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Submit ReviewConsumer credit scores have ticked higher in the last two years – but so have the rate of delinquencies and defaults. Our Global Head of Fixed Income discusses “credit score migration” with the firm's Asset-Backed Security Strategist.
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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley.
Heather Berger: And I'm Heather Berger, Asset-Backed Security Strategist.
Michael Zezas: And today, we'll be talking about the trend of migrating US consumer credit scores and the potential effect on equities and fixed income. It's Wednesday, March 27th at 10am in New York.
Heather, I really wanted to talk to you today because we've all seen some recent news reports about delinquencies and defaults in consumer credit ticking higher over the last two years. That means more people missing payments on their car loans and credit cards, suggesting the consumer is increasingly in a stressed position. But at the same time, that seems to be at odds with what's been an upward trend in consumers’ credit scores, which on its face should suggest the consumer is in a healthier position.
So, it all begs the question: what's really going on here with the consumer, and what does it mean for markets? Now, you and your colleagues have been doing some really fascinating work showing that in order to get to the truth here, we have to understand that there's a measurement problem. There’s quirks in the data that, when you understand them, mean you have a more accurate picture of the health of the consumer. And that, in turn, can clarify some opportunities in the fixed income and equity markets.
So, this measurement problem seems to center around the idea of credit score migration. Can you start by explaining what exactly is credit score migration?
Heather Berger: Sure. So, credit scores are used as a way to estimate expected default risk on consumer loans. And these scores are really the most standardized and widespread way of evaluating consumer credit quality. Scores are meant to be relative metrics at any point in time. So, a 700 score today is meant to indicate less default risk than a 600 score today, but a 700 score today isn't necessarily the same as a 700 score a few years ago.
Credit scores have been increasing throughout the past decade; most extremely from 2020 to 2021, largely due to COVID related factors such as stimulus checks. The average credit score is up 10 points in the past four years, and this trend has broadly been referred to as credit score migration.
Michael Zezas: So, just so we can have a concrete example, can you talk about how this has affected one particular consumer credit category?
Heather Berger: Well, as you mentioned earlier, delinquencies and defaults have been rising across consumer loan types, whether it's autos, credit cards, or personal loans. The macro backdrop has definitely contributed to this, as inflation has weighed on consumers real disposable income, but we do think that score migration has had an impact as well, considering the large changes over the past few years.
Looking at auto loans, for example, with the same credit scores from 2022 versus loans from 2018, we see that delinquency rates on the 2022 loans are up to 60 per cent higher than on the 2018 loans. We estimate that 30 to 50 per cent of this increase can be due to effects of credit score migration.
Michael Zezas: And is there anything we can assume here about the actual health of the US consumer? Do we see delinquencies improving or getting worse?
Heather Berger: I think one of the main takeaways here is that since score migration impacts performance metrics, we shouldn't necessarily extrapolate delinquency data to broader consumer health. Despite the high delinquency rates, our economists do expect consumers to remain afloat.
They're forecasting a modest slowdown in consumer spending this year as we move off a hot labor market and continue to face elevated interest rates.
Michael Zezas: So, let's shift to the market impacts here. Maybe you could tell us what your colleagues in equity research saw as the impact on the banks and consumer finance sectors. And in your area of expertise, what are the impacts for asset-backed securities?
Heather Berger: We think that across both of these spaces, taking into account changes in credit scores will be important to use in models moving forward; and this can help us to more accurately assess the risks of consumer loans and to predict performance. Movements in credit scores have actually been muted in the past year, which is a big change from the large increases we saw a few years ago.
So, score migration should now have a smaller impact on consumer performance and delinquency rates. This means that performance will be driven by macro factors and lending standards. As inflation comes down and with lending standards tight, we view this as a positive for asset backed securities, and our colleagues view it as a positive for their coverage of consumer finance equities.
Michael Zezas: Heather, this has been really insightful. Thanks for taking the time to talk.
Heather Berger: Great speaking with you, Michael.
Michael Zezas: And thanks for listening. If you enjoy thoughts on the market, please be sure to rate and review us on the Apple podcast app or wherever you listen. It helps more people find the show.
As investors look for clues on market durability, our Chief U.S. Equity Strategist highlights which sectors could show more widely distributed gains in the near term.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about an opportunity for energy stocks to keep working in the near term.
It's Tuesday, March 26th at 9:30 am in New York.
So let’s get after it.
Over the past five months, global stocks are up about 25 percent while many other asset prices were up double digits or more. What’s driving this appreciation? Many factors are at work. But for stock indices, it’s been mostly about easier financial conditions and higher valuations rather than improving fundamentals. Granted, higher asset prices often beget even higher prices – as investors feel compelled to participate. From our perspective, it’s hard to justify the higher index level valuations based on fundamentals alone, given that 2024 and 2025 earnings forecasts have barely budged over this time period.
