Relief and Volatility Ahead for U.S. Stocks

In light of the U.S. Treasury yield curve recently inverting, many are asking if home prices will be affected and how the housing market might look going forward. Co-Heads of U.S. Securitized Product Research Jay Bacow and Jim Egan discuss.-----Transcript-----Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. Jay Bacow: And on this edition of the podcast, we'll be talking about the state of the mortgage and housing market, amidst an inverted yield curve. It's Tuesday, April 12th at 11 a.m. in New York. Jay Bacow: Now, Jim, lots of people have come on to talk about curve inversion and Thoughts on the Market. But let's talk about the impact to the mortgage and housing market. Now, the big question that everybody wants to know, whether or not they own a home or they're thinking about buying one, is what does an inverted curve mean for home prices? Jim Egan: When we look back at the history of, let's use the Case-Shiller home price index, we look back at that into the 80’s, it's turned negative twice over that 35-year period. Both of those times were pretty much immediately preceded by an inverted yield curve. However, there's a lot of other instances where the yield curve has inverted and home prices have climbed right on through, sometimes they've accelerated right on through. So if we're using history as our guide, we can say that an inverted yield curve is necessary but not sufficient to bring home prices down. And the logical next question that follows from that is, well, what's the common denominator? And in our view, there's a very clear answer, and that clear answer is supply. The times when home prices fell, the supply of homes was abundant. The times when home prices kept rising, we really did not have a lot of homes for sale. And when we look at the environment as we stand today, the inventory of homes for sale is at historic lows. Jay Bacow: OK, but that's the current inventory. What do you think about supply for the next year? Jim Egan: So I think there's two ways we have to think about the 12-month outlook for supply. The first is existing inventory, the second is new inventory, so building homes that come on market. Existing inventory is really driving that total number to historic lows. And we think it's just headed lower from here. One of the big reasons for that is, let's just talk about mortgage rates away from curve inversion. The significant increase we've seen in mortgage rates because of the unique construction of the mortgage market today, we think are going to bring inventories lower. And that's because an overwhelming majority of mortgage borrowers have fixed rate mortgages today, much more than in prior cycles in the past. And what that means is as rates go higher, as affordability deteriorates, which is something we've discussed in previous episodes of this podcast, that's for first time homebuyers. The current homeowner locked into those low fixed rates is not experiencing affordability pressure as mortgage rates go higher. In fact, they're probably less likely to put their home on the market. Selling their home and buying a new home would involve taking out a mortgage that might be 150 to 200 basis points higher. That can be prohibitively expensive in some instances, and so you actually get an environment where supply gets tighter and tighter, which could be supporting home prices. Now the other side of the equation is new homes. If existing inventory is at all-time lows, if prices continue to climb like they have, that should be an environment where we'll see more building. And we do think that inventories are already primed to come on the market over the next year because of the fact that look, we look at building permits, we look at housing starts, we look at completions, those numbers get talked about all the time when they come out monthly and they've been climbing. But they haven't been climbing all that much relative to history. What is up is kind of the interim points between those events, between housing start and completion. Units under construction is back to where we were in kind of late 2004, early 2005. Further up the chain units that have been permitted or authorized but haven't been started yet, that's starting to swell too. Now what’s currently in the pipeline isn't enough to alleviate the tight supply situation we find ourselves in. But it is enough to soften home price growth a little bit. But the real common denominator for home price growth in a curve inverted environment is that existing inventory number, which is at historic lows and continuing to go lower. Jay Bacow: All right, Jim. So mortgage rates are a lot higher, causing people to be locked in to their mortgage, and supply is low and you're saying probably going to stay that way. So what does that mean for housing activity going forward? Jim Egan: We think sales are going to fall. Housing sales normally fall either while the curve is inverted or shortly after the curve inverts, this time is no different. When we look at the impact that the incredible decrease in affordability that we've seen over the past 6 months, over the past 12 months, that also normally leads to sales volume slowing 6 months forward and 12 months forward. We've already started to see it. Existing home sales are starting to turn negative on a year over year basis, pending home sales are negative, purchase applications have decoupled even more than those statistics. So the ingredients for that decline in sales volumes that typically follow a curve inversion, they're already in place. We think that existing home sales have already peaked for at least the next year. But Jay, if we think existing home sales are going to fall, then that would mean fewer mortgages and fewer mortgages would mean less supply for mortgage-backed securities. Now that would be a good thing, right? Jay Bacow: Yeah, look, it's not advanced research to say that less supply is good for a market, and we think that's absolutely the case here. But the other side of the supply is demand, and the biggest source of demand, the largest holder of mortgages, is domestic banks. And domestic banks have a problem in an inverted yield curve that the incremental spread that they pick up to own mortgages versus their deposits is just going to be lower in an inverted yield curve. When we look at the data historically, we see that strong statistical correlation. That as the curve flattens, bank demand goes lower. It's also exacerbated by the fact that a lot of the mortgages that banks own are in their hold to maturity portfolios, over a trillion dollars. And those bonds yield less than where we project fed funds to be at the end of the year. So when we think about the demand for mortgages, the largest source of demand, it's going away. That's going to be a problem for mortgages. Jim Egan: OK, so the largest source of demand? Banks, they're going away. Who else is going to buy, if not the banks? Jay Bacow: Well, that's when we run into an even bigger problem. The second largest source of demand is the Fed, and the Fed has basically said in the minutes that were released last week, that they're going to be normalizing their mortgage holdings. Taking those two largest sources of demand it's likely to force money managers and overseas to end up buying mortgages, but probably at wider spreads than here. And that's why we're recommending still an underweight agency mortgages, which will cause spreads to go a little wider and maybe mortgage rates to go higher, further impacting the affordability problems that you were discussing earlier in the podcast, Jim. Jim Egan: All right Jay. Thanks for taking the time to talk today. Jay Bacow: Always great speaking with you, Jim. Jim Egan: 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.

