Podd: Thoughts on the Market

Europe’s Defense Dilemma

27 januari 2025 | 7 min

Morgan Stanley Research looks at how the European defense industry might respond to military spending pressure from the Trump administration.

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Paul Walsh: Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Europe Product.

Ross Law: And I'm Ross Law, Head of the European Aerospace and Defense Team.

Paul Walsh: Today, we're discussing the outlook for European defense amid renewed pressure for more military spending from the Trump administration.

It's Monday, the 27th of January, at 9.30am in London.

Now Ross, the new Trump administration is now in place, and shifting NATO's defense burden to Europe is a top priority for President Trump. In fact, President Trump has made several comments throughout his campaign and after taking office. He has suggested that Europe should increase defense spending to 5 per cent of GDP. And just for reference, right now, many European countries are at or above NATO's target of spending 2 per cent of GDP on defense.

What's your reaction? Are President Trump's demands of 5 percent realistic?

Ross Law: In short, we don't think so. In a perfect world, yes, 5 per cent is exactly where Europe should be, to make up for the huge underspend that we've seen over the past three decades since the end of the Cold War, which we've calculated at around the $2 trillion mark. There's also a desire in Europe to reduce its reliance on the US, particularly under a Trump presidency. But we see the 5 per cent spending level as unrealistic on multiple fronts.

Firstly, from an economic perspective, given the lack of fiscal headroom in Europe; and for reference, 5 per cent would require an additional $600 billion of spend annually. Secondly, from a political perspective, given multiple pockets of uncertainty, and the fact that a rise in defense spending may mean a cut to spending elsewhere. And lastly, from an industry perspective, given the multi-decade underspend I mentioned, we don't think the industry could absorb anywhere close to such a strong increase in demand, at least near-term.

So, while we do see upside pressure to European defense spending, our base case is that 3 per cent could be a more reasonable target. Not only would this be a compromise between the current 2 per cent target and Trump's 5 per cent demands; it would also allow Europe to match the spending levels of the US, which is expected at around 3.1 per cent in 2024. Even still, this would represent a 50 per cent increase or around $200 billion per year in additional European spent. This would, of course, further improve industry fundamentals and why we remain very positive on the sector.

Paul Walsh: And as of now, Europe is heavily dependent on the U.S. for its defense. According to various data sources, more than 50 per cent of European arms imports came from the U.S. in 2019 through 2023, and that's up from 35 per cent in 2014. Given this, what steps would Europe need to take to reduce its dependence on the U.S.?

Ross Law: The first step is to invest in the defense industrial base. Europe buys equipment from the U.S. for several reasons. Firstly, because the U.S. develops some of the most advanced technologies in the world because it has consistently invested in its defense industry. Secondly, because the U.S. equipment is often cheaper due to the benefits of scale. And thirdly, because it supports the very unique relationship between Europe and the U.S., which has essentially provided a security umbrella for the past three decades.

So, Europe needs to invest, both to develop capabilities and technologies to rival U.S. peers, and also to expand capacity so that we can meet our own equipment needs. This, of course, all requires investment and also time. So, Europe will remain reliant on the U.S. for many years to come. But if Europe is serious about wanting to be more sovereign, we need a more capable defense industry.

Paul Walsh: So, you talked there, Ross, about investment and time. So now the big question, how would Europe fund this upward pressure on defense budgets?

Ross Law: Well, this is the million-dollar question, or the 200-billion-dollar question, you might say. Unfortunately, this is part of the equation that is, so far, most unclear – and the basis for an ongoing series of reports we've entitled the “European Defense Dilemma” – essentially the very clear need to spend more on defense, but no clear way to fund it. So far, we've seen some creative ways to fund near-term spending plans, from off balance sheet special funds like in Germany, to using the interest received on frozen Russian assets.

But these, in our view, all seem fairly temporary in nature. What we really need is structural change, and that requires political commitment. Clearly, there is a lot of political change happening right now in Europe. Germany is holding an election in a few weeks time. France doesn't yet have a budget. There's also fiscal issues here in the UK. But we're hoping that 2025 is the year in which we may get clearer political commitments to longer-term structural improvements in defense spending. The German election is a clear near-term catalyst for us, where the raising of the debt break may in part be used to fund higher defense spending. But we're also looking to the upcoming NATO summit in June as an opportunity to officially increase the NATO spending target, we think potentially to 3 per cent, to support a more structural increase in European defense spending.

Paul Walsh: In light of all of this, what's your outlook for the European defense industry?

Ross Law: We remain bullish. In fact, we turned even more bullish as part of our 2025 outlook published earlier this month. The pressure to raise spending even to 3 per cent of GDP should progressively benefit industry fundamentals.

So, we see upside to both forecasts. Given these are currently premised on a 2 per cent of GDP assumption, as well as devaluation multiples, which we view today as very attractive, with the sector trading in line with this long-term average – despite the improving fundamentals I've just described.

Paul Walsh: And finally, Ross, what developments if any might change your outlook?

Ross Law: The key for us this year is seeing clear political commitments from governments on more structural increases in spending. So, we're going to be watching the German election and the outcome of the French budgetary process very carefully. It's unlikely to be plain sailing. There was a media article published just this morning suggesting the UK government may be unwilling to raise spending beyond the current 2.3 per cent level. But we are hoping that as a whole 2025 sees Europe make a stronger commitment to defending itself.

Paul Walsh: Ross, fascinating as always. Thanks for taking the time to talk.

Ross Law: Great speaking with you Paul.

Paul Walsh: And thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

Have Markets Hit Peak Optimism?

24 januari 2025 | 4 min

Our Head of Corporate Credit Research Andrew Sheets argues that while investor hopes are running high, corporate confidence isn’t.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today I’m going to talk about optimism, how we measure it, whether it’s overly excessive and what lies ahead.

It's Friday January 24th at 2pm in London.

A central tenet of investing, including credit investing, is to be on the lookout for excessive optimism. By definition, the highest prices in a market cycle will happen when people are the most convinced that only great things lie ahead. The lowest prices, when you’d love to buy, happen when investors have given up all hope.

But identifying peak optimism, in real time, is tricky. It’s tricky because there is no generally agreed definition; and it's tricky because, sometimes, things just are good. Investors have been excited about the US Technology sector for more than a decade now. And yet this sector has managed to deliver extraordinary profit growth over this time – and extraordinarily good returns.

Yet this debate does feel relevant. The US equity market has soared over 50 per cent in the last two years. Equity valuations are historically high, both outright and relative to bonds. Credit risk premiums are near 20-year lows. Speculative investor activity is increasing. And so, have we finally hit peak optimism, a level from which we can go no further?

Our answer, for better or worse, is no. While we think investor optimism is elevated, corporate optimism is not. And corporations are really important in this debate, enjoying enormous financial resources that can invest in the economy or other companies. While we do think corporate confidence will pick up, it is going to take some time.

One of our favorite measures of corporate confidence is merger and acquisition activity. Buying another company is one of the riskiest things management can do, making it a great proxy for underlying corporate confidence. Volumes of this type of activity rose about 25 per cent last year, but they are still well below historical averages. And it would be really unusual for a major market cycle to end without this sort of activity being above-trend.

Another metric is the riskiness of new borrowing. Taking on new debt is another measure of corporate confidence, as you generally do something like this when you feel good about the future, and your ability to pay that debt off. But for the last three years the volume of low-rated debt in the US market has actually been shrinking, while the issuance of the riskiest grades of corporate borrowing is also down significantly from the 2017-2022 average. Again, these are not the types of trends you’d expect with excessive corporate optimism.

Uncertainties around tariffs, or the policies from the new US administration could still hold corporate confidence back. But the low starting point for corporate confidence, combined with what we expect to be a deregulatory push, mean we think it is more likely that corporate activity and aggressiveness have room to rise – and that this continues throughout 2025. Such an increase usually does present greater risk down the line; but for now, we think it is too early to position for those more negative consequences of increasing corporate aggression.

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

Big Debates: How Will M&A and IPOs Drive Markets in 2025?

23 januari 2025 | 11 min

Morgan Stanley Research analysts Michelle Weaver, Michael Cyprys and Ryan Kenny discuss the resurgence in capital markets activity and how sponsors might deploy the $4 trillion that has been sitting on the sidelines.

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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver, U.S. Thematic and Equity strategist at Morgan Stanley.

Michael Cyprys: I'm Mike Cyprys, Head of U.S. Brokers, Asset Managers and Exchanges Research.

Ryan Kenny: And I'm Ryan Kenney, U.S. Mid-Cap Advisors Analyst at Morgan Stanley.

Michelle Weaver: In this episode of our special miniseries covering Big Debates, we'll focus on the improving M&A and IPO landscape and whether retail investing can sustain in 2025.

It's Thursday, January 23rd at 10am in New York.

2023 saw the lowest level of global M&A activity in at least 30 years. But we've started to see activity pick up in 2024. Mike, what have been the key drivers behind this resurgence, and where are we now?

Michael Cyprys: Look, I think it's been a combination of factors in the context of a lot of pent-up activity and a growing urge to transact after a very subdued period of, you know, call it four- to six quarters of quite limited activity. Key drivers as we see it ranging from equity markets that have expanded across much of the world, low levels of equity volatility. broad financing, availability with meaningful issuance as you look across investment grade and high yield bond markets, tight credit spreads, interest rates stabilizing in [20]24, and then the Fed began to cut.

So, liquidity pretty robust, all of that helping reduce bid-ask spreads. In terms of where we are now, post election, think there's just a lot of excitement here around a new administration; where we could see some changes around the antitrust environment that can be helpful, as we think about unlocking greater M&A activity across sponsors as well as strategics, and helping improve corporate confidence.

But look, the recent rout of market could delay some of the transactional activity uplift. But we view that as more of a timing impact, and we are quite positive here in [20]25 as we think about scope for continued surge of activity.

Michelle Weaver: We've seen rates rising pretty substantially since December. Does that throw a wrench into this at all, or do you think we see more stabilization there?

Michael Cyprys: I think it could be a little bit of a slowdown, right? That would be the risk here, but as we think about the path for moving forward, I do think that there are a lot of factors that can be very helpful in terms of driving a continued pickup in activity, which we're going to talk about -- and why that will be the case.

Michelle Weaver: Great. And you mentioned financial sponsors earlier, I want to drill down there a little more. What do you think would get sponsor activity to pick up more meaningfully?

Michael Cyprys: Well, as I think about it, activity is already starting to pick up clearly across strategics as well as sponsors. On the sponsor side, it's been lagging a bit relative to strategics. We think both of which will build, and Ryan will get to that on the strategic side. As we think about the sponsors -- they're sitting with $4 trillion of capital to put to work that's been sitting on the sidelines where you just haven't seen as much activity over the past couple of years.

Overall activity in [20]24 was probably call it maybe around 20 per cent below peak levels, and this is burning a hole in the pockets of both sponsors as well as their clients. And so, we see a growing urge to transact here, which gets to some of your earlier questions there too.

So why is that? Well, the return clock is ticking; the lack of deployment is hurting returns within funds. Some of this dry powder also expires by the end of [20]25; and so if it's not yet deployed, then sponsors won't get some of the performance fee economics that come through to them on that capital. So that's all, all on the deployment side.

As we think about the realization or exit side, we think that's probably going to lag, but we'd still expect, a steady build through this year. Today sponsors are sitting on call it around $10 trillion of portfolio of investments that are in the ground, and they haven't really provided much in the way of liquidity back to their customers, the LPs and the funds. And so, this is putting a little bit of a strain not only on the client relationships that want more money back from their private investments that haven't received it, but it's also one of the causes of what has been a little bit of a challenging fundraising backdrop across private equity funds.

Hence if sponsors can return more capital to their clients, that can be helpful in terms of healing the overall fundraising backdrop. So, look, putting all that together, we expect an expanding pace of transactional deal activity across the sponsors from both the buy side as well as the sell side in terms of our activity.

Michelle Weaver: And Ryan, how about IPOs? Have they been part of a similar trend?

Ryan Kenny: Yes, definitely. So, with IPOs, we're also expecting a significant resurgence off of a low base. So just to put some numbers on it. In 2024, announced M&A volumes relative to nominal GDP, we're around 40 per cent below three-decade averages; equity capital markets [ECM] or ECM was even more muted, 50 per cent below three decade averages. And the leading indicators for ECM are very similar to the leading indicators for M&A. You want a strong equity market, relatively low volatility so that companies have the confidence to go public and so that deals can price well. And those conditions are really starting to materialize already in 2024; and we saw a few big IPOs price well last year, and launch well. The fourth quarter also looks strong. We saw a significant acceleration in industry ECM activity in October, November, December. 4Q volumes tracking up over 50 per cent year-over-year.

Michelle Weaver: Let's dig a little deeper into potential policies from the incoming Trump administration. What are your expectations around antitrust regulation and its impact on M&A?

Ryan Kenny: So, Trump has announced his appointments to the FTC and to the DOJ antitrust division. And our expectation is a return to normal. And that's coming off of what was a more onerous and not-clear environment under Biden. The Biden administration's approach was to disincentivize M&A; and they did that by defining M&A market concentration in novel ways -- looking at things like labor markets, and looking at how competitiveness is defined in new ways. And these new ways of defining concentration decrease the clarity of whether a specific deal would be challenged.

So, from a CEO and board perspective, you don't want to waste the time of your management team and your board going through a deal that might not go through; in addition to the risk of prolonging the deal, and the risk of higher legal expenses during the process. So now that we're returning more towards normal, that's our expectation. We expect there will still be some deals like a challenge, but it will operate under more historical norms and so that really checks the box of getting CEO confidence up to transact more.

Michelle Weaver: And I know that dynamic you’re talking about with market concentration created quite a big drag on large M&A deals and large-cap M& A. Do you think we could start to see that come back as well?

Ryan Kenny: Yeah, expect large-cap deals to rebound even more than small-cap deals. When we started to see the activity pick up in 2024, it was led by more mid-cap corporates. And now we expect to see large deals return in force at a time when financial sponsors, like what Mike was just talking about, coming back in force at the same time -- which drives up the animal spirits when all parts of the M&A market are returning at the same time.

Michelle Weaver: And what are some other catalysts beyond the political side that investors should watch in 2025 around capital markets developments?

Ryan Kenny: So, I categorize it as macro catalysts and structural catalysts The macro catalysts are clarity on tariff and immigration policies, how that will impact GDP. Clarity on the interest rate path. And look you don't need more rate cuts to get this market moving; you can still have a significant increase, even if there are no more rate cuts this year.

But narrowing the range of outcomes is important. And I think we're already there, where maybe we get no cuts this year. Maybe we get two cuts. It's a much tighter environment than where we were over the last few years. And so that helps narrow the bid-ask spread between buyers and sellers.

Structural catalysts that are really critical this cycle are the need for AI capabilities. Innovation in tech, innovation in biotech healthcare, the energy transition, reshoring and exploring your geographic footprint in a multipolar world -- are all really critical when you evaluate the types of companies that a board would want to acquire.

Michelle Weaver: What’s your outlook for 2025? And then even beyond that when it comes to both M&A and IPO activity?

Ryan Kenny: So, in 2025, we see a strong rebound in both ECM and M&A. ECM volumes in our base case, we expect to roughly double off of a low base. M&A announcements, we expect up over 50 per cent year-over-year in 2025. And importantly, that's our base case. Even in our bear case, we model an increase in both ECM and M& A volumes, given we're coming off of such low levels.

We've had three years of light activity and pent-up demand, and pipelines have already begun to build. When we look forward beyond 2025, we think this is the beginning of a multi-year capital markets growth cycle -- with bigger deal sizes and more deal count than average, driven by three years of pent-up demand and an economy that's a third larger than 2021, which was the last time we had a capital markets cycle.

Michelle Weaver: And then Mike, what does this rebound in capital markets activity, including M&A and IPOs means specifically for retail investing?

Michael Cyprys: Overall, a supportive macro backdrop with a rebound in capital markets activity, we think should be helpful in terms of bringing more investors into the markets, including retail investors. Whether it's from corporate actions and IPOs, it helps in terms of more stocks to trade; also helps in terms of revising animal spirits.

I think that's all helpful in terms of supporting engagement across both single stock volumes and equity markets as well as options. So, all of that together, we were expecting greater investor engagement here in [20]25. And confidence as well can help boost not just trading volumes but also margin lending and securities lending. And so, all of that can be helpful as we think about our forecast for our retail brokerage coverage group.

Michelle Weaver: Mike, Ryan, thank you for taking the time to talk. And to our listeners, thanks for listening. If you enjoyed the podcast, please share it with a friend or colleague today.

Potential Economic Consequences of Trump’s Executive Orders

22 januari 2025 | 3 min

On his first day in office, President Trump issued a series of executive orders, signaling his intent to deliver on campaign promises. Our Global Head of Fixed Income and Public Strategy Michael Zezas takes a closer look at economic impacts of Trump’s proposed policy path.

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Welcome to Thoughts on the Market. I’m Michael Zezas, Global Head of Fixed Income and Public Policy Strategy. On this episode of the podcast, we’ll discuss how trade policy uncertainty is creating volatility in markets.

It’s Wednesday, January 22nd, at 10am in New York.

Earlier this week, Donald Trump was again inaugurated as President of the United States. In the days that have followed, we’ve fielded tons of questions from investors, who are trying to parse the meaning of myriad executive orders and answers to press questions – looking through that noise for signals about the if, when, and how of policy changes around tariffs, taxes, and more. This effort is understandable because – as we’ve discussed here many times – the US public policy path will have substantial effects on the outlook for the global economy and markets.

And while we’ve spent some time here explaining our assumptions for the US policy path, it's important for investors to understand this. Even if you correctly forecast the timing and severity of changes to trade, tax, immigration, and other policies, you shouldn’t expect markets to consistently track this path along the way. That’s because there’s bound to be a fair amount of confusion among investors, as President Trump and his political allies publicly speculate on their policy tactics and make a wide variety of outcomes seem plausible.

Take tariff policy for example. On Monday, the President announced an America First Trade Policy, where the whole of government was instructed to come up with policy solutions to reduce goods trade deficits and related economic and national security concerns. Tariffs were cited as a tool to be used in furtherance of these goals, and instructions were given to develop authorities on a range of regional and product-specific tariff options. Said more simply, while new tariffs were not immediately implemented, the President appears to be maximizing his optionality to levy tariffs when and how he wants. That will mean that all public comments about tariffs and deadlines, including Trump’s comments to reporters on tariffs for Mexico, Canada, and China, must be taken seriously – even if they don’t ultimately come to fruition, which currently we don’t think they will for Mexico and Canada.

For markets, that max optionality can drive all sorts of short term outcomes. In the US Treasury market, for example, our economists believe these tariffs and a variety of other factors ultimately make for slower economic growth in 2026; and so we expect Treasury yields will ultimately end the year lower. But along the way they could certainly move higher first. As my colleague Matt Hornbach points out, tariff threats can drive investor concerns about temporary inflation leading markets to price in a slower pace of Fed interest rate cuts, which helps push short maturity yields higher.

So bottom line: investors should be carefully considering US public policy choices when thinking about the medium term direction of markets. But they should also expect considerable volatility along the way, because the short term path can look a lot different from the ultimate destination.

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.

Asia Outlook 2025: Three Critical Themes

21 januari 2025 | 4 min

Our Chief Asia Economist Chetan Ahya discusses how tariffs, the power of the U.S. dollar, and the strength of domestic demand will determine Asia’s economic growth in 2025.

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Welcome to Thoughts on the Market. I’m Chetan Ahya, Morgan Stanley’s Chief Asia Economist. Today on the podcast: three critical themes that will shape Asia’s economy in 2025.

It’s Tuesday, January 21, at 2 PM in Hong Kong.

Let's start with the big picture: We foresee Asia's growth decelerating from 4.5 per cent last year to 4.1 per cent in 2025. The whole region faces a number of challenges and opportunities that could sway these numbers significantly. We highlight [the] following three key factors.

First up, tariffs. They are our single biggest concern this year. The pace, scale and affected geographies will determine the magnitude of the growth drag. In our base case, within Asia, we expect tariffs to be imposed on China in a phased manner from the first half of 2025. As Mike Zezas, our Head of US Public Policy states, this will be about fast announcements and slow implementation.

Given tariffs and trade tensions are not new, we think this means corporate confidence may not be as badly affected as it was in 2018-19. But the key risk is if trade tensions escalate. For instance, into more aggressive bilateral disputes outside of US-China or if [the] US imposes universal tariffs on all imports. Asia will be most affected, considering that seven out of [the] top ten economies that run large trade surpluses with the US are in Asia. If either of these risk scenarios materialize, it could bring a repeat of [the] 2018-19 growth shock.

Next, let's consider the Fed and the US dollar. Asian central banks find themselves in a bind with the US Federal Reserve's hawkish shift – which we think will result in only two rate cuts in 2025. The Fed is taking a cautious approach, driven by worries over inflation concerns, which could be exacerbated by changes in trade and fiscal policy. This has led to strength in the US dollar and on the flipside, weakness in Asian currencies. This constrains Asian central banks from making aggressive rate reductions -- even though Asia’s inflation is in a range that central banks are comfortable with.

Finally, with [the] external environment not likely to be supportive, domestic demand within key Asian economies will be an important anchor to [the[ region's growth outlook. We are constructive on the outlook for India and Japan but cautious on China.

China has a deflation challenge, driven by excessive investment and excess capacity. Solving it requires policy makers to rely more on consumption as a means to meet its 5 per cent growth target. While some measures have been implemented and we think more are coming, we remain skeptical that these measures will be enough for China to lift consumption growth meaningfully. We see investment remaining the key growth driver and the implementation of tariffs will only exacerbate the ongoing deflationary pressures.

In India and Japan, we think domestic demand tailwinds will be able to offset external headwinds. We expect a robust recovery in India fueled by government capital expenditure, monetary easing and acceleration in services exports. This should put GDP growth back on a 6.5 per cent trajectory. In Japan we expect real wage and consumption growth reacceleration, which will lead [the] Bank of Japan to be confident in the inflation outlook such that it hikes policy rates twice in 2025.

This week marks the start of the new Trump administration. And together with my colleagues, we are watching closely and will continue to bring you updates on the impact of new policies on Asia.

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.

The Surge in Bond Yields Likely Doesn’t Present Risk – Yet

17 januari 2025 | 4 min

Government bond yields in the U.S. and Europe have risen sharply. Our Head of Corporate Credit Research Andrew Sheets explains why this surprising trend is not yet cause for concern.

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

With bond yields rising substantially over the last month, I’m going to discuss why we’ve been somewhat more relaxed about this development and what could change our mind.

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

We thought credit would have a good first half of this year as growth held up, inflation came down, and the Federal Reserve, the European Central Bank and the Bank of England all cut rates. That mix looked appealing, even if corporate activity increased and the range of longer-term economic outcomes widened with a new U.S. administration. We forecast spreads across regions to stay near cycle tights through the first half of this year, before a modest softening in the second half.

