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Heading into the end of the year, questions remain around Treasury yields and the neutral interest rate.----- Transcript -----Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Chief Global Economist. Guneet Dhingra: And I'm Guneet Dhingra, Morgan Stanley's Head of U.S. Trade Strategies. Seth Carpenter: And today on the podcast, we'll be discussing our updated economic and rates outlook for the rest of the year and into 2024. It's Monday, September 11th, at 10 a.m. in New York. Seth Carpenter: All right, Guneet. We are now about a week into September and we can take stock of what we've learned over the summer. For macroeconomists like me we care about growth, inflation, monetary policy, and I'll say this summer spending indicators came in strong, inflation continued to fall, and we had Jackson Hole, the sort of nerd temple for monetary policy. And I have to say we didn't learn quite as much as I hoped, but we kind of know the Fed has done hiking, or at least very close. But I have to say, in your domain, the Treasury yield is trading roughly 4.25%. On the last day of June, when summer began, it was around 380. Can we just attribute the higher rate to thin liquidity and move on? Guneet Dhingra: You're right Seth, it's not just thin liquidity, but the conditions of August definitely played a meaningful part in sending yields higher. Typically, as investors look to go away for August, positive carry trades are the easiest trades to have on, and playing for higher yields has been positive carry. Which is why I think in August this year and even the last year, yields tended to go higher. But beyond August, seasonality, which might be the simplest explanation, investors have 4 major narratives out there that R-star, the so-called neutral rate of interest has increased, the end of yield curve control in Japan, more Treasury supply and more recently at the end of the summer, and increased supply of corporate debt. Guneet Dhingra: So before we go there Seth, you mentioned Jackson Hole at the end of the summer. The idea that some investors have that because the economy has held up so well, despite the Fed's rate hikes, that the underlying neutral rate or R-star must be higher and so will have higher interest rates not just now, but into the future. What is your take on this whole R* debate and what have you learned from Jackson Hole? Seth Carpenter: Absolutely. So I have to say Jackson Hole was very interesting, but this time there were a lot of very academic minded papers there that were very important to talk about. I can see how they can spur debate, but I'm not sure they provide that much that's actionable in the near term for the Fed or even for markets. And when it comes specifically to R-star, color me a bit skeptical and I say that for a few reasons. One, alternate explanations just abound. We could have got stronger spending because there's more residual impetus from the fiscal policy that's already in the pipeline. And in particular, if we look at where we missed our GDP forecast, a really big part of that was nonresidential structures investment. So that could go a long way to explain it. Second, if R-star really was higher, I think that would mean that the Fed would have to raise the peak rate during this hiking cycle even higher, not just rates off in the future. And so what does that mean? That means that I at least would have expected a parallel shift higher in rates, not just along in selling off. And in fact, you might even see a steeper inversion of the curve as the rate goes higher in the near term, but then has to come down later. So take all of that together, and I guess I'm just really not convinced that there's enough evidence to conclude that R-star is higher. Guneet Dhingra: Yeah, makes a lot of sense, Seth. And listening to you about the growth and economic picture, I'm even more convinced that this R-star story doesn't quite hold water. Seth Carpenter: All right, so then there is the yield curve control story. And I will say, at the risk of patting myself on the back, our Japan team had been expecting a tweak to yield curve control in Japan, and we got it. But I know that you're skeptical that that's really the story here. Why do you push back? Guneet Dhingra: Yeah, I think one of the ways you can actually verify the impact of the yield curve control on the U.S Treasury market, is just break down the price action into different time zones. And what you saw is in the Tokyo time zone, where you would expect a lot of the so-called repatriation flows to play out, we haven't really seen much of a movement in U.S Treasury yields ever since the YCC change announcement. So I would say based on the time zone analysis, it doesn't look like YCC changes are really impacting Treasury yields. Seth Carpenter: Okay Guneet, I get it. So it wasn't from trading happening