Lisa Shalett, our CIO for Wealth Management, and our Head of Corporate Credit Research discuss how to forecast expected returns over the long term, and whether historic cycles can help make sense of the market environment today.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.

Andrew Sheets: And on part one of this special episode of the podcast, we'll be discussing long run expected returns across markets, how we think about cross asset correlations and portfolio construction, and what are the special considerations that investors might want to have in mind in the current environment.

It's Friday, May 3rd at 4pm in London.

Lisa Shalett: And it's 11am here in New York City.

Andrew Sheets: Lisa, you and I are both members of Morgan Stanley's Global Investment Committee, which brings together nine of our firm's market, economic, and portfolio management thought leaders to provide a strategic framework for advice that we give to clients.

Andrew Sheets: I wanted to touch on a unique aspect of that process because, you know, we're talking about estimating returns over different horizons for markets. And I think there's something that's kind of unique about that challenge. I mean, I think in most aspects of life, it's probably safe to say that the next decade is more uncertain than the next six months or next year. But when we're thinking about asset class returns, it's not quite as simple as that.

Lisa Shalett: Not at all. And very often this is where our understanding of history needs to play a big part. When we think about the future, what are the patterns that we think might be persistent? And therefore, encourage us to think about long run trends and mean reversion. And what dynamics might actually be disconnected, or one offs that are characteristic of maybe structural change in the economy or geopolitics or in policymaking stance.

Andrew Sheets: How have these latest capital market assumptions changed over the last year?

Lisa Shalett: I think one of the most profound changes has been our willingness to embrace the idea that, in fact, we are in a higher for longer inflation regime. And that has a couple of implications. The first has to do, of course, with nominal returns. A higher inflation environment suggests that nominal returns are actually likely to be higher. The second really has to do with where we are in the cycle and its implications for correlations. We've been through periods most recently, where stocks and bonds were, in fact, anti-correlated; or there was a diversifying property, if you will to the 60 40 portfolio. Most recently, as inflation and level of interest rates has had profound importance to both stock valuations and bond valuations, we have found that these correlations have turned positive. And that creates a imperative, really, for clients to have to look elsewhere beyond cash, bonds, and stocks to get appropriate diversification in their portfolios.

Andrew Sheets: Well, it's been less than a month since we updated our strategic recommendations. We've recently also published an update to our tactical asset allocation recommendations. So, Lisa, I guess I have two questions. One is, how do you think about these different horizons, the strategic versus the tactical? And can you also summarize what's changed?

Lisa Shalett: Sure. You know, we very often talk to clients about the tactical horizon as being in the 12 to 18-month time frame.

In our most recent adjustment, we moved from what had been roughly a, year old underweight in US large cap stocks, and we neutralized that, kind of quote unquote, back to benchmark. So, we added some exposure, and we funded that exposure by selling out of two other positions; one that we had had in both small cap value and small cap growth, as well as a position we had, that we had put on as a hedging oriented position and long duration treasuries.

Now, some might say well, given the move in interest rates, is now the right time to take that hedge off? Our decision was basically premised on the fact that we're just not seeing the value in holding duration today given the inversion of the yield curve, and we're not getting paid for the risk of duration. And so, you know, we thought redeploying into those large cap stocks was prudent. 

Now, the other rationale, really has to do with earnings achievability. A lot of our thoughts were premised early in the year on this idea of a soft landing -- and a soft landing that would include deceleration in top line growth. And so, we were skeptical that could produce what consensus was looking for, which was a 10 to 11 per cent bottom line in 2024. 

As it turns out, it looks like, nominal GDP in the US is going to continue to persist at levels above 5 per cent, and that kind of tailwind, suggested that our skepticism would prove too conservative; and that, in fact, in a, 10 per cent bottom line could be achievable -- especially if it were being driven by manufacturing oriented companies who are seeing a pick up from global growth.

Andrew Sheets: Lisa, maybe if I could just ask you kind of one more question related to some of these longer-term assumptions, you know, I imagine you get some skepticism to say, ‘Well, you know, is the market of today really comparable to, say, the stock market of 30 or 40 years ago? Can we really use metrics or mean reversion that's worked in the past when, you know, the world is different.’

Lisa Shalett: Yeah, no, that, that's a fantastic question. I mean, some of the bigger variables in the world that we look at have shown over very long periods of time tendencies to cycle, whether those are things around the business cycle, valuations, cost of capital. Those are the types of variables that over long periods of time tend to mean revert. Same thing volatility. There tend to be long term characteristics. And the history book is pretty convincing that even if sometimes mean reversion is delayed, it ultimately plays out. 

But we do think that there are elements that we need to continue to question, right. One of them is, you know, has monetary policy and central bank intervention fundamentally changed the rules of the game? Where central banks implicitly or explicitly are managing market liquidity as much as they are managing cost of capital; and as a result, the way markets interact with the central bank and the guidance -- is that different?

A second, factor has to do with market structure, right? And in a world where market prices were really being determined almost exclusively by fundamentals, right? There was this constant rotational shift between growth style and value style and where value could be determined in the market. As we've moved to a market that is increasingly driven by passive flows; there's a question that many market participants have raised about whether or not markets have gotten more inefficient because price discovery is actually, in the short run, not what's driving prices, but rather flows; passive flows are driving prices.

And so, you know, how do we account for these leads and lags in prices being actually remarked to fundamentals? So those are at least two of the things that I know we are constantly tossing around as we think about our methodologies and capital market assumptions.

Andrew Sheets: That was part one of my conversation with Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management.

Look out for part two of our conversation, where we'll be discussing the impact of higher interest rates on asset classes. And how investors should think about an unusually concentrated stock market. 

Andrew Sheets: As a reminder, if you enjoy Thoughts in the Market, please take a moment to rate and review us wherever you get your podcasts. It helps more people find the show.

Our Global Chief Economist explains why the rapid hikes, pause and pivot of the current interest rate cycle are reminiscent of the 1990s.

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Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the current interest rate cycle and the parallels we can draw from the 1990s.

It's Monday, April 8th, at 10am in New York.

Last year, we reiterated the view that the 1990s remain a useful cycle to consider for understanding the current cycle. Our European equity strategy colleagues shared our view, and they've used that episode to inform their ‘out of consensus, bullish initiation on European equities’ in January. No two cycles are identical, but as we move closer to a Fed cut, we reassess the key aspects of that comparison.

We had previously argued that the current interest rate cycle and the mid 90s cycle differ from the intervening cycles because the goal now is to bring inflation down, rather than preventing it from rising. Of course, inflation was already falling when the 1994 cycle started, in part, because of the recession in 1991.

This cycle -- because much of the inflation was driven by COVID-related shocks, like supply chains for consumer goods and shifts in housing for shelter inflation -- inflation started falling rapidly from its peak before the first hike could have possibly had any effect. In recent months, our economic growth forecasts have been regularly revised upward, even as we have largely hit our expected path for inflation.

A labor supply shock appears to be a contributing factor that accounts for some of that forecast deviation, although fiscal policy likely contributed to the real side's strength as well. Supply shocks to the labor market are an interesting point of comparison for the two cycles. In the 1990s, labor force growth was still benefiting from this multi-decade rise in labor force participation among females. The aggregate labor force participation rate did not reach its peak until 2000.