We rolled out our “Boom-Bust” thesis in 2020 based on the shift to fiscally dominant policy in response to the pandemic. At that point, our positive view on stocks was based on the boom in earnings that we expected over the 2020-2021 period as the economy roared back from pandemic lows. Our outlook anticipated both accelerating top line growth and massive operating leverage as companies could reduce headcount and other costs while people were locked down at home. The result was the fastest earnings growth in 30 years and record high margins and profitability. In other words, the boom in stocks was justified by the earnings boom that followed. Stock valuations were also supported by arguably the most generous monetary policy in history. The Fed continued Quantitative Easing throughout 2021, a year when S&P earnings grew 48 percent to an all-time high.
Today, stock valuations have reached similarly high levels achieved back in 2020 and [20]21 – in anticipation of improving growth after the earnings deterioration most companies saw last year. While the recent easing of financial conditions may foreshadow such an acceleration in earnings, bottom-up expectations for 2024 and [20]25 S&P 500 earnings remain flat post the Fed’s fourth quarter dovish shift. Meanwhile, small cap earnings estimates are down 10 percent and 7 percent for 2024 and [20]25, respectively since October. We think one reason for the muted earnings revisions since last fall, particularly in small caps, is the continued policy mix of heavy fiscal stimulus and tight front-end interest rates. We see this crowding out many companies and consumers.
The question for investors at this stage is whether the market can finally broaden out in a more sustainable fashion. As we noted last week, we are starting to see breadth improve for several sectors. Looking forward, we believe a durable broadening comes down to whether other stocks and sectors can deliver on earnings growth. One sector showing strong breadth is Industrials, a classic late-cycle winner and a beneficiary of the major fiscal outlays for things like the Inflation Reduction and CHIPS Act, as well as the AI-driven data center buildout.
A new sector displaying strong breadth is Energy, the best performer month-to-date but still lagging considerably since the October rally began. Taking the Fed’s recent messaging that they are less concerned about inflation or loosening financial conditions, commodity-oriented cyclicals and Energy in particular could be due for a catch-up. The sector’s relative performance versus the S&P 500 has lagged crude oil prices, and valuation still looks compelling. Relative earnings revisions appear to be inflecting as well. Some listeners may be surprised that Energy has contributed more to the change in S&P 500 earnings since the pandemic than any other sector. Yet it remains one of the cheapest and most under-owned areas of the market.
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.
Morgan Stanley’s Chief Fixed Income Strategist explains why private credit markets have expanded rapidly in recent years, and how they may fare if public credit makes an expected comeback.
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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the implications of the rapid growth in private credit for the broader credit markets.
It’s Monday, March 25th at 12 noon in New York.
The evolution of private credit is reshaping the landscape of leveraged finance. Investors of all stripes and all around the world are taking notice. The rapid expansion of private credit in the last few years has come against a much different backdrop in the public credit markets – a contraction in the high yield bond market and lackluster growth in the broadly syndicated loan market. What the emergence of private credit means for the public credit and the broader credit markets is a topic of active debate.
Just to be clear, let me define what we mean by private credit. Private credit is debt extended to corporate borrowers on a bilateral basis or involving very small number of lenders, typically non-banks. Lenders originate and negotiate terms directly with borrowers without the syndication process that is the norm in public markets for both bonds and loans. These private credit loans are typically not publicly rated; they’re not typically traded in secondary markets; tend to have stronger lender protections and offer a spread premium to public markets.
Given the higher overall borrowing costs as well the need to provide stronger covenant protection to lenders, what motivates borrowers to tap private credit versus public credit? Three key factors explain the recent rapid growth in private credit and show how private credit both competes and complements the public credit markets.
First, small and medium-sized companies that used to rely on banks had to find alternative sources of credit as banks curtailed lending in response to regulatory capital pressures. A majority of these borrowers have very limited access to syndicated bond and loan markets, given their modest size of borrowings.
Second, because of the small number of lenders per deal – frequently just one – private credit offers both speed and certainty of execution along with flexibility of term. The last two years of monetary policy tightening has meant that there was a lot of uncertainty around how high policy rates would go and how long they will stay elevated – which has led investors to pull back. The speed and certainty of private credit ended up taking market share from public markets against this background, given this uncertainty in the public markets.
Third, the pressure on interest coverage ratios from higher rates resulted in a substantial pick-up in rating agency downgrades into the B- and CCC rating categories. At these distressed ratings levels, public markets are not very active, and private credit became the only viable source of financing.
Where do we go from here? With confidence growing that policy tightening is behind us and the next Fed move will be a cut, the conditions that contributed to deal execution uncertainty are certainly fading. Public markets, both broadly syndicated loan and high yield bond markets, are showing signs of strong revival. The competitive advantage of execution certainty that private credit lenders were offering has become somewhat less material. Further, given the amount of capital raised for private credit that is waiting to be deployed – the so-called dry powder – the spread premium in private credit may also need to come down to be competitive with the public markets.
So private credit is both a competitor and a complement to the public markets. Its competitive attractiveness will ebb and flow, but we expect its complementary benefit as an avenue for credit where public markets are challenged to remain as well as grow.
Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts or wherever you get this podcast – and share Thoughts on the Market with a friend or colleague today.