in Tokyo, but these sort of markets are global. There could have been traders in London, traders in New York who were reacting to the change in yield curve control and selling their JGBs. And then the traders in Tokyo wake up and go, oh, nothing to do here. What do you make of that story? Why couldn't that be the explanation that it really was yield curve control? Guneet Dhingra: So if you break it down in the London Time Zone, it actually turns out that Treasury yields have actually gone lower since the YCC announcement in the London Time Zone. To my mind, that speaks to the idea that maybe investors in those time zones are more focused on the weakness in the European economy than any changes to YCC. And speaking of the New York time zone, yes, it is true that the bulk of the sell off in Treasury yields has happened in the New York time zone. But keep in mind, if hedge funds are the only major player selling yields on the back of the YCC, and it's not quite backed up by repatriation flows, it's probably not likely going to be sustainable. Seth Carpenter: Then let's turn to the last one, increased supply of debt, both Treasury debt and corporate debt. So we know that the U.S deficit is high, Issuance will have to continue for some time. We've heard all of the stories about corporates starting to stir in capital markets and issue more. Shouldn't it be logical that if demand for assets is roughly unchanged but the supply goes up, the price will fall, which should lead to a sell off in rates? What do you make of that story? Guneet Dhingra: Yeah, the story is pretty logical, but I don't think it still answers the question. If supply was really the main driver, I would expect to see more of a substantial tightening in so-called swap spreads, which is the gap between Treasury yields and the equivalent swap rates. We haven't really seen much of a tightening in swap spreads, which really undercuts the idea that Treasury supply is already on investors minds. Seth Carpenter: All right. So I think we've gone through a bunch of the narratives, pushd back on a lot of them, maybe debunked them a little bit. I guess the one other question I would have for you is, could it be that markets are waking up to the higher for longer narrative? The Fed's been trying to say that they're going to keep interest rates as high as they need to for as long as they need to in order to bring inflation back to target. Maybe the market's putting more probability on that sort of outcome. Guneet Dhingra: Just to pretend I'm smarter than the economists, I will use the word bear steepening of the curve here. So in my view, the recent bear steepening of the 2s/10s curve is a combination of two things. Number one, there has been very little change in the market implied Fed funds path through the end of 2024. And number two, the back end has moved higher with some combination of August seasonality and belief around a higher R-star. So I would say it is less about the quote unquote higher for longer expectation, but more about the idea that the Fed fund eventually settles at a higher level in the medium term. Seth Carpenter: Okay. I guess that's fair. Let's take a step back, though, and take stock of what it is that we've learned. You and I and our colleagues have published work recently, basically saying, here's the mid-year outlook we published in May, here are the data that we got over the course of the summer. What did we get right and what did we get wrong? I econ, I'd say we got right the continued and pretty rapid fall in inflation in the U.S. and the slowing in the labor market, and I'm pretty proud of that. But boy, we got wrong just how strong the U.S. economy would be. And in very stark contrast, we missed just how weak the Chinese economy would be. Boy, we really thought that there'd be a stronger, more vigorous policy response that would get better traction and we'd see a bigger cyclical rebound. What are your key takeaways from what you and your colleagues in strategy have learned over the summer? Guneet Dhingra: To start with some numbers, we had ten year yields ending at 3.5% by the end of 2023. Currently there are 4.25%. We think we missed two things. First, the market focuses on upside and growth rather than the cooling of inflation. And number two, we missed the investors and how they're behaving, once bitten twice shy, about adding duration until every data point cools down convincingly. Having said that, your forecast is for more cooling and growth and inflation through the year. And so we have only marginally raised our ten year forecast to 3.65% by the end of this year. Seth Carpenter: I have to say, Guneet, every time I talk to you, I learn something new. So thank you for taking the time to talk. Guneet Dhingra: Great speaking with you, Seth. Seth Carpenter: And thanks to the listeners 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.

