Our Head of Corporate Credit Research explains why the debt of high-rated EM countries is a viable alternative for investors looking for high yields with longer duration.

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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 why – for buyers of investment grade bonds – we see better value in Emerging Markets. 

It's Friday May 17th at 2pm in London.

This is a good backdrop for corporate credit. The asset class loves moderation and our forecasts at Morgan Stanley see a US soft landing with growth about 2 percent comfortably above recession, but also not so strong that we think we need further rate increases from the Federal Reserve. Corporate balance sheets are in good shape, especially in the financial sector and the demand for investment grade corporate bonds remains high – thanks to yields, which hover around five and a half percent.

For all these reasons, even though the additional yield that you currently get on corporate bonds, relative to say government bonds is low, we think that spread can remain around current levels, given this unusually favorable backdrop. But we're less confident about longer maturity bonds. Here, credit spreads are much more extreme, near their lowest levels than 20 years. So, what can investors do if they're looking to get some of the advantages of this macro backdrop but still access higher risk premiums.

For investors who are looking for high rated yield with longer duration, we see a better alternative: the debt of high rated countries in the Emerging Markets, or EM. Adjusting for rating, high grade Emerging Market debt currently trades at a discount to corporate bonds. That is for bonds of similar ratings, the spreads on EM debt are generally higher. And this is even more pronounced when we're looking at those longer dated borrowings; the bonds with the maturity over 10 years. In investment grade credit, you get paid relatively little incremental risk premium to lend to a company over 30 years, relative to lending it to 10. But that's not the case in Emerging Market sovereigns. There, these curves are steep. The incremental premium you get for lending at a longer maturity is much higher. 

So, what's driving this difference? Well one has been relatively different flows between these different but related asset classes. Corporate bonds have been very popular with investors, enjoying strong inflows year to date. But Emerging Market bond funds have not, and have seen money come out. Relatively weaker flows may help explain why risk premiums in the EM debt market are higher.

Another reason is that the same EM investors who are often seeing outflows have been asked to buy an unusually large amount of EM bonds. Issuance from Emerging Market sovereigns has been unusually high year to date and unusually focused on longer dated debt. We think this may help explain why Emerging Market risk premiums are even higher for longer dated bonds. 

The good news? Our EM strategy team thinks some of this issuance surge will moderate in the second half of the year. It's a good backdrop for high rated credit and this week's CPI number, which showed continued moderation. And inflation is further reinforcing the idea that the US can see a soft landing. The challenge is that – that good news has tightened spreads in the corporate market.

While we think those risk premiums can stay low, we currently see better relative value for investors, looking for yield and risk premium in high-rated EM sovereigns – especially for those looking at longer maturities. 

Thanks for listening. Subscribe to Thoughts on the Market wherever you get your podcasts and leave us a review. We'd love to hear from you. 

Our research shows travelers are willing to spend more this summer than last. U.S. Thematic Strategist Michelle Weaver explains how this will impact the airline, cruise and lodging industries. 

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Welcome to Thoughts on the Market. I’m Michelle Weaver, Morgan Stanley’s US Thematic Strategist. Along with my colleagues bringing you a variety of perspectives, today I’ll talk about the summer travel trends we’re expecting to see this year. 

It’s Thursday, May 16th at 10am in New York. 

With Memorial Day just around the corner, most of us are getting really excited about our summer vacation plans. We recently ran a survey, and our work shows that nearly 60 percent of US consumers are planning to travel this summer. This figure though skews significantly higher for upper income consumers. 75 percent of consumers making $75,000 to $150,000 are planning to travel and this figure rises to 78 percent for those who make more than $150,000. 

And travel remains a key spending priority for higher-income consumers. They place travel as one of their top priorities when compared to other discretionary purchases. This picture reverses though when you look at lower-income consumers making less than $50,000 a year. Travel tends to be among their lowest priorities when they are thinking about their discretionary purchases.

What really matters for companies though is if consumers are going to spend more this year than they did last year. And consumers who are planning a vacation are inclined to spend more this year, with 49 percent expecting to spend more and 16 percent intending to spend less. So that yields a net plus-32 percent increase in spending intentions for summer travel.

And what does this mean for key players in the travel industry? For starters, let’s look at airlines, where demand no longer seems to be a market debate within the space. It’s remained very resilient so far in 2024, contrary to what many had feared when we were going into this year. Our Transportation Analyst also has a positive view of US Airlines, especially Premium carriers. And the reason: This category caters to high-end consumers who are more likely to fly regardless of the state of the economy. Since the pandemic, Premium air travel has been one of the fastest growing and likely most resilient parts of the US Airlines industry, with premium cabin outperforming the main cabin consistently. 