12 Apr 20227min

Original Release on March 31st, 2022: As interest in using cryptocurrencies for transactions continues to rise for both consumers and businesses, crypto has begun a cycle of increased stability and popularity - but the question is, can this cycle continue? -----Transcript-----Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be asking the question - are cryptocurrencies currency? It's Thursday, March 31st at 2:00 p.m. in London. Did you really buy that house with crypto? Or did you just sell your crypto for dollars and use dollars to buy the house? Crypto skeptics think that goods cannot be priced in cryptocurrencies like bitcoin, primarily because their price is too volatile. But at some point, if crypto begins to be used for enough purchases of everyday goods and services, prices may begin to stabilize. Increased stability will further entice consumers to use crypto, and the cycle will continue. The question has always been, will this virtuous cycle ever begin? The answer is now clear, it has already begun. Here are some examples. Firstly, paying with cryptocurrency needs to be as easy as paying with a credit or debit card today. Over 50 crypto companies and exchanges have issued their own crypto cards, and these are attached to the Visa or MasterCard payments networks, meaning they're accepted all around the world. In the last quarter of 2021, Visa said its crypto related cards handled $2.5 billion worth of payments. Now that may sound small, at less than 1% of all Visa's transactions, but it is growing quickly. The difficulty in increasing crypto adoption is getting the merchant to accept crypto. It needs to be easy and cheap, which is something lots of new crypto companies and products are trying to achieve. Secondly, many would argue that something can only be a currency if you can pay your taxes with it. Even that is changing today. Over the past year, local and some national governments have introduced or proposed laws that will allow its residents to use cryptocurrency to pay their taxes. El Salvador famously made bitcoin legal tender in its country in 2021. In the past week, Rio de Janeiro announced it will become the first city in Brazil to allow cryptocurrency payments for taxes starting next year. It isn't just emerging economies, though, that are trying to attract global crypto investors. The city of Lugano in Switzerland has teamed up with Tether, the creator of the largest stablecoin - a type of cryptocurrency that's kept stable versus the U.S. dollar, to make bitcoin and two other cryptocurrencies de facto legal tender. In the U.S., Colorado is hoping to become the first state to accept crypto for taxes later in the year, and Florida's governor is investigating the logistics of doing the same. Both these proposals may be difficult to put into law in the end, as the U.S. constitution doesn't allow individual states to create their own legal tender, but it hasn't stopped these proposals and more from coming in. In both these examples, the receiver of the crypto typically immediately converts to fiat currency, like U.S. dollars, through an intermediary service provider. So let's come back to our original question - did you really buy that house with crypto? In February, a house in Florida was sold for 210 Ether, the second largest crypto, or the equivalent of over $650,000 dollars. Interestingly, the seller received the ether but didn't liquidate into U.S. dollars soon afterwards due to market volatility, because the value of ether in U.S. dollars fell by around 10%. Consumers and businesses are increasingly wanting to transact in cryptocurrency. Maybe most are simply wanting to trade the value of the asset, but as it becomes easier to transact in crypto and legal structures are defined, cryptocurrencies could start to become currency. The question is, will the virtuous cycle continue or be broken? Cryptocurrencies are beginning the long journey of challenging U.S. dollar primacy, and the president's recent executive order on digital assets shows little sign of regulators getting in their way for now. Thanks for listening. If you enjoy Thoughts on the Market, share this and other episodes with a friend or colleague today.