Since publishing that outlook in November of last year, some of it still feels very much intact. Growth – especially in the U.S. – has been good. Core inflation in the U.S. and in Europe has continued to moderate. And the Federal Reserve and the European Central Bank did lower interest rates back in December.

But the move in government bond yields in the U.S. and Europe has been a surprise. They've risen sharply, meaning higher borrowing cost for governments, mortgages and companies. How much does our story change if yields are going to be higher for longer, and if the Fed is going to reduce interest rates less?

One way to address this debate, which we’re mindful is currently dominating financial market headlines, is what world do these new bond yields describe? Focusing on the U.S., we see the following pattern.

There’s been strong U.S. data, with Morgan Stanley tracking the U.S. economy to have grown to about 2.5 per cent in the fourth quarter of last year. Rates are rising, and they are rising faster than the expected inflation – a development that usually suggests more optimism on growth. We’re seeing a larger rise in long-term interest rates relative to shorter-term interest rates, which often suggests more confidence that the economy will stay stronger for longer. And we’ve seen expectations of fewer cuts from the Federal Reserve; but, and importantly, still expectations that they are more likely to cut rather than hike rates over the next 12 months.

Putting all of that together, we think it’s a pattern consistent with a bond market that thinks the U.S. economy is strong and will remain somewhat stronger for longer, with that strength justifying less Fed help. That interpretation could be wrong, of course; but if it's right, it seems – in our view – fine for credit.

What about the affordability of borrowing for companies at higher yields? Again, we’re somewhat more sanguine. While yields have risen a lot recently, they are still similar to their 24 month average, which has given corporate bond issuers a lot of time to adjust. And U.S. and European companies are also carrying historically high amounts of cash on their balance sheet, improving their resilience.

Finally, we think that higher yields could actually improve the supply-demand balance in corporate bond markets, as the roughly 5.5 per cent yield today on U.S. Investment Grade credit attracts buyers, while simultaneously making bond issuers a little bit more hesitant to borrow any more than they have to. We now prefer the longer-term part of the Investment Grade market, which we think could benefit most from these dynamics.

If interest rates are going to stay higher for longer, it isn’t a great story for everyone. We think some of the lowest-rated parts of the credit market, for example, CCC-rated issuers, are more vulnerable; and my colleagues in the U.S. continue to hold a cautious view on that segment from their year-ahead outlook. But overall, for corporate credit, we think that higher yields are manageable; and some relief this week on the back of better U.S. inflation data is a further support.

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

Should Drop in Fed Reserves Concern Investors?

16 januari 2025 | 6 min

The Federal Reserve’s shrinking balance sheet could have far-reaching implications for the banking sector, money markets and monetary policy. Global Head of Macro Strategy Matthew Hornbach and Martin Tobias from the U.S. Interest Rate Strategy Team discuss.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

Martin Tobias: And I'm Martin Tobias from the U.S. Interest Rate Strategy Team.

Matthew Hornbach: Today, we're going to talk about the widespread concerns around the dip in reserve levels at the Fed and what it means for banking, money markets, and beyond.

It's Thursday, January 16th at 10am in New York.

The Fed has been shrinking its balance sheet since June 2022, when it embarked on quantitative tightening in order to combat inflation. Reserves held at the Fed recently dipped below [$]3 trillion at year end, their lowest level since 2020. This has raised a lot of questions among investors, and we want to address some of them.

Marty, you've been following these developments closely, so let's start with the basics. What are Fed reserves and why are they important?

Martin Tobias: Reserves are one of the key line items on the liability side of the Fed balance sheet. Like any balance sheet, even your household budget, you have liabilities, which are debts and financial obligations, and you have assets. For the Fed, its assets primarily consist of U.S. Treasury notes and bonds, and then you have liabilities like U.S. currency in circulation and bank reserves held at the Fed.

These reserves consist of electronic deposits that commercial banks, savings and loan institutions, and credit unions hold at Federal Reserve banks. And these depository institutions earn interest from the Fed on these reserve balances.

There are other Fed balance sheet liabilities like the Treasury General Account and the Overnight Reversed Repo Facility. But, to save us from some complexity, I won't go into those right now. Bottom line, these three liabilities are inversely linked to one another, and thus cannot be viewed in isolation.

Having said that, the reason this is important is because central bank reserves are the most liquid and ultimate form of money. They underpin nearly all other forms of money, such as the deposits individuals or businesses hold at commercial banks. In simplest terms, those reserves are a sort of security blanket.

Matthew Hornbach: Okay, so what led to this most recent dip in reserves?

Martin Tobias: Well, that's the good news. We think the recent dip in reserves below [$] 3 trillion was simply related to temporary dynamics in funding markets at the end of the year, as opposed to a permanent drain of cash from the banking system.

Matthew Hornbach: This kind of reduction in reserves has far reaching implications on several different levels. The banking sector, money markets, and monetary policy. So, let's take them one at a time. How does it affect the banking sector?

Martin Tobias: So individual banks maintain different levels of reserves to fit their specific business models; while differences in reserve management also appear across large compared to small banks. As macro strategists, we monitor reserve balances in the aggregate and have identified a few different regimes based on the supply of liquidity.

While reserves did fall below [$]3 trillion at the end of the year, we note the Fed Standing Repo Facility, which is an instrument that offers on demand access to liquidity for banks at a fixed cost, did not receive any usage. We interpret this to mean, even though reserves temporarily dipped below [$]3 trillion, it is a level that is still above scarcity in the aggregate.

Matthew Hornbach: How about potential stability and liquidity of money markets?

Martin Tobias: Occasional signs of volatility in money market rates over the past year have been clear signs that liquidity is transitioning from a super abundancy closer to an ample amount. The fact that there has become more volatility in money market rates – but being limited to identifiable dates – is really indicative of normal market functioning where liquidity is being redistributed from those who have it in excess to those in need of it.

Year- end was just the latest example of there being some more volatility in money market rates. But as has been the case over the past year, these temporary upward pressures quickly normalized as liquidity in funding markets still remains abundant. In fact, reserves rose by [$] 440 billion to [$] 3.3 trillion in the week ended January 8th.

Matthew Hornbach: Would this reduction in reserves that occurred over the end of the year influence the Fed's future monetary policy decisions?

Martin Tobias: Right. As you alluded to earlier, the Fed has been passively reducing the size of its balance sheet to complement its actions with its primary monetary policy tool, the Fed Funds Rate. And I think our listeners are all familiar with the Fed Funds Rate because in simplest terms it's the rate that banks charge each other when lending money overnight, and that in turn influences the interest you pay on your loans and credit cards. Now the goal of the Fed's quantitative tightening program is to bring the balance sheet to the smallest size consistent with efficient money market functioning.

So, we think the Fed is closely watching when declines in reserves occur and the sensitivity of changes in money market rates to those declines. Our house baseline view remains at quantitative tightening ends late in the first quarter of 2025.

Matthew Hornbach: So, bottom line, for people who invest in money market funds, what's the takeaway?

Martin Tobias: The bottom line is money markets continue to operate normally, and even though the Fed has lowered its policy rates, the yields on money markets do remain attractive for many types of retail and institutional investors.

Matthew Hornbach: Well, Marty, thanks for taking the time to talk.

Martin Tobias: Great speaking with you, Matt.

Matthew Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, [00:06:00] please leave us a review wherever you listen and share the podcast with a friend or colleague today.

Four Key Investment Themes for 2025

15 januari 2025 | 5 min

Our Global Head of Fixed Income & Public Policy Research Michael Zezas discusses how Morgan Stanley’s key themes – deglobalization, longevity, the future of energy, and artificial intelligence – will evolve in 2025 and beyond.

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Welcome to Thoughts on the Market. I’m Michael Zezas, Morgan Stanley’s Global Head of Fixed Income and Public Policy Research. Today I’ll discuss the key investment megatrends Morgan Stanley Research will be following closely in 2025.

It’s Wednesday, January 15th, at 10am in New York.

Short-term trends can offer investors valuable insights into immediate market dynamics. But it’s the long-term trends that truly shape the investment landscape. That’s why each year, Morgan Stanley Research identifies a short list of megatrends that we believe will provide long-term investment opportunities in an ever-changing world.

Three of Morgan Stanley’s megatrends—artificial intelligence, longevity, and the future of energy—carry over from last year. A fourth—the rewiring of the global economy—returns to our list after a hiatus in 2024. While none of these megatrends is new, each has evolved in terms of how it applies to investment strategies.

Let’s start with the rewiring of global commerce for a Multipolar World. As I mentioned, this theme rejoins our list of key megatrends after a year-long break. Why? In short, it’s clear that policymakers globally are poised to implement policies that will speed up the breakdown of the post-Cold War globalization trend. Simply put, policymakers are keen to promote their visions of national and economic security through less open commerce and more local control of supply chains and key technologies. Multinationals and sovereigns may have to accelerate their adaptation to this reality. Some will face tougher choices than others, while there are some who may still benefit from facilitating this transition. Knowing who fits into which category—and how this new reality may play out—will be critical for investors.

Our next theme—Longevity—remains an essential long-term secular trend, and this year the focus will be on measurable impacts for governments, economies, and corporates. The ripple effects of an aging population, the drive for healthy longevity, and challenging demographics across many geographies continue to impact markets. And in 2025, we see investors focusing on several specific longevity debates: First, innovation across healthcare – especially in an AI world, with obesity medications remaining front and center. Second, impacts on consumer behavior – including the drive for affordable nutrition. Third, the need to reskill aging workforces – especially if retirement ages move higher. And, finally, there’s implications for financial planning and retirement – with a bull market for financial advice just starting.

Our next theme centers around energy. When we think about the future of energy, our focus for 2025 shifts from decarbonization to the wide range of factors driving the supply, demand, and delivery of energy across geographies. And the common thread here is the potential for rapid evolution. We’ll be tracking four key dynamics: First, an increasing focus on energy security. Second, the massive growth in energy demand driven by trillions of dollars of AI infrastructure spend, to be met both by fossil fuel-powered plants and renewables. Third, innovative energy technologies such as carbon capture, energy storage, nuclear power, and power grid optimization. And fourth, increased electrification across many industries. We continue to believe that carbon emissions will likely exceed the targets in various nations’ climate pledges. So, we expect focus to shift toward climate adaptation and resilience technologies and business models.

Our last key theme is artificial intelligence and tech diffusion. Although it’s been two years since the launch of ChatGPT, we’re still in the early innings of AI's diffusion across sectors and geographies. However, while 2024 was driven by AI enablers and infrastructure companies, in 2025 we expect the market to focus on early AI downstream use cases that drive efficiency and market share. As you heard yesterday, our Global Head of Thematic Research Ed Stanley, explained that there’s alpha in understanding this rate of change. Agentic AI will be center stage, with robust enterprise adoption, stock outperformance for early adopters, positive surprises in model capabilities, greater breadth of monetization, and thus less attention to return-on-investment debates.

Before I close, it’s worth mentioning that you will likely see connections between these complex themes. As an example, the complexity of a multipolar world makes energy security all the more vital. The demand for energy connects with the enormous power requirements of AI. And AI is set to drive healthcare innovations which could help us lead longer healthier lives. We see these four themes not as static categories but as an interconnected roadmap for investing over the long-term – and we’ll be sharing more on specific debates throughout the year.

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.

Finding Opportunity in AI’s Evolution

14 januari 2025 | 5 min

Our Global Head of Thematic Research Ed Stanley discusses how artificial intelligence is changing and what could be in store for investors in 2025.

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Welcome to Thoughts on the Market. I’m Ed Stanley, Morgan Stanley’s Global Head of Thematic Research. Today I'll discuss how understanding AI’s rate of change can generate alpha in the year of AI agents.

It’s Tuesday, the 14th of January, at 2 PM in London.

Even if you haven't been using artificial intelligence in your work or home life yet – you’ll doubtless have heard about its capabilities by now. Tasked, for example, with drafting an elevator pitch for a 100-page report; it's a tedious task at the best of times. But using an AI model not only does it become a breeze, but these models can also generate you a podcast – if you so wish – through which to disseminate it, and almost in any language conceivable. But now imagine the algorithm begins thinking through multi-stage processes itself – planning, executing – to generate that 100-page report itself, in the first place. That … is an example of Agentic AI.

As the name implies, this next phase of AI development is where software programs gain agency, transitioning from reactive chatbots that we’ve been using into proactive task fulfillment agents. And this transition is happening now.

Over the past 36 months, we’ve gone from reliable output that can displace or supplement 5-second or 5-minute tasks, such as translation or quick summaries, to models that are providing reliable output for 15-minute tasks, 1-hour tasks – like the ones that I just mentioned. And each time the skeptics have claimed that model improvements are slowing down, and thus call into question the returns on hundreds of billions of dollars that have been spent on AI infrastructure, the AI research labs manage to take another leap forward, surprising even seasoned analysts.

That’s why we think this is such an important trend for 2025. AI Adopter companies that can leverage these agents will start to pull ahead of their peers. And as a result, tracking AI’s evolution in the materiality of companies’ investment cases, we think, has never been more important.

Since our first AI Adopter survey in January 2024 to our latest just published in January 2025, we've seen profound shifts in the thousands of stocks that we cover globally. This ongoing transformation not only underscores that AI’s diffusion is advancing rapidly, but that we’re still very much in its early innings.

To understand the breakneck speed of the AI evolution through the lens of its impact on the stock markets, we need to wrap our heads around the concept of “rate of change.” We just published the third iteration of our AI mapping survey of 3,700 global stocks under coverage. And it reveals that 585 of those stocks had their AI exposure or materiality to investment case changed by our analysts – and that is just versus 6 months ago. And it impacts around $14 trillion of global market cap.

And this rate of change in AI isn't just a buzzword; it's a tangible metric driving outperformance. So, if we look back in the second half of last year, 2024, stocks where our analysts previously increased both AI exposure and materiality in our last survey – went on to outperform broader equity markets by over 20 per cent in the second half of 2024. If we apply the same logic looking forward, where do we think most outperformance is going to come from? It’s in those same stocks where our analysts have just upgraded the exposure and materiality to the investment case.

Beyond this simple screen for AI outperformers we think there are three other key conclusions from our latest survey. The first is AI Enabler stocks with Rising Materiality, within which we believe that Semiconductors, which have outperformed well, might soon pass the baton to the Software layer in terms of equity market dominance. Second, Adopters with Pricing Power. These are companies that adopt AI early and use it to expand their margins but sustainably, without having to give it back to their customers. And the third is Financial stocks, in particular, where AI Rate of Change has been the fastest of any sector in our global coverage – in terms of the efficiency gains that we think it can manifest for the share prices.

So all in all, 2025 promises a slew of significant developments in AI, and, of course, we’ll be here to bring you all of the updates.

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

Big Debates: The State of the Energy Transition

13 januari 2025 | 14 min

In the latest edition of our Big Debates miniseries, Morgan Stanley Research analysts discuss the factors that will shape the global energy market in 2025 and beyond, and where to look for investment opportunities.

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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver, U.S. thematic and Equity strategist at Morgan Stanley.

Devin McDermott: I'm Devin McDermott, Head of Morgan Stanley's North America Energy Team.

Mike Canfield: And I'm Mike Canfield, Head of the Europe Sustainability Team,

Michelle Weaver: This is the second episode of our special miniseries, Big Debates, where we cover key investment debates for 2025. Today, we'll look at where we are in the energy transition and some key investment opportunities.

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

Mike Canfield: And 3pm in London.

Michelle Weaver: Since 2005, U.S. carbon emissions have fallen by about 15 percent. Nearly all of this has been tied to the power sector. Natural gas has been displacing coal. Renewable resources have seen higher penetration. When you look outside the power sector, though, progress has been a lot more limited.

Let me come to you first, Devin. What is behind these trends, and where are we right now in terms of the energy transition in the U.S.?

Devin McDermott: Over the last 20 years now, it's actually been a pretty steady trend for overall U.S. emissions. There's been gradual annual declines, ratcheting lower through much of this period. [There’s] really two primary drivers.

The first is, the displacement of coal by natural gas, which is driven about 60 percent of this reduction over the period. And the remainder is higher penetration of renewable resources, which drive the remaining 40 percent. And this ratio between these two drivers -- net gas displacing coal, renewables adding to the power sector -- really hasn't changed all that much. It's been pretty consistent even in this post COVID recovery relative to the 15 years prior.

Outside of power, there's been almost no progress, and it doesn't vary much depending on which end market you're looking at. Industrial missions, manufacturing, PetChem -- all relatively stable. And then the transport sector, which for the U.S. in particular, relative to many other markets and the rest of the world, is a big driver transport, a big driver of emissions. And there it's a mix of different factors. The biggest of which, though, driving the slow uptick in alternatives is the lack of viable economic options to decarbonize outside of fossil fuels. And the fact that in the U.S. specifically, there is a very abundant, low-cost base of natural gas; which is a low carbon, the lowest carbon fossil fuel, but still does have carbon intensity tied to it.

Michelle Weaver: You've also argued that the domestic natural gas market is positioned for growth. What's your outlook for this year and beyond?

Devin McDermott: The natural gas market has been a story of growth for a while now, but these last few years have had a bit of a pause on major expansion.

From 2010 to 2020, that's when you saw the biggest uptick in natural gas penetration as a portion of primary energy in the U.S. The domestic market doubled in size over that 10-year period, and you saw growth in really every major end market power and decarbonization. There was a big piece of it. But the U.S. also transitioned from a major importer of LNG, which stands for liquefied natural gas, to one of the world's largest exporters by the end of last decade. And you had a lot of industrial and petrochemical growth, which uses natural gas as a feedstock.

Over the last several years, globally, gas markets have faced a series of shocks, the biggest of which is the Russia-Ukraine conflict and Europe's loss of a significant portion of their gas supply, which historically had come on pipelines from Russia. To replace that, Europe bought a lot more LNG, drove up global prices, and in response to higher global prices, you saw a wave of new project sanctioning activity around the world. The U.S. is a key driver of that expansion cycle.

The U.S. over the next five years will double; roughly double, I should say, its export capacity. And that is an unprecedented amount of volume growth domestically, as well as globally, and will drive a significant uptick in domestic consumption.

So that the additional exports is pillar number one; and pillar number two, which I'd say is more of an emerging trend, is the rise of incremental power consumption. For the last 15 years, U.S. electricity consumption on a weather adjusted basis has not grown. But if you look out at forecasts from utilities, from various market operators in the country, you're now seeing a trend of growth for the balance of this decade and beyond tied to three key things.

The first is onshore manufacturing. The second is power demand tied to data centers and AI. And the third is this broader trend of electrification. So, a little bit from EV's, more electric appliances, which fit into this decarbonization theme more broadly. We're looking at now an outlet, this is our base case of U.S. electricity demand growing at just shy of 2 percent per year over the next five years. That is a growth rate that we have not seen this century. And natural gas, which generates about 40 percent of U.S. power today, will continue to be a key player in meeting this incremental demand. And that becomes then a second pillar of consumption growth for the domestic market.

Michelle Weaver: And we're coming up on the inauguration here, and I think one really important question for investors is what's going to happen to the energy sector and to renewables when Trump takes office? What are you thinking here?

Devin McDermott: Yes. Well, the policy that supports renewable development in the U.S., wind and solar specifically, has survived many different administrations, both Republican and Democratic. And there's actually several examples over the last 10 to 15 years of Republican controlled Congress extending both the production tax credit and investment tax credit for wind and solar.

So, our base case is no major change on deployments, but also unlikely to see any incremental supportive policy for these technologies. Instead, I think the focus will be on some of the other major themes that we've been talking about here.

One, there's currently a pause on new LNG export permits under the Biden administration that should be lifted shortly post Trump's inauguration. Second, there are greenhouse gas intensity limits on new power plant and existing power plant construction in the U.S. that will likely be lifted, under the incoming Trump administration. So, gas takes a larger share of incremental power needs under Trump than it would have under the prior status quo. And then lastly. Consistently over the last few years, penetration of electric vehicles and low carbon vehicles in general in the United States have fallen short of expectations.

And interestingly, if you look at just the composition of new vehicles sold in the U.S. over the past years, nearly two-thirds were SUVs or heavier light duty vehicles that offset some of the other underlying trends of some uptick in EV penetration.

Under the prior Trump administration, there was a rollback of initiatives to improve the fuel economy of both light duty and heavy-duty transport. I would not be surprised if we see that same thing happen again, which means you have more longevity to gasoline, diesel, other fossil-based transport fuels. Which kind of put this all together -- significant growth for natural gas that could accelerate under Trump, more longevity to legacy businesses like gasoline and diesel for these incumbent energy companies is not a bad backdrop.

Trade's still at double its historical discount versus the broader market. So, not a bad setup when you put it all together.

Michelle Weaver: Great. Thank you, Devin. Mike, new policies under the second Trump administration will likely have an impact far beyond the U.S. And with a potential withdrawal of the U.S. from the Paris Agreement and increased greenhushing, many investors are starting to question whether companies may walk back or delay their sustainability ambitions.

Will decarbonization still be a corporate priority or will the pace of the energy transition in Europe slow in 2025?

Mike Canfield: Yeah, that's the big question. The core issues for EU policymakers at the moment include things like competitiveness, climate change, security, digitalization, migration and the cost of living.

At the same time, Mario Draghi highlighted in his report entitled “The Future of European Competitiveness” that there are three transformations Europe has to contend with: to become more innovative and competitive; to complete its energy transition; and to adapt to a backdrop of less stable geopolitics where dependencies are becoming vulnerabilities, to use his phrase.

We do still expect the EU's direction of travel on things like the Fit for 55 goals, its targets to address critical mineral supplies, and the overall net zero transition to remain consistent. And the UK's Labour Party has advocated for Clean Power 2030 goals of 95 percent clean generation sources.

At the same time, it's fair to say some commentators have pointed to the higher regulatory burden on EU corporates as a potentially damaging factor in competitiveness, suggesting that regulations are costly and can be overcomplicated, particularly for smaller companies. While we've already had a delay in the implementation of the EU's deforestation regulation, some questions do remain over other rules, including things like the corporate sustainability, due diligence directive, and the design of the carbon border adjustment mechanism or CBAM.

We're closely watching corporates themselves to see whether they'll reevaluate their investment plans or targets. One example we've actually already seen is in the metals and mining space where decarbonisation investment plans were adjusted because of inadequate green hydrogen infrastructure and policy concerns, such as the effectiveness of the CBAM.

It does remain committed to its long-term net zero goals. But the company has acknowledged that practical hurdles may delay achievement of its 2030 climate ambitions. We wouldn't be surprised to see other companies take an arguably more pragmatic, in inverted commas, approach to their goals, accepting that technology, infrastructure and policy might not really be ready in time to reach 2030 targets.

Michelle Weaver: Do you believe there are still areas where the end markets will grow significantly and where companies still offer compelling opportunities?

Mike Canfield: Yeah, absolutely. We think sustainable investing continues to evolve and that, as with last year, stock selection will be key to generating alpha from the energy transition. We do see really attractive opportunities in enabling technologies across decarbonisation, whether that's segments like grid transmission and distribution, or in things like Industry 4.0.