And then what’s in store for cruise companies this summer? The outlook seems to be broadly positive, according to our analysts. The largest cruise operators source the majority of their guests from the US. And these companies provide leisure travel – as opposed to business travel – almost exclusively, so their revenues are closely tied to the health of the US consumer. Of the 60 percent of consumers who are planning to travel this summer, 6 percent are planning a cruise. That’s a little bit lower than pre-COVID, but cruise passengers tend to skew older and more affluent. So, they take more than one vacation frequently. This keeps the outlook broadly supportive for cruise companies. 

Finally, let’s think about Gaming and Lodging. These are your hotels and casinos. Investor sentiment is generally cautious for this space, but our analyst believes the data is encouraging. Yes, there’s been a slowdown in demand, compounded by continued – but moderating – labor inflation. This has created margin pressure for companies with higher operating leverage but the data suggests that upscale and luxury operators are outpacing midscale and economy ones. In addition, the Las Vegas strip, which tends to skew higher end, has outpaced regional casinos. And even when you look within the Las Vegas strip, baccarat is outpacing slot demand and luxury properties are outpacing more affordable options.

So, all in all, the summer looks bright for travel operators, especially those who have more exposure to the high-end consumer. 

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

Our Global Head of Fixed Income and Thematic Research explains that the Biden administration’s new tariffs on Chinese imports are narrower than those of 2018 and 2019, but still send a signal about the economic relationship between the US and China.

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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 the impact of newly announced tariffs by the United States. 

It's Wednesday, May 15th at 10:30am in New York.

Yesterday, the Biden administration announced new tariffs on the import of certain goods from China. These include semiconductors, batteries, solar cells and critical minerals among other products. For investors, this might remind them of the tariff escalation in 2018 and 2019 that led to global economic concerns. But we’d caution investors not to arrive at similar conclusions from this latest action.

Consider that the scope of this action is far more muted than the tariffs actions from a few years ago. New tariffs will affect a projected $18 billion of imports, or only about 0.5 percent of all China’s exports. And as our chief Asia economist Chetan Ahya has explained in his recent work, the sectors in scope for this round are areas where China has substantial spare capacity. Said differently, the tariffs are narrowly scoped and appear to be targeted at areas where the US perceives specific risk of imbalanced trade and market conditions. That contrasts with tariffs on roughly $360 billion of imports from China in the 2018-2019 period – a much broader approach that was in part aimed at forcing broad trade concessions from China but carried greater economic consequences by crimping corporate’s capital spending globally as they re-evaluated their production strategies. 

There is some signal for investors here though. While the scope of the Biden administration's efforts here are more narrow, it does signal something we’ve known for a few years now. There’s continuity across presidential administrations and across political parties in the US on the topic of the economic relationship with China. While each party has different tactics, there’s clear overlap in their goals, in particular on the idea that the US must continue taking steps to protect critical and emerging technologies in order to preserve its economic and national security. 

This suggests that the laws of gravity won’t apply to US tariffs any time soon, regardless of the US election outcome. So, the rewiring of the global economy in the emerging multipolar world will continue, and investors can still focus on some key regional beneficiaries of this secular trend – namely Mexico, India, and Japan.

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

Our Retail Analyst discusses the key strategies that have propelled a select few companies in U.S. consumer retail amid a challenging demand backdrop. 

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Welcome to Thoughts on the Market. I’m Simeon Gutman, Morgan Stanley’s Hardlines, Broadlines & Food Retail Analyst. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss how some retail businesses are responding to daunting consumer challenges. 

It’s Tuesday, May 14th at 10am in New York.

There have been dramatic shifts within the consumer sector over the past three years. During the pandemic, we all had to redirect our spending away from services, such as travel and leisure, to various goods, which we were able to purchase online and have delivered at home. Consumer packaged goods, for example, experienced two years of outsized growth during the pandemic. But since 2022, consumption has been declining across the value chain. 

For some categories, this dynamic may not be a temporary, post-COVID phenomenon, but rather a continuation of a longer-standing secular trend that had started prior to the pandemic. For example, non-durable goods – such as clothing, footwear and food at home – were already losing wallet share pre-COVID. Grocery spend was losing to dining out, as consumers placed more value on convenience. And although some sectors experienced unprecedented pricing power between 2020 and 2023, they’re now seeing this pricing power decline as inflation moderates. 

Against this backdrop, Consumer Packaged Goods companies and retailers are attempting to find new growth levers in the face of stagnating – or even declining – sales and decreasing pricing power. A select few companies in US consumer retail, automotive, communication services and IT hardware have been able to navigate the current consumer environment of slowing growth. We believe there’s a powerful lesson in the combination of strategies these successful outliers have deployed to reposition themselves in the face of tepid demand. 