12 Apr 20224min

Since the Fed’s first rate hike and the inversion of the U.S. Treasury yield curve, the outlook on U.S. government bonds has changed, leading to a new take on U.S. Bonds.-----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, April 8th at 2:00 p.m. in London. We've made a key change in our strategic cross-asset allocations, closing our underweight to government bonds and are overweight in cash. We did this via U.S. Treasuries. This is a big debate among investors, many of whom are underweight bonds and questioning when to buy them back. There are a couple of reasons why we made this change. First, U.S. 10 year Treasury yields are now above the 2.6% year-end yield target of Morgan Stanley's U.S. interest rate strategists, meaning our forecast for U.S. bond returns are looking better on a cross asset basis. These forecasts should reflect the impact and the uncertainty of higher inflation, quantitative tightening and the growth outlook. Second, another part of our asset allocation framework is asking what economic indicators say about future cross asset performance. On these measures the outlook for U.S. bonds is also improving. For example, bonds tend to do better on a cross asset basis after the yield curve inverts, which recently happened. Another reason we were underweight bonds is that they often underperform other asset classes during the expansion phase of our cycle indicator, a tool we've developed within Morgan Stanley research to measure the ebb and flow of the economic cycle. But this underperformance starts to shift and stop when this indicator gets very extended, and on its current measures, well, it's very extended. Third, while this change was made with a 12 month horizon in mind, we could see some reasons to take action now rather than wait. Recently, cyclical stocks have been sharply underperforming defensive stocks, and that usually coincides with unusually good bond market performance as investors worry about growth. But recently, bonds have been underperforming, even as defensive stocks have worked. That divergence is unusual, but could normalize. We also have an important release of U.S. Consumer Price Inflation next week. While a peak in inflation has so far been elusive, Morgan Stanley's economists believe it may arrive with next week's number. Of course, there are many risks to adding back to bonds at the current juncture. One of those risks is that the U.S. Federal Reserve remains hawkish, and committed to a large number of rate hikes over the next 12 months. While that is certainly possible, the market is now expecting a faster rate hiking path, reducing the chance of a Federal Reserve surprise. To raise our weight of U.S. bonds back to neutral, we are closing or overweight to cash. Cash has performed well year to date, as many other asset classes have seen price declines. But this outperformance is unusual and warrants a more balanced approach for the time being. 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.