11 Sep 20239min

Both equities and high-yield bonds could benefit from an end to ratings hikes, but may still face risks from company earnings revisions, a potential U.S. government shutdown and other events on the horizon.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research at 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, September 8th at 2 p.m. in London. The week after Labor Day is both a refreshing return to more normal market conditions, and a rush. As investors head back to school, so to speak, here are a few big issues that we think they should be focused on. First and most importantly, we think the next few months will be about cementing the idea that both the Fed and the ECB are done raising interest rates for the foreseeable future. Given better than expected core inflation data in the U.S. and worse than expected growth data in Europe, we think neither central bank will raise rates at their meetings this month. And then further out, we think they stay on hold as lowered levels of bank loan growth, slower job growth and a continued decline in core inflation will reinforce the idea that central banks have raised rates enough. For markets, the end of a central bank rate hiking cycle tends to be pretty good for high grade bonds. Indeed, going back over the last 40 years, the dates of the last Fed funds rate increase and the local high point for yields on the U.S. aggregate bond index, line up almost to the month. The logic in this relationship also feels intuitive. If the Fed is done raising rates, one of two things has probably happened. It stopped raising rates at the correct level to bring inflation down without a recession and bonds like that lower inflation and more certainty, or they stopped because they've raised rates too much, slowing growth in inflation much more, a scenario where investors like the safety of bonds. But in riskier markets, the picture greeting investors in September is more murky. Like August, September also tends to see below average returns and above average volatility, and that seasonality doesn't turn helpful until mid-October. Company earnings revisions tend to be weak around this time of year, something our equity strategists believe could repeat. Investors got a lot more optimistic over the summer, raising the hurdle for good news. And there are some specific risk events on the near-term horizon, from a potential shutdown of the US government to a strike in the auto industry. For equities and high yield bonds, we therefore think investors should exercise more patience. A third issue investors will be watching is supply. September is historically one of the heaviest months of the year for corporate bond issuance, but with corporate bond yields now at some of their highest levels in nearly 20 years, will that reduce the incentive for companies to borrow? And meanwhile, one of the reasons assigned to the recent rise in US government bond yields has been the high levels of government borrowing. The next few weeks will give a much better idea of the true impact of that potential supply. 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 Sep 20233min

A strong El Niño event in the coming months could have negative effects for food inflation, commodities markets and climate change.----- 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 discuss the global risks and impact from a potential El Niño event later this year. It's Thursday, September 7th at 10 a.m. in New York. Over the last few months, as you've been doing your backyard grilling or taking a well-deserved summertime vacation, you may have heard a passing news reference to a climate pattern called El Niño. And although I'm an equity analyst and not a meteorologist, I'm going to talk about El Niño today because it could have some significant impacts for investors. To explain, El Niño refers to a warming of the ocean surface or above average sea surface temperatures in the central and eastern tropical Pacific. It's the counterpart to La Niña, which refers to the cooling effect of the same ocean surfaces. Essentially, El Niño and La Niña represent opposite extremes in the El Niño Southern Oscillation or ENSO. ENSO follows cyclical patterns that repeat at a 2 to 7 year cadence and tend to peak in the November to February window. Current conditions imply about a 70% probability that we could be facing a moderate to strong El Niño event later this year with a range of potentially significant impacts across regions and industries. First, although El Niño starts in the Pacific equator area, it has a significant impact on global weather. El Niño tends to peak around year end, impacting global rains and temperatures. El Niño driven seasonal patterns in the U.S., Argentina and the Andes tend to be wet, while those in Southeast Asia, Australia, Brazil, Colombia and Africa tend to be dry. This dynamic creates conditions that move wildfires and hurricanes from the Atlantic into the Pacific area. El Niño events also impact the global economy and the environmental, social and governance, or ESG, factors for businesses worldwide. More specifically, a moderate to strong El Niño in combination with the Russia-Ukraine war could impact food inflation, raising questions about the emerging markets central banks easing cycles. It could also impact trade and GDP in agro-related economies such as Argentina, India, Australia, Brazil and Colombia, among others. It may also impact several commodities, including sugar, grains, animal meal, proteins, electricity, lithium, copper, iron ore, aluminum and coal. El Niño’s effects can be positive or negative for different sectors and regions. For example, El Niño tends to be a negative in emerging markets. In Latin America, given the size of the agricultural sector and the spillover effect of agriculture into other industries, growth could be affected significantly. The recession we expect in Argentina this year is partially driven by La Niña, which generated an unprecedented drought. We expect El Niño to help grain yields in Argentina and to provide significant positive base effects to GDP in 2024. Finally, when it comes to ESG, El Niño can exacerbate climate change impacts and increase concentrations of greenhouse gasses. Since this is a global issue and impacts all sectors to various degrees, we believe investors should pay close attention. Furthermore, the humanitarian impact of El Niño lasts long after the phenomenon itself, be it through impacts on food security and malnutrition, disease outbreaks, disrupted basic services and sanitation or significant impacts on livelihoods around the world. Typically, extreme weather events hit the poorest communities the hardest. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

7 Sep 20233min