We'd recommend focusing on companies with clear competitive moats and avoiding the relatively commoditized areas, as well as looking for strong pricing power, and those entities offering mission critical products or services for the transition. We do anticipate a continued investment focus on data center power dynamics in 2025 with cooling technology increasingly a topic of investor interest.

Beyond the power generation component, the urgent need for investment in everything from electrical equipment to grid technologies, smart grid software and hardware solutions, and even cables is now increasingly apparent. We expect secular growth in these markets to continue apace in 2025.

Within Industry 4.0, we do think adoption of automation, robotics, machine learning, and the industrial Internet of Things is set to grow strongly this year as well. We also see further growth potential in other areas like energetic modernization in buildings, climate resilience, and the circular economy.

Michelle Weaver: And with the current level of policy uncertainty has enthusiasm for green investing or the ‘E’ environmental pillar of ESG declined

Mike Canfield: I think evolved might be a fairer expression to use than declined. Certainly, reasonable to say that performance in some of the segments of the E pillar has been very challenging in the last 12 to 24 months -- with the headwinds from geopolitics, from the higher interest rate backdrop and inflation. At the same time, we have seen a transition towards improver investment strategies, and they're continuing to gain in popularity around the world.

As investors recognize that often the most attractive alpha opportunities are in the momentum, or direction of travel rather than simple, so-called positive screening for existing leaders in various spaces. To this end, the investors that we speak to are often focused on things like Capex trends for businesses as a way to determine how companies might actually be investing to deliver on their sustainability ambitions.

Beyond those traditional E, areas like renewables or electric vehicles, we have therefore seen investors try to diversify exposures. So, broadening out to include things like the transition enablers, the grid technologies, HVAC -- that's heating, ventilation and cooling, products supporting energy efficiency in buildings, green construction and emerging technologies even, like small modular nuclear reactors alongside things like industrial automation.

Michelle Weaver: And, given this evolution of the e pillar, do you think that creates an opportunity for the S or G, the social or governance components of ESG?

Mike Canfield: We do think the backdrop for socially focused investing is very strong. We see compelling opportunities in longevity across a lot of elements, things like advanced diagnostics, healthier foods, as well as digitalization, responsible AI, personal mobility, and even parts of social infrastructure. So things as basic as access to water, sanitation, and hygiene.

One topic we as a team have written extensively on in the last few months It's preventative health care, for example. So, while current health systems are typically built to focus on acute conditions and react to complications with pharmaceuticals or clinical care, a focus on preventative care would, at its most fundamental, address the underlying causes of illnesses to avoid problems from arising in the first place.

We argue that the economic benefits of a more effective health system is self evident, whether that's in terms of reducing the overall burden on the system, boosting the workforce or increasing productivity. Within preventative healthcare, we point to fascinating investment opportunities across innovative biopharma, things like smart chemotherapy, for example, alongside solutions like integrated diagnostics, effective use of AI and sophisticated telemedicine advances -- all of which are emerging to support healthy longevity and a much more personalized targeted health system.

Michelle Weaver: Devin and Mike, thank you for taking the time to talk, and to our listeners, 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.

Big Debates: The AI Evolution

10 januari 2025 | 9 min

In the first of a special series, Morgan Stanley’s U.S. Thematic and Equity Strategist Michelle Weaver discusses new frontiers in artificial intelligence with Keith Weiss, Head of U.S. Software Research.

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Michelle: Welcome to Thoughts on the Market I'm Michelle Weaver, Morgan Stanley's U.S. Thematic and Equity Strategist.

Keith: And I'm Keith Weiss, Head of U.S. Software Research.

Michelle: This episode is the first episode of a special series we’re calling “Big Debates” – where we dig deeper into some of the many hot topics of conversation going on right now. Ideas that will shape global markets in 2025. First up in the series: Artificial Intelligence.

It's Friday, January 10th at 10am in New York.

When we look back at 2024, there were three major themes that Morgan Stanley Research followed. And AI and tech diffusion were among them. Throughout last year the market was largely focused on AI enablers – we’re talking semiconductors, data centers, and power companies. The companies that are really building out the infrastructure of AI.

Now though, as we’re looking ahead, that story is starting to change.

Keith, you cover enterprise software. Within your space, how will the AI story morph in 2025?

Keith: I do think 2025 is going to be an exciting year for software [be]cause a lot of these fundamental capabilities that have come out from the training of these models, of putting a lot of compute into the Large Language Models, those capabilities are now being built into software functionality. And that software functionality has been in the market long enough that investors can expect to see more of it come into results. That the product is there for people to actually buy on a go forward basis.

One of the avenues of that product that we're most excited about heading into 2025 is what we're calling agentic computing, where we're moving beyond chatbots to a more automated proactive type of interface into that software functionality that can handle more complex problems, handle it more accurately and really make use of that generative AI capability in a corporate or in an enterprise software setting as we head into 2025.

Michelle: Could you give us an example of what agentic AI is and how might an end user interact with it?

Keith: Sure. So, you and I have been interacting with chatbots a lot to gain access to this generative AI functionality. And if you think about the way you interact with that chatbot, right, you have a prompt, you have a question. You have to come up with the question. going to take that question and it's going to, try to contextually understand the nature of that question, and to the best of its ability it's going to give you back an answer.

In agentic computing, what you're looking for is to add more agency into that chatbot; meaning that it can reason more over the overall question. It's not just one model that it's going to be using to compose the answer. And it's not just the composition of an answer where the functionality of that chatbot is going to end. There's actually an ability to execute what that answer is. So, it can handle more complex problems.

And it could actually automate the execution of the answer to those problems.

Michelle: It sounds like this tech is going to have a massive impact on the workplace. Have you estimated what this could do to productivity?

Keith: Yeah, this is -- really aligns to the work that we did actually back in 2023, where we did our AI index, right. We came up with the conclusion that given the current capabilities of Large Language Models, 25 per cent of U.S. occupations are going to be impacted by these technologies. As the capabilities evolve, we think that could go as high as 45 per cent of U.S. labor touched by these productivity enhancing. Or, sort of, being replaced by these technologies. That equates to, at the high end, $4 trillion of labor that's being augmented or replaced on a go forward basis. The productivity gains still yet to be seen; how much of a productivity gain you could see on average. But the numbers are massive, right, in terms of the potential because it touches so much labor.

Michelle: And finally on agentic, is the market missing anything and how does your view differ from the consensus?

Keith: I think part of what the market is missing is that these agentic computing frameworks is not just one model, right? There's typically a reasoning engine of some sort that's organizing multiple models, multiple components of the system that enable you to -- one, handle more complex queries, more complex problems to be solved, lets you actually execute to the answer. So, there's execution capabilities that come along with that. And equally as important, put more error correction into the system as well. So, you could have agents that are actually ensuring you have a higher accuracy of the answer.

It's the sugar that's going to make the medicine go down, if you will. It's going to make a lot easier to adopt in enterprise environments. I think that's why we're a little bit more optimistic about the pace of adoption and the adoption curves we could see with agentic computing despite the fact it's a relatively early-stage technology.

Michelle: You just mentioned Large Language Models, or LLMs; and one barrier there has been training these models. It requires a ton of computing power, among other constraints. How are companies addressing this, and what's in the cards for next year?

Keith: So, if you think about the demand for that compute in our mind comes from two fundamental sources. And as a software analyst, I break this down into research versus development, right? Research is investment that you make to find core fundamental capabilities.

Development is when you take those capabilities and make the investment to create product out of it. Thus far, again, the primary focus has been on the training side of the equation.

I think that part of the equation looks to be asymptotic to a certain extent. The – what people call the scaling laws, the amount of incremental capability that you're getting from putting more compute at the equation is starting to come down.

What people are overlooking is the amount of improvement that you could see from the development side of the equation. So, whereas the demand for GPUs, the demand for data center for that pure training side of the equation might start to slow down a little bit, I think what we're going to see expand greatly is the demand for inference, the demand to utilize these models more fully to solve real business problems.

In terms of where we're going to source this; there are constraints in terms of data center capacity. The companies that we cover, they've been thinking about these problems for the past decade, right? And they have these decade long planning cycles. They have good visibility in terms of being able to meet that demand in the immediate future. But these questions on how we are going to power these data centers is definitely top of mind for our companies, and they're looking for new sources of power and trying to get more creative there.

The pace with which data centers can be built out is a fundamental constraint in terms of how quickly this demand can be realized. So those supply constraints I don't think are going to be a immediate limiter for any of our names when we're thinking about calendar [20]25. But definitely, part of the planning process and part of the longer-term forecasting for all of these companies in terms of where are they going to find all this fundamental resource – because whether it's training or inference, still a lot of GPUs are going to be needed. A lot of compute is going to be needed.

Michelle: Recently we've been hearing about so called artificial general intelligence or AGI. What is it? And do you think we're going to see it in 2025?

Keith: Yeah, so, AGI is the – it's basically the holy grail of all of these development efforts. Can we come up with models that can reason in the human world as well as we can, right? That can understand the inputs that we give it, understand the domains that we're trying to operate in as well or better than we can, so it can solve problems as effectively and as efficiently as we can.

The easiest way to solve that systems integration problem of like, how can we get the software, how could we get the computers to interact with the world in the way that we do? Or get all the impact that we do is for it to replicate all those functionalities. For it to be able to reason over unstructured text the same way we do. To take visual stimuli the same way that we do. And then we don't have to take data and put into a format that's readable by the system anymore.

2025 is probably too early to be thinking about AGI, to be honest. Most technologists think that there's more breakthroughs needed before the algorithms are going to be that good; before the models are going to be that good.

There's very few people who think Large Language Models and the scaling of Large Language Models in themselves are going to get us to that AGI. You're probably talking 10 to 20 years before we truly see AGI emerge. So, 2025 is probably a little bit too early.

Michelle: Well, great, Keith. Thank you for taking the time to talk and helping us kick off big debates. It looks like 2025 we'll see some major developments in AI.

And to our listeners, 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.

2025: Setting Expectations

10 januari 2025 | 4 min

Our Head of Corporate Credit Research, Andrew Sheets, offers up bull, bear and base cases for credit markets in the year ahead.

----- Transcript -----

Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today, I’m going to revisit our story for 2025 – and what could make things better or worse.

It's Thursday, January 9th at 2pm in London.

Based on the number of out-of-office replies, I have a sneaking suspicion that many investors took advantage [of] the timing of holidays this year for a well deserved break. With this week marking the first full week back, I thought it would be a good opportunity to refresh listeners on what we expect in 2025, and realistic scenarios where things are better or worse.

Our base case is that credit holds up well this year, doing somewhat better in the first half of 2025 than the second. Credit likes moderation, and while we think the shift in U.S. policy leadership generally means less moderation, and a wider range of economic outcomes, this shift doesn’t arrive immediately. On Morgan Stanley’s forecasts, the bulk of the disruptive impact from any changes to tariffs or immigration policy hits in 2026.

Meanwhile, Credit is entering 2025 with some pretty decent tailwinds. The economy is good. The all-in yield – the total yield – on US investment grade corporate bonds, at above 5.4 per cent, is the highest to start any year since January of 2009 – which we think helps demand. And while we think corporate confidence and aggression will rise this year, normally a bad thing for credit; this is going to be coming off of a low, conservative starting point.

We think that credit spreads will be modestly tighter by mid-year relative to where they finished 2024, and then start to widen modestly in the second half of the year – as the market attempts to price that greater policy uncertainty in 2026. We think that issuers in the Financial and Utilities sectors outperform, and we think bonds between five- and ten-year maturity will do the best.

The bear case is that we exit the current period of moderation more quickly. At one end, a deregulatory push by a new administration could usher in an even faster rise in corporate confidence and aggression, leading to more borrowing and riskier dealmaking. At the other extreme, the strong current state of the economy and jobs market could make further gains harder to come by. If the rise in unemployment that our economists expect in 2026 is larger or arrives earlier, credit could start to weaken well ahead of this.

So, how could things be better – especially given the relatively low, tight starting point for credit spreads? Well, we’d argue that the current mix of data for credit is border-line ideal: reasonable growth, falling inflation, still-low levels of corporate aggressiveness, and still-high yields that are attracting buyers. Recall that the tightest levels of credit in the modern era, which are still tighter than today, occurred during a period with similar characteristics – the mid-1990s.

When thinking about the mid-90s as a bull case, there’s a further detail that’s relevant and topical, especially this week. At that time, interest rates stayed somewhat high and the Fed only lowered short-term rates modestly because the economy held up. In short, in the best environment that we’ve seen for credit, less action by the Federal Reserve was fine – so long as the economic data was good.

This is a bull-case, rather than our base case, because there are also a number of key differences with the mid 1990s, not the least being a much worse trajectory – today – for the US government's budget. But in a scenario where things change less, and the status quo lasts longer, it could come into play.

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

Market Implications of Trump’s Agenda

8 januari 2025 | 4 min

With the inauguration of President-elect Donald Trump approaching, our Global Head of Fixed Income and Public Policy Research weighs the impact for investors of his potential policy measures.

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Welcome to Thoughts on the Market. I’m Michael Zezas, Morgan Stanley’s Global Head of Fixed Income and Public Policy Research. Today on the podcast I'll be talking about what investors need to know about recent US policy developments.

It’s Wednesday, Jan 8th, at 2:30pm in New York.

In less than two weeks, Donald Trump will again become the sitting President of the United States. The economic and market consequences of the policies he might enact, either on his own or in concert with the Congress, continue to be an important debate for investors. Our view has been that the sequencing and severity of policy choices across tariffs, taxes, immigration, and regulation would be very meaningful to the market's outlook.

So, have we learned anything from news around the policy discussions inside the incoming administration and congressional leaders? Let’s consider it here and level set.

First, there‘s been news about Republicans debating their approach to legislating some of President Trump’s top policy priorities. That debate centers around whether to create one big bill around taxes, immigration, and a host of other issues or to break it into multiple bills. Leading with immigration reforms, where there may be more consensus within Republicans’ slim Congressional majority; and then following it up with tax cuts and extensions, which may take more time to negotiate given myriad interests. While investors have asked us about this debate quite a bit, the distinction between the approaches may not make much of a difference to investors.

At the end of the day, what should matter most to markets is the timing and size of the fiscal impact driven by tax changes. Going with one big bill may seem faster, but we’re reminded of the saying ‘Nothing is agreed until everything is agreed.’ In other words, that one big bill would probably only pass as fast as Republicans could agree on its toughest negotiating points – so likely not very soon.

As for the size of fiscal impact, we continue to see consensus around extending most of the tax cuts that expire at the end of 2025, with some new benefits, like a domestic manufacturing tax credit. So, there should be some fiscal expansion in 2026, a few hundred billion dollars in our view; but this is meaningfully different than the trillions of dollars that the media cites when discussing the whole of the tax policy wish list.

There’s also been some news on the approach to tariffs, but again it seems more noise than signal. Recent media reports are that Trump might adopt a tariff plan focused on specific products as opposed to a blanket approach on all imports. Trump denied the report via social media. But even if he hadn’t, it's unclear that such a plan could be executed quickly through existing executive powers or through legislation, where it's far from clear that tariffs could be enacted given Democrats' opposition and procedural barriers from budget reconciliation. So, our view remains that new tariffs will likely be enacted but through executive authority – which means a phased-in focus on China and Europe in 2025; and any new authorities developed via existing laws might not be enactable until 2026. So said more simply, the impact of tariffs on the economy may be a late 2025 into 2026 story.

Putting it together for investors: So far, the news flow hasn’t materially changed our view on the US policy path. Yes, important policy changes are coming, but their implementation may be slow. That should mean that, to start 2025, the healthy fundamentals of the US economy should help drive risk markets, namely U.S. equities and corporate credit, to outperform. If we’re wrong and, for example, tariffs are implemented in larger magnitude at a quicker pace, then it may be a year where less risky assets, like government bonds, outperform.

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.

What Could Shape the Global Economy in 2025

7 januari 2025 | 5 min

Our Global Chief Economist Seth Carpenter weighs the myriad variables which could impact global markets in 2025, and why this year may be the most uncertain for economies since the start of the pandemic.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist, and today I'll be talking about 2025 and what we might expect in the global economy.

It's Tuesday, January 7th at 10am in New York.

Normally, our year ahead outlook is a roadmap for markets. But for 2025, it feels a bit more like a choose your own adventure book.

uncertainty is a key theme that we highlighted in our year ahead outlook. The new U.S. administration, in particular, will choose its own adventure with tariffs, immigration, and fiscal policy.

Some of the uncertainty is already visible in markets with the repricing of the Fed at the December meeting and the strengthening of the dollar. Our baseline has disinflation stalling on the back of tariffs and immigration policy, while growth moderates, but only late in the year as the policies are gradually phased in.

But in reality, the sequencing, the magnitude and the timing of these policies remains unknown for now, but they're going to have big implications for the economies and central banks around the world. The U.S. economy comes into the year on solid footing with healthy payrolls and solid consumption spending.

Disinflation is continuing, and the inflation data for November were in line with our forecast, but softer in terms of PCE than what the Fed expected. While the Fed did lower their policy rate 25 basis points at the December meeting, Chair Powell's tone was very cautious, and the Fed's projections had inflation risks skewed to the upside.

The chair noted that the FOMC was only beginning to build in assumptions about policy changes from the new administration. Now, we have conviction that tariffs and immigration restriction will both slow the economy and boost inflation -- but we've assumed that these policies are phased in gradually over the entirety of the year. And consequently -- that materially Stagflationary impetus? Well, it's reserved for 2026, not this year.

Similarly, we've assumed that effectively the entire year is consumed by the process of tax cut extensions. And so, we've penciled in no meaningful fiscal impetus for this year. And in fact, with the bulk of the process simply extending current tax policy, we have very little net fiscal impact, even in 2026.

Now, in China, the deflationary pressure is set to continue with any policy reaction further complicated by U.S. policy uncertainty. The policymaker meeting in late December that they held provided only a modest upside surprise in terms of fiscal stimulus, so we're going to have to wait for any further details on that spending until March with the National People's Congress.

Meanwhile, during our holiday break, the renminbi broke above 7.3, and that level matches roughly the peaks that we saw in 2022 and 2023. The strong dollar is clearly weighing on the fixing. The framework for policy will have to account for a potentially trade relationship with the U.S. So, again, in China, there's a great deal of uncertainty, a lot of it driven by policy.

The euro area is arguably less exposed to U.S. trade risks than China. A weaker euro may help stabilize inflation that's trending lower there, but our growth forecasts suggest a tepid outlook. Private consumption spending should moderate, and maybe firm a bit, as inflation continues to fall, and continued policy easing from the ECB should support CapEx spending.

Fiscal consolidation, though, is a key risk to growth, especially in France and Italy, and any postponement in investment from potential trade tensions could further weaken growth.

Now, in Japan, the key debate is whether the Bank of Japan will raise rates in January or March. After the last Bank of Japan meeting, Governor Ueda indicated a desire for greater confidence on the inflation outlook.

Nonetheless, we've retained our call that the hike will be in January because we believe the Bank of Japan's regional Branch manager meeting will give sufficient insight about a strong wage trend. And in combination with the currency weakness that we've been watching, we think that's gonna be enough for the BOJ to hike this month. Alternatively, the BOJ might wait until the Rengo negotiation results come out in March to decide if a hike is appropriate. So far, the data remains supportive and Japanese style core CPI inflation has gone to 2.7 per cent in November. The market's going to focus on Deputy Governor Himino's speech on January 14th for clues on the timing – January or March.

Finally, as the Central Bank of Mexico highlighted in their most recent rate cut decision, caution is the word as we enter the new year. As economists, we could not agree more. The year ahead is the most uncertain since the start of the pandemic. Politics and policy are inherently difficult to forecast. We fully expect to revise our forecasts more -- and more often than usual.

Thanks for listening, and 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.

Will 2024’s Weak Finish Extend into the New Year?

6 januari 2025 | 5 min

Our CIO and Chief U.S. Equity Strategist Mike Wilson considers the year-end slump in U.S. stocks, and whether more market-friendly policies can change the narrative.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Today on the podcast I’ll be discussing the weak finish to 2024 and what it means for 2025.

It's Monday, Jan 6th at 11:30am in New York.

So let’s get after it.

While 2024 was another solid year for US equity markets, December was not. The weak finish to the year is likely attributable to several factors. First, from September to the end of November, equity markets had one of their better 3-month runs that also capped the historically strong 1- and 2-year advances. This rally was due to a combination of events including a reversal of recession fears this summer, an aggressive 50 basis points start to a new Fed cutting cycle, and an election that resulted in both a Republican sweep and an unchallenged outcome that led to covering of hedges into early December. This also lines up with my view in October that the S&P 500 could run to 6,100 on a decisive election outcome.

Second, long-term interest rates have backed up considerably since the summer when recession fears peaked. Importantly, this 100 basis point back-up in the 10-year US Treasury yield occurred as the Fed cut interest rates by 100 basis points. In my view, the bond market may be calling into question the Fed’s decision to cut rates so aggressively in the context of stabilizing employment data. The fact that the term premium has risen by 77 basis points from the September lows is also significant and may be a by-product of this dynamic and uncertainty around fiscal sustainability. As we suggested two months ago, if the change in the term premium was to materially exceed 50 basis points, the equity market could start to take notice and hurt valuations. Indeed, Equity multiples peaked in early- to mid-December around the time when the term premium crossed this threshold.

Finally, the rise in rates and the Trump election win has ushered in a stronger dollar which is now reaching a level that could also weigh on equities with significant international exposure. More specifically, the US dollar is quickly approaching the 10 per cent year-over-year rate of change threshold that has historically pressured S&P 500 earnings growth and guidance.

All of these factors have combined to weigh on market breadth, something that still looks like a warning. The divergence between the S&P 500 Index as a ratio of its 200-day moving average and the percent of stocks trading above their 200-day moving average has rarely been wider. This divergence can close in two ways—either breadth improves or the S&P 500 trades closer to its own 200-day moving average, which is 10 per cent below current prices. The first scenario likely relies on a combination of lower rates, a weaker dollar, clarity on tariff policy and stronger earnings revisions. In the absence of those developments, we think 2025 could be a year of two halves with the first half being more challenged before the more market-friendly policy changes can have their desired effects.

It's also worth pointing out that this gap between index pricing and breadth has been more persistent in recent years, something that we attribute to the generous liquidity provisions provided by the Treasury and the Fed. It's also been aided by interventions from other central banks. While not a perfect measure, we do find that the year-over-year change in global money supply in US Dollars is a good way to monitor key inflection points, and that measure has recently rolled over again.

The recent moves in rates and US dollar is just another reason to stick with quality equities. Our quality bias is rooted in the notion that we remain in a later cycle environment which is typical of a backdrop that is consistent with outperformance of this cohort and the fact that the relative earnings revisions for this high quality factor are inflecting higher. As long as these dynamics persist, we think it also makes sense to stay selective within cyclicals and focused on areas of the market that are showing clear relative strength in earnings revisions. These groups include Software, Financials, and Media & Entertainment.

