.2% in 2024. So households will start to rebuild that cushion. Now we're in the midst of a sharp housing correction, and we expect a double digit decline in residential investment to continue. But we don't expect a commensurate drop in home valuations. Our housing strategies predict just a 4% drop in national home prices in 2023, and further price declines are likely in the years ahead, but that's a much milder drop in home valuations compared with the magnitude of the drop off in housing activity. So we think that residential wealth, real estate wealth will continue to be a strong backdrop for household balance sheets. Now going forward, mortgage rates will start to fall again after reaching these peaks around 7%. And with healthy job gains, and that increase in real disposable income growth affordability should begin to ease somewhat, we think starting in the back half of 2024. Turning to the labor market, while signs of falling inflation is important to the Fed, so are signs that the labor market is softening and we expect softer demand for labor and further labor supply gains to create the slack in the labor market the Fed is looking for. So we expect job growth will likely fall below the replacement rate by the second quarter of 2023, pushing up the unemployment rate to 4.3% by the end of next year and 4.4% by the end of 2024. In sum, we think the U.S. economy is at a turning point, but not a turning point toward recession, a turning point toward what is likely to prove to be two sluggish years of growth in the economy. The Fed's hiking cycle is working as it should. The labor market is softening. The inflation rate is coming down. And we think that puts the U.S. economy on track for a soft landing in 2023. 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.

2 Dec 20224min

As Asia and Emerging Markets move from a year of major adjustment in 2022 towards a less daunting 2023, investors may want to change their approach for the beginning of a new bull market.----- Transcript -----Welcome to Thoughts on the Market. I'm Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, in this episode on our 2023 outlook, I'll focus on why we recently turned more bullish on our coverage. It's Thursday, 1st of December at 8 a.m. in Singapore. 2022 was a year of major adjustment, with accelerating geopolitical shifts towards a multipolar world, alongside macro volatility caused by a surge in developed markets inflation, and the sharpest Fed tightening cycle since the Paul Volcker era 40 years ago. This took the U.S. dollar back to early 1980s peaks in real terms, and global equities fell sharply, with most markets down by double digit percentages. North Asian markets performed worse as a slowdown in tech spending, and persistently weak growth in China, weighed on market sentiment. But structural improvement in macro stability and governance frameworks was rewarded for Japan equities, as well as markets in Brazil, India and Indonesia. Our 2023 global macro outlook paints a much less daunting picture for equity markets, despite a slower overall GDP growth profile globally than in 2022. Current market concerns are anchored on inflation and that central banks will keep hiking until the cycle ends with a deep recession, a financial accident en route, or perhaps worse - that they leave the job half done. But, and crucially, our economists forecast that U.S. core PCE inflation will fall to 2.5% annualized in the second half of next year. Alongside slowing labor market indicators, our team sees January as the last Fed hike, with rates cuts coming as soon as the fourth quarter of 2023, down to a rate of 2.375% at the end of 2024. Meanwhile, inflation pressures in Asia remain more subdued than elsewhere. This top down outlook of growth, inflation and interest rates all declining in the U.S. and continued reasonable growth and inflation patterns in Asia should lead to a weaker trend in the U.S. dollar, which tends to be associated with better performance from Asia and emerging market equities.Meanwhile, for the China economy, we think a gradual easing of COVID restrictions and credit constraints on the property sector deliver a cyclical recovery, which drives growth reacceleration from 3.2% in 2022 to 5.0% in 2023. Consumer discretionary spending, which is well represented in the offshore China equity markets, should show the greatest upturn year on year as 2023 progresses. Crucially, this means that we expect corporate return on equity in China, which has declined in both absolute and relative terms in recent years, to pick up on a sustained basis from the current depressed level of 9.5%. We also think that end market weakness in semiconductors and technology spending, consequent upon the reversal of the COVID era boom, should gradually abate. Our technology and hardware teams expect PC and server end markets to trough in the fourth quarter of this year, whereas smartphone has already bottomed in the third quarter. They recommend looking beyond the near-term weakness to recognize upside risks, with valuations for the sector now at prior market troughs and the current pain and fundamentals priced in by recent earnings estimates downgrades in our view. We therefore upgraded Korea and Taiwan and the overall Asia technology sector in early October and expect these parts of our coverage to lead the new bull market into 2023. Finally, given greater GDP growth resilience and less sector exposure to global downturns, Southeast Asian markets such as Singapore, Malaysia, Indonesia and Thailand, collectively ASEAN, tend to outperform emerging markets in Asia during bear markets, but underperform in bull markets given their low beta nature. Having seen a sharp spike in ASEAN versus Asia, relative performance in the prior bear market, which we think is now ending, our view is that the trend should reverse from here. Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and recommend Thoughts on the Market to a friend or colleague today.