Investors anticipate new legislation on tech regulation, AI and defense, amid speculation about a potential government shutdown.-----Transcription -----Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about Congress coming back in the session and its impact on markets. It's Wednesday, September 6th, at 10 a.m. in New York. Congress returns from summer break this week with a full agenda. Expect to see tons of headlines on various policies that markets care about. Tech regulation, artificial intelligence regulation, defense spending, disaster relief aid and the risk of a government shutdown, are just some of the issues that should be tackled. It can be a bit overwhelming, so here's our cheat sheet for September in D.C. to help cut through the noise and understand why this could be a good set up for U.S bonds. On tech regulation and A.I, don't expect any meaningful movement here. New versions of legislative proposals on data privacy and liability for spreading misinformation may come, but there's still no comprehensive bipartisan agreement that could turn proposals into law. So we continue to expect that this only becomes possible after the 2024 election delivers a new government makeup. On defense spending, we expect that aid to Ukraine will continue and the Congress will approve overall defense spending levels in excess of the cap set by the agreement put in place alongside the hike of the debt ceiling. There's bipartisan agreement here, with the exception of House Republicans. Resolving issues with those holdouts will likely take brinkmanship over a government shutdown and perhaps even an actual government shutdown, but ultimately we see a deal that should be positive for a defense sector which has benefited recently by elevated spending by Western governments. The biggest story to track, though, is that risk of a government shutdown. As we previously discussed on this podcast, a shutdown is a real risk because House Republicans are not in sync with the rest of the House of Representatives and Senate on spending levels for fiscal 2024. Further, there's the sense that both sides may rightly or wrongly perceive political value in a shutdown. So there's both motive and opportunity here. And while a shutdown on its own is not sufficient to ruin our economists' expectation of a soft landing for the U.S. economy, it does add some fresh downside risk to growth in the 4th quarter, which economists already expect would be challenged. Major entertainment events in the U.S. boosted consumption above expectations this summer, and those effects should start to wane at the same time that the student loan moratorium rolls off, meaning many households will again have to direct some level of their income away from consumption toward servicing loans come October 1st. Put it all together, and it's a strong rationale for our view that high grade bonds have value here. U.S. government bond yields should be near their peak, with the market moving beyond the notion that the Fed may have to hike substantially more this economic cycle. 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 Sep 20232min

While valuations may be on the rise, fears around the resiliency of the economy could return and leave unguarded investors on uneven footing.----- 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 Tuesday, September 5th at 10 a.m. in New York. So let's get after it. In a world of price momentum, opinions about the fundamentals are often driven by the direction of price. Some of this is due to the view that markets are all knowing and often the best leading indicator for the fundamentals. After all, stocks are discounting machines and tell us what's likely to happen in the future rather than what is happening today. The old adage "buy the rumor and sell the news", is another way to think about this relationship. Using this philosophy, the move higher in stocks this year has provided the confidence for many to turn fundamentally bullish from what was an overly bearish consensus backdrop in the first quarter. The entire move in the major U.S. equity averages this year has been the result of higher valuations. However, with forward price earnings multiples reaching 20 times on the S&P 500 last month, not only are stocks anticipating higher earnings and growth, but they now require it. The other reason price momentum works has little to do with the fundamental outlook. Instead, price momentum often leads investors to chase or sell that momentum. It's human nature to want to go with the trend both up and down. Most were too negative on the economy at the beginning of the year, including us. The failure of a few large regional banks and negative price reaction in the stock market reinforced that view. However, when the recession didn't arrive, there was a fundamental reason to reverse that view. The price action in April and May supported that pivot, further feeding the bullish narrative. However, the move in price was very narrow, led by just a handful of Mega-cap growth stocks. In June, breadth improved, dragging investor confidence toward the optimistic fundamental outcome. But since then, breath has rolled over again and remains weak. We recommend maintaining a late cycle mindset, which means a barbell of growth stocks and defensive, not cyclicals or smaller stocks. Going into the second quarter earnings season we suggested it would be a "sell the news event", mainly because stocks had rallied in the mid-July, which was a change from the past several quarters where stocks trended weaker into results. Now that earnings season is over, we know that the price reaction post reporting was some of the weakest we've witnessed in the past decade. We think stocks may be starting to question the sustainability of the economic resiliency we experienced in the first half of the year. Defensives and growth stocks have done better than cyclicals. As an aside, the earnings results have not kept pace with the economy this year outside of a few areas which have been driven mostly by cost cutting rather than top line growth which furthers the idea we are still late cycle, not early or mid. This past week, equity prices have rebounded sharply, led once again by growth stocks. With softer economic data weighing on Treasury yields, stock market participants seem willing to bid valuations back up on the view the late cycle environment is being extended once again. With inadequate evidence to affirm or contradict that view, price continues to be the governing factor for many investors' conclusions about where we are in the cycle. Bottom line price momentum is a key driver of sentiment, especially in a late cycle environment when uncertainty about the outcome is high. We continue to recommend a more defensive growth posture in one's portfolio given that the fears of recession or financial distress could return at any moment in the late cycle environment in which we find ourselves, particularly as we enter September. 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 help's more people to find the show.