Now, as we've noted in several publications, the surge in immigration is providing a similar supply side boost, at least for a couple of years. But the key lesson for me for the policy cycle is that monetary policy is not on a pre-set, predetermined course merely rising, peaking and then falling. Cycles can be nuanced. In 1994, the Fed hiked the funds rate to 6 per cent, paused at that peak and then cut 75 basis points over 1995 and 1996. After that, the next policy move was actually a hike, not a cut.

Currently, we think the Fed starts cutting rates in June; and for now, we expect that cutting to continue into next year. But as our US team has noted, the supply side revisions mean that the path for policy next year is just highly uncertain and subject to review. From 1994 to 1996, job gains trended down, much like they have over the past two years.

That slowing was reflective of a broader slowing in the economy that prompted the Fed to stop hiking and partially reverse course. So, should we expect the same now, only a very partial reversal? Well, it's too soon to tell, and as we've argued, the faster labor supply growth expands both aggregate demand and aggregate supply -- so a somewhat tighter policy stance could be appropriate.

In 1996, inflation stopped falling, and subsequently rose into 1997, and it was that development that supported the Fed's decision to maintain their somewhat restrictive policy. But we can't forget, afterward, inflation resumed its downward trajectory, with core PCE inflation eventually falling below 1.5 per cent, suggesting that that need to stop cutting and resume hiking, well, probably needs to be re-examined.

So, no two cycles match, and the comparison may break down. To date, the rapid hikes, pause and pivot, along with a seeming soft landing, keeps that comparison alive. The labor supply shock parallel is notable, but it also points to what might be, just might be, another possible parallel.

In the late 1990s, there was a rise in labor productivity, and we've written here many times about the potential contributions that AI might bring to labor productivity in coming years.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen to podcasts and share Thoughts on the Market with a friend or colleague today.

Our experts discuss U.S. dollar strength and its far-reaching impact on the global economy and the world’s stock markets.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research.

James Lord: I'm James Lord, Head of FX Strategy for Emerging Markets.

David Adams: And I'm Dave Adams, Head of G10 FX Strategy.

Michael Zezas: And on this episode of Thoughts on the Market, we'll discuss one of the most debated topics in world markets right now, the strength of the US dollar.

It's Wednesday, May 1st, at 3 pm in London.

Michael Zezas: Currencies around the world are falling as a strong US dollar continues its reign. This is an unusual situation. So much so that the finance ministers of Japan, South Korea, and the United States released a joint statement last month to address the effects being felt in Asia. The US dollar's dominance can have vast implications for the global economy and the world stock markets.

So, I wanted to sit down with my colleagues, James and David, who are Morgan Stanley's currency strategy experts for emerging markets and developed markets. James, just how dominant is the US dollar right now and what's driving the strength?

James Lord: So, we should distinguish between the role the US dollar plays as the world's dominant reserve currency and its value, which can go up and down for other reasons.

Right now, the dollar remains just as dominant in the international monetary system as it has been over the past several decades, whilst it also happens to be very strong in terms of its value, as you mentioned. That strength in its value is really being driven by the continued outperformance of the US economy and the ongoing rise in US interest rates, while growth in the rest of the world is more subdued.

The dollar's international role remains dominant simply because no other economy or market can match the depth of the US capital markets and the liquidity that it provides, both as a means of raising capital, but also as a store of value for investment; while also offering the strong protection of property rights, strong sovereign credit ratings, the rule of law, and an open capital account. There simply isn't another market that can challenge the US in that respect.

Michael Zezas: And can you talk a bit more specifically about the various ways in which the dollar impacts the global economy?

James Lord: So, one of the strongest impacts is through the price of the dollar, and the price of dollar debt, which have an impact beyond the borders of the US economy. Because the majority of foreign currency denominated debt that corporates outside of the US issue is denominated in US dollars, the interest rate that's set by the US Federal Reserve has a big impact on the cost of borrowing. It's also the same for many emerging market sovereigns that also issue heavily in US dollars. The US dollar is also used heavily in international trade, cross border lending, because the majority of international trade is denominated in US dollars. So, when US interest rates rise, it also tightens monetary conditions for the rest of the world. That is why the US Federal Reserve is often referred to as the world's central bank, even though Fed only sets policy with respect to the US economy.

And the US dollar strengthens, as it has been over the past 10 years, it also makes it more challenging for countries that borrow in dollars to repay that debt, unless they have enough dollar assets.

Again, that's another tightening of financial conditions for the rest of the world. I think it was a US Treasury Secretary from several decades ago who said that the US dollar is our currency, but your problem. And that neatly sums up the global influence the US dollar has.

Michael Zezas: And David, nothing seems to typify the strength of the US dollar recently, like the currency moves we're seeing with the Japanese Yen. It looks very weak at the moment, and yet the Japanese stock market is very strong.

David Adams: Yeah, weak is an understatement for the Japanese yen. In nominal terms, the yen is at its weakest level versus the dollar since 1990. And if we look in real terms, it hasn't been this weak since the late 1960s. Why it's weak is pretty easy to explain, though. It's monetary policy divergence. Theory tells us that as long as capital is free to move, a country can't both control its interest rates and control the exchange rate at the same time.

G10 economies typically choose to control rates and leave their currencies to float, and the US and Japan are no exception. So, while the while the Fed's policy rate has risen to multi-decade highs, Japan's has been left basically unchanged, consistent with its economic fundamentals.

Now, you mentioned Japanese equities, which is also increasingly important to this story. As foreign investors have deployed more cash into the Japanese stock market, a lot of them have hedged their FX [foreign exchange] exposure, which means they're buying back dollars in the forward market. The more that Japanese equities rise, the more hedges they add, increasing dollar demand versus the yen.

So, put simply, the best outcome for dollar yen to keep rising is for US rates versus Japan and Japanese equities to both keep marching higher. And for a lot of investors, this seems increasingly like their base case.

Michael Zezas: That makes sense. And yet, despite the dollar's clear dominance at the moment, the consensus view on the dollar is that it's going to get weaker. Why is that the case and what's the market missing?

James Lord: Yeah, the consensus has been on the wrong side of the dollar call for quite a few years now, with a persistently bearish outlook, which has largely been incorrect. I think for the most part this is because the consensus has underestimated the strength of the US economy. It wasn't that long ago when the consensus was calling for a hard landing in the US economy and a pretty deep easing cycle from the Fed. And yet here we are with GDP growth north of 2 per cent and murmurings of another rate hike entering the narrative. I also wonder whether this debate about de-dollarization, whereby the dollar's global influence starts to wane, has impacted the sentiment of forecasters a bit as well.

We have seen over the past three to four years much more noise in the media on this topic, and there appears to be a correlation between the extent to which the consensus is expecting dollar weakness and the number of media articles that are discussing the dollar's status as the world's major reserve currency.

Maybe that's coincidence, but it's also consistent with our view that the market generally worries too much about this issue and the impact that it could have on the dollar's outlook.

Michael Zezas: Now there've been a few notable changes to Morgan Stanley's macro forecasts over the last few weeks. Our US economist, Ellen Zentner revised up her forecast for US growth and inflation. And she also pushed back our expectations for the first Fed cut. Along with this, our US rate strategy team also revised their 10-year treasury yield expectations higher. Do these updates to the macro-outlook impact your bullish view on the dollar, both near term and longer term?