Our Head of Corporate Credit notes that while recent central bank meetings offered few surprises, there was still plenty to be gleaned that could affect credit valuations.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about this week’s central bank meetings, and why as expected outcomes can still mean new information for credit investors.
It's Friday, March 22nd at 2pm in London.
When a good friend was interviewing at Morgan Stanley, many years ago, he was asked a version of the ‘Monty Hall Problem.’ Imagine that you’re on a game show with a prize behind one of three doors. You make your guess of door 1, 2 or 3. And then the host opens one of the doors you didn’t pick, showing that it’s empty. Should you change your original guess?
While it’s a bit of a paradox, you should. Your original odds of finding the prize were 1-in-3. But by showing you a door with a wrong answer, the odds have improved. The host gave you new information.
And that’s what came to mind this week, after important meetings from the Federal Reserve and Bank of Japan. Both banks acted in-line with our economists’ expectations. But those meetings and what came after still provided some valuable new information. Information that, in our view, was helpful to credit.
On Tuesday, the Bank of Japan raised interest rates for the first time since 2016, ended Yield Curve Control, and ended its purchases of equities. All of these measures had been previously used to help boost too-low inflation. But they have also resulted in a significant weakening of Japan’s currency, the Yen. And that, in turn, had made it attractive for Japanese investors to invest in overseas bonds in other currencies – which were gaining value as the Yen weakened.
So, one risk heading into this week was that these big changes in the Bank of Japan would reverse these other trends. It would strengthen the currency and make buying corporate bonds from the US or Europe less attractive to Japanese investors. But this meeting has now come and gone, and the Yen saw little movement. That is helpful, new information. Before Tuesday, it was impossible to know how the currency would react.
Then on Wednesday, the Fed confirmed its expectation from December that it was planning to cut interest rates three times this year. On the surface, that was another ‘as expected’ outcome. But it still contained new information. The Fed’s forecast suggested more confidence that stronger 2024 growth wouldn’t lead to higher inflation. And that endorsed the idea that the productive capacity of the US economy is improving. Solid growth and lower inflation co-existing, thanks to better productivity, will be closer to a 1990s style outcome. And that was a pretty good scenario for credit.
This week’s central bank meetings have come and gone without big surprises. But sometimes ‘as expected’ can still deliver new information. We continue to expect credit valuations to hold at richer-than-average levels, and like US leveraged loans, as a high yielding market well-suited for a mid-90s scenario.
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.
The perspective from our recent European Financials Conference looked positive for UK markets, loan demand and M&A activity. Our European heads of Diversified Financials and Banks Research discuss.
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Bruce Hamilton: Welcome to thoughts on the Market. I'm Bruce Hamilton, head of European Diversified Financials Research.
Alvaro Serrano: And I'm Alvaro Serrano, head of European Banks Research.
Bruce Hamilton: And on this episode of the podcast, we'll discuss some of the key takeaways from Morgan Stanley's just concluded 20th European Financials Conference. It's Thursday, March 21st at 3 pm in London.
Alvaro, we were both at the European Financials Conference in London. More than 100 companies attended the event. 95 percent of the attendees were from CE level management. There was a lot to take in.
Investor sentiment heading into the conference seemed noticeably more upbeat than last year's, thanks in part to stronger-for-longer net interest income (NII), an M&A cycle that is heating up, attractive capital returns, and increasing activity in private markets.
Now you were the conference chair, Alvaro. And you have a unique overview of this event. What's, in your view, the single most important takeaway?
Alvaro Serrano: Thanks, Bruce. Look, I think for me that if I had to summarize in two words is ‘risk on.’ I think the tone of the conference has been positive almost across the board. The lower rate outlook has increased market confidence. And corporates were pointing that out. They've seen stronger activity, so far this year, in many product lines. They've called out loan demand being stronger. They've called out debt capital market activity being stronger. They've announced M&A -- we know is up strongly and asset management inflows are up strong as well. So yes, a strong start to the year - confidence is back, and I would summarize it as risk on.
Bruce Hamilton: Got it. And in terms of the other key themes and debates that emerged from company presentations at the conference.
Alvaro Serrano: Yeah, look, I think the main themes following up from what I was saying earlier are: First of all, I would say leadership change. Within the sector, we've been calling for leadership change in our outlook. And I think what we heard at the conference supports this. So, given market activities coming back, I think a lot of investors were more keen to look for more resilient revenue models; maybe less peripheral banks, less NII retail-centric banks. And looking for more fee growth that could benefit from that market recovery.
The second point I would point out is UK. There’s definitely a change in sentiment around the UK in the polling questions. It came out as a preferred region, and I think what's behind that preference is that we're seeing an inflection point in NII.
And I think the third and final theme for me is investment banking and wealth recovery. Look, wealth may not recover already in Q1. But as this confidence builds up, we definitely expect inflows to pick up in the second half, both in quantity and margin.
Bruce Hamilton: So, based on your own work and what you heard at the conference, what's your overall view on the financial sector and what drives that from here?
Alvaro Serrano: We continue positive the sector. Look, the valuation is depressed. The multiples, the PE multiples on six times. Historically, it's been much closer to double-digit. We think, recovering PMIs should help re-rate that multiple. And while we do wait for those PMIs to recover, you're being paid 11 per cent yield between dividends and buybacks.