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

Lessons to Take Into 2025

3 januari 2025 | 4 min

With the start of the new year, our Head of Corporate Credit Research Andrew Sheets looks back to look ahead at trends for credit and other markets in 2025.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today I’ll be discussing the lessons we can learn from 2024 – a remarkable year that also may be easily forgotten.

It's Friday January 3rd at 2pm in London.

In 2024 I celebrated my 20th year with Morgan Stanley. Among my regrets over this time was not keeping a better journal. It’s notable how quickly events in the market that seemed large and remarkable at the time can fade in one’s memory as the years merge together. How markets that seem easy or obvious in hindsight were anything but.

I say this because many years from now, 2024 may end up being one of those relatively forgettable years. Another year where – as usually happens – the stock market went up. Another year where stocks outperformed bonds, the US dollar strengthened, and US stocks beat those abroad.

Yet what is significant about 2024 is the scale of all these trends. For anyone managing money, the question of “stocks versus bonds”, “US versus rest-of-world”, “large versus small” or “growth versus value” are some of the most fundamental strategic questions one faces.

These calls don’t always matter. But last year, they did – to a very large degree. Global stocks outperformed bonds by about 20 percent. Growth outperformed Value by practically the same amount. US stocks beat their global peers by 13 per cent. In short, one’s experience in 2024 and relative performance could have varied significantly, based on just a few relatively simple decisions.

Related to that is the second lesson. 2024 was the reminder that while Valuation is a powerful long-term force, it can be a much more frustrating 12-month guide. All of those relative relationships I just mentioned – stocks versus bonds, growth versus value, US versus International – all worked in favor of the market that was historically richer entering last year.

For our third lesson from last year, we’ll focus on Credit, where investors earned a premium over safer government bonds by lending to riskier corporate borrowers. Notable for this asset class in 2024 was, for the most part, it did its own thing; showing some encouraging independence from other markets and highlighting the value of digging into a borrower’s details.

Specifically, I think this independence showed up in a few different ways. Credit showed low correlation to government bonds, for example, delivering good excess returns despite very large swings in yields or central bank expectations. It also, even more impressively, bucked some of 2024’s biggest trends.

For example, while the outperformance of the US economy and US assets was one of the biggest stories of 2024, that wasn’t the case in Credit – where Europe and Asia credit actually did marginally better. In contrast to the equity market, smaller companies and Credit outperformed, as spreads and higher yielded loans outperformed larger Investment Grade spreads, even after adjusting for risk.

And this was true even at a more granular level. Rising corporate activity, alongside more aggressive strategies for companies to deal with their own borrowing created very dispersed outcomes driven by bond-level documentation; far removed from the macro machinations of politics and monetary policy.

This somewhat weaker connection to the broader world is central to how we think about Credit looking ahead. While big economic and political questions certainly loom in 2025, we think that Credit, for now, will be driven more by more micro, company level trends, and show somewhat lower correlation to other assets – at least through the first half of this year.

From all of us at Thoughts on the Market, we wish you a very Happy New Year, and all the best for 2025.

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

A Bumpy Road Ahead for Onshoring EVs

2 januari 2025 | 5 min

Our Head of Global Autos & Shared Mobility Adam Jonas discusses why the electric vehicle market may see a small reset in 2025, but ultimately accelerate under a Trump Administration.

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Adam Jonas: Welcome to Thoughts on the Market. I'm Adam Jonas, Morgan Stanley's Head of Global Autos and Shared Mobility. Today, I'll be talking about the outlook for U.S. automakers and electric vehicles.

It's Thursday, January 2nd at 1pm in New York.

With Trump's inauguration just around the corner, we've seen a resurgence in many auto stocks tied to Internal Combustion Engines, also known as ICE. While questions swirl around the outlook for electric vehicles. In the near term we do think it'll be a bumpy ride for the U.S. EV market. But looking toward the second half of this year and beyond, we think there's hidden value in the EV sector for a number of reasons.

First, let's look at the big picture. In our 2025 outlook for U.S. auto sales, we anticipate demand of 16.3 million units, a modest increase from the previous year, underpinned by projected U.S. GDP growth of around 1.9 percent and lower policy interest rates for auto loans. Looking specifically at EVs, we think the trajectory will be first a dip, then a rip scenario. That is, we're lowering our 2025 forecasts for U.S. EV penetration to 8.5 percent, down slightly from 9 percent previously. However, our long-term outlook remains unchanged, and we continue to forecast significant growth for EVs by 2040.

Now for the big question. What does a Trump administration mean for EVs? Following the U.S. election, investors hopped on the ‘ICE is Nice’ trade based on the expectation that a Trump administration will bring more relaxed U.S. emission standards, reduced EV incentives, and finally increased tariffs – which would drive up the costs of key EV components, such as batteries and semiconductors, predominantly manufactured in Asia.

But the real story is more nuanced. You can't talk about EVs without talking about Elon Musk, who will be leading Trump's Department of Government Efficiency. And we struggle with the idea that the incoming Trump administration working in close partnership with Musk would structurally impede U.S. participation in two of the most important industrial transitions in over a century: electrification and embodied AI.

If the U.S. wants to be a leader in autonomy, it must ultimately embrace EVs, which are the sockets of autonomous capability, and expand its EV infrastructure. How long will the U.S. cling to the soothing vibrations of its internal combustion fleet, while its rivals in China solidify their dominance in software defined electric mobility? Not for very long, in our opinion.

While a rolling back of incentives under Trump may make 2025 a reset year for EV adoption, we view this mainly as a temporary action to help support a more capable and sustainable crop of domestic champions.

That takes us to a resurgence in U.S. onshoring. Bringing manufacturing back to American soil has gained significant momentum and is another factor influencing the long-term outlook; not just for EV makers, but the entire supply chain. With the U.S. light vehicle market predominantly ICE-based at 92 percent of total sales, the real issue isn't the presence of gas powered combustion engines, but the glaring lack of advanced onshore EV production capabilities.

Again, this puts the U.S. at a disadvantage compared to its global competitors and raises questions the Trump administration will need to address. Just what type of manufacturing does the U.S. want to prioritize? Are we looking to maintain the status quo with ICE, or are we aiming to be at the forefront of EV technology?

No doubt, the U.S. auto industry stands at a crossroads between maintaining traditional technologies and embracing new, potentially disruptive advancements in EV and AV sectors. The decisions made in the next few years will likely dictate the pace and direction of the U.S.'s role in the global automotive landscape; and for investors, this brings new challenges – as well as opportunities.

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

Special Encore: Will US Tariffs Drive Mexico Closer to China?

31 december 2024 | 10 min

Original Release Date November 22, 2024: Our US Public Policy Strategist Ariana Salvatore and Chief Latin America Equity Strategist Nikolaj Lippmann discuss what Trump’s victory could mean for new trade relationships.

----- Transcript -----

Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's US Public Policy Strategist.

Nikolaj Lippmann: And I'm Nik Lippmann, Morgan Stanley's Chief Latin American Equity Strategist.

Ariana Salvatore: Today, we're talking about the impact of the US election on Mexico's economy, financial markets, and its trade relationships with both the US and China.

It's Friday, November 22nd at 10am in New York.

The US election has generated a lot of debate around global trade, and now that Trump has won, all eyes are on tariffs. Nik, how much is this weighing on Mexico investors?

Nikolaj Lippmann: It’s interesting because there's kind of no real consensus here. I'd say international and US investors are generally rather apprehensive about getting in front of the Trump risk in Mexico; while, interestingly enough, most Mexico-based investors and many Latin American investors think Trump is kind of good news for Mexico, and in many cases, even better news than Biden or Harris. Net, net, Mexican peso has sold off. Mexico's now down 25 per cent in dollar terms year to date, while it was flat to up three, four, 5 per cent around May. So, we've already seen a lot being priced then.

Ariana, what are your expectations for Trump's trade policy with regards to Mexico?

Ariana Salvatore: So, Mexico has been a big part of the trade debate, especially as we consider this question of whether or not Mexico represents a bridge or a buffer between the US and China. On the tariff front, we've been clear about our expectations that a wide range of outcomes is possible here, especially because the president can do so much without congressional approval.

Specifically on Mexico, Trump has in the past threatened an increase in exchange for certain policy concessions. For example, back in 2019, he threatened a 5 per cent tariff if the Mexican government didn't send emergency authorities to the southern border. We think given the salience of immigration as a topic this election cycle, we can easily envision a scenario again in which those tariff threats re-emerge.

However, there's really a balance to strike here because the US is Mexico's main trading partner. That means any changes to current policy will have a substantial impact.

So, Nik, how are you thinking about these changes? Are all tariff plans necessarily a negative? Or do you see any potential opportunities for Mexico here?

Nikolaj Lippmann: Look, I think there are clear risks, but here are my thoughts. It would be very hard for the United States to de-risk from China and de-risk from Mexico simultaneously. Here it becomes really important to double-click on the differences in the manufacturing ecosystems in North America versus Southeast Asia and China.

The North American model is really very integrated. US companies are by a mile the biggest investor. In Mexico – and Mexican exports to the US kind of match the Mexican import categories – the products go back and forth. Mexico has evolved from a place of assembly to a manufacturing ecosystem. 25 years ago, it was more about sending products down, paint them blue, put a lid on it. Now there's much more value add.

The link, however, is still alive. It's a play on enhancing US competitiveness. You can kind of, as you did, call it a China buffer; a fender that helps protect US competitiveness. But by the end of the day, I think integration and alignment is going to be the key here.

Ariana Salvatore: But of course, it's not just the direct trade relationship between the US and Mexico. We need to also consider the global geopolitical landscape, and specifically this question of the role of China. What's Mexico's current trade policy like with China?

Nikolaj Lippmann: Another great question, Ariana, and I think this is the key. There is growing evidence that China is trying to use Mexico as a China bridge.

And I think this is an area where we will see the biggest adjustments or need for realignment. This is a debate we've been following. We saw, with interest, that Mexico introduced first a 25 per cent tariff and then a 35 per cent tariff on Chinese imports. And saw this as the initial signs of growing alignment between the two countries.

However, Mexican import from China never really dropped. So, we started looking at like the complicated math saying 35 per cent times $115 billion of import. You know, best case scenario, Mexico should be collecting $40 billion from tariffs; that's huge and almost unrealistic number for Mexico. Even half of that would go a long way to solve fiscal challenges in that country.

However, when we started looking at the actual tax collection from Chinese imports, it was closer to $3 billion, as we highlighted in a note with our Mexico economist just recently. There's just multiple discounts and exemptions to effective tariffs at neither 25 per cent nor 35 per cent, but actually closer to 2.5 [or] 3 per cent. I think there's a problem with Chinese content in Mexican exports, and I think it's likely to be an area that policymakers will examine more closely. Why not drive-up US or North American content?

Ariana Salvatore: So, it sounds like what you're saying is that there is a political, or rhetorical at least, alignment between the US and Mexico when it comes to China. But the reality is that the policy implementation is not yet there.

We know that there's currently nothing in the USMCA treaty that prevents Mexico from importing goods from China. But a lot has changed over the past four years, even since the pandemic. So, looking forward, do you expect Mexico's policy vis-a-vis China to change after Trump takes office?

Nikolaj Lippmann: I think, I certainly think so, and I think this is again; this is going to be the key. As you mentioned, there's nothing in the USMCA treaty that prevents Mexico from buying the stuff from China. And it's not a customs union. Mexican consumers, much like American consumers, like to buy cheap stuff.

However, the geopolitics that you refer to is important. And when I reflect, frankly, on the bilateral relationship between the two countries, I think Mexican policymakers need to perhaps pause and think a little bit about things like the spirit of the treaty and not just the letter of the treaty; and also about how to maintain public opinion support in the United States.

By the end of the day, when we see what has happened with regards to China after the pandemic, it has been a significant change in political consensus and public opinion. When I think Americans are not necessarily interested in just using Mexico as a China bridge for Chinese products.

During the first Trump administration, the NAFTA agreement was renegotiated as the US Mexico Canada agreement, the USMCA, that took effect or took force in mid 2020. This agreement will come under review in 2026.

Ariana, what are the expectations for the future of this agreement under the Trump administration?

Ariana Salvatore: So, I think this USMCA review that's coming up in 2026 is going to be a really critical litmus test of the US-Mexico relationship, and we're going to learn a lot about this China bridge or buffer question that you mentioned. Just for some very brief context, that agreement as you mentioned was signed in 2020, but it includes a clause that lets all parties evaluate the agreement six years into a 16-year time horizon.

So, at that point, they can decide to extend the agreement for another 16 years. Or to conduct a joint review on an annual basis until that original 16 years lapses. So, although the agreement will stay in force until at least 2036, the review period, which is around June of [20]26, provides an opportunity for the signing parties to provide recommendations or propose changes to the agreement short of a full-scale renegotiation.

We do see some overlapping objectives between the two parties. For example, things like updating the foundation for digital trade and AI, ensuring the endurance of labor protections, and addressing Mexico's energy sector. But Trump's approach likely will involve confronting the auto EV disputes and could possibly introduce an element of immigration policy within the revision. We also definitely expect this theme of Chinese investment in Mexico to feature heavily in the USMCA review discussions.

Finally, Nik, keeping in mind everything that we've discussed today, with global supply chains getting rewired post the pandemic, Mexico has been a beneficiary of the nearshoring trend. Do you think this is going to change as we look ahead?

Nikolaj Lippmann: So, look, we [are] still underweight Mexico, but I think risk ultimately biased with the upside over time with regards to trade.

We need evidence to be able to lay it out, these scenarios; Mexico could end up doing quite well with Trump. But much work needs to be done south of the border with regards to all the areas that we just mentioned there, Ariana.

When we reflect on this over the next couple of years, there's a couple of things that really stand out. Number one is that first wave of reshoring or nearshoring, which was really focused on brownfield. It was bringing our manufacturing ecosystems where we already had existing infrastructure.

What is potentially next, and what we're going to be watching in terms of sort of policy maker incentives and so on, will be some of the greenfield manufacturing ecosystems. That could involve things like IT hardware, maybe EV batteries, and a couple of other really important sectors.

Ariana Salvatore: And that's something we might get some insight into when we hear personnel appointments from President-elect Trump over the coming months. Nik, thanks so much for taking the time to talk.

Nikolaj Lippmann: Thank you very much, Arianna.

Ariana Salvatore: And thank you 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.

Special Encore: Uncertainty Surrounds 2025 U.S. Equities Outlook

30 december 2024 | 12 min

Original Release Date November 26, 2024: Morgan Stanley’s CIO and Chief U.S. Equity Strategist Mike Wilson joins Andrew Pauker of the U.S. Equity Strategy team to break down the key issues for equity markets ahead of 2025, including the impact of potential deregulation and tariffs.

----- Transcript -----

Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Mike Wilson: Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist.

Andrew Pauker: And I'm Andrew Pauker from our US Equity Strategy Team.

Mike Wilson: Today we'll discuss our 2025 outlook for US equities.

It's Tuesday, November 26th at 5pm.

So let's get after it.

Andrew Pauker: Mike, we're forecasting a year-end 2025 price target of 6,500 for the S&P 500. That's about 9 percent upside from current levels. Walk us through the drivers of that price target from an earnings and valuation standpoint.

Mike Wilson: Yeah, I mean, I think, you know, this is really just rolling forward what we did this summer, which is we started to incorporate our economists’ soft-landing views. And, of course, our rate strategist view for 10-year yields, which, you know, factors into valuation.

We really didn't change any of our earnings forecast. That's where we've been very accurate. What we've been not accurate is on the multiple. And I think a lot of clients have also -- investors -- have been probably a little bit too conservative on their multiple assumption. And so, we went back and looked at, you know, periods when earnings growth is above average, which is what we're expecting. And that's just about 8 percent; anything north of that. Plus, when the Fed is actually cutting rates, which was not the case this past summer, it's just very difficult to see multiples go down. So, we actually do have about 5 percent depreciation in our multiple assumption on a year-over-year basis, but still it's very high relative to history.

But if the base case plays out, but from an economic standpoint and from a rate standpoint, it's unlikely earnings rates are going to come down. So, then we basically can get all of the appreciation from our earnings forecast for about, you know, 10-12 percent; a little bit of a discount from multiples, that gets you your 9 percent upside.

I just want to, you know, make sure listeners understand that the macro-outcomes are still very uncertain. And so just like this year, you know, we maybe pivot back and forth throughout the year … as [it] becomes [clear], you know, what the outcome is actually going to be.

For example, growth could be better; growth could be worse; rates could be higher; the Fed may not cut rates; they may have to raise rates again if inflation comes back. So, I would just, you know, make sure people understand it's not going to be a straight line no matter what happens. And we're going to try to navigate that with, you know, our style sector picks.

Andrew Pauker: There are a number of new policy dynamics to think through post the election that may have a significant impact on markets as we head into 2025, Mike. What are the potential policy changes that you think could be most impactful for equities next year?

Mike Wilson: Yeah, and I think a lot of this started to get discounted into the markets this fall, you know, the prediction polls were kinda leaning towards a Republican win, starting really in June – and it kind of went back and forth and then it really picked up steam in September and October. And the thing that the markets, equity market, are most excited about I would say, is this idea of deregulation. You know, that's something President-elect Trump has talked about. The Republicans seem to be on board with that. That sort of business friendly, if you will, kind of a repeat of his first term.

I would say on the negative side what markets are maybe wary about, of course, is tariffs. But here there’s a lot of uncertainty too. We obviously got a tweet last night from President-elect Trump, and it was, you know, 10 percent additional tariffs on certain things. And there’s just a lot of confusion. Some stocks sold off on that. But remember a lot of stocks rallied yesterday on the news of Scott Bessent being announced as Treasury Secretary because he's maybe not going to be as tough on tariffs.

So, what I view the next two months as is sort of a trial period where we're going to see a lot of announcements going out. And then the people in the cabinet positions who are appointed along with the President-elect are going to look at how the market reacts. And they're going to want to try to, you know, think about that in the context of how they're going to propose policy when they actually take office.

So, a lot of volatility over the next two months as these announcements are kind of floated out there as trial balloons. And then, of course, you also have the enforcement of immigration and the impact there on growth and also labor supply and labor costs. And that could be a net negative in the first half of next year. And so, look, it's going to be about the sequencing. Those are the two easy ones that you can see – tariffs of some form, and of course, immigration enforcement. And those are probably the two biggest potential negatives in the first half of next year.

Andrew Pauker: Mike, the title of our Outlook is “Stay Nimble Amid Changing Market Leadership,” and I think that reflects our mentality when it comes to remaining focused on capturing the leadership changes under the surface of the market. We rotated from a defensive posture over the summer to a more pro-cyclical stance in the fall. Talk about our latest views when it comes to positioning across styles, themes, and sectors here.

Mike Wilson: Yeah, I mean, you know, you have to understand that that pivot was not about the election as much as it was about kind of the economy, moving from the risk of a hard landing, which people were worried about this summer to, soft landing again. And then of course we got the Fed to, you know, aggressively begin a new rate cutting cycle with 50 basis points, which was a bit of a surprise given, you know, the context of a still decent labor markets.

That was the main reason for kind of the cyclical pivot, and then, of course, the election outcome sort of turbocharges some of that. So that's why we're sticking with it for now.

So, to be more specific, what we basically did was we went to quality cyclical rotation. What does that mean? It means, you know, we prefer things like financials, maybe industrials, kind of a close second from a sector standpoint. But this quality feature we think is important for people to consider because interest rates are still pretty high. You know, balance sheets are still a little stretched and, you know, price levels are still high.

So that means that lower quality businesses -- and the stocks of those lower quality businesses -- are probably a higher risk than we want to assume right now. But going into year end first and in 2025, we're going to stick with what we've sort of been recommending. On the defensive side. We didn't abandon all of them – because of , you know, we don't know how it's going to play out. So, we kept Utilities as an overweight because it has some offensive properties as well – most notably lever to kind of this, power deficiency within the United States. And that, of course with deregulation, a new twist on that could be things like natural gas, deployment of, you know, natural gas resources, which would help pipelines, LNG facilities potentially, and also, new ways to drive electricity production.

So, with that, Andrew, why don't you maybe dig in a little bit deeper on our financials column, and why it's not just, you know, about the election and kind of a rotation, but there's actually fundamental drivers here.

Andrew Pauker: Yeah, so Financials remains our top sector pick, following our upgrade in early October. And the drivers of that view are – a rebounding capital markets backdrop, strong earnings revisions, and the potential for an acceleration in buybacks into next year. And then post the election, expectation for deregulation can also continue to drive performance for the sector in addition to those fundamental catalysts. And then finally, even with the outperformance that we've seen for the group, over the last month and a half or so, relative valuation remains on demand – and kind of the 50th percentile of historical levels.

So, Mike, I want to wrap up by spending a minute on investor feedback to our outlook. Which aspects of our view have you gotten the most questions on? Where do investors agree and where do they disagree?

Mike Wilson: Yeah, I mean, it's sort of been ongoing because, as we noted, we really pivoted, more constructively on kind of a pro-cyclical basis a while ago. And the pushback then is the same as it is now, which is that equities are expensive. And I mean, quite frankly, the reason we pivoted to some of these more cyclical areas is because they're not as expensive. But that doesn't take away from the fact that stocks are pricey. And so, people just want to understand this analysis that, you know, we did this time around, which kind of just shows why multiples can stay higher.

They do appreciate that, you know, things can change. So, you know, we need to be, you know, cognizant of that. I would say, there's also debate around small caps. You know, we're neutral on small caps; we upgraded that about the same time after having been underweight for several years.

I think, you know, people really want to get behind that. It's been a; it's been a trade that people have gotten wrong, repeatedly over the last couple years trying to buy small caps. This time it seems like there may be some more behind it. We agree. That's why we went to neutral. And I think, you know, there are people who want to figure out, well, why? Why don't we go overweight now? And what we're really waiting for is for rates to come down a bit more. It's still sort of a late cycle environment. So, you know, typically you want to wait until you kind of see the beginnings of a new acceleration in the economy. And that's not what our economists are forecasting.

And then the other area is just this debate around government efficiency. And this is where I'm actually most excited because this is not priced at all in my view. There's so much skepticism around the ability or, you know, the likelihood of success in shrinking the government. That's not really what we're, you know, hoping for. We're just hoping for kind of a freezing of government spending. And it's so important to just, to think about it that way because that's what the fiscal sustainability question is all about, where then rates can stay contained. But then if you take it a step further, you know, our view for the last several years has been that the government has been essentially crowding out the private economy, and that really has punished small, medium businesses as well as many consumers.

And so, by shrinking or at least freezing the size of the government and redeploying those efforts into the private economy, we could see a very significant increase in productivity, but also see a broadening out in this rally. I mean, one of the reasons the market's been; equity market's been so narrow is because is because scale really matters in this crowded out, sort of environment.

If that changes, that creates opportunity at the stock level and that broadening out, which is a much healthier bull market potential.

So, what are you hearing from investors, Andrew?

Andrew Pauker: Yeah, I mean, I think the debate now, in addition to the factors that you mentioned, is really around the consumer space. A lot of pessimism is in the price already for consumer discretionary goods on the back of – kind of wallet share shift from goods to services, high price levels and sticky interest rates in addition to the tariff risk.