8 Apr 20223min

As the European Central Bank prepares to meet, the war in Ukraine continues to add to uncertainty, forcing investors in Europe to adjust their expectations for the remainder of the year. Chief Cross Asset Strategist Andrew Sheets and Chief Europe Economist Jens Eisenschmidt discuss.Important note regarding economic sanctions. This research references country/ies which are generally the subject of 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 incidental to general coverage of the issuing entity/sector as germane to its overall financial outlook, 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 -----Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset Strategist.Jens Eisenschmidt And I'm Jens Eisenschmidt. Morgan Stanley's Chief Europe Economist.Andrew Sheets And today on the podcast we'll be talking about the outlook for Europe's economy amid possible rate hikes, business reopenings and the war in Ukraine. It's Thursday, April 7th at 3 p.m. in London.Andrew Sheets Jens, clearly we're dealing with a lot in Europe right now amid the Ukraine conflict and I want to get into that situation and the impacts on the economy. But given that the European Central Bank is meeting in just a few days and there is speculation about possible rate hikes, let's start there. Maybe you could give a bit of a background on what we expect the ECB is going to do.Jens Eisenschmidt Thanks a lot, Andrew. First of all, let me say that we don't expect any change at next week's meeting relative to what the ECB has been saying in March at their last meeting. They're essentially keeping all options open. They have started on a gradual exit from their very accommodative monetary policy. They have increased the pace of policy normalization at their last meeting, and we do not expect the ECB to change that roadmap now. Just as a reminder, the roadmap is asset purchases could end in Q3 and any interest rate hike would come sometime thereafter. And any decision on ending asset purchases and rate hikes is highly data dependent. And that really it takes us to the current situation. Inflation continues to surprise to the upside. We just had a 7.5 percentage point print in March, and this undoubtedly does increase the pressure on the ECB to act. At the same time, there are significant downside risks to the outlook for growth in the Euro area stemming essentially from the Ukraine-Russia conflict, and this puts a premium on treading very carefully with any changes to the monetary policy configuration, hence the emphasis on optionality, flexibility and gradualism by the ECB.Andrew Sheets Jens, when you talk about gradualism, that implies that the inflation that we're seeing in Europe is more temporary, is more transitory, isn't going to get out of hand. Can you talk a little bit about what is different at the moment between inflation in Europe and inflation in the U.S.?Jens Eisenschmidt I think there are a lot of technical aspects that indeed you could be looking at on that question, but I think it's sufficient for our purposes here really to focus on the key difference. In the U.S. there's a huge internal demand component to inflation. While the same is not true for the euro area, where most of the inflation, you could argue, largest part is imported through energy. Another difference is that the outlook for the economy is slightly different. While you would say that in the U.S., if you're talking about an overheated economy, you have a very tight labor market, it's very difficult to see, you know, some sort of self-correcting forces bringing down inflation, which is why the Fed is embarking on a relatively aggressive tightening cycle. Here in the euro area, there is, of course, growth we see in '22 in our base case but at the same time, we are far away from such an overheating situation and even we are here now relying increasingly on fiscal stimulus to keep the growth momentum going given the high energy prices that are coming, dampening growth. So I think the situation is fundamentally a different one.Andrew Sheets And so Jens, maybe digging more into that growth outlook. You mentioned this rise in energy prices. There is uncertainty over the war in Ukraine. And yet in your team's base case, we see GDP growth in Europe growing about 3% this year, which would be pretty good by the standards of the last decade. What's behind that overall outlook?Jens Eisenschmidt You're right. our base case has the euro area economy growing by 3% in '22 on the back of the ongoing recovery from the pandemic, 'reopening' in one word, which has lagged here relative to, say, the U.S., as well as due to the fiscal stimulus. But we see increasing headwinds emerging as you were just also referencing. We had this series of consumer confidence prints clearly affected by high inflation and the ongoing conflict, and we are watching attentively how this develops. Energy prices have skyrocketed. So, while we stick to our base call for now, we think that the balance of risks is slowly migrating to the downside. As for the ECB, the projections presented at their last meeting in March are more optimistic in terms of growth than ours. Now, clearly, if the ECB's view of the world prevails, so growth comes in better than we expect, we think the ECB will start to raise rates as early as September this year. Contrary to that, we think that incoming data will disappoint the ECB and this is why we have the first rate hike only in December. In any case, you can see the ECB is clearly on the path of policy normalization, the need