David Adams: So, higher US rates are often helpful for the dollar, but we think some nuance is required. It's not that US rates are moving; it's why they're moving. And our four-regime dollar framework shows that increases or decreases in rates can give us very different dollar outcomes depending on the reason why rates are moving.

So far this year, rates have been moving higher in a pretty benign risk environment. And in a world where US real interest rates rise alongside equities; the dollar tends to go nowhere in the aggregate. It gains versus low yielding funders like the Japanese yen, the Swiss franc, and the euro, but it tends to weaken versus those higher beta currencies with positive carry, like the Mexican peso. It's why we've been neutral on the dollar overall since the start of the year, but we still emphasize dollar strength, especially versus the euro.

If rising rates were to start weighing on equities, that would lead the dollar to start rallying broadly, what we call Regime 3 of our framework. It's not our base case, but it's a risk we think markets are starting to get more nervous about. It suggests that the balance of risks are increasingly towards a higher dollar rather than a lower one.

Michael Zezas: And finally, Dave, I wanted to ask about potential risks to the US dollar's current strength.

David Adams: I'd say the clearest dollar negative risk for me is a rebound in European and Chinese growth. It's hard for investors to get excited about selling the dollar without a clear alternative to buy. A big rebound in rest of world growth could easily make those alternatives look more attractive, though how probable that outcome is remains debatable.

Michael Zezas: Got it. So, this discussion of risk to the strong dollar may be a good time to pause. There's so much more to talk about here. We've barely scratched the surface. So, let's continue the conversation in the near future when we can talk more about the dollar status as the world's dominant reserve currency and potential challenges to that position.

James Lord: This sounds like a great idea, Mike. Talk to you soon.

David Adams: Likewise. Thanks for having me on the show and look forward to our next conversation.

Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us wherever you listen to podcasts and share Thoughts on the Market with a friend or colleague today.

Our analysts survey the hurdles, opportunities and investment trends in energy renovation.

Please note that Laurel Durkay is not a member of Morgan Stanley’s Research department. Unless otherwise indicated, her views are her own and may differ from the views of the Morgan Stanley Research department and from the views of others within Morgan Stanley. We make no claim that Ms Durkay’s representations are accurate or complete.

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Cedar Ekblom: Welcome to Thoughts on the Market. I'm Cedar Ekblom, Equity Research Analyst, covering the European building and construction sector for Morgan Stanley Research.

Laurel Durkay: And I'm Laurel Durkay, head of the Global Listed Real Assets Team within Morgan Stanley Investment Management.

Cedar Ekblom: And on this special episode of Thoughts on the Market, we'll discuss the opportunities, risks, and latest investment trends when it comes to decarbonizing buildings.

It's Tuesday, April 30th, at 2pm in London.

Laurel Durkay: And 9am in New York.

Cedar Ekblom: So, let's take a step back. Picture the gleaming towers of New York, London, or Hong Kong. Now think about these buildings breathing out carbon dioxide. The built environment is responsible for about a third of all global energy consumption and CO2 emissions. And so, if we want to get to Net Zero by 2050, which means emitting as much CO2 into the atmosphere as we take out of it, decarbonizing the building stock is essential.

We've been doing a lot of work in Europe from the research side to try and understand how the investment trends are linked to this topic. But Laurel, I wanted to have you on the podcast because I wanted to understand how you're coming at it from the other side as a real estate investor and portfolio manager.

Laurel Durkay: Yeah, Cedar, so I've seen some of your notes and I actually wasn't too surprised by your conclusion that energy renovation is seeing rising investment momentum in Europe. And this is despite the high upfront costs which are driven by government regulation, build cost inflation and higher interest rates.

Cedar Ekblom: Yeah, we decided to do this work because we've had a lot of incoming from investors around what's happening from an investment perspective because we have seen a few government policy sidesteps or backtracks in the last 12 to 18 months around this topic. And so, we did some proprietary survey work in the residential, non-residential and providers of capital space. And we had some really interesting outcomes.

I think the most interesting was that despite the fact that government subsidies have been dialed back a little bit, and the cost of investment has gone up because of inflation, actually private investment is really robust. And I think it's because there is a clear economic incentive that both homeowners and non-residential building owners are actually talking to.

I mean, the first one is that homeowners are telling us that they see a 12 per cent increase in their home equity value if they green that property. And when we look at the non-residential space, what we're seeing is that renovation budgets are up 4 per cent year over year, even in a backdrop of higher interest rates.

We see a huge runway of investment to come through on this topic. It is multi-decade. It's not going to happen overnight.

You're talking about 2.8 trillion euros of investment by 2030 on our estimates, and that number extending to potentially 5 trillion euros by 2050. And that's just in Europe.

Laurel Durkay: So the scope and need for investment really is huge. What do you think are the hurdles to delivering this opportunity?

Cedar Ekblom: It's such an interesting question. I mean, there are so many. It's a little bit daunting at points when you think about it, but we're looking at really complicated projects. We're looking at skills bottlenecks. We're looking at upfront costs being really high. We're also looking at energy policy, not necessarily being aligned in every region in Europe.

So yes, it's going to cost you a lot, but basically the respondents to the surveys tend to suggest that the benefits are actually starting to outweigh those potential costs.

So, Laurel, I think that there's been some really interesting overlaps between what you and I cover, but from different angles. Let me pivot to you. How do you think about sustainability when it comes to real estate investment in your seat?

Laurel Durkay: Yeah, bottom line is that understanding and incorporating sustainability and real estate investing really is very important; and we need to be aware not only of the physical risks, but also those transition risks associated with buildings. Taking a step back, what I'm observing is that real estate is seeing the sustainability focus really play out from three different constituents, and that's from investors, from regulators, and from tenants.

So, from that investor perspective, we're seeing increasing demand for sustainable linked financing investing. Think green bonds. In some cases, you're actually seeing more favorable spreads for green financing versus traditional -- and ultimately that means better cash flows for companies.

We also have that coming from the government. What we see is a continued evolution on regulations, and there have been several real estate specific laws being adopted across the states.

All of these have the objective of providing greater transparency on carbon emissions with the ultimate goal of reducing such emissions. Now lastly, for tenants, we're seeing increasing demand for sustainable and best in class buildings.

There's actually a growing body of evidence that shows sustainability is impacting leasing decisions and resulting in rent premiums

Cedar Ekblom: So, how do we think about integrating ESG into your investment process?

Laurel Durkay: So, there's a number of different metrics that we're looking at. We've run a proprietary analysis really trying to identify the most financially material factors. And we've ultimately concluded that the most important factors to be looking at are the absolute level of emissions and then the progress towards reducing those emissions -- water and waste usage, green certified buildings -- among a number of other factors.

Ultimately, what we need to do is put together a framework that helps us assess the expenditures in order to really adhere to the regulatory requirements that I was just describing and ultimately allow the buildings to enjoy operational cost savings from implementing sustainability measures.

This is really about future proofing buildings and enhancing value.

Cedar Ekblom: So, it sounds like really a topic around trying to understand where they may or may not be stranded assets. We've spoken a lot about this topic in Europe, but maybe you could talk a little bit about what's happening from a sort of policy backdrop in the US.

Laurel Durkay: Yeah, so government really is driving a lot of this change, both at a federal and at a state level. So, from a federal perspective, it really is more of a carrot as opposed to a stick with regard to implementation and adoption, really rewarding those who embrace sustainability. Now, interestingly, from a state perspective, it's a bit more of a stick than a carrot.