So, what we did in our note this week is we laid out a couple of drivers that could potentially get us more positive on that cohort. And those include a reversion in terms of the wallet share shift actually back towards goods. I think that would be a function of lower price levels. Lower interest rates – our rate strategists expect the 10-year yield to fall to 355 by year end 2025. So that would be a constructive backdrop for some of the more interest rate sensitive and housing areas within consumer discretionary.

Those are all factors that watching closely in order to get more constructive on that space. But that is another area of the market that I have received a good amount of questions on.

Mike Wilson: That's great, Andrew. Thanks a lot. Thanks for taking the time to talk today.

Andrew Pauker: Thanks, Mike. Anytime.

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

Special Encore: A $10 Trillion Opportunity in US Reshoring

27 december 2024 | 4 min

Original Release Date October 25, 2024: After decades of offshoring, the pendulum for US manufacturing is swinging back toward domestic production. Our US Multi-Industry Analyst Chris Snyder looks at what’s behind this trend.

----- Transcript -----

Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Chris Snyder: Welcome to Thoughts on the Market. I’m Chris Snyder, Morgan Stanley’s US Multi-Industry Analyst. Today I’ll discuss the far-reaching implications of shifting industrial production back to the United States.

It’s Friday, October 25th, at 10am in New York.

Global manufacturing is undergoing a seismic shift, and the United States is at the epicenter of this transformation. After decades of offshoring and relying on international supply chains, the pendulum is swinging back toward domestic production. This movement – known as reshoring – is not just a fleeting trend but a strategic realignment of manufacturing capabilities that is indicative of the “multipolar” theme playing out globally.

In fact, we believe the US is entering the early innings of re-Industrialization – a multi-decade opportunity that we size at $10 trillion and think has the potential to restore growth to the US industrial economy following more than 20 years of stagnation.

The reshoring of manufacturing to the US is fueled by a combination of factors that are making domestic production both viable and lucrative. While the initial sparks were ignited by policy changes, including tariffs and trade agreements, the COVID-19 pandemic laid bare the risks of elongated supply chains and over-dependence on foreign manufacturing.

Meanwhile, the diffusion of cutting-edge technologies, such as automation, artificial intelligence, and advanced robotics, has diminished the cost advantages of low-wage countries. The US -- with its robust tech sector and innovation ecosystem -- is uniquely positioned to leverage technology to revitalize its manufacturing base.

Who are the direct beneficiaries? High-tech sectors, such as semiconductors, pharmaceuticals, and advanced manufacturing systems, are likely to be the biggest winners. Traditional industrial sectors, such as automotive and aerospace, are also seeing a resurgence. Finally, companies that invest in more sustainable manufacturing processes stand to gain from both policy-driven incentives and a growing market demand. All told, these businesses should see shorter supply chains, reduced legal and tariff costs, and a more resilient operational structure.

As for the broader US economy? We think the implications are pretty profound. In altering the US industrial landscape, reshoring promises not only to boost GDP growth, but it could also stabilize and potentially reverse the trade deficits that have plagued the US economy for years.

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.

Special Encore: Housing, Currency Markets in Focus

26 december 2024 | 13 min

Original Release Date November 19, 2024: On the second part of a two-part roundtable, our panel gives its 2025 preview for the housing and mortgage landscape, the US Treasury yield curve and currency markets.

----- Transcript -----

Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. This is part two of our special roundtable discussion on what's ahead for the global economy and markets in 2025.

Today we will cover what is ahead for government bonds, currencies, and housing. I'm joined by Matt Hornbach, our Chief Macro Strategist; James Lord, Global Head of Currency and Emerging Market Strategy; Jay Bacow, our co-head of Securitized Product Strategy; and Jim Egan, the other co-head of Securitized Product Strategy.

It's Tuesday, November 19th, at 10am in New York.

Matt, I'd like to go to you first. 2024 was a fascinating year for government bond yields globally. We started with a deeply inverted US yield curve at the beginning of the year, and we are ending the year with a much steeper curve – with much of that inversion gone. We have seen both meaningful sell offs and rallies over the course of the year as markets negotiated hard landing, soft landing, and no landing scenarios.

With the election behind us and a significant change of policy ahead of us, how do you see the outlook for global government bond yields in 2025?

Matt Hornbach: With the US election outcome known, global rate markets can march to the beat of its consequences. Central banks around the world continue to lower policy rates in our economist baseline projection, with much lower policy rates taking hold in their hard landing scenario versus higher rates in their scenarios for re-acceleration.

This skew towards more dovish outcomes alongside the baseline for lower policy rates than captured in current market prices ultimately leads to lower government bond yields and steeper yield curves across most of the G10 through next year. Summarizing the regions, we expect treasury yields to move lower over the forecast horizon, helped by 75 [basis points] worth of Fed rate cuts, more than markets currently price.

We forecast 10-year Treasury yields reaching 3 and 3.75 per cent by the middle of next year and ending the year just above 3.5 per cent.

Our economists are forecasting a pause in the easing cycle in the second half of the year from the Fed. That would leave the Fed funds rate still above the median longer run dot.

The rationale for the pause involves Fed uncertainty over the ultimate effects of tariffs and immigration reform on growth and inflation.

We also see the treasury curve bull steepening throughout the forecast horizon with most of the steepening in the first half of the year, when most of the fall in yields occur.

Finally, on break even inflation rates, we see five- and 10-year break evens tightening slightly by the middle of 2025 as inflation risks cool. However, as the Trump administration starts implementing tariffs, break evens widen in our forecast with the five- and 10-year maturities reaching 2.55 per cent and 2.4 per cent respectively by the end of next year.

As such, we think real yields will lead the bulk of the decline in nominal yields in our forecasting with the 10-year real yield around 1.45 per cent by the middle of next year; and ending the year at 1.15 per cent.

Vishy Tirupattur: That's very helpful, Matt. James, clearly the incoming administration has policy choices, and their sequencing and severity will have major implications for the strength of the dollar that has rallied substantially in the last few months. Against this backdrop, how do you assess 2025 to be? What differences do you expect to see between DM and EM currency markets?

James Lord: The incoming administration's proposed policies could have far-reaching impacts on currency markets, some of which are already being reflected in the price of the dollar today. We had argued ahead of the election that a Republican sweep was probably the most bullish dollar outcome, and we are now seeing that being reflected.

We do think the dollar rally continues for a little bit longer as markets price in a higher likelihood of tariffs being implemented against trading partners and there being a risk of additional deficit expansion in 2025. However, we don't really see that dollar strength persisting for long throughout 2025.

So, I think that is – compared to the current debate, compared to the current market pricing – a negative dollar catalyst that should get priced into markets.

And to your question, Vishy, that there will be differences with EM and also within EM as well. Probably the most notable one is the renminbi. We have the renminbi as the weakest currency within all of our forecasts for 2025, really reflecting the impact of tariffs.

We expect tariffs against China to be more consequential than against other countries, thus requiring a bigger adjustment on the FX side. We see dollar China, or dollar renminbi ending next year at 7.6. So that represents a very sharp divergence versus dollar yen and the broader DXY moves – and is a consequence of tariffs.

And that does imply that the Fed's broad dollar index only has a pretty modest decline next year, despite the bigger move in the DXY. The rest of Asia will likely follow dollar China more closely than dollar yen, in our view, causing AXJ currencies to generally underperform; versus CMEA and Latin America, which on the whole do a bit better.

Vishy Tirupattur: Jay, in contrast to corporate credit, mortgage spreads are at or about their long-term average levels. How do you expect 2025 to pan out for mortgages? What are the key drivers of your expectations, and which potential policy changes you are most focused on?

Jay Bacow: As you point out, mortgage spreads do look wide to corporate spreads, but there are good reasons for that. We all know that the Fed is reducing their holdings of mortgages, and they're the largest holder of mortgages in the world.

We don't expect Fed balance sheet reduction of mortgages to change, even if they do NQT, as is our forecast in the first quarter of 2025. When they NQT, we expect mortgage runoff to continue to go into treasuries. What we do expect to change next year is that bank demand function will shift. We are working under the assumption that the Basel III endgame either stalls under the next administration or gets released in a way that is capital neutral. And that's going to free up excess capital for banks and reduce regulatory uncertainty for them in how they deploy the cash in their portfolios.

The one thing that we've been waiting for is this clarity around regulations. When that changes, we think that's going to be a positive, but it's not just banks returning to the market.

We think that there's going to be tailwinds from overseas investors that are going to be hedging out their FX risks as the Fed cuts rates, and the Bank of Japan hikes, so we expect more demand from Japanese life insurance companies.

A steeper yield curve is going to be good for REIT demand. And these buyers, banks, overseas REITs, they typically buy CUSIPs, and that's going to help not just from a demand side, but it's going to help funding on mortgages improve as well. And all of those things are going to take mortgage spreads tighter, and that's why we are bullish.

I also want to mention agency CMBS for a moment. The technical pressure there is even better than in single family mortgages. The supply story is still constrained, but there is no Fed QT in multifamily. And then also the capital that's going to be available for banks from the deregulation will allow them – in combination with the portfolio layer hedging – to add agency CMBS in a way that they haven't really been adding in the last few years. So that could take spreads tighter as well.

Now, Vishy, you also mentioned policy changes. We think discussions around GSE reform are likely to become more prevalent under the new administration.

And we think that given that improved capitalization, depending on the path of their earnings and any plans to raise capital, we could see an attempt to exit conservatorship during this administration.

But we will simply state our view that any plan that results in a meaningful change to the capital treatment – or credit risk – to the investors of conventional mortgages is going to be too destabilizing for the housing finance markets to implement. And so, we don't think that path could go forward.

Vishy Tirupattur: Thanks, Jay. Jim, it was a challenging year for the housing market with historically high levels of unaffordability and continued headwinds of limited supply. How do you see 2025 to be for the US housing market? And going beyond housing, what is your outlook for the opportunity set in securitized credit for 2025?

James Egan: For the housing market, the 2025 narrative is going to be one about absolute level versus the direction and rate of change. For instance, Vishy, you mentioned affordability. Mortgage rates have increased significantly since the beginning of September, but it's also true that they're down roughly a hundred basis points from the fourth quarter of 2023 and we're forecasting pretty healthy decreases in the 10-year Treasury throughout 2025. So, we expect affordability to improve over the coming year. Supply? It remains near historic lows, but it's been increasing year to date.

So similar to the affordability narrative, it's more challenged than it's been in decades; but it's also less challenged than it was a year ago.

So, what does all this mean for the housing market as we look through 2025? Despite the improvements in affordability, sales volumes have been pretty stagnant this year. Total volumes – so existing plus new volumes – are actually down about 3 per cent year to date. And look, that isn't unusual. It typically takes about a year for sales volumes to pick up when you see this kind of significant affordability improvement that we've witnessed over the past year, even with the recent backup in mortgage rates.

And that means we think we're kind of entering that sweet spot for increased sales now. We've seen purchase applications turn positive year over year. We've seen pending home sales turn positive year over year. That's the first time both of those things have happened since 2021. But when we think about how much sales 2025, we think it's going to be a little bit more curtailed. There are a whole host of reasons for that – but one of them the lock in effect has been a very popular talking point in the housing market this year. If we look at just the difference between the effective mortgage rate on the outstanding universe and where you can take out a mortgage rate today, the universe is still over 200 basis points out of the money.

To the upside, you're not going to get 10 per cent growth there, but you're going to get more than 5 per cent growth in new home sales. And what I really want to emphasize here is – yes, mortgage rates have increased recently. We expect them to come down in 2025; but even if they don't, we don't think there's a lot of room for downside to existing home sales from here.

There's some level of housing activity that has to happen, regardless of where mortgage rates or affordability are. We think we're there. Turnover measured as the number of transactions – existing transactions – as a share of the outstanding housing market is lower now than it was during the great financial crisis. It's as low as it's been in a little bit over 40 years. We just don't think it can fall that much further from here.

But as we go through 2025, we do think it dips negative. We have a negative 2 per cent HPA call next year, not significantly down. We don't think there's a lot of room to the downside given the healthy foundation, the low supply, the strong credit standards in the housing market. But there is a little bit of negativity next year before home prices reaccelerate.

This leaves us generically constructive on securitized products across the board. Given how much of the capital structure has flattened this year, we think CLO AAAs actually offer the best value amongst the debt tranches there. We think non-QM triple AAAs and agency MBS is going to tighten. They look cheap to IG corporates. Consumer ABS, we also think still looks pretty cheap to IG corporates. Even in the CMBS pace, we think there's opportunities. CMBS has really outperformed this year as rates have come down. Now our bull bear spread differentials are much wider in CMBS than they are elsewhere, but in our base case, conduit BBB minuses still offer attractive value.

That being said, if we're going to go down the capital structure, our favorite expression in the securitized credit space is US CLO equity.

Vishy Tirupattur: Thank you, Jay and Jim, and also Matt and James.

We'll close it out here. As a reminder, if you enjoyed the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Special Encore: What’s Ahead for Markets in 2025?

24 december 2024 | 11 min

Original Release Date November 18, 2024: On the first part of a two-part roundtable, our panel discusses why the US is likely to see a slowdown and where investors can look for growth.

----- Transcript -----

Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Vishy Tirupattur: Welcome to Thoughts on the Market. I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Today in the podcast, we are hosting a special roundtable discussion on what's ahead for the global economy and markets in 2025.

I'm joined by my colleagues: Seth Carpenter, Global Chief Economist; Mike Wilson, Chief US Equity Strategist and the firm's Chief Investment Officer; and Andrew Sheets, Global Head of [Corporate] Credit Research.

It's Monday, November 18th, at 10am in New York.

Gentlemen. Thank you all for taking the time to talk. We have a lot to cover, and so I'm going to go right into it.

Seth, I want to start with the global economy. As you look ahead to 2025, how do you see the global economy evolving in terms of growth, inflation and monetary policy?

Seth Carpenter: I have to say – it's always difficult to do forecasts. But I think right now the uncertainty is even greater than usual. It's pretty tricky. I think if you do it at a global level, we're not actually looking for all that much of a change, you know, around 3-ish percent growth; but the composition is surely going to change some.

So, let's hit the big economies around the world. For the US, we are looking for a bit of a slowdown. Now, some of that was unsustainable growth this year and last year. There's a bit of waning residual impetus from fiscal policy that's going to come off in growth rate terms. Monetary policy is still restrictive, and there's some lag effects there; so even though the Fed is cutting rates, there's still going to be a little bit of a slowdown coming next year from that.

But I think the really big question, and you alluded to this in your question, is what about other policy changes here? For fiscal policy, we think that's really an issue for 2026. That's when the Tax Cut and Jobs Act (TCJA) tax cuts expire, and so we think there's going to be a fix for that; but that's going to take most of 2025 to address legislatively. And so, the fiscal impetus really is a question for 2026.

But immigration, tariffs; those matter a lot. And here the question really is, do things get front loaded? Is it everything all at once right at the beginning? Is it phased in over time a bit like it was over 2018? I think our baseline assumption is that there will be tariffs; there will be an increase in tariffs, especially on China. But they will get phased in over the course of 2025. And so, as a result, the first thing you see is some increase in inflation and it will build over time as the tariffs build. The slowdown from growth, though, gets backloaded to the end of 2025 and then really spills over into to 2026.

Now, Europe is still in a situation where they've got some sluggish growth. We think things stabilize. We get, you know, 1 percent growth or so. So not a further deterioration there; but not a huge increase that would make you super excited. The ECB should probably keep cutting interest rates. And we actually think there's a really good chance that inflation in the euro area goes below their target. And so, as a result, what do we see? Well, the ECB cutting down below their best guess of neutral. They think 2 percent nominal is neutral and they go below that.

China is another big curveball here for the forecast because they've been in this debt deflation spiral for a while. We don't think the pivot in fiscal policy is anywhere near sufficient to ward things off. And so, we could actually see a further slowing down of growth in China in 2025 as the policy makers do this reactive kind of policy response. And so, it's going to take a while there, and we think there's a downside risk there.

On the upside. I mean, we're still bullish on Japan. We're still very bullish on India and its growth; and across other parts of EM, there's some bright spots. So, it's a real mixed bag. I don't think there's a single trend across the globe that's going to drive the overall growth narrative.

Vishy Tirupattur: Thank you, Seth. Mike, I'd like to go to you next. 2024 has turned out to be a strong year for equity markets globally, particularly for US and Japanese equities. While we did see modest earnings growth, equity returns were mostly about multiple expansion. How do you expect 2025 to turn out for the global equity markets? What are the key challenges and opportunities ahead for the equity markets that you see?

Mike Wilson: Yeah, this year was interesting because we had what I would say was very modest earnings growth in the US in particular; relative to the performance. It was really all multiple expansion, and that's probably not going to repeat this year. We're looking for better earnings growth given our soft landing outcome from an economic standpoint and rates coming down. But we don't think multiples will expand any further. In fact, we think they'll come down by about 5 percent. But that still gets us a decent return in the base case of sort of high single digits.

You know, Japan is the second market we like relative to the rest of the world because of the corporate governance story. So there, too, we're looking for high single digit earnings growth and high single digits or 10 percent return in total. And Europe is when we're sort of down taking a bit because of tariff risk and also pressure from China, where they have a lot of export business.

You know, the challenges I think going forward is that growth continues to be below trend in many regions. The second challenge is that, you know, high quality assets are expensive everywhere. It's not just the US. It's sort of everywhere in the world. So, you get what you pay for. You know, the S&P is extremely expensive, but that's because the ROE is higher, and growth is higher.

So, you know, in other words, these are not well-kept secrets. And so just valuation is a real challenge. And then, of course, the consensus views are generally fairly narrow around the soft landing and that's very priced as well. So, the risks are that the consensus view doesn't play out. And that's why we have two bull and two bear cases in the US – just like we did in the mid-year outlook; and in fact, what happened is one of our bull cases is what played out in the second half of this year.

So, the real opportunity from our standpoint, I think this is a global call as well – which is that we continue to be pretty big rotations around the macro-outlook, which remains uncertain, given the policy changes we're seeing in the US potentially, and also the geopolitical risks that still is out there.

And then the other big opportunity has been stock picking. Dispersion is extremely high. Clients are really being rewarded for taking single stock exposures. And I think that continues into next year. So, we're going to do what we did this year is we're going to try to rotate around from a style and size perspective, depending on the macro-outlook.

Vishy Tirupattur: Thank you, Mike. Andrew, we are ending 2024 in a reasonably good setup for credit markets, with spreads at or near multi-decade tights for many markets. How do you expect the global credit markets to play out in 2025? What are the best places to be within the credit spectrum and across different regions?

Andrew Sheets: I think that's the best way to frame it – to start a little bit about where we are and then talk about where we might be going. I think it's safe to say that this has been an absolutely phenomenal backdrop for corporate credit. Corporate credit likes moderation. And I think you've seen an unusual amount of moderation at both the macro and the micro level.

You've seen kind of moderate growth, moderating inflation, moderating policy rates across DM. And then at the micro level, even though markets have been very strong, corporate aggressiveness has not been. M&A has been well below trend. Corporate balance sheets have been pretty stable.

So, what I think is notable is you've had an economic backdrop that credit has really liked, as you correctly note. We've pushed spreads near 20-year tights based on that backdrop. But it's a backdrop that credit markets liked, but US voters did not like, and they voted for different policy.

And so, when we look ahead – the range of outcomes, I think across both the macro and the micro, is expanding. And I think the policy uncertainty that markets now face is increasing both scenarios to the upside where things are hotter and you see more animal spirits; and risk to the downside, where potentially more aggressive tariffs or action on immigration creates more kind of stagflationary types of risk.

So one element that we're facing is we feel like we're leaving behind a really good environment for corporate credit and we're entering something that's more uncertain. But then balancing that is that you're not going to transition immediately.

You still have a lot of momentum in the US and European economy. I look at the forecasts from Seth's team, the global economic numbers, or at least kind of the DM economic numbers into the first half of next year – still look fine. We still have the Fed cutting. We still have the ECB cutting. We still have inflation moderating.

So, part of our thinking for this year is it could be a little bit of a story of two halves that we titled our section, “On Borrowed Time.” That the credit is still likely to hold in well and perform better in the first half of the year. Yields are still good; the Fed is still cutting; the backdrop hasn't changed that much. And then it's the second half of the year where some of our economic numbers start to show more divergence, where the Fed is no longer cutting rates, where all in yield levels are lower on our interest rate forecasts, which could temper demand. That looks somewhat trickier.

In terms of how we think about what we like within credit, we do think the levered loan market continues to be attractive. That's part of credit where spreads are not particularly tight versus history. That's one area where we still see risk premium. I think this is also an environment where regionally we see Asia underperforming. It's a market that's both very expensive from a spread perspective but also faces potentially kind of outsized economic and tariff uncertainty. And we think that the US might outperform in context to at least initially investors feeling like the US is at less relative risk from tariffs and policy uncertainty than some other markets.

So, Vishy, I'll pause there and pass it back to you.

Vishy Tirupattur: Thanks, Mike, Seth, and Andrew.

Thank you all for listening. We are going to take a pause here and we'll be back tomorrow with our year ahead round table continued, where we'll share our forecast for government bonds, currencies and housing.

As a reminder, 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.

The Many Potential Policy Paths of Trump’s Second Term

23 december 2024 | 6 min

Our Global Head of Fixed Income and Thematic Research joins our U.S. Public Policy Strategist to give investors their policy expectations for President-elect Trump’s second term, including the potential market and economic consequences of those policies if enacted.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's global head of fixed income and thematic research.

Ariana Salvatore: And I'm Ariana Salvatore, U.S. public policy strategist.

Michael: And on this episode of Thoughts on the Market, we'll talk about potential policy paths the second Trump administration might pursue.

It's Monday, December 23rd at 10am in New York.

The U.S. presidential election is behind us and we're well into the holiday season, but we're still focusing closely on what U.S. policy might look like in 2025. Ariana, what have we learned in the past couple of weeks regarding Trump's policy plans for next year?

Ariana: So the variables or policy items that we're watching are still the same ones that we were tracking over the past year or so. That's tariffs, taxes, immigration and deregulation. But to your point, the election is now obviously behind us, and we do have some incremental information that's helped us construct a base case across these variables. For example, President elect Trump has made some key personnel appointments that we think are going to play a big role in exactly how these policies are carried out. His pick for Treasury Secretary, Scott Besant, is a good example that gives us conviction in a more gradual, incrementalist approach to tariffs. Translating that principle across all the policy variables, as well as the extremely thin majority the Republicans have in the House of Representatives, has helped us form the foundation of our base case, which we call “fast decisions, slow implementation.”

In short, we think that means you should expect major policy changes will be announced quickly, think first quarter of next year, but achieved more slowly. That, in our view, enables more benign macro conditions to persist into 2025, but does create some more uncertainty, both positive and negative, into 2026. We think that lag is attributable to a variety of logistical, legal, and political constraints, and does vary depending on the policy area and executive authorities. For example, we think Trump might have an easier time unilaterally modifying tariff rates, but other constraints outside of timing might limit implementation nonetheless.