for which is driven by the high inflation regime we are in and even the less favorable growth outlook won't change that fundamentally.Andrew Sheets Jens, given that we were discussing the ECB, I'd also like to talk about what higher interest rates mean in Europe. How do you think about that debate and do you see a scenario where the ECB might be quicker to take rates from negative to zero, but then pause at zero for a more extended period of time?Jens Eisenschmidt I think this is a fair question, given that the negative rate experiment, if you want to call it, is really unique in its scope in the Euro area. And there has been a lot of debate about the effect of negative rates on banks, and you can probably argue that revising or returning from negative to zero is a little bit of a different journey than just raising rates in positive territory like what the what the Fed is going to do or is about to do now. So I'd say while there are some merits in the argument that probably, you know, getting rid of negative rates in the front end will help banks and may be good for lending in some sense, I think overall, our assessment would be increasing rates is something that detracts from economic activity.Andrew Sheets So Jens, you know, you mentioned some of the risks around energy supply, and I think it's safe to say this is the single biggest area of questions for investors who are in Europe or are looking at Europe is, how would the region respond to either cutting off its imports of gas and oil from Russia voluntarily or this disruption happening involuntarily? What would a complete cut off of Russian oil and gas mean for Europe's economy? And how does somebody in your position even go about trying to model that sort of outcome?Jens Eisenschmidt So we have, of course, tried to get our head around this question and we we have published last week a note on exactly that issue. The typical approaches or the approaches that we have as economists here is really you look at the sectoral dependencies on on these flows of gas and oil, say. You make some assumptions and of course, it gives rise to ranges which are relatively wide. What we can say with certainty is that in a scenario of a complete cut off of Russian supplies in terms of oil and gas, we we are very, very likely in a recession in 22 in the euro area. And we are really talking about a significant recession risk. While only through higher energy prices, so oil going the direction of 150, but you know, other than that supply still flowing, we also see huge dampening impact on the economy with a shallow recession emerging not as bad as we would see in a total cutoff scenario. But I have to admit there's huge uncertainty.Jens Eisenschmidt But Andrew, I was going to ask you a similar question as a strategist looking at different asset classes around the world. What's your team's view on Europe?Andrew Sheets Well thanks, Jens. So I think, unfortunately, the outlook for Europe, as you mentioned, has deteriorated since the start of the year. This terrible conflict in Ukraine has introduced additional uncertainty and binary risks to Europe around energy security that are difficult for investors to price and to discount. So, we've lowered our price target for European equities, which now leaves very limited upside versus current prices. And I think the region is now less attractive than something like Japan, for example, where I think you still have some of the same positive arguments that apply to Europe. The valuations are low. The currency is weak. Investors, I do not think are overly positioned in the region, but with less risk around aggressive central bank policy and with less risk around energy security. So for those reasons, we now think Japan is going to be outperforming market on a on a global basis.Andrew Sheets So Jens, all that said, the war in Ukraine is a wild card for our forecasts. What are the developments or indicators that you and your team are going to be watching?Jens Eisenschmidt We are really dependent on what's happening in the political sphere, given that the cut off of energy supplies will be either a decision by Russia or by the EU to no longer accept delivery of any gas or oil or coal. And obviously, this is a political process for which you have many ingredients, so you would want to watch these ingredients and some of which are essentially in the conflict itself. So I think we are attentively watching the developments that the conflict is taking. And there for instance, the news flow coming out of potential war crimes that certainly has not helped the case of energy supplies flowing freely. So there is a discussion right now in the European Union to restrict import of coal. And I think it's exactly these sort of developments that you have to be watching. Another space that we attentively watch is energy markets because high energy prices are so detrimental for the growth outlook. And might remind you, we have one scenario, our so-called bear scenario, which sees energy prices almost as high as we have seen them or higher a little bit maybe as we have seen them in early March. That is a scenario which would get us very, very close to recessionary territory. So, in some sense, it's a situation where we have to watch the energy markets as much as we have to watch the political scene and see how this conflict evolves.Andrew Sheets Well, clearly a lot that we'll need to follow. Jens, thanks for taking the time to talk.Jens Eisenschmidt Great speaking with 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.