I think the confidence build up that we're seeing in the tone of the conference suggests an early indicator of those PMIs recovering, if you ask me. And then in the panels, we've had plenty of discussions around asset quality. Obviously, commercial real estate exposure is a big theme. But we think it's a manageable problem. It's less than 5 per cent of the loan books, within that office is less than a third. And within that US office spaces is a fraction. So overall, we think it's a manageable problem and our highest single conviction in the sectors that the yields are sustainable and resilient.
So, with a strong valuation underpin, we continue, positive of the sector.
Bruce, why don't I turn it over to you? Given your focus on private markets, exchanges, and asset management sub-sectors within diversified financials, can you talk us through private markets and deal activity space?
Bruce Hamilton: Yeah, our fireside chats with panels, and with private market management teams, saw more optimistic commentary on capital markets activity. And similarly fundraising improvements are expected to be closely linked to cash flows from exit activity flowing back to institutional clients, who can then reallocate to new funds.
So there's a little delay. But overall, the direction of travel clearly feels positive and pointed to a reacceleration in the private markets’ flywheel in due course, which has been, of course, the rationale behind the more positive view we have taken on this subsector since our outlook piece in November last year.
Alvaro Serrano: AI is obviously a dominant theme across sectors and industries globally. Also, by the way, a frequent topic in the discussion of this podcast. Can you give us an update on AI and its implications for wealth and asset management?
Bruce Hamilton: Sure. I mean, our discussions with asset management CEOs highlighted the transformative potential of AI, as they see it as a source of significant efficiency potential across the value chain. From sales and marketing, through investments and research, to middle and back office -- in areas such as report writing, research synthesis and client servicing. The benefits of starting early, with leaders having been working on this for 12 months or more, seems clear given the need to manage risks, for example, ensuring data quality to avoid hallucinations.
One asset management CEO indicated that his firm had identified 85 use cases, with 35 already in production. The initial opportunities for asset managers were seen as principally in driving cost efficiencies; though in wealth management a greater revenue potential we think exists given the scope to improve the effectiveness of wealth advisors in targeting and servicing clients.
Exchanges also noted scope for AI to both support revenue momentum. For example, via chatbots, assisting clients in accessing data more effectively. And in driving efficiency in report writing, as well as in costs. So, think about scope to drive efficiencies in areas such as client servicing and data ingestion and organization where large language models (LLMs) are already driving efficiency gains for employees.
Alvaro Serrano: Finally, let's talk about private credit, another big theme. What did you hear, at the conference around the growth of private credit? And what's your outlook from here?
Bruce Hamilton: Sure. So, the players were positive on the potential for growth in private credit from here. In the near-term deployment opportunities probably look stronger in the private credit space relative to private equity, where some differences in buyer-seller expectations is still acting as a bit of a constraint. There are opportunities given bank retrenchments, even if the Basel III endgame is expected to be less negative than initial draft proposals. And the appetite from insurance -- institutional, as well as retail clients for the diversification benefits and attractive yields on offer -- remains pretty significant.
Both private market specialists and traditional asset managers continue to explore ways to extend their capabilities in the space, with some adopting an organic approach and others looking to accelerate scaling via M&A.
We expect that as we look forward, that some recovery in the bank's syndicated lending markets is likely to reduce the record market share enjoyed by private credit in private equity deals last year. However, we think a more vibrant overall deal environment is likely to drive opportunities for both bank syndicated and private credit looking forward.
The democratization theme with wealth clients increasing allocations to private markets remains an additional powerful growth theme as we look forward; both for private credit providers, as well as players active in private equity infrastructure and real estate.
I'm sure there'll be lots more to unpack from the conference in the near future. Let's wrap it up for this episode. Alvaro, thanks a lot for taking the time to talk.
Alvaro Serrano: Great speaking with you, Bruce.
Bruce Hamilton: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.
Our Global Head of Fixed Income and Thematic Research outlines the potential impact the upcoming U.S. elections could have on increasing treasury yields, US-China policy and Japan’s current trajectory.
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Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income and Thematic Research. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about overseas investors' view on the US election.
It's Wednesday, Mar 20th at 10:30 am in New York.
I was in Japan last week. And as has been the case with other clients outside the US, the upcoming American elections were a key concern. To that end, we’re sharing the three most frequently asked questions, as well as our answers, about the impact of the U.S. election on markets coming from clients outside the US.
First, clients are curious what the election could mean for what’s recently been a very rosy outlook for Japan. The central bank is taking steps toward normalizing monetary policy which, combined with corporate reforms, is driving renewed investment. And it doesn’t hurt that multinationals are finding it more challenging to do new business in China due to U.S. policy restrictions. In our view, regardless of the election outcome, these positive secular trends will continue. While its true that Republicans are voicing greater interest in tariffs on US friend and foe alike, in our view there are other geographies more likely to bear the impact of stricter trade policy from the US – such as Europe, Mexico, and China; areas where there’s clearer overlap between US trade interests and the geopolitical preferences of the Republican party.