So, Michael, taking this a step beyond just the policy paths, how should investors be thinking about the potential market and economic consequences of our base case? Aside from the specific policy changes, how do you think about our base case in terms of broader market themes?

Michael: I think the key takeaway here is that the policy path we're describing puts pressure on economic growth, but on a lag. So most of these effects are for later in 2025 or into 2026 per economist expectations. So I think the key takeaway here is that the policy path we're describing exerts pressure on economic growth, albeit on a lag. So in our economist expectations later in 2025 and into 2026. So what that means is as we go into 2025, there's still a pretty good growth backdrop to support risk assets and equities in particular. It's also a pretty good backdrop for bonds because as we get closer to 2026, our bond strategist expectation is that markets will start to reflect expectations of growth pressure. And they'll probably be less concerned about what's a debate right now, which is the size of U.S. deficits. There's been this expectation that policies extending tax cuts would really grow the deficit substantially in the way that might put downward pressure on bond prices.

However, we think when investors take a closer look, they'll see that extending current tax cuts, which is our expectations, basically, they'll be able to extend current tax cuts with a few sweeteners on top, that's mostly an extension of current policy, as opposed to some of the headlines in the news talking about major deficit expansion, that's an expansion relative to if Congress did nothing and just let tax cuts expire. So the year over year difference in deficits is perhaps not as big as some of the headlines would suggest. So that's a good backdrop for bonds and a pretty good backdrop for equities and risk assets, at least to start the year.

Ariana: But of course, there's a lot of uncertainty embedded in these policy paths. Can you talk through how we're thinking about potential risks to our base case, or maybe some key signposts that could indicate that other scenarios are becoming plausible?

Michael: So if there are policies that shift that growth downside sooner, so instead of it manifesting in 2026, it manifests sooner in 2025, that's the type of thing that might make us less constructive on risk assets and equities. So if we got indications, for example, that tariffs were going to be implemented more quickly and to a greater degree, for example, announcements happening quickly, but also showing implementation is happening very quickly, that's the type of thing that might skew risk assets in a more negative direction. Similarly, if Congress were to pledge to appropriate more powers to the executive branch on tariff authority, not necessarily something we think they could get done, but that could be an indication that there could be more powerful tariff potential relative to what the executive branch currently has.

On the more positive side, if Congress indicates that it wants to move much faster and bigger on tax cuts and the executive branch were to flag that tariffs are going to be implemented later or suggest that there's more negotiating room with trade partners to avoid tariffs, then that might be the type of sequencing of policy that enables the market to focus more on the good aspects of policy, the helpful aspects to corporate earnings, to individual consumption, and to GDP growth that might just make for an all around more conducive environment to risk assets.

So there's a lot to keep an eye on between now and inauguration day. In the meantime, enjoy your holiday. Ariana, thanks for taking the time to talk.

Ariana: Great speaking with you, Mike.

Michael: And as a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us wherever you listen, and share our thoughts on the market with a friend or colleague today.

More Talk, Less Action Could Be Good for Credit Markets

20 december 2024 | 4 min

Our Head of Corporate Credit Research lists realistic scenarios for why credit could outperform expectations in 2025, despite some risks posed by policy changes from the incoming administration.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Today I’ll be discussing realistic scenarios where things could be better than we expect.

It's Friday December 20th at 2pm in London.

Credit is an asset class that always faces more limited upside, and the low starting point for spreads as we enter 2025 further limits potential gains. Nevertheless, there are still a number of ways where this market could do better than expected, with spreads tighter than expected, into next year.

An obvious place to start is U.S. policy. Morgan Stanley’s public policy strategy team thinks the incoming administration will be a story of “fast announcement, slow implementation”, with the growth and inflation impact of tariffs and immigration falling more in 2026 (rather than say earlier). And so if one looks at Morgan Stanley’s forecasts, our growth numbers for 2025 are good, our 2026 numbers are weaker.

The bull case could be that we see more talk but less ultimate action. Scenarios where tariffs are more of a negotiating tool than a sustained policy would likely mean less change to the current (credit friendly) status quo, and also increase the likelihood that the Federal Reserve will be able to lower interest rates even as growth holds up. Rate cuts with good growth is a rare occurrence, but when you do get it, it can be extremely good. If one thinks of the mid-1990s, another time where we had this combination, credit spreads were even tighter than current levels. Another path to the bull case is better funding conditions in the market. Some loosening of bank capital requirements or stronger demand for collateralized loan obligations could both flow through to tighter spreads for the assets that these fund, especially things like leveraged loans. If we think back to periods where credit spreads were tighter than today, easier funding was often a part of the story.

Now, a more aggressive phase of corporate activity could be a risk to credit, but M&A can also be a positive event, especially on a name by name basis. If merger and acquisition activity becomes a story of, say, larger companies buying smaller ones, that could mean that weaker, high yield credits get absorbed by larger, stronger, investment grade balance sheets. And so for those high yield bonds or loans, this can be an outstanding outcome. Another way things could be better than expected for credit is that growth in Europe and China is better than expected. In speaking with investors over the last few weeks, I think it's safe to say that expectations for both regions are pretty low. And so if things are better than these low expectations, spreads, especially in Europe, which are not as tight as those in the U.S., could go tighter.

But the most powerful form of the credit bull case might be the simplest. Morgan Stanley expects the Federal Reserve, the Bank of England, and the European Central Bank to all lower interest rates much more than markets expect next year, even as, for the most part, growth in 2025 holds up. Due in a large part to those expected rate cuts, we also think the yields fall more than expected. If that's right, credit could quietly have an outstanding year for total return, which is boosted as yields fall. Indeed, on our forecast, U.S. investment grade credit, a relatively sleepy asset class, would see a total return of roughly 10%, higher than our expected total return for the mighty S&P 500. Not all credit investors care about total return. But for those that do, that outcome could feel very bullish.

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

Fed Signals Inflation Fight Isn’t Over

19 december 2024 | 9 min

Our Global Head of Macro Strategy joins our Chief U.S. Economist to discuss the Fed’s recent rate cut and why persistent inflation is likely to slow the pace of future cuts.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist.

Matthew: Today, we're going to talk about the Federal Open Market Committee meeting and the path for rates from here.

It's Thursday, December 19th at 10a.m. in New York.

The FOMC meeting concluded yesterday with the Federal Reserve cutting rates by a quarter of a percentage point, marking the third rate cut for the year. This move by the Fed was just as the consensus had anticipated. However, in its meeting yesterday, the Fed indicated that 2025 rate cuts would happen at a slower pace than investors were expecting. So Mike, what are committee members projecting in terms of upcoming rate cuts in 2025 and 2026?

Michael: Yeah, Matt, the Fed dialed back its expectations for policy rate easing in both 2025 and 2026. They now only look for two rate cuts of 50 basis points worth of cuts in 2025, which would bring the funds rate to 3.9% and then only another 50 basis points in 2026, bringing the policy rate to 3.4%. So a major dialing back in their expectations of rate cuts over the next two years.

Matthew: What are the factors that are driving what now appears to be a slightly less dovish view of the policy rate?

Michael: Chair Powell mentioned, I think, two things that were really important. One, he said that many committee members saw recent firmness in inflation as a surprise. And so I think some FOMC members extrapolated that strength in inflation going forward and therefore thought fewer rate cuts were appropriate. But Chair Powell also said other FOMC members incorporated expectations about potential changes in policy, which we inferred to mean changes about tariffs, immigration policy, maybe additional fiscal spending. And so whether they bake that in as explicit assumptions or just saw it as risks to the outlook, I think that these were the two main factors. So either just momentum in inflation or views on policy rate changes, which could lead to greater inflation going forward.

Matthew: So Mike, what were your expectations going into this meeting and how did yesterday's outcome change Morgan Stanley's outlook for Federal Reserve policy next year and the year thereafter?

Michael: We are a little more comfortable with inflation than the Fed appears to be. So we previously thought the Fed would be cutting rates three times next year and doing all of that in the first half of the year. But we have to listen to what they're thinking and it appears that the bar for rate cuts is higher. In other words, they may need more evidence to reduce policy rates. One month of inflation isn't going to do it, for example. So what we did is we took one rate cut out of the forecast for 2025. We now only look for two rate cuts in 2025, one in March and one in June.

As we look into 2026, we do think the effect of higher tariffs and restrictions on immigration policy will slow the economy more, so we continue to look for more rate cuts in 2026 than the Fed is projecting but obviously 2026 is a long way away. So in short, Matt, we dialed back our assumptions for policy rate easing to take into account what the Fed appears to be saying about a higher bar for comfort on inflation before they ease again.

So Matt, if I can actually turn it back to you: how, if at all, did yesterday's meeting, and what Chair Powell said, change some of your key forecasts?

Matthew: So we came into this meeting advocating for a neutral stance in the bond market. We had seen a market pricing that ended up being more in line with the outcome of the meetings. We didn't expect yields to fall dramatically in the wake of this meeting, and we didn't expect yields to rise dramatically in the wake of this meeting. But what we ended up seeing in the marketplace was higher yields as a result of a policy projection that I think surprised investors somewhat and now the market is pricing an outlook that is somewhat similar to how the Fed is forecasting or projecting their policy rate into the future.

In terms of our treasury yield forecasts, we didn’t see anything in that meeting that changes the outlook for treasury markets all that much. As you said, Mike, that in 2026, we're expecting much lower policy rates. And that ultimately is going to weigh on treasury yields as we make our way through the course of 2025. When we forecast market rates or prices, we have to think about where we are going to be in the future and how we're going to be thinking about the future from then. And so when we think about where our treasury yield's going to be at the end of 2025, we need to try to invoke the views of investors at the end of 2025, which of course are going to be looking out into 2026.

So when we consider the rate policy path that you're projecting at the moment and the factors that are driving that rate policy projection - a slower growth, for example, a bit more moderate inflation - we do think that investors will be looking towards investing in the government bond market as we make our way through next year, because 2026 should be even more supportive of government bond markets than perhaps the economy and Fed policy might be in 2025.

So that's how we think about the interest rate marketplace. We continue to project a 10 year treasury yield of just about three and a half percent at the end of 2025 that does seem a ways away from where we are today, with the 10 year treasury yield closer to four and a half percent, but a year is a long time. And that's plenty of time, we think, for yields to move lower gradually as policy does as well. On the foreign exchange side. The dollar we are projecting to soften next year, and this would be in line with our view for lower treasury yields. For the time being, the dollar reacted in a very positive way to the FOMC meeting this week but we think in 2025, you will see some softening in the dollar. And that primarily occurs against the Australian dollar, the Euro, as well as the Yen. We are projecting the dollar/yen exchange rate to end next year just below 140, which is going to be quite a move from current levels, but we do think that a year is plenty of time to see the dollar depreciate and that again links up very nicely with our forecast for lower treasury yields.

Mike, with that said, one more question for you, if you would: where do things stand with inflation now? And how does this latest FOMC signal, how does it relate to inflation expectations for the year ahead?

Michael: So right now, inflation has been a little bit stronger than we and I think the Fed had anticipated, and that's coming from two sources. One, hurricane-related effects on car prices. So the need to replace a lot of cars has pushed new and used car prices higher. We think that's a temporary story that's likely to reverse in the coming months. The more longer term concern has been around housing related inflation, or what we would call shelter inflation. The good news in that is in November, it took a marked step lower. So I do think it tells us that that component, which has been holding up inflation, will continue to move down. But as we look ahead to your point about inflation expectations, the real concern here is about potential shifts in policy, maybe the implementation of tariffs, the restriction of immigration.

We as economists would normally say those should have level effects or one-off effects on inflation. And normally I'd have a high confidence in that statement. But we just came out of a very prolonged period of higher than normal inflation, so I think the concern is repetitive, one-off shocks to inflation, lead inflation expectations to move higher. Now, we don't think that will happen. Our outlook is for rate cuts, but this is the concern. So we think inflation moves lower. But we're certainly watching the behavior of inflation expectations to see if our forecast is misguided.

Matthew: Well, great Mike. Thanks so much for taking the time to talk.

Mike: Great speaking with you, Matt.

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

Banking on Deregulation

18 december 2024 | 4 min

Of all of the potential policy changes from the incoming U.S. presidential administration, deregulation could have the most significant impact on markets. Our Chief Fixed Income Strategist explains what’s coming.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Today I'll be discussing the policy changes that we have the highest conviction in terms of their market impact.

It's Wednesday, December 18th at 10 a.m. in New York.

As our regular readers are aware, Morgan Stanley strategists and economists around the globe came together to formulate our outlook for 2025 across the wide range of markets and economies we cover. A key aspect of this year's outlook is the potential for policy changes ahead from the incoming administration. The substance, severity, and sequencing of policies will matter and will have an important bearing on how markets perform over the course of 2025. We would put the potential range of policy changes into four broad categories: Tariffs and Trade Policy; Immigration Controls; Tax Cuts and Fiscal Policy; and finally, Deregulation. In terms of sequencing, our central case is for tariffs to go first and tax cuts to be last. As our public policy team sees it, the incoming administration will see fast announcements but a slow implementation of policy, especially in terms of tariffs and immigration. Slower implementation will mean that the changes will also be slow and the impacts on the economy and markets likely to be a lot more gradual.

That said, it is in the area of deregulation that we expect to see the highest impact on markets, even though precise measurement of these impacts in terms of macroeconomic indicators such as growth and inflation is hard to come through. So with deregulation, we expect an environment in support of bank activity. As our bank equity analysts have noted, banks in their coverage area currently are sitting on record levels of excess capital: 177 billion of excess capital and a weighted average CET1 ratio of 12.8 percent, which is 140 basis points higher than pre-COVID levels of 11.4 percent.

If Basel III Endgame is re proposed in a more capital neutral manner, we expect U.S. banks will begin deploying their excess capital into lending, supporting clients in trading and underwriting, increasing their securities purchases, as well as increasing buybacks and dividends. Changes to the existing Basel III Endgame proposal will also make U.S. banks more competitive globally.

We also believe all global banks with significant capital markets businesses will benefit from the return of the M&A. Another by-product of Basel III Endgame being reproposed in a capital neutral way pertains to what banks do in their securities portfolios. In the last few years, in anticipation of higher capital requirements, U.S. banks have not been very active in deploying their capital in securities purchases, particularly Asian CMBS and CLO AAAs. With the deregulation focus, we expect that banks will revert to buying the assets that they have stayed away from, in particular, Asian CMBS and CLO AAAs.

The return of bank demand for CLO AAAs will have a bearing on the underlying broadly syndicated loan market and even more broadly on credit formation and sponsor activity, which will be supportive of a stronger return of M&A than our credit strategists have been expecting. So in fixed income, if you pardon the pun, we are really banking on the impact of deregulation, which supports our view on the range of relative value opportunities and spread products, especially in securitized products.

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

The Calm Before the Storm?

17 december 2024 | 5 min

Our Global Chief Economist explains why a predictable end to 2024 for central banks may give way to a tempestuous 2025.

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Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist, and today I'll be talking about how the year end is wrapping up with, surprisingly, a fair amount of certainty about central banks.

It's Tuesday, December 17th at 10 a. m. in New York.

Unlike the rest of this past year, year end seems to have a lot more certainty about the last few central bank meetings. Perhaps it is just the calm before the storm, but for now, let's enjoy a benign central bank week ahead of the holidays. Last Thursday, the ECB cut interest rates 25 basis points, right in line with what we were thinking and what the market was thinking. Similarly, but I have to say, with a pretty different narrative, we expect the Fed to cut 25 basis points this week and the market seems to be all in there as well.

The Bank of England, the Bank of Japan, well, we think they're closed accounts; that is to say, they're going to be on pause until the new year. Last week's 25 basis point cut by the ECB came amidst a debate as to whether or not the ECB should accelerate their pace of rate cuts. With most doubts about disinflation resolved, it’s downside growth risks that have gained prominence in the decision making process there. Restrictive monetary policy is starting to look less and less necessary and President Lagarde’s statement seems to reflect that the council's negotiated stance, that easing will continue until the ECB reaches neutral. The question is what happens next? In our view, the ECB will come to see there's a need to cut through neutral and get all the way down to 1%.

In stark contrast, there's the Fed, where there are very few residual growth concerns, but there have been more and more questions about the pace of disinflation. The recent employment data, for example, clearly suggests that the recession risk is low. Some members on the committee have started to express concerns, however, that inflation data really have proven stickier and that maybe the disinflation process is stalled.

From our perspective, last week's CPI data and all the other inflation data we just got really point to the next PCE print showing continued clear disinflation, leaving very little room for debate for the Fed to cut 25 basis points in December. And indeed, if it's as weak as we think it is, that provides extra fuel for a cut in January.

That said, our baseline view of cuts in March and May are going to get challenged if future data releases show a reversal in this disinflationary trend, if it's from residual seasonality or maybe pass through from newly imposed tariffs, and Chair Powell's remarks at next week's press conference are really going to be critical to see if they really are becoming more cautious about cuts.

Now, we don't expect the Bank of England or the Bank of Japan to move until next year. The recent currency weakness in Japan has raised the prospect of a rate hike as soon as this month, but we've kept the view that a January rate hike is much more likely. The timing would allow the Bank of Japan to get greater insight into the Shunto wage negotiations, and that gives them greater insight into future inflation. And recent communications from the Bank of Japan also aligns with our view and in particular, there is a scheduled speech by Deputy Governor Himino on January 14th, one week before the January 23rd and 24th meeting. All of that says the stars are lined up for a January rate hike. Market pricing over the past couple weeks have moved against a hike in December and towards our call for a hike in January.

Now, the market's also pricing the next Bank of England cut to be next year rather than this year. We expect those cuts to come at alternating meetings. December on pause, a cut in February, and gradual rate cuts thereafter. Now, services inflation, the key focus of the Bank of England so far, has remained elevated through the end of the year, but we expect to see mounting evidence of labor market weakness, and as a result, wage growth deceleration, and that, we think, is what pushes the MPC towards more cuts. All of that said, the recent announcement of fiscal stimulus in the UK starts to raise some inflationary risks at the margin.

All right, well, as the year comes to an end, it has been quite a year to say the least. Elections around the world, not least of which here in the United States, wildly swinging expectations for central banks, and a structural shift in Japan ending decades of nominal stagnation. And I have to say an early glimpse into 2025 suggests that the roller coaster is not over yet. But for now, let's take some respite because there should be limited drama from central banks this week. Happy holidays.

Well, thanks for listening, and 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.

How Investors Can Best Position for 2025

16 december 2024 | 4 min

Our CIO and Chief U.S. Equity Strategist recaps how equity markets have fared in 2024, and why they might look more conservative early in the new year.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Today on the podcast I’ll be discussing how to position as we head into the new year.

It's Monday, Dec 16th at 11:30am in New York. So let’s get after it.

The big question for most investors trying to beat the S&P 500 is whether returns will continue to be dominated by the Magnificent 7 and a few other high quality large cap stocks or if we're going to will see a sustainable broadening out of performance to new areas. Truth be told, 2024 has been a year during which investors have oscillated between a view of broadening out or continued narrowing. This preference has coincided with the ever-changing macro view about growth and inflation and how the Fed would respond.

To recount this past year, our original framework suggested investors would have to contend with markets reacting to these different macro-outcomes. More specifically, whether the economy would end up in a soft landing, a hard landing or a “no landing” outcome of accelerating growth and inflation. Getting this view right helped us navigate what kinds of stocks, sectors and factors would outperform during the year. The perfect portfolio this year would have been overweight broad cyclicals like energy, industrials and financials in the first quarter, followed by a Magnificent 7 tilt in early 2Q that got more defensive over the summer before shifting back toward high quality cyclicals in late third quarter. Lately, that cyclical tilt has included some lower quality stocks while the Magnificent 7 has had a big resurgence in the past few weeks. We attributed these shifts to the changing perceptions on the macro which have been more uncertain than normal.

Going into next year, I think this pattern continues, and it currently makes sense to have a barbell of large cap high quality cyclicals and growth stocks even though small caps and the biggest losers of the prior year tend to outperform in January as portfolios rebalance. We remain up the quality curve because it appears the seasonal low quality cyclical small cap rally was pulled forward this year due to the decisive election outcome. In addition to the large hedges being removed, there was also a spike in many confidence surveys which further spilled into excitement about this small cap lower quality rotation.

Therefore, it makes sense that the short-term euphoria that's now taking a break with the rotation back toward large cap quality mentioned earlier. The fundamental driver of this rotation is earnings. Both earnings revisions and the expected growth rate of earnings next year remain much better for higher quality stocks and sectors. Given the uncertainty around policy sequencing and implementation on tariffs, immigration and how much the Fed can cut rates next year, we suspect equity markets will tread a bit more conservatively in the first quarter than what we observed this fall.

The biggest risks to the upside would be a more modest implementation of tariffs, a de-emphasis on deportations of working illegal immigrants and perhaps more aggressive de-regulation that is viewed as pro-growth. Other variables worth watching closely include how quickly and aggressively the new department of government efficiency acts with respect to shrinking the size of the Federal agencies. While I'm hopeful this new effort can prove the skeptics wrong, success may prove to be growth negative in the near term given how much the government has been driving overall GDP growth for the past few years. In my view, a true broadening out of the economy and the stock market is contingent on a smaller government both in terms of regulation and absolute size. In my view, this is the most exciting potential change for taxpayers, smaller businesses and markets overall. However, it is also likely to take several years to fully manifest.

In the meantime, I wish you a happy holiday season and a healthy and prosperous New Year.

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

Why the Airline Industry Could Take Off in 2025

13 december 2024 | 4 min

After an up-and-down 2024 for the U.S. airlines industry, our Freight Transportation & Airlines Analyst Ravi Shanker explains why he is bullish about the sector’s trajectory over the next year.

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Welcome to Thoughts on the Market. I’m Ravi Shanker, Morgan Stanley’s Freight Transportation and Airlines analyst. Today I’ll discuss why we remain bullish on the US Airlines industry for 2025.

It’s Friday, December 13, at 10am in New York.

The Airline industry entered 2024 with good momentum, lost it during the middle of the year with some concerns around the economy and capacity, but then turned it around in the fall to finish the year with the strongest run that the Airlines have had since the pandemic. The coast looks clear for 2025, and we remain bullish on the US Airlines for next year.

While many airline stocks enter 2025 close to post-pandemic if not all-time highs, valuations are still attractive enough across the space to see upside across the industry. The big question right now is: will the focus on premium services continue to pay off, or will there be a resurgence in domestic travel that alters the market dynamics? We think the answer is both.

Premium beneficiaries will continue to shine in 2025. We believe the premiumization trend in the industry is structural and will continue next year. Legacy carriers have successfully capitalized on this trend, enhancing their revenue streams significantly through upgraded service offerings such as premium seating and lounge access. This move isn't just about luxury—it's a calculated play to boost ancillary revenues, which are becoming a more critical component of financial stability in the airline industry. The premium leaders are building annuity-like business models – think razorblades, printers or smartphones – where the sale of a popular gateway product is followed by the bulk of the profitability coming from ancillary revenues generated in the following years, as loyalty and adjacent revenues contribute a steady stream of earnings and free cash flow to the airlines.