Buildings not in compliance will be subject to fines and penalties. I should also mention that the SEC is getting really involved with the adoption of new climate related disclosure requirements.

Now this isn't real estate specific, but it is impactful, nonetheless. New requirements mandate companies to disclose material Scope 1 and Scope 2 greenhouse gas emissions.

Right now, less than 30 per cent of US companies even attempt to disclose Scope 3, and that's even less for real estate. Now Cedar, these scope three emissions are really where our worlds intersect most given the built environment.

So, for a typical property owner, Scope 1 emissions represent about 25 per cent. Scope 2 is about 55 per cent of their missions. And then the remainder is going to be this Scope 3. But if you look at a developer and an owner, that's where you see Scope 3 emissions range between 80 to 95 per cent of their total emissions.

Cedar Ekblom: So, if we look towards the future, what are you hearing from clients and colleagues about where sustainability investment trends go from here?

Laurel Durkay: I think the trends have to be towards reducing these Scope 3 emissions, or maybe I just I hope that's where the trend is. You really need for building developers and owners to focus on development processes, building products and materials, and you need to see innovation within that space.

Now, how about from your side, Cedar? What are you hearing from various companies you cover about the trends they foresee?

Cedar Ekblom: The building materials and products businesses are really bullish on the long-term investment horizon on this topic. And we can see that in some of the data in Europe. The new build environment is under a lot of pressure. Higher interest rates have impacted affordability, and we have some activity in new build down 20 to 30 per cent.

And yet when you look at the renovation and the refurbishment sector, we actually have a much more resilient backdrop.

So look, our companies are really bullish on this. We ultimately see this manifesting in a higher multiple for businesses linked to this theme over the medium term. In all honesty, we're really just at the beginning of this theme. We think there's a lot of runway of investment still to come and we're keeping an eye on it.

So, with that, Laurel, I'd like to say, thanks for taking the time to talk.

Laurel Durkay: It was great speaking with you, Cedar.

Cedar Ekblom: And as a reminder to our listeners, if you've enjoyed thoughts on the market, please take a moment to rate and review us wherever you listen to the podcast. It helps more people to find the show.

Our analysts find that despite the obvious differences between retail fashion and airlines, struggling brands in both industries can use a similar playbook for a turnaround.

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Ravi Shanker: Welcome to Thoughts on the Market. I'm Ravi Shanker, Morgan Stanley's North American Freight Transportation and Airlines Analyst.

Alex Straton: And I'm Alex Straton, Morgan Stanley's North America Softlines, Retail and Brands Analyst.

Ravi Shanker: On this episode of the podcast, we'll discuss some really surprising parallels between fashion, retail, and airlines.

It's Monday, April 29th at 10am in New York.

Now, you're probably wondering why we're talking about airlines and fashion retail in the same sentence. And that's because even though they may seem worlds apart, they actually have a lot in common. They're both highly cyclical industries driven by consumer spending, inventory pressure, and brand attrition over time.

And so, we would argue that what applies to one industry actually has relevance to the other industry as well. So, Alex, you've been observing some remarkable turnaround stories in your space recently. Can you paint a picture of what some fashion retail businesses have done to engineer a successful turnaround? Maybe go over some of the fundamentals first?

Alex Straton: What I'll lead with here is that in my North America apparel retail coverage, turnarounds are incredibly hard to come by, to the point where I'd argue I'm skeptical when any business tries to architect one. And part of that difficulty directly pertains to your question, Ravi -- the fundamental backdrop of the industry.

So, what are we working with here? Apparel is a low single digit growing category here in North America, where the average retailer operates at a mid single digit plus margin level. This is super meager compared to other more profitable industries that Ravi and I don't necessarily have the joy of covering. But part of why my industry is characterized by such low operating performance is the fact that there are incredibly low barriers to entry in the space. And you can really see that in two dynamics.

The first being how fragmented the competitive landscape is. That means that there are many players as opposed to consolidation across a select few. Just think of how many options you have out there as you shop for clothing and then how much that has changed over time. And then second, and somewhat due to that fragmentation, the category has historically been deflationary, meaning prices have actually fallen over time as retailers compete mostly on price to garner consumer attention and market share.

So put differently, historically, retailers’ key tool for drawing in the consumer and driving sales has been based on being price competitive, often through promotions and discounting, which, along with other structural headwinds, like declining mall traffic, e-commerce growth and then rising wages, rent and product input costs has actually meant the average retailers’ margin was in a steady and unfortunately structural decline prior to the pandemic.

So, this reliance on promotions and discounting in tandem with those other pressures I just mentioned, not only hurt many retailers’ earnings power but in many cases also degraded consumer brand perception, creating a super tough cycle to break out of and thus turnarounds very tough to come by -- bringing it full circle.

So, in a nutshell, what you should hear is apparel is a low barrier to entry, fragmented market with subsequently thin margins and little to no precedent for successful turnarounds. That's not to say a retail turnaround isn't possible, though, Ravi.

Ravi Shanker: Got it. So that's great background. And you've identified some very specific key levers that these fashion retail companies can pull in order to boost their profitability. What are some of these levers?

Alex Straton: We do have a recent example in the space of a company that was able to break free of that rather vicious cycle I just went through, and it actually lifted its sales growth and profitability levels above industry average. From our standpoint, this super rare retail turnaround relied on five key levers, and the first was targeting a different customer demographic. Think going from a teens focused customer with limited brand loyalty to an older, wealthier and less fickle shopper; more reliable, but differently.

Second, you know, evolving the product assortment. So, think mixing the assortment into higher priced, less seasonal items that come with better margins. To bring this to life, imagine a jeans and tees business widening its offering to include things like tailored pants and dresses that are often higher margin.

Third, we saw that changing the pricing strategy was also key. You can retrain or reposition a brand as not only higher priced through the two levers I just mentioned, but also try and be less promotional overall. This is arguably, from my experience, one of the hardest things for a retailer to execute over time. So, this is the thing I would typically, you know, red flag if you hear it.

Fourth, and this is very, very key, reducing the store footprint, re-examining your costs. So, as I mentioned in my coverage, cost inflation across the P&L (profit and loss) historically, consumers moving online over time, and what it means is retailers are sitting on a cost base that might not necessarily be right for the new demand or the new structure of the business. So, finding cost savings on that front can really do wonders for the margins.

Fifth, and I list this last because it's a little bit more of a qualitative type of lever -- is that you can focus on digital. That really matters in this modern era. What we saw was a retailer use digital driven data to inform decision making across the business, aligning consumer experience across channels and doing this in a profitable way, which is no easy feat, to say the least.

So, look, we identified five broad enablers of a turnaround. But there were, of course, little changes along the way that were also done.

Ravi Shanker: Right.

Alex Straton: So, Ravi, given what we've discussed, how do you think this turnaround model from fashion retail can apply to airlines?

Ravi Shanker: Look, I mean, as we discussed, at the top here, we think there are significant similarities between the world of fashion retail and airlines; even though it may not seem obvious, at first glance. I mean, they're both very consumer discretionary type, demand environments. The vicious circle that you described, the price deflation, the competition, the brand attrition, all of that applies to retail and to airlines as well.