5 Sep 20233min

Although back-to-school spending appears to be trending higher than in 2022, there are signs that U.S. consumers could feel pinched before the holiday season.----- Transcript -----Sarah Wolfe: Welcome to Thoughts on the Market. I'm Sarah Wolfe from Morgan Stanley's U.S. Economics Team. Simeon Gutman: And I'm Simeon Gutman, an Equity Analyst covering the U.S. Hard Lines, Broad Lines and Food Retail Industries. Sarah Wolfe: And on this special episode of the podcast, we'll focus on back to school shopping trends and what they suggest for the U.S. consumer outlook for the rest of the year. It's Friday, September 1st at 10 a.m. in New York. Simeon Gutman: Sarah, back to school shopping is in full swing as we go into the Labor Day weekend and end of the summer. As an economist who focuses on the U.S. consumer. I know you track it closely. Why is back to school shopping such an important indicator in general, and what is it suggesting about the overall health of the U.S. consumer? Sarah Wolfe: Back to school is a large shopping event across July and August each year, which is an event that is only as strong as the strength of the U.S. household. If households feel good about job prospects and inflation is not eating away at their buying power, you should see that reflected in back to school sales. If we go back to summer 2022, headline inflation was 8% going into back to school shopping, and there were lingering concerns about COVID disrupting school. In 2023, certain headwinds to the consumer are risks to spend, these include higher debt service costs, tighter lending standards and a student loan moratorium expiring in October, but a still strong labor market and abating inflationary pressures that have supported a recovery in real wages should outweigh the downside risk and lead to a moderate back to school spending year. So what does this all mean for what we're seeing in the data? Our early read on July back to school shopping and in-store sales is that they're going to be weaker than the historical average, however, August matters most. If we see August sales in line with the historical average, then back to school sales for 2023 on a year-over-year basis would be quite a bit stronger than 2022 still, but roughly in line with the historical run rate from 2011 to 2019. This jives with our early readings from our AlphaWise Consumer Poll survey that this year back to school shopping is looking stronger than last year, but it is not a blowout. Simeon Gutman: And how about end of year holiday spending? Is back to school a predictor of holiday spending trends? Sarah Wolfe: Back to school shopping is indeed a predictor of holiday shopping trends. However, the early read through to holiday shopping points to a holiday season that's actually weaker than 2022, but in line with the historical run rate as well. Total retail sales on a non seasonally adjusted basis across November and December have been 8% year-over-year from 2011 to 2019 in 2021, the growth was 33% and 2022 was 12%. This was due to stronger than usual demand for goods as a result of COVID and stimulus. So while the consumer remains relatively healthy and is spending more on back to school shopping than last year, it'll be tough to beat 2022 holiday shopping growth. The preliminary forecast for holiday shopping is to see growth in line with the historical run rate, but weaker than next year. We still get a couple more retail sales reports that are going to help us fine tune our holiday shopping forecast. Simeon, turning it over to you, what specific trends are you observing during this back to school shopping season? Simeon Gutman: So far, it's mixed. On the surface, it looks like the consumer is healthy. If we look at durable goods spending the last couple of months, we have June and now July, low 2% range. That's decent. But under the surface, it's a bit of a different story. If you look at the Q2 comps across the coverage universe, they were roughly flat. That's not a great indicator of spending. And we see a shift towards consumables and supplies and must haves. Consumers are not prioritizing discretionary items. Big ticket items are under pressure. The companies that are growing and doing well, they look like they're taking market share, there's a shift towards value, so discount stores, dollar stores, off price stores, and it looks like it's a story of product categories, beauty and auto parts. What we've seen specifically for back to school, July was a strong month, but there was potentially some pull forward from earlier in the season. August seems to be good, but may have slowed a little and we'll see about September. But consumers are definitely shopping more on occasion and it's been a little bit choppy. Sarah Wolfe: These are great insights, Simeon, on how consumer behavior is slowly evolving as the macro backdrop becomes a little bit tougher. You've also highlighted electronics as one particular area that appears most at risk. What exactly does that mean and what's driving it? Simeon Gutman: So we conducted an AlphaWise survey, that Morgan Stanley did about a month ago, that suggests electronics have the most risk. We had a net neutral spending intention from consumers year-over-year. In contrast to other categories, we asked about clothing and apparel had a 21% net positive spending intention while school supplies was also positive 12%. The largest public company in the electronics space, they posted a -6% same store sales number in their recent quarter on top of a pretty