For example, these companies are shifting their value proposition by focusing on products in faster-growing markets. They are also exiting underperforming areas to optimize their core brand and product portfolios. They’re streamlining their internal operations by changing organizational structures, revamping their supply chains, and using AI to automate processes. All of this helps to reduce costs and enhance productivity. Successful retail companies are also looking to alternative revenue sources and profit pools to grow their businesses, focusing on higher growth areas within their industries. Discount retail is a prime example as it focuses on high margin digital media, which has the potential to lift operating profit margins for the entire sector. Furthermore, a shift to omni-channel has revolutionized Retail, by capturing greater consumer wallet share and reducing delivery costs. And finally, successful companies have prioritized free cash flow by divesting non-core assets in less profitable areas. 

Businesses that have been able to deploy these strategies have been rewarded by the market. They have seen their average 12-month price to earnings multiples expand more than 35 percent over the past five years, meaning that the market's outlook for these companies is considerably better than it was previously. Several of these strategies have also led to stronger top-line growth and margin expansion, which our US equity strategists identify as the two major drivers of shareholder value across consumer staples and consumer discretionary.

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

Our experts highlight their biggest takeaways from the International Monetary Fund’s recent meetings, including which markets around the globe are on an upward trajectory.

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Simon Waever: Welcome to Thoughts on the Market. I'm Simon Waever, Morgan Stanley's Global Head of Emerging Markets, Sovereign Credit and Latin America Fixed income strategy. 

Neville Mandimika: And I'm Neville Mandimika from the Emerging Markets Credit Strategy team with a focus on Central and Eastern Europe, Middle East and Africa.

Simon Waever: And on this episode of Thoughts on the Market, we'll discuss what we believe investors should take away from the International Monetary Fund’s Spring Meetings in Washington, DC. 

It's Monday, May 13th at 10am in New York.

Neville Mandimika: And it's 3 pm in London.

To give some context, every year, the Spring Meetings of the International Monetary Fund (IMF) and the World Bank provide a forum for country officials, private sector market participants and academics to discuss critical global economic issues. This time around, the meetings were held against a backdrop, as you might imagine, of rising geopolitical tensions, monetary policy pivots, and limited fiscal space.

Simon, we were both at the event, and I wanted to discuss what we took away from our own meetings, as well as discussions with other market participants. How would you describe the mood this time around compared to the annual meetings in October last year?

Simon Waever: So, I would say sentiment was cautiously optimistic. Of course, it did happen in the backdrop of inflation; the first quarter not being as well behaved as everyone had hoped for. So that really put the focus on central banks being more cautious in their easing paths, which is actually a point the IMF also made back in October.

But away from that, growth has held up better than expected. In the US for sure, but also more globally. So, I would say it could have been a lot worse.

Neville Mandimika: Was it just me or there was a particular focus on fiscals this time around? What did you make of this?

Simon Waever: No, there was for sure and interestingly it was focused on both developed economies and developing economies, which isn't usually the case. And I think it's clear that not only the IMF but also the markets are worried that we're still some distance away from stabilizing debt in most countries. And not only that but that it's going to be hard to close that gap due to lower growth and spending pressures. So that meant that there was a lot of discussions on how much term premier there needs to be in government bond curves and whether they need to be steeper.

Neville Mandimika: It's often very difficult to talk about, you know, the global economic dynamics without talking about AI, which seems to be the catchphrase this year. How is the fund viewing this in light of the potential for the global economy?

Simon Waever: So, the issue is that the IMF has often had to revise down medium-term growth outlook; something that it pretty much had to do every year since 2010, actually. And today it stands at only 2.8 globally. If you look at the IMF's publications, they attribute the key reasons to this to misallocation of capital and labor.

But what they also did this time around was look at what could turn it around; and maybe unsurprisingly structural reforms that reduces that misallocation would be the larger potential factor that could boost this up again. They estimate about around 1.2 per cent of GDP. But then to your point the adoption of AI is seen as another new driver.

Of course, it's also a lot more uncertain because there needs to be a lot of a lot more work done around it. But they think it could add nearly one percentage point to global growth in a positive scenario. 

But Neville, with that, let's dig deeper into the issues of developing countries which, after all, is the focus of the meetings. The cost of debt is rising, which has led to some countries experience debt distress. But from our side, we've also frequently pushed back against the idea that there is a growing debt crisis. So, coming back from the meetings, what kind of debt restructuring progress has been made? And how do you see it playing out for the remainder of the year? 

Neville Mandimika: Yeah, interestingly, there was still plenty of talk in the meetings about EM (emerging market) debt crisis, but the backdrop to the conversation was significantly better this time around compared to October 2023.

Since last year, we've seen progress from Suriname, which is a small part of the Emerging Market Bond Index, close its restructuring, Zambia reaching a deal with private bondholders with the expectation that all of this could be buttoned up by June this year, multiple proposals in Sri Lanka and Ukraine making some progress.

This gives me some hope that the number of sovereigns in default will be lower by the end of this year. And I think more importantly, we don't expect any country, any new country, to get into default -- as countries like Pakistan and Tunisia have made some progress in avoiding restructuring its own debt.