And so, I think when you look at the five enablers of the turnaround or levers that you pull to make it happen, I think those can apply from retail to airlines as well. For instance, you target a different customer, one that likes to travel, one that is a premium customer and, and wants to sit in the front of the plane and spend more money.

Second, you have a different product out there. Kind of you make your product better, and it's a better experience in the sky, and you give the customer an opportunity to subscribe to credit cards and loyalty program and have a full-service experience when they travel.

Third, you change your distribution method. You kind of go more digital, as you said. We don't have inventory here, so it'd be more of -- you don't fly everywhere all the time and be everything to everyone. You are a more focused airline and give your customer a better experience. So, all of those things can drive better outcomes and better financial performance, both in the world of fashion retail as well as in the world of airlines.

Alex Straton: So, Ravi, we've definitely identified some pretty startling similarities between fashion retail and airlines. Definitely more so than I appreciated when you called me a couple months ago to explore this topic. So, with that in mind, what are some of the differences and challenges to applying to airlines, a playbook taken from the world of fashion retail?

Ravi Shanker: Right, so, look, I mean, they are obviously very different industries, right? For instance, clothing is a basic human staple; air travel and going on vacations is not. It's a lot more discretionary. The industry is a lot more consolidated in the airline space compared to the world of retail. Air travel is also a lot more premium compared to the entire retail industry. But when you look at premium retail and what some of those brands have done where brands really make a difference, the product really makes a difference. I think there are a lot more similarities than differences between those premium retail brands on the airline industry.

So, Alex, going back to you, given the success of the turnaround model that you've discussed, do you think more retail businesses will adopt it? And are there any risks if that becomes a norm?

Alex Straton: The reality is Ravi, I breezed through those five key enablers in a super clear manner. But, first, you know, the enablers of a turnaround in my view are only super clear in hindsight. And then secondly, one thing I want to just re-emphasize again is that a turnaround of the nature I described isn't something that happens overnight. Shifting something like your consumer base or changing investor perception of discounting activity is a multi year, incredibly difficult task; meaning turnarounds are also often multi year affairs, if ever successful at all.

So, looking ahead, given how rare retail turnarounds have proven to be historically, I think while many businesses in my coverage area are super intrigued by some of this recent success; at the same time, I think they're eyes wide open that it's much easier said than done, with execution far from certain in any given turnaround.

Ravi Shanker: Got it. I think the good news from my perspective is that hindsight and time both the best teachers, especially when put together. And so, I think the learnings of some of the success stories in your sector can not only be lessons for other companies in your space; they can also be lessons in my space. And like I said, I think some airlines have already started embarking on this turnaround, others are looking to see what they can do here. And I'm sure again, best practices and lessons can be shared from one sector to another. So, Alex, thanks so much for taking the time to talk to us today.

Alex Straton: It was great to speak with you, Ravi.

Ravi Shanker: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen to the show and share the podcast with a friend or colleague today.

Our Head of Europe Thematic Research discusses revolutionary “Longshot” technologies that can potentially alter the course of human ageing, and which of them look most investible to the market.

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Welcome to Thoughts on the Market. I’m Ed Stanley, Morgan Stanley’s Head of Thematic Research in London. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss the promise of technology that might help us live longer and better lives.  

It’s Friday, the 26th of April, at 2pm in London.

You may have heard me discuss Moonshots and Earthshots on this podcast before. Moonshots are ambitious solutions to seemingly insurmountable problems using disruptive technology, predominantly software; while Earthshots, by contrast, are radical planet-focused technologies to accelerate decarbonization and mitigate global warming, predominantly hardware challenges.

But today I want to address a third group of revolutionary solutions that I call Longshots. These are the most promising Longevity technologies. And in terms of the three big secular themes that Morgan Stanley is focused on – which are Decarbonization, Tech Diffusion, and Longevity – Longshots straddle the latter two. 

Unlike software-based Moonshots or hardware-based Earthshots, these Longshots face some of the greatest challenges of all. First, we know remarkably little about the process of ageing. Second, these are both hardware and software problems. And third, the regulatory hurdles are far more stringent in healthcare, when compared to most other emerging technology fields.      

We believe the success of Longshots depends on a deep understanding of Longevity. And loosely speaking, you can think of that as a question of whether someone's phenotype can outweigh their genotype. In other words, can their lifestyle, choices, environment trump the genetics that are written into their DNA.

Modern medicine, by focusing almost exclusively on treating disease rather than preventing it, has succeeded in keeping us alive for longer – but also sicker for longer. Preventing disease increases our health spans and reduces morbidity, and its associated costs.

So, in this regard, can we learn anything from the centenarians - the people who live to a hundred and beyond? They number around 30 people in every 100,000 of the population. And many of them live healthy lives well into their eighties. And what makes them so rare is they are statistically better at avoiding what the medical industry calls the Four Horsemen: coronary disease, diabetes, cancer and Alzheimer’s. So, can Longshots help to replicate that successful healthy ageing story for a larger slice of the population?

We look to technology for ways to delay the onset of these chronic diseases by 10 to 30 years, giving healthy life extension for all. That’s not an outlandish goal in theory; but in practice we need a new approach to medical research. And we will be watching how the ten key Longshots we have identified play into this.

Two of these Longshots are already familiar to our listeners: Diabesity medication and Smart Chemotherapy treatments, with a combined addressable market – according to our analysts – of a quarter of a trillion dollars. The other eight Longshots include AI-enabled drug discovery, machine vision embryo selection dramatically increasing the odds of fertility via IVF, bioprinting of organs, brain-computer Interfaces, CRISPR, DNA synthesis, robotics and psychedelics. 

In assessing the maturity and investibility of these ten Longshots, we find that obesity medication, smart chemo, and AI-assisted drug discovery are better understood by the market and look more investible. Many of the others are seeing material outcome- and cost-improvements but they remain earlier-stage, more speculative, particularly for public market investors.

In contrast to Moonshots and Earthshots, where venture investors make up the lion's share of most of the early-stage capital, Longshots have substantially higher exposure to government agencies that make investments in early-stage healthcare projects. Governments are making hundreds of bets on Longshots in searches for solutions to reduce overall healthcare spending – or at the very least get a better return on that investment – which in 2023 amounted to $4.5 trillion in the US, and a whopping $10 trillion globally.

Clearly, the stakes are very high, and the market opportunity is vast, particularly as AI technologies advance in tandem. And so, we’ll keep you updated on the promise of these Longshots. 

Thanks for listening. If you enjoy the show, please leave a review and share Thoughts on the Market with a friend or a colleague today.

With interest in anti-obesity medications growing significantly, the head of our European Pharmaceuticals Team examines just how large that market could become.

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Welcome to Thoughts on the Market. I’m Mark Purcell, head of Morgan Stanley’s European Pharmaceuticals Team. Along with my colleagues bringing you a variety of perspectives, today I’ll talk about the enormous ripple effects of anti-obesity drugs across the global economy. 

It’s Thursday, April the 25th, and it’s 2pm in London. 

Obesity is one of the biggest health challenges of our time. More than a billion people are living with obesity worldwide today, with 54 per cent of adults expected to be either overweight or obese by 2035. Growing rates of obesity worldwide combined with rising longevity are putting a heavy burden on healthcare systems.