Second, clients wanted to know what the election would mean for US-China policy. The first thing to understand is that both parties are interested in policies that build barriers protecting technologies critical to US economic and national security. For Democrats, this has meant a focus on extending non-tariff barriers such as export and investment restrictions; many of which end up affecting the trade relationship between the US and China, and over time have resulted in US direct investment tilting away from China and toward the rest of the world. Republicans support these policies too. But key party leaders, including former President and current candidate Trump, also want to use tariffs as a tool to negotiate better trade agreements; and, potentially as a fall back, to harmonize tariff levels between countries. So, the election is unlikely to yield an outcome that eases trade tension between the US and China. But an outcome where Republicans win could create more volatility for global trade flows and corporate confidence, creating more economic uncertainty in the near term.
Third and finally, clients wanted to know if there were any election outcomes that would reliably change the trajectory of US growth, inflation, and accordingly the trajectory for treasury yields. In particular there was interest in outcomes that could cause yields to move higher. Our take here is that there’s been no solidly reliable outcome that points in that direction -- at least not yet. While it's likely that a potential Trump presidency would favor tax cuts and tariffs, it’s not clear that either of these definitively lead to inflation. Cutting taxes for companies with healthy balance sheets doesn’t necessarily yield more investment. Tariffs increase the cost of the thing being tariffed, but that could lead to prices of other goods in the economy suffering from weaker demand. Relatedly, the idea that a more dovish Fed could enable inflation is not a foregone conclusion because – as we’ve discussed on prior episodes – the President's ability to influence monetary policy is more limited than you might think.
Still, because of the pileup of these factors, it wouldn’t be surprising to see rates rise at some point this year on election risk perceptions. But it's not clear this would be a sustained move, and so it's not causing us yet to recommend clients’ position for it. For clients looking for more reliable market moves from the election, we’re still focused on key sectoral impacts: sectors like industrials and telecom which could benefit from tax cuts in a Republican win scenario; and sectors like clean tech which benefit in a Democratic win scenario, on greater certainty for the spend of energy transition money in the IRA.
Of course, as markets change and price in different outcomes, interesting macro markets opportunities will emerge -- and we’ll be here to tell you all about it.
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.
Our Chief Asia and Emerging Market Equity Strategist reviews an up-and-down first quarter for markets across the region, and gives an update on which sectors investors should be eyeing.
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Welcome to the Thoughts on the Market. I’m Jonathan Garner, Morgan Stanley’s Chief Asia and Emerging Market Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about our key investment views in Asia. It's Tuesday, Mar 19th at 9 am in Singapore.
It's been quite a first quarter in Asian equities with a wide degree of dispersion in market returns. At one end of the spectrum Japan’s Nikkei index is up 16 percent. At the other end, despite a recent rally, the Hang Seng index in Hong Kong is down 2 percent for the year. Meanwhile, the AI thematic has helped Taiwan into second place regionally, with a 10 percent gain; but Korea has risen by a lot less.
Our highest conviction views remains that we’re in the midst of multi-year secular bull markets in Japan and India, whilst at the same time China is in a secular bear market. So, let’s lay out the building blocks of those theses.
Firstly, Japan’s Return on Equity Journey. We think that markets – like stocks – reward improvement in profitability or ROE. The drivers of the ROE improvement are numerous but include domestic reflation, a weaker Yen, a productive capex cycle and improved capital management by Japan’s leading firms. And these together have led to improving net income margins in two-thirds of industries versus a decade ago.
We forecast robust EPS growth of around 9 percent in 2024, with similar growth in 2025. Now that’s assuming our foreign exchange strategists’ USD/JPY forecast of 140 for the fourth quarter of this year is accurate. This week the BOJ – the Bank of Japan – is considering whether to exit its Negative Interest Rate Policy and abolish or flex yield curve control. If it does so, that will be a sign – along with recent strong wage gains – that Japan has definitively exited deflation.
Secondly, India’s Decade. Multipolar world trends are supporting foreign direct investment (FDI) flows and portfolio flows to India, whilst positive demographics from a rapidly growing working age population are also supporting the equity market. India is holding national elections in May, and we will be watching the policy framework thereafter. But our base case is little change; success that India has achieved in macro-stability is underpinning a strong capex and profits outlook.
Finally, China’s Deflationary Challenge. China continues to battle what we’ve termed its 3D challenge of Debt (now standing at 300 per cent of GDP), Demographics and Deflation. And profitability has fallen steadily in recent years – so going in the opposite direction from Japan; approximately halving since the middle of the last decade, whilst earnings have missed for nine straight quarters. We think more forceful countercyclical measures are needed to boost demand in China given incipient balance sheet recession due to headwinds from property and local government austerity.
Finally, to summarize some of our sector and style views. We still like Korea and Taiwan’s semiconductors, into an expected 2024 recovery in traditional product areas such as smart phone, as well as the new theme of AI related demand. We are positive on Financials in India, Indonesia and Singapore; Industrials in India and Mexico; and Consumer Discretionary in India. On the quant and style side, we’re neutral on value versus growth as we expect the path to lower yields to be bumpy – as inflation risk remains. And we have recently recommended investors to reduce momentum exposure for risk management purposes given the strong outperformance year to date.