The other important thing that came out from my vantage point is that the Global Sovereign Debt Roundtable seems to be making some progress, particularly on outlining the structure of EM debt crises, which is, you know, emphasizing parallel negotiations between official and private creditors and, of course, timely sharing of information between stakeholders.

Simon Waever: Then another focus has been that the IMF has been making some concessions to try to increase financing for countries that need it. Do you think there was progress on this front? 

Neville Mandimika: Yeah, it certainly seems so. You know, there seems to be some momentum on that front. You'd remember that last year, there was a resolution to increase the IMF's lending capacity by increasing country quotas by 50 per cent. Once this is buttoned up, heavy borrowers like Egypt and Argentina would greatly benefit, I think.

Until this is done, the fund extended its temporary higher access limits to allow countries to borrow more in the meantime. There was also increased dialogue on reducing surcharges, which is the additional interest payments the IMF imposes on borrowers. The reduction of these would greatly help the likes of Argentina and Ecuador. Unfortunately, not much concrete progress has been made on this front.

Simon Waever: And then finally, across all the meetings we held, which countries did you come away more positive on and which ones would still be of concern?

Neville Mandimika: Yeah, I certainly came out a lot more positive on Senegal, as fears of large policy changes like leaving the CFA franc were eased. Egypt was also another clear positive, given the commitment to reforms, despite large financing that was received earlier this year. Nigeria, there was also some momentum on this front as reforms is still very much front and center from the political authorities. And lastly, Turkey saw authorities affirming their commitment to fighting inflation and loosening the grip on the foreign exchange market.

And I'll throw the same question to you, Simon. Which countries are you positive on?

Simon Waever: Yeah, I mean, it was pretty hard to take away the excitement from Egypt, but I would say that Argentina is another country where people came away pretty positive. The imbalances are significant, but they're just making very good headway in unwinding them; and they have the support of the IMF to do so. Ecuador would be the other one where sentiment in general is positive. On the more cautious side, I would point towards those countries where fiscal deficits are heading in the wrong direction, which goes back to the worries about fiscals we spoke about earlier -- and Colombia is one such example.

But with that, let's wrap it up. Neville, thanks for taking the time to talk.

Neville Mandimika: Great speaking with you, Simon.

Simon Waever: And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us wherever you listen to the podcast. It helps more people find the show.

Morgan Stanley’s Chief Latin America Strategist explains the importance of Mexico’s upcoming presidential election, laying out the possible investment implications of potential policy reforms.

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Welcome to Thoughts on the Market. I’m Nik Lippman, Morgan Stanley’s Chief Latin America Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll talk about why Mexico’s upcoming election matters for markets. 

It's Friday, May 10, at 10am in Sao Paulo. 

Voters in Mexico will choose a new president in less than a month, on June 2. The two leading candidates – Claudia Sheinbaum and Xóchitl Gálvez – have presented strong campaigns amidst a tense political backdrop. And yet, asset prices have not yet begun to react to potential election outcomes. 

There’s significant policy differences between Sheinbaum and Galvez – thus an important investment debate around each of them. However, polls suggest a strong lead for Sheinbaum, who is the candidate from the ruling party Morena. In fact, it seems that the key debate that markets are focused on right now is not so much who wins, but rather what type of president Sheinbaum would be, if she does get elected.

If she does indeed win, the expectation is for policy continuity post-election—particularly as it relates to Mexico’s nearshoring – or moving industrial supply chains from Asia to North America. This trend has been a major driver of the country’s economy and major asset classes. 

And so the market seems to be focusing squarely on policy decisions that may be taken by the incoming administration. Mexico is in a strong position to benefit from its relationship with the United States and as well as the nearshoring opportunities. We see a positive skew for both equities and credit, and think the election can act as a catalyst for assets that have traded cheaply.

Yet, significant reforms are necessary to take full advantage of this setup. Indeed, we would argue that rapid and deep structural reforms would be crucial, especially when it comes to fiscals and the energy space. For example, we think there could be a need for stronger partnership between the public and the private sector and a rethink of parts of Mexico’s electricity model. If Mexico solves its electricity supply-side challenges, it can build on its favorable nearshoring position. But on the other hand, there’s no industrial revolution without electricity. 

However, the risk-reward for the Mexican peso is slightly different. It has already benefited from the rise in foreign investment - and the high interest rate differential between Mexico and the United States.

With all that said, there are risks from the elections, too. If any political party wins two-thirds majority, it opens the possibility for changes to the constitution. And current proposals by Mexico’s sitting president could open the door for larger fiscal deficits; and potentially some more unorthodox policies down the road. We will continue to keep you posted on Mexico’s election outcomes.

Thank you for listening. If you enjoy Thoughts on the Market, take a moment to rate and review us wherever you listen. It helps more people find the show.