Our Global Pharma team has covered obesity extensively over the last 18 months. When we wrote our original report in the summer of 2022, the whole debate centered on establishing the patient-physician engagement. The historic precedent we looked at was the hypertension market in the 1980s when high blood pressure was considered a disease caused by stress rather than a chronic illness. And obesity was seen as the result of genetics or a lack of willpower.

But through the influence of social media and an increasingly weight-centric approach to treating diabetes, demand for anti-obesity medications skyrocketed. Back in July 2022, we saw obesity as a $55 billion market. And at that point the key question was if and when these drugs would be reimbursed. 

If you fast-forward to July 2023, what we saw was reimbursement kicking in the U.S. much more quickly than we anticipated. There were almost 40 million people who had access to these medicines, and 80 percent of them were paying less than $25 out of pocket. 

By the end of 2023 we had the first landmark obesity trial called SELECT, and that finally established that weight management saves lives in individuals not living with diabetes. These SELECT data supported the cardiac protection GLP-1 medicines have already established for individuals living with diabetes. We expect weight management with anti-obesity medicines will improve the outlook for more than 200 chronic diseases, or so-called co-morbidities, including heart failure and kidney disease, as well as complications like sleep apnea, osteoarthritis, and even potentially Alzheimer's disease.

Now the debate is no longer about demand for these medicines, but it’s about supply. The major pharma companies in the space are investing almost $60 billion of capital expenditure in order to establish a supply chain that can satisfy this vast demand. 

And beyond supply, the other side of the current debate is the ripple effects from anti-obesity drugs. How will they impact the broader healthcare sector, consumer goods, food, apparel? And how do lower obesity rates impact life expectancy? 

So, with all this in mind, our base case, we estimate the global obesity market will now reach $105 billion in 2030. Right now, supply is being primarily diverted to the U.S., but in the long term we think that the market opportunity will become bigger outside the US. 

Furthermore, the size of the obesity market will be determined by co-morbidities and improved supply. So, if all these factors play out, our bull scenario is a $144 billion total addressable market. However, if supply constraints continue, then we can see a market more restricted to $55 billion as of 2030. So, things are developing fast, and we will continue to keep you updated. 

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen to podcasts and share Thoughts on the Market with a friend or colleague today.

As the U.S. presidential election remains closely contested, our experts discuss what a change in administration could mean for European equities in terms of trade, China relations and other key issues.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research.

Marina Zavolock: And I'm Marina Zavolock, Chief European Equity Strategist.

Michael Zezas: And on this episode of Thoughts on the Market, we'll discuss how the U.S. election could impact European markets.

It's Wednesday, April 24th at 10am in New York.

Marina Zavolock: And 3pm in London.

Michael Zezas: As the U.S. presidential election gets closer and the outcome remains highly uncertain, we're exploring the impact of a potential departure from the current status quo of President Biden in the White House. Today, my colleague Marina and I want to discuss just what that would mean for European equity markets.

Marina, how closely is Europe following the election, and why?

Marina Zavolock: So, European equities derive about 25 percent of their market cap weighted revenues from the U.S. And the U.S. is the largest export market for European firms outside of Europe. So, of course, interest in U.S. elections here is very high; and this is in terms of the exposures of European stocks, sectors, asset classes, and economics as a whole. European investors, I would say that their peak interest in U.S. elections was around the Republican primaries, and it's stayed elevated ever since.

And Mike, I know you want to dig in specifically on how European markets would react in a change in status quo scenario. But first let's talk about your outlook on some of the key policies that may change if Biden loses the election. What are your thoughts on trade policy and tariffs?

Michael Zezas: Trump's been clear about his view that countries levying higher tariffs on U.S. imports than the US levies on their imports is unfair, and he's willing to correct it with tariffs. And while in his term as president he focused more on China, he was interested in tariff escalation with Europe. But he reportedly was moved off that position by advisors and members of his own party who were wary of creating more noise in the transatlantic alliance. But this time around, the Republican party's views are much more aligned with Trump's. So, imports on European goods like autos could easily come into scope.

Marina, how are you thinking about the impact of potentially higher tariffs on the European market? What sectors might be most affected?

Marina Zavolock: The initial reaction to recent tariff related headlines we've been fielding from investors is around the risks to our bullish European equities view in particular. The general investor feedback we get is that European equities may continue to rally for now, but as we approach November and as we approach US elections, the downside risks from this event start to build.

What our in-depth analysis demonstrates, however, is that it's far more nuanced than that. As I mentioned, Europe derives about 25 per cent of its weighted revenues from the US. But, when we've dug into that number, most of these revenues are in the form of services or local to local goods, meaning goods produced locally in the US and sold in the US -- but by European companies. Only about 6 per cent of Europe's overall weighted revenue exposure is to goods exported into the US. So, we find the risk is far more idiosyncratic from a change in tariff policy than broad based. And in terms of individual sectors most exposed to tariff risks, these include a lot of healthcare sectors -- med tech, life sciences, pharma, biotech -- aerospace as well, metals and mining; of course, autos as you mentioned, and a number of others.

After tariffs, the Inflation Reduction Act (IRA) is the next most common policy area we get asked about in Europe, given relatively high exposures for European utilities, construction materials, and the capital goods sector.

Overall, we find European equities aggregate exposure to IRA is also low, is less than 2 percent of weighted revenues, so even lower than that of tariffs. But the stocks most exposed in Europe to IRA are underperforming the rest of the market. What are your scenarios around the IRA if Trump wins, Mike?

Michael Zezas: Well, we think the money appropriated in the IRA is here to stay. Many of that program's investments overlap with geographies represented by Republicans in Congress, which means repealing the IRA may be a better talking point than a political strategy -- similar to how Republicans in 2017 failed to repeal the Affordable Care Act despite campaigning on that as a priority. But Trump could certainly slow the spending of that money through regulatory means such as ratcheting up the rules about how much of the materials involved have to be sourced from within the US.

Now switching gears, Marina, you mentioned the performance of European stocks related to our election scenarios. Based on your recent work, you have very granular stock level data on relative exposure to potential administration policies. How are stocks with the greatest exposures behaving overall?

Marina Zavolock: Yeah, this was a very interesting conclusion from our work. We thought that it's still fairly early ahead of US elections for stocks to start to diverge on the basis of potential policy changes. But what we found when we surveyed our analysts and collected data for over 350 European stocks with material US exposure is that when we break out these exposures and we aggregate them, the stocks with the highest level of potential risk exposure to Trump administration policies are underperforming the overall market. And the stocks with the greatest potential positive exposure, to Trump administration policies are outperforming.

And then you have groups like moderate exposure that are in the middle, and these groups, no matter how we slice the data for different policies, are lining up. Exactly as you might expect, depending on their level of exposure as the market starts to price in some probability of either scenario coming through. We're also starting to see the volatility of the stocks most exposed start to rise. But this is a very early trend.

The other big area that we get asked about is China. So, Europe has about 8 per cent of its weighted revenues exposed to China. It's the highest of any major developed market region in the world. What are your expectations about China policy under a new Trump administration?

Michael Zezas: Well, it's bipartisan consensus now that China is a rival and that more protective barriers to trade are needed to protect the US' tech advantage in order to safeguard US national and economic security. But like with Europe, Trump appears more willing to use tariffs as a tool in this rivalry, which can create more rhetorical and fundamental noise in the economic relationship.

Marina, how do you think this would impact Europe?