On the flip side, the conversation around better margins on domestic travel is gaining momentum as well. 2024 saw a big shift where several domestic carriers made significant changes and even in some cases fundamentally overhauled their business models to fly less, fly differently, bundle fares, and move upmarket. This change brought significant disruption in 2024 but could be set to pay dividends in 2025 and reignite investor interest in these domestic names. This shift toward domestic travel could potentially redistribute market share and redefine competitive dynamics within the entire Airlines industry.

To sum up, the setup for 2025 looks very good. But volatility could remain high due to external factors. The biggest risk into 2025 -- especially the second half of [20]25 -- continues to be the macro backdrop. More specifically, our economists' view of a sharply slowing GDP growth and services spending environment in the second half of [20]25 and into [20]26. While we take comfort from the resilience of travel spending so far, we know that things could change quickly. We will continue to keep you updated throughout the next year.

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

Could Private-Label Products Transform Retail?

12 december 2024 | 5 min

Our U.S. Retail Analyst Simeon Gutman discusses shoppers’ embrace of a private labels super cycle and how changing consumer behavior could fundamentally change grocery and discount retailers.

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Welcome to Thoughts on the Market. I’m Simeon Gutman, Morgan Stanley’s US Hardlines, Broadlines and Food Retail Analyst. Today, we’ll talk about a fascinating shift in the retail landscape: the rise of private label products and what this could mean for the future of grocery and discount retailers.

It’s Thursday, December 12, at 10am in New York.

Think about your recent trip to your favorite grocery store. As you reached towards the shelves for your preferred brand of mayonnaise, frozen pizza, or bread, you may have noticed that more and more shelves are stocked with store-brand products. Products that not only match the quality of national brands but often exceed it. This isn't just a minor trend. We estimate private label sales growth will accelerate by 40 per cent to reach $462 billion by 2030. An expansion that will redefine market dynamics significantly.

In essence, we think the private label grocery market is on the cusp of a super cycle. This super cycle is a by-product of COVID-era shifts in the way that customers shop and how retailers invest into this trend. At the same time, private label groceries reflect the rise of mega platforms, which are taking ever greater consumer wallet share and are innovating more than ever before.

When you look at macro drivers, US consumers have been navigating a difficult post-COVID environment. While inflation is currently moderating, overall food prices remain 30-34 per cent above their 2018 levels. Most consumers are spending more on food at home vs. food away from home, which is a positive catalyst for private label acceleration. Further, consumers are willing to substitute lower priced goods, especially groceries, and these categories present a growth opportunity for private labels. This is the tipping point that we’re talking about. High costs, recent innovation, and innovation like we’ve never seen before – with the rise of these mega platforms, this industry looks like it’s ripe for disruption.

The market views private label penetration as a slow, gradual, and ongoing event. But our work challenges this premise. We believe the rate of change in private label growth will accelerate substantially over the next few years. We think private label products will grow at double the rate of the overall grocery market bringing private label market penetration from about 19 per cent in 2023 to about 23 per cent by 2030.

This growth is not just about stocking up the shelves. It's about changing consumer perceptions and behavior. Consumers increasingly see private labels as viable alternatives to national brands because they often offer better value and innovation. From healthier ingredients, like no more seed oils, to organic products that you had no idea they can produce, to premium products like frozen lobster ravioli to mushroom and truffle pizza. There are a couple of retailers in the US that are all private label and they are among the fastest growing ones, taking away the stigma of what private label products could mean.

So what does this mean for the broader retail and consumer packaged good industries? For grocers and discounters with already strong private label offerings, this shift presents a significant opportunity for growth. It’s also accretive to margins. On the flip side, traditional food companies might face increased competition. These companies have historically relied on brand superiority. But as private label gains market share – particularly in food categories – these national brands could see a hit to their gross profit growth, which could fall from 3 per cent historically to about 2 per cent. And while household and personal care categories have seen some resilience against private label encroachment, the ongoing economic pressures and shifts in consumer spending habits could challenge the status quo.

Looking ahead, the rise of private labels could lead to a reevaluation of what brands mean to consumers. As private label becomes synonymous with quality and value, we may see a new era in which traditional brand loyalty becomes less significant compared to product quality and cost-effectiveness.

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.

What Could Go Wrong for Corporate Credit?

11 december 2024 | 4 min

Our Head of Corporate Credit Research Andrew Sheets explains why corporate credit may struggle in 2025, including the risks of aggressive policy shifts in the U.S. along with political and structural challenges in Europe and Asia.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Today I’ll be discussing realistic scenarios where things are worse than we expect. Next week, I’ll cover what could be better.

It's Wednesday, December 11th at 2pm in London.

Morgan Stanley strategists and economists recently completed our forecasting process for the year ahead, and regular listeners will have now heard our expectations across a wide range of economies and markets. But I’d stress that these forecasts are a central case. The world is uncertain, with a probability distribution around all forecasts. So in the case of credit, what could go wrong?

As a quick reminder, our baseline for credit is reasonably constructive. We think that low credit spreads can remain low, especially in the first half of next year – as policy change is slow to come through, economic data holds up, the Fed and European Central Bank ease rates more than expected, and still-high yields on corporate bonds attract buyers.

So how does all of that go wrong? Well, there are a few specific, realistic factors that could lead us to something worse, i.e., our bear case.

Let me start with US policy. Morgan Stanley’s Public Policy team’s view is that the incoming US administration will see fast announcement, but slow implementation on key issues like tariffs, fiscal policy, and immigration; and that that slower implementation of any of these policies will mean that change comes less quickly to the economy. But that change could happen faster, which would mean weaker growth and higher prices – if, for example, tariffs were to hit earlier and or in larger size. In the case of immigration, we are actually still forecasting positive net immigration over the next several years. But a larger change in policy would raise the odds of a more severe labor shortage.

Even outside any specific change from the new US administration, there’s also a risk that the US economy simply runs out of gas. The recovery since COVID has been extraordinary – one of the fastest on record, especially in the labor market. The risk is that companies have now done all the hiring they need to do, meaning a slower job market going forward. Even in their base-case, Morgan Stanley’s economists see job market growth slowing, adding just 28,000 jobs/month in 2026. And to give you a sense of how low that number is, the average over the last 12 months was 190,000. And so, the bear case is that the labor market slows even more, more quickly, raising the risk of recession and dramatically lowering bond yields, both of which would reduce investor demand for corporate bonds.

At the other extreme, credit could be challenged if conditions are too hot. Because current levels of corporate aggression are still quite low, we think they could rise in 2025 without creating a major problem. But if those corporate animal spirits arrive more rapidly, it could be a negative.

Outside the US, we think the growth in Europe holds up as the European Central Bank cuts rates and Europeans end up saving at a slightly less elevated rate, and that that can keep growth near this year’s levels, around 1 per cent. But you don’t need me to tell you that Europe is riddled with challenges: from the political in France, to major structural questions around Germany’s economy. Meanwhile, China, the world’s second largest economy, continues to struggle with too little inflation. We think that growth in China muddles through, but a larger trade escalation could drive downside risk; one reason we prefer ex-China credit within Asia.

Of course, maybe the most obvious risk to Credit is simply valuation. Credit spreads in the US are near 20-year lows, while the US Equity Price-to-Earnings Multiples for the equity market is near 20-year highs. In our view, valuation is a much better guide to returns over the next six years, rather than say the next six months. And that’s one reason we are currently looking through this. But those valuations do leave a lot less margin for error.

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

How Equity Markets Are Feeling About 2025

10 december 2024 | 5 min

Our CIO and Chief U.S. Equity Strategist says that while equity market activity suggests a measured level of optimism about 2025, the questions around tariffs and inflation have tempered expectations.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Today on the podcast I will be discussing how equity markets have traded post the election and how this fits with our thinking.

It's Tuesday, Dec 10 at 11:30am in New York. So let’s get after it.

Post the election, our focus has been on the potential for a rebound in animal spirits like we observed following the 2016 election. During that historical period, we saw a broad-based surge in corporate, consumer and investor confidence as the sentiment analysis we’ve done shows. So far over the last month, sentiment data has reflected a more measured level of optimism led by small business confidence while services related business outlooks were actually tempered somewhat.

Our assessment of the details of these surveys and commentary from corporates suggests that consumers and companies are feeling more optimistic heading into 2025. But the uncertainty around tariffs and the still elevated price levels are likely holding back the type of exuberance we saw post the 2016 election.

In 2016, we were also coming out of an industrial/manufacturing downturn, which was then aided by aggressive China stimulus. Due to that downturn, interest rates were much lower globally and sovereign deficits and balance sheets were in much better shape to absorb reflationary type policies like tax cuts and deregulation. As a result, the equity market almost immediately embraced an expansionary fiscal agenda that was interpreted as being pro-growth. Today, that policy agenda appears to be less front-footed in this regard, perhaps due to some of these constraints.

Nevertheless, these dynamics are still supportive of our preference for more cyclical sectors. However, given the stickiness of interest rates, it also makes sense to remain up the quality curve within cyclicals and constructively focused on sectors with clearer de-regulation tailwinds. As a result, Financials remain our preferred over-weight, followed by Software, Utilities and Industrials.

On the topic of interest rates, we find it interesting that the correlation of S&P 500 returns versus the change in bond yields remains in positive territory. In other words, good macro data is good for equity returns. Furthermore, there is a clear bifurcation in terms of this correlation between cyclical and defensive sectors. Cyclical sectors are showing a positive correlation to rates, with one exception of Materials, while defensive cohorts are showing a negative correlation except for Utilities.

In our view, this is a sign that cyclicals and the market overall still like stronger macro data even if it comes amid higher yields. Having said that, there is a point where this dynamic would likely reverse if interest rates rise due to less dovish monetary policy or an increase in the term premium. In April of this year, that level was 4.5 per cent on the 10-year Treasury yield when growth and inflation drove the term premium higher. For now, rates remain contained well below that threshold and the term premium is close to zero.

On the flipside, a material decline in yields due to weakness in the macro growth data would also hurt cyclical stocks disproportionately leaving 4.00-4.50 per cent on the 10-year treasury yield as the sweet spot for equity valuations. Yields below that range can certainly be tolerated by equities assuming the driver is Fed rate cuts in the absence of a material slowdown in growth. Yields above that range can also be tolerated if the pace of the rate rise is measured, and the driver is stronger nominal growth versus a more hawkish Fed or a rising inflation.

Finally, as we approach year-end, December seasonality is likely to be a focal point for investors. Over the past 45 years, the S&P 500's median return over the month of December is 1.5 per cent and the index has a positive return 73 per cent of the time. Notably, almost all of that performance comes in the second half of the month. These trends are directionally consistent for the Russell 2000 small cap index except that it’s even stronger at about 2.5 per cent. This performance could be further enhanced by the larger post-election spike in small business confidence mentioned earlier.

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

How AI Is Revolutionizing Healthcare

9 december 2024 | 13 min

Morgan Stanley Research and Investment Management analysts discuss how AI can keep costs down for the industry and give patients a more personalized experience.

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Craig Hettenbach: Welcome to Thoughts on the Market. I'm Craig Hettenbach, Morgan Stanley's U.S. Healthcare Technology and Providers analyst.

Today I'm here with my colleague Steve Rodgers from Morgan Stanley Capital Partners to talk about a growing and underappreciated segment of healthcare – the behind-the-scenes technology that is transforming the sector to keep costs down and improve patient care.

It's Monday, December 9th at 9am in New York.

In 2022, the size of the U.S. healthcare sector was [$]4.5 trillion and is projected to grow to [$]6.8 trillion in 2030, accounting for 20 per cent of overall U.S. GDP. We know that the U.S. population is aging, and we expect to see 71 million U.S. citizens age 65 and over by 2030. That puts ever growing demand on health care systems.

So, Steve, you and your colleagues in investment management have been looking lately at key macro trends driving change in the healthcare sector.

What are these drivers and how do they work together?

Steve Rodgers: When we look at the health care landscape, we really think about four major macro trends. The first is cost containment. And this is just this simple idea that costs are escalating at an unsustainable rate. The second is demographics; we also know that things like obesity is increasing the prevalence of chronic conditions and increasing the overall utilization of the healthcare system. And so, we're looking at ways to invest behind that macro trend.

We've also identified something called consumerism. And consumerism stems from the reality that today, patients are taking more of a financial responsibility in their healthcare. And with that comes more decision making. So, the old days – where the patient received healthcare services, but the payer paid, and there was really no link between the two – have moved on.

We call it the retailization of health care. Waiting in the office for your appointment for 30 minutes used to be a standard. Today, that's unacceptable because these patients will move to the next provider who's providing them a better retail experience.

The final macro driver we call enabling technology. Health care has lagged many other industry segments in the use of technology as a source of efficiency. I like to give the example of chemotherapy treatments, right? Technology would produce a new chemotherapy treatment, and while that's great for patient care and outcomes. It actually could lead to increased costs to the system because it was an added route that people would go down.

Now there's technology which allows a provider to say, “Start with this one because of your genetic makeup.” And not only will you have a better outcome more quickly, but it will be less cost to the system. We're also seeing that kind of efficiency happen on the administrative side of healthcare as well.

The way we think about these macro trends and how they work together is really thinking about demand versus supply. So, we see demand drivers coming from demographics and consumerism. We see supply drivers coming from cost containment and really enabling technology has impacts on both demand and supply.

Craig Hettenbach: Let's focus more specifically on just how digitization and cost containment dovetail. When people talk about the impact of AI and ML on healthcare, typically the focus is on things like big pharma, medical equipment, and hospitals. But there's actually a whole intricate infrastructure that helps healthcare run.

Can you talk about these behind-the-scenes businesses and why investment managers are so interested in the opportunities they offer?

Steve Rodgers: Yeah, it's really important. We focus on investments that are using technology to enable their businesses. And so that's automation. That's machine learning. It's AI. But all of these technologies are being used behind the scenes to make care more efficient and they're a better use of our dollars.

For example the personalization of communications from health plans. So historically a health plan would send the same communication, you know, to – the same form to every patient.

Well now, technology allows the health plan, at the point of generating that communication, to know that information about the person that's getting it. And having the ability to personalize it in ways that might help them be more likely to interact with it. Maybe they're trying to get them to do something about their health. Well, they can take an administrative communication, you know, called an explanation of benefit, which really just explains how much you owe versus how much the health plan owes. And you can also add important information to that that might help you utilize your benefits better.

Another example that we see is on the hospital side. As people I think have heard, hospitals have been very inefficient, right? They pay bills the wrong bills, they're duplicative invoices, and there haven't been really good ways to figure that out. Well, we now have technology that can identify those duplicative invoices, that can actually identify that there are multiple contracts that they have with a vendor and direct them to use the cheapest one.

Last one that I would highlight is around the procurement of pharmaceuticals. So, again, if you imagine a hospital system that has 50 different hospitals and one person at each hospital might be buying the pharmaceuticals that fit to the needs they have in that facility. Well, now there's technology that's really helping consolidate those purchases, get the benefits of scale. Also tracking what is a very dynamic pricing market and figuring out today this channels is less costly than that one, so buy it from here; tomorrow it might be different.

We're seeing behind-the-scenes uses of technology in all of those types of areas, which are leading to efficiencies.

Craig Hettenbach: That's really interesting and I agree. Sometimes investors can overlook healthcare infrastructure as an area offering a lot of hidden growth. Let's take a subsector like Revenue Cycle Management or RCM. What is it exactly and what opportunities does it offer when it comes to technology and cost containment?

Steve Rodgers: What it is, it really is the whole process from start to finish of a healthcare episode. So, starting with something as simple as eligibility, or is this patient eligible for this procedure?

Then once that procedure happens, it has to be documented and coded and billed. And then once that bill goes out that needs to be collected and paid on. So, this whole process is really how healthcare works and it's one of the most important business processes for healthcare companies .

And what we've seen with revenue cycle is it's been a very, historically, a very manual process that involved a lot of human effort. So early on, some of the most basic functions of revenue cycle were automated. So, the example I can give there would be the front-end entry of a claim.

So that used to be sent over by fax and a person would have to look at that and type it into a computer and start the processing that way. Well that, for a long time, that's now been automated with either what's called OCR, which is a scanning technology. But even, you know, now, a lot of that's coming in digitally. But a lot of the rest of the process is still manual. And the reason is because the tasks are so complex. So, to resolve a claim, you often need to pull data from multiple sources. There'd be some subjective determinations about what's allowed or not allowed.

You would then need to apply [it] against a multiple complex rules and benefits. And sometimes the sheer dollars involved would make it too risky to just pay that claim without someone actually looking at it. Really we're entering an automation cycle where some of these new technologies are making it possible to reliably automate these more complex functions.

And so it's a combination of machine learning and AI but it's really driving efficiencies that are really exciting from an investment perspective to us right now.

Craig Hettenbach: Got it. In addition to revenue cycle management, are there any other subsectors that look interesting to you right now?

Steve Rodgers: We also, we call it cost cycle management. This is the idea of applying the same principles that we're seeing in revenue cycle to the purchasing of providers. So that can be supply costs, inventory management. Another area that we think is interesting is self insured employer outsourcing. One of the main frustrations that we hear time and time again from self insured employers is that their employees are not utilizing the benefits that they have. With technology, companies that are finding ways to get broader and better adoption; then in turn allowing these employers to see better utilization, which is going to lead to a healthier workforce and hopefully do so also, with some cost containment.

So Craig, it's clear that there's an overlap between what we look at from the investment management side and what you and your colleagues focus on in research. How do you think about analyzing how AI and machine learning are impacting healthcare?

Craig Hettenbach: Yeah, so for research across the department, we came up with a framework to look at and that's the NEXT framework. So number one, new business opportunities to evaluate. Number two, efficiencies. Number three, external productivity. And number four, content creation. So those are four things to help kind of frame what the opportunity set looks like, when leveraging AI and technology.

Steve Rodgers: And how does this framework apply to your space, healthcare services and technology specifically?

Craig Hettenbach: The second point of that next framework, the E for efficiencies, is something that we're already starting to see the tangible benefits. And so, just to give you some context here, the CEO of a leading hospital, at a conference recently said that 25 to 30 per cent of overall healthcare costs are tied to administrative.

So there is a lot of low hanging fruit there. There's other areas within whether you think about things like prior authorizations that are still done manually, either via fax, phone, email. Those are things that some health plans and technology partners are looking to automate. So, I think the efficiencies – we’re still early on, but you're starting to see at least the business case in terms of investments there.

And then there's the longer term look on the clinical side. And I think the understanding there is that's going to take longer. An executive at a recent industry conference I was at, I thought he said it best when he said, ‘You know, AI is going to save time before it saves lives.’

Steve Rodgers: How is this technology changing how physicians or providers do their jobs?

Craig Hettenbach: When we look at what's happened with physicians and nurses and still not too far removed from COVID and just burnout, it's palpable. And I think it's something that technology can certainly be used as an enhancer.

So ambient listening is a new technology. When we think about electronic health records; yes, it's great to get that information into that record, but it's also timely and consuming. And so, I think things like that – that can listen to and populate notes – is going to be a real time saver for both doctors and patients.

And on the patient side as well, when we think about just our experience, right? Healthcare just has a long ways to go in terms of response time. And that's something that I think more automation and technology, whether it's things like scheduling or check-ins and things like that, I think ultimately you'll see more technology deployed.

Okay, Steve, are there any other potentially overlooked near term or longer-term pockets of opportunity within health care that you think investors should focus on?

Steve Rodgers: Yeah, I think a general rule for investors or, you know, a heuristic that they should think about is, really trying to invest behind the things that are providing – really trying to stay on the right side of healthcare. And so, when we look at things like cost containment, you know, we see companies out there where they might be benefiting from inefficiency in the system. Those are things that I'd stay away from.

I'd focus on companies that are providing better quality care at a lower cost and staying on the right side of healthcare. Because I do believe that a lot of these investments – the AI, the technology – are going to drive efficiency and really eradicate some of these business models that are really taking advantage of the inefficiencies in the healthcare system.

Craig Hettenbach: Great, Steve, well that's very helpful and thanks for taking the time to talk today.

Steve Rodgers: Great speaking with you, Craig.

Craig Hettenbach: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleagues today.

A Very Merry Start to U.S. Holiday Shopping

6 december 2024 | 9 min

Morgan Stanley Research analysts see a strong start following Black Friday but question whether the short shopping season will hurt retailers.

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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver, Morgan Stanley's U.S. Thematic and Equity Strategist.

Simeon Gutman: I'm Simeon Gutman, U.S. Hardlines, Broadlines, and Food Retail analyst.

Alex Straton: And I'm Alex Straton, North America Softlines, Retail, and Brands analyst.

Michelle Weaver: Thanksgiving and Black Friday are behind us; and now that the holiday shopping season is in full swing, we have some interesting new data we wanted to dig into. We also recently concluded Morgan Stanley's Global Consumer and Retail Conference in New York, and we'll share some key takeaways from that.

It's Friday, December 6th at 10am in New York.

I was recently on the show to talk about our holiday shopping outlook and survey takeaways, and noted that overall, we're expecting stronger spending this holiday season relative to last year. Inflation's cooled, and U.S. consumers are more positive on spending this season versus the past two holiday seasons. Now that we've got Black Friday in the rearview mirror, Simeon, within your space, how's holiday season tracking so far?

Simeon Gutman: Better. And the three key metrics – traffic, physical store sales, digital sales – all seem to be tracking better. The question is the magnitude and the length of ahead that the entire industry is – and what does that give us through the rest of the season? As we all know, the holiday season, shopping season is shorter; with the later fall of Thanksgiving, we're losing a weekend. The tone at our conference affirmed all of this, all the data points we heard were pretty upbeat. And it seems like the weather couldn't have broken at a better time, which is different from the October lead up to holiday.

So, it seems like we're off to a pretty healthy start. I think there's some questions of what do we make up in the last three weeks in this final push. Some companies at our conference sounded good on that. Some were a little bit, call it cautiously optimistic about the rest of the season.

Michelle Weaver: And what are you expecting for the rest of the holiday season?

Simeon Gutman: In theory, and as we do our models what the good start typically portends a pretty good finish. There will be like a frenetic, frantic rush till the end. And because we lose that last weekend, you know, we might just lose some days. That's what history has told us. And those couple of days, it could end up being a couple of points or a couple hundred points of growth. That's understandable. I think the market knows that. And if that were to happen, as long as the underlying tone of business is healthy, I think it's pretty excusable because it's either made up in the subsequent months, and it'll especially be made up in the following year.

Michelle Weaver: Great. And then Alex, in your space with Black Friday now behind us, were there any surprises?

Alex Straton: The headline on Black Friday out of the apparel and footwear space was very positive. That's the message everyone should hear. I think I'll break down how we thought about – and what we observed – into two buckets. One being what we saw on demand, and the other being what we saw on promotional or discounting activity.

Now, starting with demand, I think context is really important here, and we had a pretty lackluster September and October trend line in the space. To us, this was a function of adverse weather; it was much hotter than usual, really deterring apparel spending. We also had high hurricane activity, which deterred overall discretionary spending. And then also we had the election overhang upon consumers, which can, you know, deter spending as well.