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.
Our CIO and Chief Equity Strategist discusses the continued uncertainty in the markets, and how investors are now looking at earnings growth and improving valuations.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the risk of higher interest rates and equity valuations.
It's Monday, March 18th at 11:30 am in New York.
So let’s get after it.
Long term interest rates peaked in October of last year and coincided with the lows in equities. The rally began with the Treasury's guidance for less coupon issuance than expected. This surprise occurred at a time when many bond managers were short duration. When combined with the Fed’s fourth quarter policy shift, there was a major squeeze in bonds. As a result, 30-year Treasury bonds returned 19 per cent over the October-December 2023 period, beating the 14 per cent return in the S&P 500. Nearly all of the equity return over this period was attributable to higher valuations tied to the fall in interest rates.
Fast forward to this year, and the story has been much different. Bond yields have risen considerably as investors took profits on longer term bonds, and the Fed walked back several of the cuts that had been priced in for this year. The flip side is that the growth data has been weaker in aggregate which argues for lower rates. Call it a tug of war between weaker growth and higher inflation than expected.
There is also the question of supply which continues to grow with the expanded budget deficit. From an equity standpoint, the rise in interest rates this year has not had the typically negative effect on valuations. In other words, equity investors appear to have moved past the Fed, inflation and rates – and are now squarely focused on earnings growth that the consensus expects to considerably improve.
As noted in prior podcasts, the consensus earnings per share (EPS) growth estimates for this year are high, and above our expectations – in the context of sticky cost structures and falling pricing power as fiscal spend crowds out both labor and capital for the average company. In our view, this crowding out is one reason why fundamentals and performance have remained relatively muted outside of the large cap, quality winners. We have been expecting a broadening out in leadership to other large cap/quality stocks away from tech and communication services; and recently that has started to happen. Strong breadth and improving fundamentals support our relative preference for Industrials within broader cyclicals.
Other areas of relative strength more recently include Energy, Materials and Utilities. Some of this is tied to the excitement over Artificial Intelligence and the impact that will have on power consumption. The end result is lower valuations for the index overall as investors rotate from the expensive winners in technology to laggards that are cheaper and may do better in an environment with higher commodity prices.
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.
Our Head of Corporate Credit Research explains why leveraged loans would benefit if bumpy inflation data leads the Federal Reserve to delay interest rate cuts.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I’ll be talking about the ramifications of the fed rate cuts, and what it could mean for credit – and what would benefit if rates stay higher for longer. It's Friday, March 15th at 2pm in London.
The big story in markets this week was inflation. U.S. Consumer Price inflation continues to moderate on a year-over-year basis, but the recent path has been bumpier than expected.
And as U.S. Economic growth in the first quarter continues to track above initial expectations, there’s growing debate around whether the U.S. economy is still too strong to justify the Federal Reserve lowering rates.
Morgan Stanley’s economic base case is that these inflation readings will remain bumpy – but will trend lower over the course of the year. And if we couple that with our expectations that job growth will moderate, we think this still supports the idea that the Federal Reserve will start to lower interest rates starting in June.
Yet the bumpiness of this recent data does raise questions. What if the Federal Reserve lowers rates later? Or what if they lower rates less than we expect?
For credit, we think the biggest beneficiary of this scenario would be leveraged loans. For background, these represent lending to below-investment grade borrowers, similar to the universe for high yield bonds. But loans are floating rate; their yields to investors rise and fall with central bank policy rates.
Coming into 2024, there were a number of concerns around the levered loan market. Worries around growth had led markets at the start of the year to imply significant rate cuts from the Fed. And that’s a double whammy, so to speak, for loans; as loans are both economically sensitive to that weaker growth scenario and would see their yields to investors decline faster if there are more rate cuts. Meanwhile, an important previous buyer of loans, so-called Collateralized Loan Obligations, or CLOs, had been relatively dormant.
Yet today many of those factors are all looking better. Estimates for US 2024 GDP growth have been creeping up. CLO activity has been restarting. And some of this recent growth and inflation data means that markets are now expecting far fewer rate cuts – which means that the yield on loans would also remain higher for longer. And that’s all happening at a time when the spread on loans is relatively elevated, relative to similar fixed rate high yield bonds.
A question of whether or not U.S. inflation will be sticky remains a key debate. While we think inflation resumes its improvement, we like leveraged loans as a high yielding, floating rate instrument that has a number of key advantages – if rates stay higher, for longer, than we expect.
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Morgan Stanley’s chief economists have their quarterly roundtable discussion, focusing on the state of inflation across global regions, the possible effect of the US election on the economy and more.
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Seth Carpenter: Welcome to Thoughts On the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist. On this episode, on this special episode of the podcast, we'll hold our second roundtable discussion covering Morgan Stanley's global economic outlook as we look into the second quarter of 2024.
It's Thursday, March the 14th at 10 am in New York.
Jens Eisenschmidt: And it's 2 pm in London.