Our Chief Fixed Income Strategist explains why the Federal Reserve’s most recent meeting was so consequential, and the likeliest path ahead for interest rates.

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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 last week’s FOMC meeting and its impact on fixed income markets.  

It's Thursday, May 9th at 1pm in New York.

Last week’s Fed meeting was consequential. It had a clear and unambiguous messaging about the path ahead for Fed’s monetary policy. Fed’s next move in policy rate is unlikely to be a hike. The Fed’s focus now is on how long the current target range for the fed funds rate will be maintained; and the next move, whenever it happens, is likely a cut. Importantly, the FOMC’s decision was unanimous and their statement maintained an overall easing bias.

In the aftermath of recent upside surprises to inflation and the reaction in the rates market, many market participants, yours truly included, were apprehensive that the FOMC’s tone might be overtly hawkish. Turns out, that was not the case. By setting a very high bar for the next move to be a hike, the Fed’s message has meaningfully narrowed the distribution of outcomes for policy rates, at least in 2024 As our economists led by Ellen Zentner note, the two likely policy outcomes now are keeping the rates on hold or cutting. 

Given the prospect that policy rates may remain in the current target range, the negative carry of an inverted yield curve keeps us from pounding the table to move to outright long in duration, although the direction of travel does suggest that. We would note that Guneet Dhingra, our head of US interest rate strategy, sees better risk/reward in duration longs through 3 month 10 year receivers than in the very crowded curve steepener trade. In general, spread products in fixed income – agency MBS, corporate credit and securitized credit – stand to benefit the most from this notably less hawkish messaging, in our view.

As Jay Bacow, our head of agency MBS strategy, observes, the backdrop in which tail risks of higher policy rates are much more remote than they were before the FOMC meeting is supportive for agency MBS. At current valuations, agency MBS offers an attractive expression for investors seeking to play for lower interest rates, lower interest rate volatility or both. 

Their high all-in yields have bolstered strong inflows and sustained demand for corporate credit across a wide range of investor types. If policy rates remain in the current range, we expect the demand for corporate credit to accelerate. If policy rates stay in the current range or go lower, pressures on interest coverage are unlikely to get worse going forward. Given their high single-digit all-in yields, we see an attractive risk/reward calculus favoring leveraged loans. We like expressing this view directly in loans as well as in securitized credit through CLO tranches.  

In sum, the message from the Fed was clear and unambiguous. The policy rate path ahead is for rates to remain in the current range or decline, and the bar for the next move to be a hike is very high. This bodes well for a wide range of instruments in fixed income.

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

Our expert panel explains the U.S. dollar’s current status as the primary global reserve currency and whether the euro and renminbi, or even crypto currencies are positioned to take over that role.

Digital assets, sometimes known as cryptocurrency, are a digital representation of a value that function as a medium of exchange, a unit of account, or a store of value, but generally do not have legal tender status. Digital assets have no intrinsic value and there is no investment underlying digital assets. The value of digital assets is derived by market forces of supply and demand, and is therefore more volatile than traditional currencies’ value. Investing in digital assets is risky, and transacting in digital assets carries various risks, including but not limited to fraud, theft, market volatility, market manipulation, and cybersecurity failures—such as the risk of hacking, theft, programming bugs, and accidental loss. Additionally, there is no guarantee that any entity that currently accepts digital assets as payment will do so in the future. The volatility and unpredictability of the price of digital assets may lead to significant and immediate losses. It may not be possible to liquidate a digital assets position in a timely manner at a reasonable price.

Regulation of digital assets continues to develop globally and, as such, federal, state, or foreign governments may restrict the use and exchange of any or all digital assets, further contributing to their volatility. Digital assets stored online are not insured and do not have the same protections or safeguards of bank deposits in the US or other jurisdictions. Digital assets can be exchanged for US dollars or other currencies, but are not generally backed nor supported by any government or central bank.

Before purchasing, investors should note that risks applicable to one digital asset may not be the same risks applicable to other forms of digital assets. Markets and exchanges for digital assets are not currently regulated in the same manner and do not provide the customer protections available in equities, fixed income, options, futures, commodities or foreign exchange markets. 

Morgan Stanley and its affiliates do business that may relate to some of the digital assets or other related products discussed in Morgan Stanley Research. These could include market making, providing liquidity, fund management, commercial banking, extension of credit, investment services and investment banking.

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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 whether the US status as the world's major reserve currency can be challenged, and how.

It's Wednesday, May 8th, at 3pm in London.

Last week, you both joined me to discuss the historic strength of the US dollar and its impact on the global economy. Today, I'd like us to dive into one aspect of the dollar's dominance, namely the fact that the dollar remains the primary global reserve asset.

James, let's start with the basics. What is a reserve currency and why should investors care about this?