So as a result, we had fall apparel spending not necessarily as robust as many retailers would have liked. We've seen that in third quarter earnings reports. And we viewed Black Friday as, almost this very powerful potential catalyst for pent up demand. It was very weather dependent, though, and Simeon mentioned this briefly. We got a cold front across the country, and I think that created this important catalyst to kick off the holiday season. So, demand was strong.

Just to put some numbers around it. Our line counts were up 30 per cent year-over-year. That's a data set that typically grows mid-single digits. So, speaks to, you know, outstanding demand. It doesn't capture conversion, so it's not perfect, but it gives you a sense for our confidence and how strong it was.

The second piece that I wanted to cover is just promotions. And what we saw there was consistent activity year-over-year. That was a positive surprise for me. We were braced for discounting to be higher across the group because we exited both the second quarter and out of the early third quarter reporters with some excess inventory. So, we thought they might look to clear it.

We had seen a recent uptick in promotional activity in October across the group. And then also, we're facing down a pretty competitive fourth quarter set up because of a number of the dynamics that Simeon mentioned. So, the fact that we didn't see retailers, kind of, push the panic button on discounting and promotions to drive that strong sales result, I think further underscores how strong it was; and also tells you retailers are willing to wait later for the consumer, similar to how they behaved last year.

Michelle Weaver: In your outlook for holiday shopping this year, you cautioned about some potential headwinds. What were they and have they been playing out as you expected?

Alex Straton: Yeah. So, since the start of the year, there's been a number of dynamics that we're going to weigh on the fourth quarter, no matter what. The first is that it's companies in my coverage most difficult year-over-year comparison quarter from both the sales and a profitability perspective. The second is that we have a compressed holiday shopping period, five fewer days, one less weekend; that’s very impactful for these retailers. And the last thing is that most retailers are lapping an extra week last year. They have a 53rd week calendar dynamic that reverses out this week. So, think about it as one last less week of sales opportunity.

And so, I could have sat here in January and told you all of that. What we've learned since is that these retailers are now also facing incremental freight headwinds in the back half. Some of which are just repercussions from the Red Sea dynamic. And then second, this inventory build that I mentioned that started to show up in the second quarter and some of these earlier third quarter reporters. So, all of those headwinds, I'm putting them on the table.

I think the good news is that the market seems to now mostly appreciate those. There's not really high bars as we think about fourth quarter results expectations or even sentiment more broadly. So, while it is a very challenging set up, I feel like it's mostly appreciated.

Michelle Weaver: Great. And final question for both of you. What are some of your key takeaways from the fireside chats you hosted at the conference that just closed?

Simeon Gutman: A few thoughts. First on the tone of holiday, I'll reiterate again: companies that are most exposed to holiday, in my coverage – ones that have weather exposure, ones that have seasonal exposure, ones that have large Black Friday promotions and into Cyber Monday – sounded good. There was a sense of relief that we're making up sales, especially on cold weather categories, and there's momentum that's being carried into the rest of the year.

Second, in our chats with some of the largest companies, a discussion around how starting from a retail point of view and leveraging into Omnichannel has actually been beneficial, because now as these companies gain scale and leverage, the economies of scale in Omnichannel are actually more beneficial for profits than they thought; and in some cases that's just getting started. So, an interesting dichotomy, or almost an irony for the way that these businesses were positioned about 10 to 15 years ago.

Third inventories – building; companies acknowledge that, but generally feel good. That reflected underlying optimism on sales trends and buying good inventory they think the customer will respond to. And then lastly, on housing; acknowledgment that the backdrop and the rebuild will be slow and steady, but at the same time that the industry is bottoming.

Alex Straton: Yeah, on my end, I would underscore what Simeon said on demand in the holiday. Clearly a strong start in terms of the weather finally turning around this big initial event with Black Friday.

Secondly, on inventory we're asking our companies the same question is – how do they feel about this build that we're seeing? And they attributed to a little bit of a pull forward of receipts in advance of holiday. Some also pulling forward even further than normal to offset some of the freight expense, or they were worried about some degree of freight disruption that could have impacted the receipts. So they have explanations for why that's the case, but we're monitoring it nonetheless.

And then lastly, the one magic dynamic we didn't mention yet is tariff, of course, and what the outlooks are there. I would say most companies in my space feel that they have a number of levers that they can pull to offset any potential incremental tariff next year. But the reality there is that apparel is a deflationary category. There's no pricing power. So I'll be really interested to see how this plays out next year.

Michelle Weaver: Simeon and Alex, thank you for taking the time to talk. And to our listeners, 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.

AI as a Second Set of Eyes

5 december 2024 | 4 min

Our Europe MedTech Analyst digs into the transformational impact of AI-driven diagnostic imaging on healthcare systems.

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Welcome to Thoughts on the Market, I’m Robert Davies, Morgan Stanley’s Head of the Europe MedTech research team. Today I want to take you behind the scenes to show you how AI is revolutionizing our approach to medical diagnostics via Smart Imaging.

It’s Thursday, December 5, at 10 AM in Boston.

When was the last time you needed to get an X-Ray, a CT scan, or an ultrasound? Depending on where you live, your wait time could be as long as a month.

Medical diagnostics through imaging is facing enormous challenges right now. Population growth, rising longevity, and intensifying chronic disease burdens are driving ever increasing volumes of medical scans. In the U.S. alone, CT scan volumes have quadrupled since 1995. So, what is the impact of this? Imagine a radiologist interpreting a CT or MRI image every 3-4 seconds during an eight-hour workday. This is the current pace needed to meet the soaring demand.

At the same time, the U.S. population is getting older and a growing number of people are signing up for Medicare. Healthcare costs are continually rising, total U.S. healthcare spend is now hitting $4.5 trillion. That's nearly 20% of U.S. GDP. On top of that, patients need fast, accurate diagnosis. But long wait times often mean that patients don’t get the diagnostic done in time or sometimes not at all. All of this indicates that more and more stress is being placed on hospital systems each year in terms of diagnostic imaging.

Smart Imaging uses AI tools to improve imaging processing and workflows to enhance traditional image gathering, processing, and analysis. It sits at the intersection of Longevity and Tech Diffusion, two of Morgan Stanley Research’s big themes for 2024. And it can help solve these acute demand challenges. In fact, AI is already transforming the $45 billion Diagnostic Imaging market.

AI-driven Smart Imaging integrates into the diagnostic imaging workflow at multiple stages—from preparation and planning, all the way to image processing and interpretation. The primary benefits of using AI are twofold. Firstly, it enhances image quality, which ensures more accurate diagnoses. And secondly it improves the speed, efficiency, and overall comfort of the patient journey. At the same time, AI effectively acts as a second set of eyes for the radiologist, often surpassing human accuracy in pattern recognition. That's crucial in reducing diagnostic errors—a problem costing the U.S. healthcare system around $100 billion annually at the moment.

In addition to minimizing misdiagnosis, AI is not only capable of identifying the primary disease, but also registering any potential secondary diseases. Otherwise, this isn’t normally a priority for the radiologist who is only able to spend 3-4 seconds looking at any individual image. But it’s a potentially life-saving benefit for using Smart Imaging applications.

So how does AI fit into the clinical setting? There are multiple stages to the Diagnostic Imaging workflow and AI can play a role across the entire value chain from preparing a patient’s scan, to processing the images, and finally, aiding in the diagnosis, reporting, and treatment planning.

Radiology is currently dominating the FDA list of AI/Machine Learning-Enabled Medical Devices. And when we look at the broader economic implications, it's clear Smart Imaging represents a pivotal development in healthcare technology that has broad implications for healthcare costs, quality of care, and better healthcare outcomes.

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.

What Investors Should Know About Trump’s Tariffs

4 december 2024 | 4 min

Our Global Head of Fixed Income and Thematic Research explains why President-elect Trump’s proposed tariff plans may look different than the policies that are ultimately put in place.

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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. Today on the podcast I'll be talking about what investors need to know about tariffs.

It’s Wednesday, Dec 4, at 2 pm in London.

There’s still over a month before Trump takes office again. But in the meantime he’s started sending messages about his policy plans. Most notably, for investors, he’s started talking about his ideas for tariffs. He’s floated the idea of tariffs on all imports from China, Mexico, and Canada. He’s talked about tariffs on all the BRICs countries unless they publicly dismiss the idea of pursuing an alternative reserve currency to the US dollar. In short, he’s talking about tariffs a lot.

While we certainly don’t dismiss Trump’s sincerity in suggesting these tariffs, nor the ability for a President to execute on tariffs like these – well, mostly anyway – it’s important for investors to know that the ultimate policies enacted to address the concerns driving the tariff threats could look quite different than what a literal interpretation of Trump’s words might suggest. After all, there are plenty of examples of policies enacted on Trump’s watch that address his concerns that were not implemented exactly as he initially suggested.

The Tax Cuts and Jobs act is a good example, where Trump advocated for a 15 percent corporate tax rate but signed a bill with a 21 percent tax rate. Another is the exceptions process for the first round of China tariffs, where some companies got exceptions based on modest onshoring concessions. These examples speak to the idea that procedural, political, and economic considerations can shape policy in a way that’s different from what’s initially proposed.

This is why our base case for the US policy path in 2025 includes higher tariffs announced shortly after Trump takes office; but with a focus on China and some exports from Europe; and implementation of those tariffs would ramp up over time, as has been suggested by key policy advisors. There's broad political consensus on a stronger tariff approach to China, and there’s already executive authority to take that approach. Something similar can be said about Europe, but with a focus more on certain products than across imports broadly. However, we see scope for Mexico to avoid incremental tariffs through negotiation. And a global tariff via executive order risks getting held up in court, and we’re skeptical even a Republican-controlled Congress would authorize this approach.

Of course we could be wrong. For example it's possible the incoming administration might be less concerned about the economic challenges posed by a rapid escalation of tariffs. So if they start quicker and are more severe than we anticipate, then our 2025 economic projections are probably too rosy, as are our expectations for equities and credit to outperform over the next 12 months. The US dollar and US Treasuries might be the outperformer in that scenario.

So stick with us, we’ll be paying attention and trying to tease out the policy path signal from the media noise from the new administration.

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.

Private vs. Public Credit Competition Intensifies

4 december 2024 | 7 min

Our Chief Fixed Income Strategist Vishy Tirupattur and Leveraged Finance Strategist Joyce Jiang discuss how the dynamic between private and public credit markets will evolve in 2025, and how each can find their own niches for success.

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Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Today we'll be talking about how private credit has evolved over 2024 and the outlook for 2025. I'm joined by my colleague, Joyce Jiang, from our Leveraged Finance Strategy team.

It's Tuesday, December 3rd at 10am in New York.

A lot has happened over 2024 in private credit. We are credit people. Let's talk about defaults and returns. How has 2024 been thus far for private credit in terms of defaults and returns?

Joyce Jiang: It's always tricky to talk about defaults in private credit because the reported measures tend to vary a lot depending on how defaults are defined and calculated. Using S&P's credit estimate defaults as a proxy for the overall private credit defaults, we see that defaults appear to have peaked, and the peak level was significantly lower than during the COVID cycle.

Since then, defaults have declined and converged to levels seen in public loans. In this cycle, the elevated policy rates have clearly weighed on the credit fundamentals, but direct lenders and sponsors have worked proactively to help companies extending maturities and converting debt into PIK loans. Also, the high level of dry powder enabled both private credit and PE funds to provide liquidity support, keeping default rates relatively contained.

From a returns perspective for credit investors, the appeal of private credit comes from the potential for higher and more stable returns, and also its role as a portfolio diversifier. Data from Lincoln International shows that over the past seven years, direct lending loans have outperformed single B public loans in total return terms by approximately 2.3 percentage point annually, largely driven by the better carry profile. And this year, although the spread premium has narrowed, private credit continues to generate higher returns.

So, Vishy, credit spreads are close to historical tights. And the market conditions have clearly improved compared to last year. With that, the competition between the public and private credit has intensified. How do you see this dynamic playing out between these two markets?

Vishy Tirupattur: The competition between public and private credit has indeed intensified, especially as the broadly syndicated market reopened with some vigor this year.

While the public market has regained some share it lost to private credit, I think it is important to note that the activity has been, especially the financing activity, has been really more two-way. Improved market conditions have lured some of the borrowers back to the public markets from private credit markets due to cheaper funding costs.

At the same time, borrowers with lower rating or complex capital structure seem to continue to favor private credit markets. So, there is really a lot of give and take between the two markets. Also, traditionally, private credit markets have played a major role in financing LBOs or leveraged buyouts. Its importance has really grown during the last Fed's hiking cycle when elevated policy rates and bouts of market turmoil weaken banks’ risk appetite and tighten the public-funding access to many leveraged borrowers.

Then, as the Fed's policy tightening ended, and uncertainty about the future direction of policy rates began to fade, deal activity rebounded in both markets, and more materially in public markets. This really led to a decline in the share of LBOs financed by private credit. Of course, the two markets tend to cater for deals of different sizes. Private credit is playing a bigger role in smaller size deals and a broadly syndicated loan market is relatively much more active in larger sized LBOs. So, overall, public credit is both a complement and competitor to private credit markets.

Joyce Jiang: The decline in spread basis is evident in larger companies, but more recently, the spread basis have even compressed within smaller-sized deals, although they don't have the access to public credit. This is likely due to some private credit funds shifting their focuses to deals down in the site spectrum. So, the growing competition got spilled over to the lower middle-market segment as well. In addition to pricing conversions, we've also seen a gradual erosion in covenant quality in private credit deals. Some data sources noted that covenant packages have increasingly favored borrowers, a reflection of the heightened competition between these two markets.

So Vishy, looking ahead, how do you see this competition between public and private credit evolving in 2025, and what implications might this have for returns?

Vishy Tirupattur:, The competition, I think, will persist in [the ]next year. We have seen strong demand from hold to maturity investors, such as insurance companies and pension funds; and this demand, we think, will continue to sustain, so the appetite for private credit from these investors would be there.

On the supply side, the deal volume has been light over the last couple of years. Next year, acquisition LBO activity, likely to pick up more materially given the solid macro backdrop, lower rates that we expect, and sponsor pressure to return capital to investors. So, in 2025, we could see greater specialization in terms of deal financing. Instead of competing directly for deals, public and private credit markets can find their own niches. For example, public credit might dominate larger deals, while private credit could further strengthen its competitive advantage within smaller size deals or with companies that value its unique advantages, such as the flexible terms and speed of execution.

Regarding returns, while spread premium in private credit has indeed come down, a pickup in deal activity could to some extent be a release valve. But sustained competition may keep the spreads tight. Overall, private credit should continue to offer attractive returns, although with tighter margins compared to historical levels.

Joyce, it was great speaking with you on today's podcast.

Joyce Jiang: Thank you, Vishy, for having me.

Vishy Tirupattur: Thank you all for listening. If you enjoy today's podcast, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Will 2025 Be a Turning Point for Credit?

2 december 2024 | 4 min

Our Head of Corporate Credit Research Andrew Sheets recaps an exceptional year for credit — but explains why 2025 could be a more challenging year for the asset class.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Today I’ll be discussing the Outlook for global Credit Markets in 2025.

It’s Monday, Dec 2nd at 2 pm in London.

Morgan Stanley Strategists and Economists recently completed our forecasting process for the year ahead. For Credit, 2025 looks like a year of saying goodbye.

2024 has been an exceptionally good environment for credit. As you’ve probably grown tired of hearing, credit is an asset class that loves moderation and hates extremes. And 2024 has been full of moderation. Moderate growth, moderating inflation and gradual rate cuts have defined the economic backdrop. Corporates have also been moderate, with stable balance sheets and still-low levels of corporates buying each other despite the strong stock market.

The result has been an almost continuous narrowing of the extra premium that companies have to pay relative to governments, to some of the lowest, i.e. best spread levels in over 20 years.

We think that changes. The U.S. election and resulting Republican sweep have now ushered in a much wider range of policy outcomes – from tariffs, to taxes, to immigration. These policies are in turn driving a much wider range of economic outcomes than we had previously, to scenarios that include everything from much greater corporate optimism and animal spirits, to much weaker growth and higher inflation, under certain scenarios of tariffs and immigration.

Now, for some asset classes, this wider range of outcomes may simply be a wash, balancing out in the aggregate. But not for credit. This asset class doesn’t stand to return more if corporate activity booms; but it stands to still lose if growth slows more than expected. And given the challenges that tariffs could pose to both Europe and Asia, we think these dynamics are global. We see spreads modestly wider next year, across global regions.

But if 2025 is about saying goodbye to the credit-friendly moderation of 2024, we’d stress this is a long goodbye. A key element of our economic forecasts is that even if major changes are coming to tariffs or taxes or immigration policy, that won’t arrive immediately. Today’s strong, credit-friendly economy should persist – well into next year. Indeed, for most of the first half of 2025, Morgan Stanley’s forecasts look much like today: moderate growth, falling inflation, and falling central bank rates.

In short, when thinking about the year ahead, 2025 may be a turning point for credit – but one that doesn’t arrive immediately. Our best estimate is that we continue to see quite strong and supportive conditions well into the first half of the year, while the second half becomes much more challenging. We think leveraged loans offer the strongest risk-adjusted returns in Corporate Credit, while Agency Mortgages offer an attractive alternative to corporates for those looking for high quality spread.

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

Special Encore: The Beginning of an M&A Boom?

29 november 2024 | 4 min

Original Release Date November 15, 2024: Our head of Corporate Credit Research Andrew Sheets explains why a stronger economy, moderate inflation and future rate cuts could prompt deal-making.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Today I’ll discuss why we remain believers in a large, sustained uptick in corporate activity.

It's Friday, November 15th at 2pm in London.

We continue to think that 2024 will mark the start of a significant, multiyear uplift in global merger and acquisition activity – or M&A. In new work out this week, we are reiterating that view. While the 25 percent rise in volumes this year is actually somewhat short of our original expectations from March, the core drivers of a large and sustained increase in activity, in our view, remain intact.

Those drivers remain multiple. Current levels of global M&A volumes are still unusually low relative to their own historical trend or the broader strength that we see in stock markets. The overall economy, which often matters for M&A activity, has been strong, especially in the US, while inflation continues to moderate and rate cuts have begun. We see motivations for sellers – from ageing private equity portfolios, maturing venture capital pipelines, and higher valuations for the median stock. And we see more factors driving buyers from $4 trillion of private market "dry powder," to around $7.5 trillion of cash that's sitting idly on non-financial balance sheets, to wide-open capital markets that provide the ability to finance deals.

These high level drivers are also confirmed bottom up by boots on the ground. Our colleagues across Morgan Stanley Equity Research also see a stronger case for activity – and we polled over 60 global equity teams for their views. While the results vary by geography and sector, the Morgan Stanley Equity analysts who cover these sectors in the most depth also see a strong case for more activity.

The policy backdrop also matters. While activity has risen this year, one reason it might not have risen as much as we initially expected was uncertainty about both when central banks would start cutting rates and the outcome of US elections.

But both of those uncertainties have now, to some extent, waned. Rate cuts from the Fed, the ECB, and the Bank of England have now started, while the Red Sweep in US elections could, in our view, drive more animal spirits. And Europe is an important part of this story too, as we think the European Union’s new approach to consolidation could be more supportive for activity. For investors, an expectation that corporate activity will continue to rise is, in our view, supportive for Financial equities.

Where could we be wrong? M&A activity does fundamentally depend on economic and market confidence; and a weaker than expected economy or weaker than expected equity market would drive lower than expected volumes. Policy still matters. And while we view the incoming US administration as more M&A supportive, that could be misguided – if policy changes dent corporate confidence or increase inflation.

Finally, we think that a more multipolar world could actually support more M&A, as there’s a push to create more regional champions to compete on the global stage. But this could be incorrect, if those same global frictions disrupt activity or confidence more generally. Time will tell.

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

Special Encore: How Young People Think About Money

27 november 2024 | 4 min

Original Release Date November 1, 2024: Our US Fintech and Payments analyst reviews a recent survey that reveals key trends on how Gen Z and Millennials handle their personal finances.

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Welcome to Thoughts on the Market. I’m James Faucette, Morgan Stanley’s Head of US Fintech and Payments. Today I’ll dig into the way young people in the US approach their finances and why it matters.

It’s Friday, November 1st, at 10am in New York.

You’d think that Millennials – also commonly known as Gen Y – and Gen Z would come up with new ways to think about money. After all, they live most of their lives online, and don’t always rely on their parents for advice – financial or otherwise. But a survey we conducted suggests the opposite may be true.

To understand how 16 to 43 year-olds – who make up nearly 40 per cent of the US population – view money, we ran an AlphaWise survey of more than 4,000 US consumers.

In general, our work suggests that both Millennials and Gen Z’s financial goals, banking preferences, and medium-term aspirations are not much different from the priorities of previous generations. Young consumers still believe family is the most important aspect in life, similar to what we found in our 2018 survey. They have a positive outlook on home ownership, college education, employment, and their personal financial situation. 28-to-43-year-olds have the second highest average annual income among all age cohorts, earning more than $100,000. They spend an average of $86,000 per year, of which more than a third goes toward housing.

Gen Y and Z largely expect to live in owned homes at a greater rate in five to 10 years, and younger Gen Y cohorts' highest priority is starting a family and raising children in the medium term. This should be a tailwind for many consumer-facing real estate property sectors including retail, residential, lodging and self-storage. However, Gen Y and Z are less mobile today than they were pre-pandemic. Compared to their peers in 2018, they intend to keep living in the same area they're currently living in for the next five to 10 years.

Gen Y and Z consumers reported higher propensity for saving each month relative to older generations, which could be a potential tailwind for discretionary spending. And travel remains a top priority across age cohorts, which sets the stage for ongoing travel strength and favorable cross-border trends for the major credit card providers.

In addition to all these findings, our analysis suggests several surprising facts. For example, our survey results contradict the widely accepted notion that younger generations are "credit averse." The vast majority of Gen Z consumers have one or more traditional credit cards – at a similar rate to Gen X and Millennials. Although traditional credit card usage is higher among Millennials and Gen Z than it was in 2018, data suggests this is driven by convenience, not financing needs. Younger people’s borrowing is primarily related to auto and home loans from traditional lenders rather than fintechs.

Another unexpected finding is that while Gen Y and Z are more drawn to online banking than their predecessors, about 75 per cent acknowledge the importance of physical branch locations – and still prefer to bank with their traditional national, regional, and community banks over online-only providers. What’s more, they also believe physical bank branches will be important long-term.

Overall, our analysis suggests that generations tend to maintain their key priorities as they age. Whether this pattern holds in the future is something we will continue to watch.

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.

Uncertainty Surrounds 2025 U.S. Equities Outlook

26 november 2024 | 11 min

Morgan Stanley’s CIO and Chief U.S. Equity Strategist Mike Wilson joins Andrew Pauker of the U.S. Equity Strategy team to break down the key issues for equity markets ahead of 2025, including the impact of potential deregulation and tariffs.