1 Dec 20224min

As China tries to smooth out its COVID caseload, investors should take note of the impacts those COVID policies have on global economies and key markets.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, November 30th, at 11 a.m. in New York. Investors remain intently focused on China's COVID policies, as the tightening and loosening of travel and quarantine policies has implications for key drivers of markets. Namely the outlook for global inflation, monetary policy and global growth. We're paying close attention, and here's what we think you need to know. Importantly, our China economics team thinks that China's restrictive COVID zero policy will be a thing of the past come spring of 2023, but there will be many fits and starts along the way. Increased vaccination, availability of medical treatment and public messaging about the lessening of COVID dangers will be signposts for a full reopening of China, but we should expect episodic returns to restrictions in the meantime as China tries to smooth out its COVID caseload. This dynamic is important to understand for its implications to the outlook for the global economy and key markets. For example, the economic growth story for Asia should be weak in the near term, but begin to improve and outperform the rest of the world from the second quarter of 2023 through the balance of the year. In the U.S., the reopening of the China economy should help ease inflation as the supply of core goods picks up with supply chains running more smoothly. This, in turn, supports the notion that the Fed will be able to slow and eventually pause its rate hikes in 2023, even if headline inflation sees a rebound via higher gas prices from higher China demand for oil. And where might this overall economic dynamic be most visible to investors? Look to the foreign exchange markets. China's currency should relatively benefit, particularly if reopening leads investors back to its equity markets. The U.S. dollar, however, should peak, as the Fed approaches pausing its interest rate hikes and, accordingly, ceasing the increase in the interest rate advantage for holding U.S. dollar assets versus the rest of the world. Of course, the evolution of the COVID pandemic has been anything but straightforward. So we'll keep monitoring the situation with China and adjust our market views as needed. 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.

30 Nov 20222min

Traditional ESG investing strategies highlight companies with top scores across ESG metrics, but new research shows value in focusing instead on those companies who have a higher rate of change as they improve their ESG metrics.----- Transcript -----Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research. Along with my colleagues, bringing you a variety of perspectives, today I'll focus on our new approach to identifying opportunities that can generate both Alpha and ESG impact. It's Tuesday, November 29th, at 10 a.m. in New York. On previous episodes of this podcast we've discussed how, although sustainable investing has been a trend over the past decade, it has faced significant pushback from critics arguing that ESG strategies - or environmental, social and governance - sacrifice long term returns in favor of the pursuit of certain ESG objectives. We have done some new work here at Morgan Stanley, suggesting that it is possible to identify opportunities that can deliver excess returns, or alpha, and make an ESG impact. Our research found that what we call "ESG rate of change", companies that are leaders on improving ESG metrics, should be a critical focus for investors looking to identify companies that meet both criteria. What do we mean by "ESG rate of change"? Traditional ESG screens focus on "ESG best-in-class" metrics. That is, companies that are already scoring well on sustainability factors. But there is a case to be made for companies that are making significant improvements. For example, we find that there are companies using innovative technologies that can reduce costs and improve efficiency. These companies, which we call deflation enablers, generally screen very favorably on a range of ESG metrics and are reaping the financial benefits of improved efficiency. A surprisingly broad range of technologies are dropping in cost to such an extent that they offer significant net benefits, both financial and ESG oriented. Some examples of such technologies are very cheap solar, wind and clean hydrogen, energy storage cost reductions, cheaper carbon capture, improved molecular plastics recycling, more efficient electric motors, a wide range of recycling technologies, and a range of increasingly inexpensive waste to energy technology. To get even more specific, as we look at these various technologies and the sectors they touch, we think the utility sector is arguably the most advantaged among the carbon heavy sectors in terms of its ESG potential. Why is that? Because many utilities have the potential to create an "everybody wins" outcome in which customer bills are lower, CO2 emissions are reduced, and utility earnings per share growth is enhanced. This is a rare combination. In the U.S. utility sector many management teams are shutting down expensive coal fired power plants and building renewables, energy storage and transmission, which achieve superior earnings per share growth. Many of these stocks would screen negatively on classic ESG metrics such as carbon intensity, but these ESG improvers may be positioned to deliver superior stock returns and play a critical role in the transition to clean energy. As with most things, applying this new strategy we're proposing isn't simply a matter of looking at companies with improving ESG metrics. It's about really understanding what's driving these changes. Here's where sector specific expertise is key. In fact, we believe that in the absence of fundamental insight, ESG criteria can be misapplied and could lead to unintended outcomes. The potential for enhanced performance, in our view, comes from a true marriage of ESG investing principles and deep sector expertise. 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.