Chetan Ahya: And 10pm in Hong Kong.
Seth Carpenter: Excellent. So, things around the world have changed significantly since our roundtable last quarter. US growth is notably stronger with few signs of a substantial slowdown. Inflation is falling, but giving some hints that things could stay -- maybe -- hotter for longer.
In Europe, things are evolving mostly as anticipated, but energy prices are much lower, and some data suggest hope for a recovery. Meanwhile, in China, debt deflation risks are becoming a reality. And the last policy communication shows no sign of reflation. And finally, Japan continues to confirm the shift in equilibrium, and we are expecting the policy rate change imminently.
So, let's dig into these developments. I am joined by the leaders of the economics team in key regions. Ellen Zentner is our Chief US Economist, and she's here with me in New York. Chetan Ahya is our Chief Asia Economist, and Jens Eisenschmidt is our Chief Europe Economist.
Ellen, I'm going to start with you and the US. Have the stronger data fundamentally changed your view on the US economy or the Fed?
Ellen Zentner: So, coming off of 2023, growth was just stronger than expected. And so, carrying that into 2024, we have revised upward our GDP forecast from 1.6 per cent Q4 over Q4 to 1.8 per cent. So already we've got stronger growth this year. We have not changed our inflation forecast though; because this could be another year of stronger data coming from supply side normalization, and in particular the labor market -- where it's come amid higher productivity and decelerating inflation. So, I think we're in store for another year like that. And I would say if I add risks, it would be risk to the upside on growth.
Seth Carpenter: Okay, that makes sense. But if there's risk to the upside on growth -- surely there's some risk that the extra strength in growth, or even some of the slightly stronger inflation that we've seen, that all of that could persist; and the Fed could delay their first cut beyond the June meeting, which is what you've got penciled in for the first cut. So how do you think about the risks to the timing for the Fed?
Ellen Zentner: So, I think you've got a strong backdrop for growth. You've got relatively easy financial conditions. And Fed policymakers have noted that that could pose upside risks to the economy and to inflation. And so, they're very carefully parsing every data point that comes in. Chair Powell said they need a bit more confidence on inflation coming down. And so that means that the year over year rate on core PCE -- their preferred measure of inflation -- needs to continue to take down.
I think that the risk is more how long they stay on hold -- than if the next move is a hike, which investors have been very focused on. Do we get to that point? And so certainly if we don't see the next couple of months and further improvement, then I think it just does lead for a longer hold time for the Fed.
Seth Carpenter: All right. A risk of a longer hold time. Chetan, how do you think about that risk?
Chetan Ahya: That risk is important to consider. We recently published on the idea that Asian central banks will have to wait for the Fed. Even though inflation across Asia is settling back into target ranges, central banks appear to be concerned that real rate differentials versus US are negative and still widening, keeping Asian currencies relatively weak.
This backdrop means that central banks are still concerned about future upside to inflation and that it may not durably stay within the target. Finally, growth momentum in Asia excluding China has been holding up despite the move in higher real rates -- allowing central banks more room to be patient before cutting rates.
Seth Carpenter: I got it. Okay, so Jens, what about for the ECB? Does the same consideration apply if the Fed were to delay its cutting cycle?
Jens Eisenschmidt: I'm glad you're asking that question, Seth, because that's sort of the single most asked question by our clients. And the answer is, well, yes and no. In our baseline, first of all, to stress this, the ECB cuts before the Fed, if only by a week. So, we think the ECB will go on June 6th to be precise. And what we have heard, last Thursday from the ECB meeting exactly confirms that point. The ECB is set to go in June, barring a major catastrophe on growth or disappointments on inflation.
I think what is key if that effect cuts less than what Ellen expects currently; the ECB may also cut less later in the year than we expect.
So just to be precise, we think about a hundred basis points. And of course, that may be subject to downward revision if the Fed decides to go later. So, it's not an idle or phenomenon. It's rather a rather a matter of degree.
Seth Carpenter: Got it. Okay, so that's really helpful to put the, the Fed in the context of global central banks. But, Ellen, let me come back to you. If I'm going to look from here through the end of the year, I trip over the election. So, how are you thinking about what the US election means for the Fed and for the economy as a whole?
Ellen Zentner: Sure. So, I think the important thing to remember is that the Fed has a domestic directive. And so, if there is something impacting the outlook -- regardless, election, geopolitics, anything -- then it comes under their purview to support the economy. And so, you know, best example I can give maybe is the Bush Gore election, when we didn't know who was going to be president for more than two months.
And it had to go to the Supreme Court, and at that time, the uncertainty among households, among businesses on who will be the next president really created this air pocket in the economy. So that's sort of the best example I can give where an election was a bit disruptive, although the economy bounced back on the other side of that.
Seth Carpenter: But can I push you there? So, it sounds like what you're saying is it's not the election per se that the Fed cares about. the Fed's not entering into the political fray. It's more what the ramification of the election is for the economy. Is that a fair statement?
Ellen Zentner: Absolutely. Absolutely fair.