big negative number the prior year. So it underscores the survey. The only caveat, and maybe a silver lining is, there is chatter about units in electronics beginning to bottom, so there could be some silver lining. Sarah Wolfe: Finally, Simeon, if we were to widen the lens a bit, how have back to school shopping trends evolved over the last 5 to 10 years? And what is your longer term outlook for what lies ahead in terms of potential future trends? Simeon Gutman: Drum roll, please. Not much. It doesn't seem that we've gotten a big shift in spending. So we looked back over the last ten years at the percentage of spend that consumers have made over the July, August and September timeframe, which captures the back to school season. As a percentage of retail sales, it's surprisingly consistent in the 24 to 25% range. In this kind of COVID post-COVID era, we've seen it tick up a bit, but this makes sense because the consumer has shifted spend from services to goods. So it's run rating around 25%, but as we've seen reversion in other categories, we think this will moderate as well. So our future prediction would be consistent with the prior trend line; it doesn't seem to be trading off sales with other periods, including the holiday. The one trend we have seen is e-commerce penetration is rising, in this timeframe for both non store retailers and for physical retailers who have seen a higher mix of online sales. But as far as the future goes, we don't expect a big change. Sarah Wolfe: Simeon, thanks for taking the time to talk. Simeon Gutman: Great speaking with you, Sarah. Sarah Wolfe: 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.

1 Sep 20236min

While recent news of a potential debt deflation loop in China’s equity market is causing concern for investors, Japan’s equity market resilience may bring optimism.----- Transcript -----Welcome to Thoughts on the Market. I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the Japanese equity market vis-a-vis China. It's Thursday, August 31st at 9 a.m. in Singapore. We recently did a three part series on this show focusing on our economic and market outlook for Japan. We discussed a bullish view on Japan equities, which is driven by three powerful drivers of outperformance coming together, namely macro, micro and the transition to a multipolar world. Recently, however, there's been investor concern about the potential impact on Japan from a Chinese debt-deflation loop, that is a scenario where prices fall, debt rises and economic growth stagnates, and this is the risk that I will discuss today. As a reminder, our economists came into 2023 flagging Japan as a standout developed market for growth momentum. In contrast to a U.S and European slowdown, as Japan continues to benefit from COVID reopening, ongoing stimulatory policy and a competitive currency. Since then, we have seen upside surprises, such as in wages and capital investments amid what we see as confirmation of a move into a structurally higher nominal GDP growth path. Indeed, Japan's recent second quarter GDP figures confirmed that trend, with a surge in real and nominal GDP to 6% and 12% annualized respectively. Following this result, our economists have doubled their 2023 GDP forecast to 2.2%, and this stands in contrast to China's GDP growth trend, where our economists have been reducing forecasts and will see nominal GDP growth slow below that of Japan to 4.8% over the last year. So the key exception to a generally bullish picture for Japan has been its linkages to China. While this may appear to be a legitimate investor concern for the market as a whole, it's important to note that Japanese revenues are driven much more by the U.S and Europe, which together make up a quarter of total sales. Instead, China makes up just 5% less than many assume, and far lower than that of Singapore, Taiwan, Australia or South Korea. However, there are some pockets of China exposure that we note, including in semis and semi-cap equipment, electronic components and factory automation. Another reason for our optimism about Japan's equity market resilience amid the slowdown in China is that China exposed Stocks in Japan have almost fully unwound the outperformance seen during the early COVID zero and post-COVID reopening phases. In contrast, Asia-Pacific ex-Japan companies with high exposures to China, many of them in the technology or resources sector, stand close to their relative highs. So while we do see from here less upside to the aggregate MSCI Emerging Markets Index and the Tokyo Stock Price Index, known as TOPIX, after the post October rally, we do see good reason for Japanese equities to continue to outperform. Valuations on a 12 month forward basis are in line or slightly below their ten year historical averages, and we expect 10% earnings growth in 2023 and 2024 as that nominal GDP growth recovery and corporate reform rolls through the market. The key downside risk will, of course, be not just the Chinese debt deflation loop, but adding on top a US recession, which ironically would be similar to what happened in the 1990s, when in Japan, imbalances, excess leverage and insufficient policy stimulus tipped the economy into structural deflation and stagnation. So while that risk is more relevant for China and Japan is in a completely different situation now, we are closely monitoring the risks of this bear case scenario and what that would mean for parts of the Asia and emerging markets universe. So 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.