29 Nov 20223min

As we head into a new year, Europe faces multiple challenges across inflation, energy and financial conditions, meaning investors will want to keep an eye on recession risk, the ECB, and European equities. Chief European Equity Strategist Graham Secker and Chief European economist Jens Eisenschmidt discuss.----- Transcript -----Graham Secker Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist.Jens Eisenschmidt And I'm Jens Eisenschmidt, Morgan Stanley's Chief European Economist.Graham Secker And on this special episode of the podcast, we'll discuss our 2023 outlook for Europe's economy and equity market, and what investors should pay close attention to next year. It's Monday, November the 28th, at 3 p.m. in London.Graham Secker So Jens, Europe faces multiple challenges right now. Inflation is soaring, energy supply is uncertain, and financial conditions are tightening. This very tricky environment has already impacted the economy of the euro area, but is Europe headed into a recession? And what is your growth outlook for the year ahead?Jens Eisenschmidt So yes, we do see a recession coming. In year-on-year terms we see negative growth of minus 0.2% next year. There's heterogeneity behind that, Germany is most affected of the large countries, Spain is least affected. In general, the drivers are that you mentioned, we have inflation that eats into real disposable income that is bad for consumption. We have the energy situation, which is highly uncertain, which is not great for investment. And we do have monetary policy that's starting to get restrictive, leading to a tightening in financial conditions which is actually already priced into markets. And, you know, that's the transmission lack of monetary policy. So that leads to lower growth predominantly in 23 and 24.Graham Secker And maybe just to drill into the inflation side of that a little bit more. Specifically, do you expect inflation to rise further from here? And then when you look into the next 12 months, what are the key drivers of your inflation profile?Jens Eisenschmidt So inflation will rise, according to our forecast, a little bit further, but not by an awful lot. We really see it peaking in December on headline terms. Just to remind you, we had an increase to 10.7 in October that was predominantly driven by energy and food inflation, so around 70% of that was energy and food. And of course, it's natural to look into these two components to see what's going to happen in the future. Here we think food inflation probably has still some time to go because there is some delayed response to the input prices that have peaked already at some point past this year. But energy is probably flat from here or maybe even slightly falling, which then gets you some base effects which will lead and are the main driver of our forecast for a lower headline inflation in the next year. Core inflation will be probably more sticky. We see 4% this year and 4% next. And here again, we have these processes like food inflation, services inflation that react with some lag to input prices coming down. So, it will take some time. Further out in the profile, we do see core inflation remaining above 2% simply because there will be a wage catch up process.Graham Secker And with that core inflation profile, what does that mean for the ECB? What are your forecasts for the ECB's monetary policy path from here?Jens Eisenschmidt We really think that the ECB needs to have seen the peak in inflation, and that's probably you're right, both core and headline. We see a peak, as I said, in December, core similarly, but at a high level and, you know, convincingly only coming down afterwards. So, the ECB will have to see it in the rear mirror and be very, very clear that inflation now is really falling before they can stop their rate hike cycle, which we think will be April. So, we see another 50 basis point increase in December 25, 25 in February, in March for the ECB then to really stop its hiking cycle in April having reached 2.5% on the deposit facility rate, which is already in restrictive territory. So, Graham, turning to you, bearing in mind all that just said about the macro backdrop, how will it impact European equities both near-term and longer term?Graham Secker Having been bearish on European equities for much of this year, at the beginning of October we shifted to a more neutral stance on European equities specifically. But we've had pretty strong rally over the course of the last couple of months, which sets us up, we think, for some downside into the first quarter of next year. In my mind, I really have the profile that we saw in 2008, 2009 around the global financial crisis. Then equity valuations, the price to earnings ratio troughed in October a weight, the market rallies for a couple of months, but then as the earnings downgrades kicked in the start of 2009, the actual index itself went back down to the lows. So, it was driven by earnings and that's what we can see happening again now. So perhaps Europe's PE ratio troughed at the end of September. But once the earnings downgrades start in earnest, which we think probably happens early in 2023, we can see that taking European equities back down towards the lows again. On a 12-month view from here we see limited upside. We have 1-2% upside to our index target by the end of next year. But obviously, hopefully if we do get that correction in the first quarter, then there'll be more to play for. We just got a time entry point.Jens Eisenschmidt Right. So how should I, as an investor, be positioned then in the year ahead?Graham Secker From a sector perspective, we would be underweight cyclicals. We think European earnings next year will fall by about 10% and we think cyclicals will be the key area of earnings disappointment. So, we want to be underweight the cyclicals until we get much closer to the economic and earnings trough. Having been positive on defensives for much of this year, we've recently moved them to neutral. We've upgraded the European tech sector, the medtech sector, and also luxury goods as well.Jens Eisenschmidt So what are the biggest risks then to your outlook for 23, both on the positive and the negative side?Graham Secker So on the positive side, I'd highlight two. Firstly, we have the proverbial soft landing when it comes to the economic backdrop, whether that's European and or global. That would be particularly helpful for equities, if that was accompanied by a bigger downward surprise on inflation. So, if inflation falls more quickly and growth holds up, that would be pretty positive for equity markets. A second positive would be any form of geopolitical de-escalation that would be very helpful for European risk appetites. And then on the negative side, the first one would be a bigger profit recession. If earnings do fall 10% next year, which is our projection, that would be very mild in the context of previous downturns. So in our base case, we see European earnings falling 20%, not the 10% decline that we see in that base case. The other negatives that I think a little bit about is whether or not what we've seen in the UK over the last couple of months could happen elsewhere. I.e., interest rates start to put more and more pressure on government finances and budget deficits, and we start to see a shift in that environment. So that could be something that could weigh on markets next year as well.Graham Secker But, Jens, thanks for taking the time to talk today.Jens Eisenschmidt Great speaking with you, Graham.Graham Secker 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.

28 Nov 20227min