7 Apr 202211min

As the U.S. government attempts to combat high gas prices by drawing on its oil reserves, investors should pay attention to the impacts on the U.S. economy and consumer behavior.----- 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, April 6th at 10 a.m. in New York.Last week President Biden announced the largest release of oil reserves in history, about 1 million barrels per day for the next 6 months from the government's Strategic Petroleum Reserve. The move is intended to put downward pressure on the price of gasoline by increasing the supply of oil, thereby relieving pressure on the American consumer from higher costs at the pump. Will it work? That remains to be seen, but investors should pay close attention, not just because it impacts their cost of driving, but also because it impacts the outlook for the U.S. economy by affecting how consumers behave.Our U.S. economics team, led by Ellen Zentner, has done some work worth highlighting here. The big takeaway is this; oil price shocks do dampen consumer activity, but not right away. The jump in oil prices seems to have to sustain itself before having a big impact. For example, consumption in real dollar terms seems to weaken after initial oil price increases, but it's not until 2 to 3 months after that shock that consumers start to buy less of other things in order to have enough money to pay the higher costs of filling up their cars. Looking at this effect on a specific product, for instance automobiles, you can see a similar pattern. Spending on cars doesn't seem to change in the first month after a price shock but drops almost 10% thereafter for 8 months.So the bottom line is this; the White House's move on releasing oil reserves has some time to play out. But if it doesn't reduce gas prices in the next couple months, then it becomes one cost pressure among several, including labor costs, that could start slowing the U.S. economy from its currently healthy pace. It's one reason our equity strategy team continues to see higher costs creating some pressure in key sectors of the stock market, notably consumer services, apparel and staples.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.

6 Apr 20222min

Original Release on March 30th, 2022: As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.-----Transcript-----Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York. Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now? Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s. Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle? Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this... Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists. Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home. Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today? Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy. Michael Zezas: Well, Matt, thank you for taking the time to talk with me today. Matthew Hornbach: It was great talking with you, Michael, Michael Zezas: And 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.