Marina Zavolock: So, we've been talking about China as a risk factor for some time for a variety of reasons, and recently when I mentioned that European stocks are starting to react to potential change in administration policies. This hasn't so much been the case on China exposures. China exposures are behaving as they were before. We're not seeing any great divergences as we approach elections; though in our overall model, we do favor sectors with lower exposure to China.

Mike, and how are you thinking about Ukraine? We have a huge amount of interest in the defense sector, and it's one of the best performing sectors in Europe this year.

Michael Zezas: Yeah. So here Trump's been pretty clear that he'd like to push for a rapid reconciliation between Russia and Ukraine. What investors should pay attention to is that a Trump attempt at rapid reconciliation, perhaps in contrast with the European approach. And then when you couple that with potential tariffs on Europe from the US, it can send a signal to Europe that they have to shift their own defense and economic strategy. And one manifestation of that could be greater security spending, particularly defense spending in Europe and globally. It's a key reason why defense is a sector we favor in both the US and Europe.

So, Marina, what are some of the bottom-line conclusions for investors?

Marina Zavolock: I think there's two main conclusions from our work. First, the aggregate exposures in Europe to potential changes in policy from a Trump administration are pretty low and quite idiosyncratic by stock. We talked about a few of the greatest exposure areas, but in aggregate, if we take all the policy areas that we've analyzed, net exposure of Europe's revenues is about 7 per cent.

Second, the stocks that are most exposed, either positively or negatively, are already moving based on those relative exposures, and we think that will continue, and these groups of stocks will also have increased volatility as we get closer to November.

Michael Zezas: Marina, thanks for taking the time to talk.

Marina Zavolock: Great speaking with you, Mike.

Michael Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us wherever you listen to podcasts; and share Thoughts on the Market with a friend or colleague today.

Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.

New data on both immigration and inflation defied predictions and may have shifted the Fed’s perspective. Our Chief U.S. Economist and Head of U.S. Rates Strategy share their updated outlooks.  

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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief US Economist.

Guneet Dhingra: And I'm Guneet Dhingra, Head of US Rates Strategy.

Ellen Zentner: And today on the podcast, we'll be discussing some significant changes to our US economic outlook and US rates outlook for the rest of this year.

It's Tuesday, April 23rd at 10am in New York.

Guneet Dhingra: So, Ellen, last week you put out an updated view on your outlook -- with some substantial forecast changes. Can you give us the headlines on GDP, inflation and the Fed forecast path? And what has really changed versus your last update?

Ellen Zentner: Sure Guneet. So, our last economic outlook update was in November last year. And since that time, really, the impetus for all of these changes came from immigration. So, we got new immigration data from the CBO, and just to give you a sense of the magnitude of upward revision, we thought we had an increase of 800,000 in 2023. It turns out it was 3.3 million. And so far, the flows of immigrants suggest that we're going to get about as many as last year, if not a little bit more. And so, what does that mean? Faster population growth, those are more mouths to feed. You've got a faster labor force growth. They can work. They are working. And data historically shows that their labor force participation rates are higher than native born Americans.

So, you've got to take all this into account. And it means that you've got this big positive supply side shock. And so, when the labor market has been about balance now between demand and supply, as Chair Powell's been noting, you're now going to have supply outrun demand this year.

And so, you basically got much more labor market slack. You've got -- and I'm going to steal Chair Powell's words here -- you've got a bigger economy, but not a tighter economy. So, it's faster GDP growth. We have taken out one Fed cut, and I know we're going to talk about that because inflation has surprised the upside recently. But you've got slower wage growth. More labor market slack. And so, we did not change our overall inflation numbers on the back of this better growth and better labor force growth.

Guneet Dhingra: That's very helpful. That's a very interesting read in the economy, Ellen. Do you think the Fed is reading the supply side story the same way as you are? And said differently, is the Fed on the same page as you? And if not, when do you think they could be?

Ellen Zentner: Yeah. So, you know, Chair Powell, if you go back to his speeches and the minutes from the Fed. They've been talking about immigration. I think we've known for a while that the numbers were bigger than previously thought. But how you interpret that into an outlook can be different. And it takes some time. It even took us some time -- about a month -- to finally digest all the numbers and figure out exactly what it meant for our outlook. So, here's the biggest, I think, change for them in terms of what it means. The break-even level for payrolls is just that much higher.

Now what does break even mean? It means it's the pace of job gains you need to generate each month in order to just keep the unemployment rate steady. And six months ago, we all thought it was 100, 000, including the Chair. And now we think it's 265,000. That is eye popping. And it means that when you see these big labor market numbers -- 250, 000; 300,000. That's normal. And that's not a labor market that's too tight.

And so, I think the easiest thing the Fed, has realized is that they don't need to worry about the labor market. There's a lot more slack there. There's going to be a lot more slack there this year. Wage growth has come down because of it. ECI, or Employment Cost Index, is going to come down for this year. The unemployment rate is going to be higher. They do still need to reflect that in their forecast. And that means that we could show, sort of, this flavor of bigger but not tighter economy when we get their forecast updates in June.

Guneet Dhingra: I think the medium-term thesis is very compelling, Ellen, but how do you fit the three back-to-back upside surprises in CPI here? How does that fit with the labor supply story?

Ellen Zentner: So, that is sort of disconnected from the bigger but not tighter economy, because we did have to take into account that inflation has surprised to the upside. I mean, these have been some real volatile prints in the last three months, and we're now tracking March core PCE at 0.25 per cent and we're going to get that number later this week. And so that's above the threshold that we think the Fed needs in order to gain confidence that that pace of deceleration we saw late last year, is not in danger of slowing down for them to gain further confidence.

Ellen Zentner: And so, the way I would characterizes this is that it's a bigger but not tighter economy. But we also had to take into account these inflation upside surprises, which is really what led us to push the June cut off to July.

So, after we get that March, core PCE print, let's see what that data holds, but we think a few prints around 0.2 per cent are needed to satisfy Chair Powell, and gain that consensus to cut. So, I want to stress to the listeners that, you know, our conviction that inflation will head toward target remains high.

And it was also helped last week by fresh data on new tenant rents. So that is a leading indicator for rental inflation in our models. And it's slowed again. And suggests an even faster pace of deceleration ahead.

But here's where I think it matters for the Fed. Whereas before, they were very convicted that this rental inflation story was going to play out, that rent inflation was going to come down. They used similar models to us. But because of the inflation data being so volatile over the past three months, rather than providing forward guidance on what you're going to do around rental inflation coming down, you want to see it. You want to see it in the data. And so that's why they've been so willing to say, you know what, we're just going to, we're going to hold longer here.

Guneet Dhingra: Perfect. So just to get the Fed call on the record, what exactly are you calling for the Fed? And I know investors love the hypothetical question. What is the probability in your mind that the Fed doesn't cut at all in 2024?

Ellen Zentner: Yeah, they do love scenario analysis. So here we go. So, our baseline is they cut in July. They skip September. By November, the inflation data is coming down to monthly prints that tell them they're on track for their 2 per cent goal and at risk of falling below it. So, from November to June next year, they're cutting every meeting to roughly around three and a half percent.