James Lord: The most simplistic and straightforward definition of a reserve currency is simply that central banks around the world hold that currency as part of its foreign currency reserves. So, the set of reserve currencies in the world is defined by the revealed preferences of the world's central banks. They hold around 60 percent of those reserves in U.S. dollars, with the euro around 20 percent, and the rest divided up between the British pound, Japanese yen, Swiss franc, and more recently, the Chinese renminbi.

But the true essence of a global reserve currency is broader than this, and it really revolves around which currency is most commonly used for cross border transactions of various kinds internationally. That could be international trade, and the US dollar is the most commonly used currency for trade invoicing, including for commodity prices. It could also be in cross border lending or in the foreign currency debt issuance that global companies and emerging market governments issue. These all involve cross border transactions.

But for me, two of the most powerful indications of a currency's global status.

One, are third parties using it without the involvement of a home country? So, when Japan imports commodities from abroad, it probably pays for it in US dollars and the exporting country receives US dollars, even though the US is not involved in that transaction. And secondly, I think, which currency tends to strengthen when risk aversion rises in the global economy? That tends to be the US dollar because it remains the highly trusted asset and investors put a premium on safety.

So why should investors care? Well, which currency would you want to own when global stock markets start to fall, and the global economy tends to head into recession? You want to be positioning in US dollars because that has historically been the exchange rate reaction to those kinds of events.

Michael Zezas: And so, Dave, what's the dollar's current status as a reserve currency?

David Adams: The dollar is the most dominant currency and has been for almost a hundred years. We looked at a lot of different ways to measure currency dominance or reserve currency status, and the dollar really does reign supreme in all of them.

It is the highest share of global FX reserves, as James mentioned. It is the highest share of usage to invoice global trade. It's got the highest usage for cross border lending by banks. And when corporates or foreign governments borrow in foreign currency, it's usually in dollars. This dominant status has been pretty stable over recent decades and doesn't really show any major signs of abating at this point.

Michael Zezas: And the British pound was the first truly global reserve currency. How and when did it lose its position?

David Adams: It surprises investors how quick it really was. It only took about 10 years from 1913 to 1923 for the pound to begin losing its crown to king Dollar. But of course, such a quick change requires a shock with the enormity of the First World War.

It's worth remembering that the war fundamentally shifted the US' role in the global economy, bringing it from a large but regional second tier financial power to a global financial powerhouse. Shocks like that are pretty rare. But the lesson I really draw from this period is that a necessary condition for a currency like sterling to lose its dominant status is a credible alternative waiting in the wings.

In the absence of that credible alternative, changes in dominance are at most gradual and at least minimal.

Michael Zezas: This is helpful background about the British pound. Now let's talk about potential challengers to the dollar status as the world's major reserve currency. The currency most often discussed in this regard is the Chinese renminbi. James, what's your view on this?

James Lord: It seems unlikely to challenge the US dollar meaningfully any time soon. To do so, we think China would need to relax control of its currency and open the capital account. It doesn't seem likely that Beijing will want to do this any time soon. And global investors remain concerned about the outlook for the Chinese economy, and so are probably unwilling to hold substantial amounts of RNB denominated assets. China may make some progress in denominating more of its bilateral trade in US dollars, but the impact that that has on global metrics of currency dominance is likely to be incremental.

David Adams: It’s an interesting point, James, because when we talk to investors, there does seem to be an increasing concern about the end of dollar dominance driven by both a perceived unsustainable fiscal outlook and concerns about sanctions overreach.

Mike, what do you think about these in the context of dollar dominance?

Michael Zezas: So, I understand the concern, but for the foreseeable future, there's not much to it. Depending on the election outcome in the US, there's some fiscal expansion on the table, but it's not egregious in our view, and unless we think the Fed can't fight inflation -- and our economists definitely think they can -- then it's hard to see a channel toward the dollar becoming an unstable currency, which I believe is what you're saying is one of the very important things here.

But James, in your view, are there alternatives to the US led financial system?

James Lord: At present, no, not really. I think, as I mentioned in last week's episode, few economies and markets can really match the liquidity and the safety that the US financial system offers. The Eurozone is a possible contender, but that region offers a suboptimal currency union, given the lack of common fiscal policy; and its capital markets there are just simply not deep enough.

Michael Zezas: And Dave, could cryptocurrency serve as an alternative reserve currency?

David Adams: It's a question we get from time to time. I think a challenge crypto faces as an alternative dominant currency is its store of value function. One of the key functions of a dominant currency is its use for cross border transactions. It greases the wheels of foreign trade. Stability and value is important here. Now, usually when we talk to investors about value stability, they think in terms of downside. What's the risk I lose money holding this asset?

But when we think about currencies and trade, asset appreciation is important too. If I'm holding a crypto coin that rises, say, 10 per cent a month, I'm less likely to use that for trade and instead just hoard it in my wallet to benefit from its price appreciation. Now, reasonable people can disagree about whether cryptocurrencies are going to appreciate or depreciate, but I'd argue that the best outcome for a dominant currency is neither. Stability and value that allows it to function as a medium of exchange rather than as an asset.