31 Aug 20233min

Although Europe has been the global leader when it comes to greening its economy, recent challenges may be a cause for concern.----- Transcript -----Rob Pulleyn: Welcome to Thoughts on the Market. I'm Rob Pulleyn, Morgan Stanley's Head of Utilities of Clean Energy Research in Europe. Jens Eisenschmidt: And I'm Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist. Rob Pulleyn: On this special episode of this podcast, we'll be discussing the future of Europe's energy transition, including whether its clean energy goals are realistic and the implications for investors and Europe's broader economy. It's the 30th of August, 10 a.m. in London. Rob Pulleyn: Europe has long been a global leader when it comes to greening its economy. Strong societal and political support has bolstered the region's transition to clean sources of energy, with a European Green Deal and climate target plan aiming to reduce CO2 emissions by at least 55% by 2030 and achieve net zero by 2050. While substantial progress has been made over the previous decades, the region is now facing several challenges. Jens, can you give us the backdrop to Europe's energy transition and some of what's changed recently? Jens Eisenschmidt: Yes Rob, I mean, you have explained it already. There are big change targets, climate change related targets to the energy transition that Europe has subscribed to. These targets were in place already before the 24th of February in 22, when we saw the Russian invasion in Ukraine that changed the European energy set up profoundly. Now, why is this important? It's important because these targets were done in sort of a plan that relied on a certain energy source that is no longer existing. So let me give you an example. Let's take Germany, which was anyway already quite progressed in its journey onto increasing the share of renewables in electricity production. If you take Germany, they have been turning their back on nuclear power generation, which is another source of emission free power generation, and have embraced as a flex load provider, so as a provider of electricity when renewables are unavailable to natural gas. Now this natural gas supply from Russia is no longer available, as we all know, and of course, that implies that the Germans and other member states of the European Union as well have to change the plan by which they transit to a carbon free economy. And, you know, this is very complicated because it's not only switching one energy source for the other or exchanging one for the other. You also have to look about the infrastructure, you have to see what is essentially giving your energy mix the stability, as I said before, when we don't have sun shining and wind blowing, you need to have a source that's about the question about storage technologies, that's not entirely independent of the energy sources that you have available. And so the last year provided a profound challenge to the way Europe had planned its energy transition, so they have to replan it, and the complexity of that is huge. Essentially, it's something you want to ideally plan at the European level in order to harness all the comparative advantages all the countries have, given example, you have a lot of sun hours in Spain, less so in Germany, so ideally you want to put solar for Europe somewhere south and not so much somewhere north. But that of course means something for the grid, you have to deploy around it. So all that complexity is huge, all the coordination needs are huge and so this is the new situation we are in. Rob Pulleyn: Yeah, that new situation clearly puts increased pressure on Europe, if electricity prices remain elevated, Europe's large industrial base and you mentioned Germany would continue to shoulder this burden. You know margins, pricing, competitiveness would all suffer and the region's place in the global value chain might be at risk. Now, renewables are increasingly cost competitive, but even when the solar power is still very intermittent and that requires either a stable baseload or at least flexible generation. And as you mentioned, this previously was facilitated partly by Russian gas. Now, with all that in mind Jens, how much investment is needed to fund the transition and is there economic risk associated with this? Jens Eisenschmidt: So the numbers are huge. We have said that number could be around $5 trillion, other sources estimate this to be slightly higher, but more or less the ballpark is the same. We also know that already $1.4 trillion is earmarked from public funds, so EU budget, meaning that $3.6 are left for the private sector to deploy or for member states to come up from national budgets. So the figure itself boiling down to somewhere between $5 to $600 billion a year until at least 2030 and maybe beyond, these figures are not in itself the problem. The problem is how do you, according to which plan, do you deploy this and what is the sort of economic backdrop in which this investment happens? So ideally, from an economist perspective, this is a productivity increasing undertaking, and if it's done in that way, it won't be necessarily inflationary, it would be mildly growth enhancing. But of course there is a risk that all