5 Apr 20226min

With the end of the first financial quarter of 2022 the market has begun to price in some of the continuing risks to economic growth, forcing investors to reconsider the trajectory for the rest of the year.-----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, April 4th, at 11:00 a.m. in New York. So let's get after it. Given how bad first quarter returns were for both stocks and bonds, most investors were probably happy to see it end. Furthermore, the rally in the second half of March made it considerably better for stocks than it was looking just a few weeks ago. In the end, though, bond returns ranked worse than stocks from a historical perspective, with Treasuries posting the worst quarter in 50 years. The tough first quarter was very much in line with our view coming into 2022. To recall, we didn't see many fat pitches given the Fed's resolve to fight the surge in inflation in the face of slowing growth. Whether it was for technical or fundamental reasons, bond and stock markets ignored this risk into year-end. Apparently, they required a more obvious signal, which appeared on January 5th with the minutes of the Fed's December meeting. From that moment, both stocks and bonds made a sharp U-turn and never really looked back for the entire first month of the year. In short, headline indices for both stocks and bonds finally adjusted to the fire part of our narrative, a risk that started to price under the surface back in November. With inflation and the Fed the number one concern during the first quarter, it makes sense that bonds would be worse than equities. It also makes sense that stocks more vulnerable to higher interest rates underperformed. As an example, the Nasdaq performance was considerably worse than both the S&P 500 and the small cap Russell 2000, a very rare occurrence over the past few years. And this is after a major rally in the past two weeks that was led by the Nasdaq. Our conclusion is that markets were preoccupied in the first quarter with the Fed's sharp pivot, more than anything else, and it played out in asset prices appropriately. Of course, the other major driver for markets in the first quarter was the war in Ukraine. While tensions had been building since late last year, it's fair to say markets had ignored that risk, too. The only difference is that the Fed's pivot was well telegraphed, while Russia's invasion was far from a sure thing and more of an unknown known to most, including us. Obviously, such an event did materially factor into the risk for the first quarter by accentuating the fire and ice by making inflation worse whilst simultaneously dampening growth prospects. It also has rattled confidence for both businesses and consumers, especially in Europe. This was not in our calculus when we made our forecast for 2022. As such, we find ourselves incrementally more negative on growth trends than we were at the end of last year. Last fall, we pushed out the timing of the ice part of our narrative to the first half of this year, when we realized that the economy still had plenty of strength left for companies to deliver on earnings growth. But now investors face multiple headwinds to growth that will be harder to ignore. These include the payback in demand from last year's fiscal stimulus, demand destruction from higher prices, food and energy price spikes from the war that serves as a tax and inventory bills that have now caught up to demand. While the employment report for March last Monday was strong once again, the Purchasing Managers Survey for Manufacturing showed a sharp deterioration in the orders component. Relative to inventories it looks even worse, with the inventory component of the index now below orders for the first time since the recovery began. Think of this ratio as the book to bill for the broader manufacturing economy. Perhaps this survey is the moment of recognition for the slowdown, much like the Fed's minutes were for inflation and Fed policy. The bottom line is that the fundamental outlook for stocks has deteriorated in our view since the end of last year. While markets have reflected some of this deterioration, we think it remains vulnerable to disappointing growth and increased risk of a recession next year. As such, we continue to recommend investors position for this late cycle setup. More specifically, that means favor defensively oriented sectors like Utilities, REITs and Healthcare, while avoiding stocks more vulnerable to a payback in consumer demand. Thanks for listening. If you enjoyed 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.

4 Apr 20224min

Investors are looking to the U.S. Treasury bond market as concerns rise around what the flattening, and potential inversion, of the yield curve might mean.-----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, April 1st at 2:00 p.m. in London. The so-called flattening and inversion of the U.S. yield curve is a dominant story in financial markets. As rates have risen, short term interest rates have risen more, meaning investors receive about the same yield on a 2 year U.S. Treasury as its 10 year version. This is unusual, and raises big questions for both bond investors and the economic outlook overall. Unsurprisingly, investors are usually paid more for investing in longer term bonds because these are generally more volatile. When that's not the case, it often means the market thinks the economy is going to be good in the near term, keeping short term central bank rates high, but possibly weaker in the longer term, which would imply lower future central bank rates and more supportive policy further out. And that feels like a pretty decent encapsulation of the current market debate. The U.S. economy is very strong at the moment, with the US unemployment rate recently falling to just 3.6%. But that strength is driving inflation and leading the Federal Reserve to raise interest rates more aggressively, rate increases that investors fear could weaken growth further out in the future. With implications like this it's no wonder that a lot of other asset classes, from credit markets, to equity markets, to commodities, really care about what the bond market is doing. And for these investors, we think there are a number of interesting implications. Let me start by saying that similar yields on 2 year and 10 year government bonds is not, in itself, a sell signal. Indeed, the last five times these rates were the same, global stocks rose by an average of about 10% over the following year. What we do see, however, is that a flat yield curve starts to support the outperformance of higher quality, more defensive assets. I try to explain this by the idea that investors do try to retain some growth in income exposure, given the strong current economic conditions, but try to move away from assets that could be much more vulnerable if growth deteriorates in the future. Specifically, when the U.S. 2 year and 10 year yields become similar, investment grade bonds start to outperform high yield bonds. Developed market stocks start to outperform emerging market stocks. And defensive sectors like health care and utilities outperform the broader market over the ensuing 12 months. Today, we think all of those strategies make sense. That's not because we necessarily think a recession is likely. Rather, we think it's a prudent reading of history in response to current bond market signals. 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.

1 Apr 20223min