Now, as you asked, what if inflation doesn't go down? So, inflation doesn't go down, you know, then the Fed's forecast and our forecast are going to be wrong and the three rate cuts they envision is predicated on that inflation forecast coming true. So, you know, the most important takeaway from that scenario is that the result would be a Fed on holder for longer. But as opposed to a hike being the next move -- and I think that's really important here. The Fed is still very strongly convicted on they will cut this year. This is about the timing. Now, the hold period could last into 2025, I mean, we don't know, but what happens if inflation accelerates from here?

So, I'm going to provide another scenario here. So, there is a scenario where inflation accelerates on a backdrop of strong growth, which would suggest it might be sustained, and perhaps begins to lift inflation expectations. Now, you know, that's a recipe for a hold that then turns into additional hikes as the Fed realizes neutral is just higher than where rates currently sit. But at this point, I would put quite a low probability on that scenario. But from a risk weighted perspective, I suppose it should be taken into account.

So, given all this and the changes that we've made, what is your expectation for rates for the rest of the year?

Guneet Dhingra: Yeah, I think we also, based on the forecast revision you guys have, we also revised up our treasury yield forecast. We earlier had 10 year yields ending slightly below 4 per cent by the end of 2024. Now we have them at about 4.15 percent which again is a 20-basis point uplift from our forecast before this. But still, I think it's not the higher for longer number that people are expecting because when I look at the forecast you have on the Fed, I think Fed path you have is well below what the markets expect.

I think the forecast you have has about seven cuts from July this year to the middle of next year. The market for contrast is only four. There's a pretty massive gap that opens up, I think, between the way we see it -- and ultimately that does come down to the interpretation of the data that we're seeing so far.

So, for us, the forecast numbers are slightly higher than before, but the message still is: we are not in the hire for longer camp, and we do expect rates to end up below the market applied forwards.

Ellen Zentner: All right. So, you know, I've talked a lot about immigration. One could say I've been pretty obsessed with it over the last couple of months. But from a rates perspective, you know, what are the broader implications of the immigration story for that? You know, this, this bigger but not tighter economy. How do you translate that into rates?

Guneet Dhingra: Yeah, let me say your obsession has been contagious. You know, I've caught on to that bug, the immigration bug. And, you know, I've been I've been discussing this thesis with investors, quite a lot. And I think it seems to me as you framed it pretty nicely. It's a bigger but not a tighter economy. I don't think investors have caught on to that page yet. I think most investors continue to think of these inflation prints is telling you that this is a tighter economy. Bigger, yes -- maybe on the margin. But the tighter part is still very much in people's minds. And when I look at the optics off the CPI numbers, the payroll numbers, investors have just been very conditioned, very reflexively conditioned to look at a 250K number on payrolls as a very strong number. They look at the 3 per cent number of GDP as a very strong number.

And as you laid out earlier, these numbers may not be necessarily telling you about an overheating economy. But simply a bigger economy. So, I think the disconnect is there, pretty pervasive. And I think for me, most investors will take a lot of time to get over the optics. The optics of three strong points of inflation, the optics of 250K payrolls. I think it's gradually seeping in. But for now, I think the true impact or the true learnings from the immigration story is not very well understood in the investment community.

Ellen Zentner: Okay, but is there, is there anything else missing in your view?

Guneet Dhingra: Yeah, quite a few things. I think you can add more nuances to this immigration story itself. For example, when I think about last year, when rates were going up massively in third quarter, fourth quarter, one of the focal points was Atlanta Fed GDP Now. My GDP now was tracking close to four and a half, five per cent, and inflation was cooling pretty clearly in the second half of last year. And so investors had a choice to make. Do we actually trust the GDP growth numbers? Because they are probably an inflation risk in the future. And the markets very clearly chose to focus on growth with the belief that this growth is eventually going to lead to high inflation. And so, I think that disconnect has really translated into, sort of, what I would call like a house of cards where investors have built the entire market level on growth upside, and growth upside, and growth upside.

So, I think the market level -- when I do the math and try and suss out the counterfactual -- the market level of 4.6 per cent tenure should have and could have been a market level of 3.8 per cent tenure based on my calculations. And so, there's an 80-basis point gap from where we are to where we could have been based on a misunderstanding of the supply story and the immigration story.

Ellen Zentner: Yeah, I certainly wish the volatility was a lot lower here. It would make it easier for the Fed and for us to separate signal from noise. Certainly difficult for market participants to do that. But Guneet, thanks for taking the time to talk.

Guneet Dhingra: Great speaking with you, Ellen.

Ellen Zentner: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen to podcasts and share the podcast with a friend or colleague today.

Recent data indicates the economy may avoid either a soft or hard landing for now. Our Chief U.S. Equity Strategist explains why investors should seek out quality as the economy stays aloft.

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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 the impact of better economic growth and stickier inflation on stocks.

It's Monday, April 22nd at 11:30am in New York. 

So let’s get after it.

In our first note of the year, I cited three potential macro-outcomes for 2024 with similar probability of occurring.

First, a soft landing with slowing, below potential GDP growth and falling inflation toward the Fed's target of 2 per cent. Second, a no landing scenario under which GDP growth re-accelerated with stickier inflation. And third, a hard landing, or recession. 

Of course, each scenario has very different implications for asset prices generally and equity leadership, specifically. Just a few months ago, the consensus view skewed heavily toward a soft landing. However, the macro data have started to support the no landing outcome with recent growth and inflation data exceeding most forecasters' expectations – including the Fed’s. 

Over the past year, consensus views have gone from hard landing in the first quarter of 2023 to soft landing in the second quarter, back to hard landing in the third quarter to soft landing in the fourth quarter, and now to no landing currently. This shift has not been lost on markets with assets that benefit from higher inflation doing well over the past few months. However, while cyclically sensitive stocks and sectors have started to outperform, quality remains a key attribute for the leaders. 

We think this combination of quality and cyclical factors makes sense in the context of what is still a later, rather than early cycle re acceleration in growth. If it was more the latter, we would not be observing such persistent under performance of low-quality cyclicals and small caps. Furthermore, we continue to believe much of the upside in economic growth over the past year has been the result of government spending, funded by growing budget deficits. 

This has led to a crowding out of many smaller and lower quality businesses – and the lowest small business sentiment since 2012. As with most fiscal stimulus packages, the plan is for the bridge of support to buy time until a more durable growth outcome arrives – driven by organic private income, and consumption and spending. 

Until this potential outcome is more solidified, the equity market should continue to trade with a quality bias. The largest risk for stocks more broadly is higher 10-year Treasury yields as investors begin to demand a larger term premium due to higher inflation and the growing supply of bonds to pay for the endless deficits. 

While leadership within the equity market continues to broaden toward cyclicals it still makes sense to stay up the quality curve. Our recent upgrade of large cap Energy fits the shifting narrative to the no landing outcome, and it remains one of the cheapest ways to get exposure to the reflation theme. Other reflation trades are more extended in our view. Our primary concern for equities at this point is that aggressive fiscal spending has led to better economic growth. But it keeps upward pressure on inflation and prevents the Fed from cutting interest rates that many economic participants desperately need at this point. 

In short, a no landing outcome may make the crowding out problem even worse for smaller businesses, many consumers and even regional banks. This is all in-line with our 2024 outlook that suggests the major equity indices are overvalued while the best opportunities are likely beneath the surface in underappreciated sectors like energy that are positively levered to stickier inflation and higher interest rates. 

Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen to podcasts and share the podcast with a friend or colleague today.