Michael Zezas: So, James, Dave, bottom line, king dollar doesn't really have any challengers.

James Lord: Yeah, that pretty much sums it up.

Michael Zezas: Well, both of you, thanks for taking the time to talk.

David Adams: Thanks much for having us.

James Lord: Yeah, great speaking with you, Mike.

Michael Zezas: And 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.

As the U.S. economy continues to send mixed signals, our CIO and Chief US Equity Strategist explains how markets are likely to oscillate between “soft landing” and “no landing” outcomes. 

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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 higher-than-normal uncertainty in economic data and its impact on markets. 

It's Tuesday, May 7th at 1:30 pm in New York. 

So let’s get after it. 

In recent research, I’ve discussed how markets are likely to oscillate between the "soft landing" and “no landing" outcomes in today's late cycle environment. Continued mixed and unpredictable macro data should foster that back and forth, and last week was a microcosm in that respect. Tuesday's Employment Cost Index report came in stronger than expected, leading to a rise in the 10-year Treasury yield to nearly 4.7 per cent. Meanwhile, the Conference Board Consumer Confidence Index turned down, falling to its lowest level since July of 2022. 

On Friday, the equity market rose sharply as bond yields fell on the back of a weaker labor report, while the ISM Services headline series fell to its lowest level since December of 2022. 

In our view, this uncertain economic backdrop warrants an investment approach that can work as market pricing and sector/factor leadership bounces between these potential outcomes. As such, we recommend a barbell of quality cyclicals which should outperform in a "no landing" scenario and quality growth, the relative winner in a "soft landing.” One might even want to consider adding a bit of exposure to defensive sectors like Utilities and Staples in the event that growth slows further.  

Meanwhile, last week's Fed meeting materialized largely as expected. Chair Powell expressed somewhat lower confidence on the timing of the first cut given recent inflation data, but he pushed  back on the notion that the next move would be a hike which eased some concerns going into the  meeting. The April Consumer Price Index released on May 15th is the next key macro event informing the path of monetary policy and the market's pricing of that path. As usual, the price reaction on the back of this release may be more important than the data itself given how influential price action has been on investor sentiment amid an uncertain macro set up. 

On the rate front, our view remains consistent with our recent research—the relationship between the 6-month rate of change on the 10-year yield and the S&P 500 price earnings multiple implies that yields around current levels are about 10 per cent headwind to valuation through the end of June but a tailwind thereafter, all else equal.

Given the uncertainty and unpredictability of the economic data more recently, we think it's useful to look at the technicals for insight into what comes next. In early April, we highlighted that the breakdown in the S&P 500 from its well-defined uptrend was an important early warning sign that performance could become more challenged. 

Based on our analysis, this headwind to valuation is likely to remain with us through the end of June unless yields fall significantly in the near term. Assuming interest rates stay around current levels, stronger valuation support lies closer to 19 times earnings, which would also imply price support closer to the 200-day moving average or 4800.

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. 

Lisa Shalett is a member of Morgan Stanley’s Wealth Management Division and 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.

Our CIO for Wealth Management, Lisa Shalett, and our Head of Corporate Credit Research continue their discussion of the impact of interest rates on different asset classes, the high concentration of value in equity markets and more.

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Welcome to Thoughts on the Market, and to part two of a conversation with Lisa Shalett, chief investment officer for Morgan Stanley wealth management. 

I'm Andrew Sheets, head of corporate credit research at Morgan Stanley.

Today, we'll be continuing that conversation, focusing on how higher interest rates could impact asset classes, and also some recent work about the unusually high concentration of stocks within the equity market.

We begin with Lisa's very topical question about how higher interest rates might impact credit. 

Lisa Shalett: So, Andrew, let me ask you this. From your perspective as the Global Head of Corporate Credit Research, what happens if we're, in fact, in this new regime of rates being higher for longer? 

Andrew Sheets: Yeah, thanks, Lisa. It seems more topical by the day as we see yields continuing to march higher. So I think like a lot of things in the market, it kind of depends a little bit on what the fundamental backdrop is that's driving those interest rates higher. Because if I think about the modern era for credit, which I’ll define as maybe the last 40 years, the tightest that we've ever seen corporate credit spreads was not when the Fed or the European central bank was buying bonds. It was not when you had lots of leverage building up in the financial system prior to the financial crisis. 

It was in the mid 90s when the economy was pretty good. The Fed had hiked rates a lot in [19]94 and then it cut them a little. And, you know, the mid nineties, I think, are one of the poster children for, kind of, a higher for longer rate environment amidst a pretty strong economy. 

So, if that is what we're looking at, we're looking at rates being higher for longer because the economic output of the US and other regions is generally stronger. I think that's an environment where you can have the overall credit market performing still pretty well. You'll certainly have dispersion around that as not every balance sheet, not every capital structure was planned, was created with that sort of rate environment in mind.