that investment in particularly being driven by the public sector, crowds out other productive investment. And in that case, it would be less productivity enhancing and more inflationary, which we think is the more realistic case here for Europe. We don't think that this is the end of the world in terms of inflation, but we do estimate a sizable impact of around 20 basis points per year that inflation could turn out to be higher. That all being said, if electricity prices can be reliably and durably lowered, that would have the potential to generate more innovation. Rob, you have your finger on the pulse of new technology, what do you see emerging that may advance the progress of Europe's transition? Rob Pulleyn: Yeah, thanks Jens. So historically, we've been positively surprised by the pace of levelized cost of energy coming down, particularly in renewables. And we've also been positively surprised by technological developments elsewhere. As we think about the key challenge of this new wind and solar capacity ambitions, the key is intermittency, and therefore industrial scale batteries are going to be key, fuel cells should also be, green gas, which is also needed for industrial abatement, could also be part of that solution. I also think we need to talk about behind the meter, which is really rooftop solar, whether it's solar panels but more crucially one of the parts of the value chain is the inverters. More efficient inverters are one of the most key components for reducing the cost of solar. As we think about electrification of the home in terms of heat pumps, you know, there's another technology which will develop and also passenger vehicles moving to electric, this behind the meter rooftop solar generation will be important combined with batteries and as I said, the inverters are a key part of that. Also will be software, how to manage all of this demand side response, I think is something you're going to hear much more from many of the retail companies we cover and innovating in the space. Now, as we think about the sequence and the steps of decarbonization here, step one, decarbonize the existing power system, step two electrify as much as possible, step three move to green gasses. We will eventually reach an area whereby we cannot decarbonize any further, and that's where carbon capture and storage comes in, for which we're already seeing significant improvement. So, there's many technologies which I think will play a significant role in this. And I suspect despite the current pressures we're seeing at the moment, we will continue to see significant positive surprises over the coming decade and thereafter, notwithstanding that the cost of capital is, of course, higher than it was over the last decade. Jens Eisenschmidt: So which sectors are likely to benefit the near-term and in the longer term? Rob Pulleyn: So the obvious answer, and somewhat self-serving, is utilities. To that number you mentioned earlier of $5 billion spent, we also think that the utilities could probably contribute around a European utility in Europe around $1.5 to $2 trillion of this. That still leaves a sizable gap versus what you were talking and perhaps there is upside risk to these investment spends. But within utilities, the obvious route is renewables. Having a tough time, I would say in 2023, trapped within higher costs and capital costs, but also, you know, policy impasse. But if we separate the wood for the trees under the vast majority of scenarios out to 2030 and 2050, the increase in green electricity is going to be substantial and utilities are the natural developers of those assets as they migrate away from coal and some degree gas, into clean energy. But it's not the only area. There's also networks. We need to invest in distribution and transmission, in electricity to actually accommodate these renewables and connect the new areas of upstream electricity generation to the areas of demand, which is primarily the cities and industry. Speaking about industry, there's also a need for green gas, and I actually think other sectors are going to contribute here, most notably oil and gas, which has the technical expertise and of course the industrial plant for industrial gasses. As we look into the supply chains, another area that's been in focus this year, both the OEMs in terms of turbines and solar manufacturers, the cabling, the software, the heat pumps, I think there are many aspects within equity stories which are ancillary to utilities but could create different risk rewards and different opportunities to what you may find in my sector. I think we can both agree that while significant progress has been made, Europe still has a long way to go for the next step of this journey. Jens Eisenschmidt: I fully agree. I would say that not all hope is lost that current targets will be met, but there are headwinds that cannot be denied. Rob Pulleyn: Jens, thank you very much for taking the time to talk today. Jens Eisenschmidt: Thanks, Rob. It was great to speak with you. Rob Pulleyn: And thank you all for listening. Subscribe to Thoughts on the Market, on Apple Podcasts or wherever you listen, and please leave us a review. We'd love to hear from you.

30 Aug 20239min