Chetan Ahya: One issue the election does force us to confront is the prospect of geopolitical tension, and in particular the fact that President Trump has discussed further tariffs. For China, it is worth considering the implications, given the current weakness.
Seth Carpenter: That’s a really good point, Chetan, but before we even get there, maybe it's worth having you just give us a view on where things stand now in China. Is there hope of reflationary fiscal policy?
Chetan Ahya: Unfortunately, doesn’t seem like a lot right now. We have been highlighting that China needs to stimulate domestic demand with expansionary fiscal policy targeted towards boosting consumption. And it is in this context that we were closely watching policy announcement during the National People's Congress a couple of weeks ago.
Unfortunately, the announcement in NPC suggests that there are very limited reflationary policies being implemented right now. More importantly, the broad policy focus remains firmly on supporting investment and the supply side; and not enough on the consumption side. So, it does seem that we are far away from getting that required reflationary and rebalancing policies we think is needed to lift China back to moderate 2 to 3 per cent inflation trajectory.
Jens Eisenschmidt: I would jump in here and say that part of the ongoing weakness we see in Europe and in particularly Germany is tied to the slowdown in global trade and the weakness Chetan is talking about for China.
Seth Carpenter: Okay, Jens, if you're going to jump in, that's great. Could you just let us know where do you think things go in Europe then for the rest of this year and into next year?
Jens Eisenschmidt: So, we see indeed a small rebound. So, things are not looking great on numbers. But, you know, where we are coming from is close to recessionary territory; so everything that's up looks will look better.
So, we have 0. 5 on year and year growth rates; 1 percent next year; 0.5 for this year. In terms of quarterly profiles -- so, essentially we are hitting at some point later this year a velocity between 0.2 to 0.3, which is close to potential growth for the Euro area, which we estimate at 1.1.
Seth Carpenter: Got it. Okay, so outside of the U. S. then. China's week. Europe's lackluster Chetan, I gotta come back to you. Give us some good news. Talk to us about the outlook for Japan. We were early adopters of the Japan reflation story. What does it look like now?
Chetan Ahya: Well, the outlook in Japan is the exact opposite of China. We are constructive on Japan's macro-outlook, and we see Japan transitioning to a moderate but sustainable inflation and higher normal GDP growth environment.
Japan has already experienced one round of inflation and one round of wage growth. But to get to sustained inflation, we need to see wage growth to stay strong and more evidence of wage passing through to inflation. In this context, we are closely watching the next round of wage negotiations between the trade unions and the corporate sector.
We expect the outcome of first round of negotiations to be announced on March 15th, and we think that this will reflect a strong acceleration in wage growth in Japan. And that, we think, will allow Japan's core inflation to be sustained at 1.5 to 1.75 per cent going forward.
This rise in inflation will mean higher normal GDP growth and lower real interest rates, reviving the animal spirits and revitalize the corporate sector. We do see BOJ moving from negative rates to positive rates in March 19th policy meeting and later follow up with another 15 bps (basis points) hike in July policy meeting. But we think overall policy environment will remain accommodative supporting Japan's reflation story.
Seth Carpenter: All right, that does make me feel a little bit better about the global economy outside of the US. But I'm seeing the indication from the producers, we've got to wrap up. So, I'm going to go to each of you, rapid fire questions. Give me two quick risks to your forecast. Ellen for the US…
Ellen Zentner: All right. If we're wrong and the economy keeps growing faster, I think I would peg it on something like fiscal impulse, which has been difficult to get a handle on. Maybe throw in easier than expected financial conditions there that fuel the economy, fuel inflation. I think if we slow a lot more then it's likely because of some stresses in the banking sector.
Let's think about CRE; we say it's contained, maybe it's not contained. And then also if companies decide that they do need to reduce headcounts because economic growth is weaker, and so we lose that narrative of employee retention.
Seth Carpenter: Got it. Okay, Jens, you're up. Two risks.
Jens Eisenschmidt: The key upside risk is clearly consumption. We have a muted part for consumption; but consumption isn't really back to where it has been pre-COVID or just barely so. So, there's certainly more way up and we could be simply wrong because our outlook is too muted.
Downside, think of intensification of supply chain disruptions. Think about Red Sea. The news flow from there is not really encouraging. We have modeled this. We think so far so good. But if persists for longer or intensified, it could well be a downside risk because either inflation goes up and/or growth actually slows down.
Seth Carpenter: Perfect. All right, Chetan, let me end with you and specifically with China. If we are going to be wrong on China, what would that look like?
Chetan Ahya: We think there are two upside risks to our cautious view on China's macro-outlook. Number one, if global trade booms, that helps China to use its excess capacity and enables it to de-lever and lift its inflation. And number two, if we see a shift in the reflationary and rebalancing policies, such that there is aggressive increase in social expenditure on things like healthcare, education, and public housing. This would help households to unlock precautionary saving, boost consumption demand, and get China out of current deflationary environment.
Seth Carpenter: Got it. Ellen, Chetan, Jens, thank you each for joining us today. And to the listener, thank you for listening. If you enjoy the show, please leave us a review wherever you listen to the show and share thoughts on the market with a friend or a colleague today.
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