Overall, if you had to say, is credit more afraid of a kind of higher for longer scenario or is it more afraid of, growth being a lot weaker than expected, but that would bring low rates. I actually think a lot of credit investors would much rather have a more stable growth environment, even if that brings somewhat fewer rate cuts and higher for longer rates.

Lisa Shalett: One other thing, I know that the Global Investment Committee has been debating is this idea between the haves and the have nots that's been somewhat unique to this business cycle where, there's been a portion of the mega cap and large cap universes who have demonstrated, quite frankly, total insensitivity to interest rates because of their cash balances. Or because of their lack of need for actual borrowing. And then there's smaller midsize companies, these smaller cap or unprofitable tech companies, some of the companies that may have been born in the venture capital boom of the early 2020s. 

How is this have, have not, debate playing out in the credit markets? Are there parts of the credit markets that are starting to worry that there's a tail?

Andrew Sheets: Yeah, I think that's just a fascinating question at the moment because we’ve lived in this very macro world where it seemed like big picture questions about central banks: Will we go into recession? What will commodity prices do is driving everything. And even this week, questions about interest rates are dominating the headlines on TV and on the news.

But I think if you peel things back a little bit, this is an incredibly micro market, you know, we're seeing some of the lowest correlations and co-movement between individual stocks in the US and Europe that we haven't in 15 years. If I think about the credit market, the credit market is not just sailing into this environment, happy go lucky, no risk on the horizon. It's showing some of the highest tiering that we've seen in a very long time between CCC rated issuers, which is the lowest rated, main part of performing credit and Single-B issuers, which are still below investment grade rated, but are somewhat better. Market is charging a very high price premium between those two, which suggests that it is exactly as you mentioned, differentiating based on business model strength and level of leverage and the likes.

So, this environment of differentiation -- where the overall market is kind of okay, but you have lots of churning below the surface -- I think it's a very accurate description of credit. I think it's a very accurate description of the broader market, and it's certainly something that we're seeing investors take advantage of we see it in the data.

Andrew Sheets: Lisa, you recently published a special report on the consequences of concentration, which focuses on some of these mega cap stocks and how they may present underappreciated risks for investors. What were the key takeaways from that that we should keep in mind when it comes to market concentration and how should we think about that?

Lisa Shalett: The fundamental point we were trying to make -- and it really has to do with some of the unintended risks potentially that passive investors may be embracing that they don't fully appreciate -- is really through the end of 2023, US equity indices became extraordinarily, concentrated; where the top 10 names were accounting for greater than, a third of the market capitalization. And history has shown that such high levels of concentration are rarely sustainable. But what was particularly unique about the era of the Magnificent Seven or these top 10 mega cap tech stocks is not only were they a huge portion of the whole index, but in many ways they had become correlated to one another, right? Both, in terms of their trading dynamics and their valuations, but in terms of their factor exposures, right? 

They were all momentum oriented. They were all tech stocks. They were all moving on an AI, narrative. In many cases, they had begun competing with each other; one another directly in businesses, like the cloud, like streaming services and media, et cetera.

Andrew Sheets: And Lisa, kind of further on that idea, I assume that one counterpoint that you get to this work is that some of these very large mega cap names are just great companies. They've got strong competitive positions; they've got opportunities for future growth. As an investor, how do you think about how much you are supposed to pay up for quality, so to speak? And, you know, maybe you could talk just a little bit more about how you see the valuations of some of these larger names in the market.

Lisa Shalett: What we always remind clients is, there is no doubt that, these are great companies and they have cash flows, footprints, dominant positions, and markets that are growing. But the question is twofold. When is that story fully discounted, right?

And when do great companies cease to be great stocks? And if you look back in history, history is littered with great companies who cease to be great stocks and very often, clients quote unquote never saw it coming because they hung their hat on this idea, but it's a great company.

Andrew Sheets: Any parting thoughts as we move closer to the midpoint for 2024?

Lisa Shalett: The line that I'm using most with clients is that, I fundamentally believe that uncertainty in terms of the economic scenarios that could play out from here. Whether we're talking about a no landing, we're talking about a hard landing, we talk about a stagflation. And the policy responses to that, whether it's the timing of the Fed, and what they do. And what's their mix between balance sheet and rates, and then what happens post the presidential elections in the US. And is there a policy change that shifts some of the growth drivers in the economy. 

I just think overall uncertainty is rising through the end of the year, and that continues to argue, for a position as we've noted, where clients and their advisors are particularly active towards risk management, and where the premium to diversification is above average. 

Andrew Sheets: Lisa, thanks for taking the time to talk. Hope we can have you back again soon.

Lisa Shalett: It's great to speak with you, as always, Andrew.

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.

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.

----- Transcript -----

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.