Morgan Stanley IM: From Too Tight to Too Easy. What’s Next for Asset Prices?

• In what was otherwise slated to be a slow week for data last week, a lot happened. The narrative in the market started to change from worries that the Fed may be making a mistake and tightening too much, to now questioning whether the Fed might be too easy and need to do more.
• Once again the culprit is inflation and inflation expectations. Investors are starting to question if inflation will fall enough and stay low. As you know, this has consistently been a key risk factor: the risk that inflation becomes unanchored and the Fed needs to do more than what's priced.
• But as they say, sometimes it's not just about the destination, the journey may be just as, if not more important. Why? Because market prices are often path dependent.
• Let's get into it!

The Initial Conditions: A review of risks before the journey started

• Going back to December's FOMC meeting. The market understood the Fed to be leading the market into a recession, as a necessary requirement to reduce demand and bring inflation lower, to target, and keep it there.
• Inevitably, the labor markets were expected to suffer and the unemployment rate to spike. Thereby deepening recession risks.
• Many started to call for an end to the tightening cycle at 4.75% at the Feb 2 meeting. The Fed was driving the economy off a cliff into recession.
• Cash was at record and cycle high levels as investors were understandably worried.
• Calls for earnings collapsed, and a deeper equity market correction were abundant.
• The UST 10y yield drop toward 3.30% seemed to all but confirm the 1H23 recession. Because, after all, the bond market is 'smarter' than the equity market, right? Except when it isn't.

The Journey – Part 1: What we observed along the way

• The jobs market turned out to be stronger. Just see the data from a few weeks ago.
• Noticing the strength in jobs, the Fed changed its base case to a soft-landing. The significance is that the Fed no longer feels a need to push back against higher asset prices to accomplish its goal of containing inflation. Supporting this change was:
  • Powell doubling down on his 'disinflation' comment at a speech last week. No walking things back.
  • Last week the Fed's Williams also acknowledged that 5% to 5.25% may be appropriate. Previously he was thought to be closer to 5.5%
  • A solid belief from the Fed that we will see falling inflation: 1) goods deflation, 2) wages falling as layoffs in higher paying tech/industrial sectors are shifting to lower paying service sectors.
  • It is now possible for the Fed to see inflation fall without being forced to drive the economy into a recession and bring the unemployment rate higher… Thus making the Fed less worried about rising asset prices.
• Asset prices, credit and equities, took notice and valuations rose. This is bringing cash off the sidelines to chase returns.
• Earnings are falling as expected but investors are willing to look through this and keep valuations, or multiples elevated

The Journey – Part 2: What may happen in the months ahead

• The narrative in the market shifted from hard landing to soft landing. Maybe the next step is no landing at all.
• This will keep high levels of cash looking to buy dips and chase returns. 'Risk-on' is a risk. Investors can't afford to miss a rally.
• The blame game. Inflation got the blame for keeping earnings elevated in 2022. As we started 2023 inflation got the blame for pushing earnings lower. But if growth does not slow as much as expected, will inflation get the blame for stabilizing earnings? Possibly. This suggests 'good' inflation that comes from better growth. IMPORTANT!
• Inflation is falling though, keep that in mind. This is increasing real wages and consumer purchasing power. A net positive for top line revenue growth.
• Pushing the bad news out to 2^nd half from 1^st half of 2023
  • Recession has been pushed out becoming expected by consensus to come in 2H23 vs 1H23
  • As this shift, or pushing out of bad news continues, markets may perform well as 'risk' of a soft, or no landing scenario needs to be factored in.

Destination Unknown

• It all comes down to inflation, not just falling but becoming anchored at acceptable levels near target. We see the big risk to be that it becomes unanchored, which would make the Fed restart the hiking cycle. But we are not there yet!
• In the meantime:
  • Fed fund futures are not priced for this. Thus there is a risk that the market pricing believes the Fed and those rates rise.
  • As those discount rates rise, it could weigh on valuations, push yields higher, spreads wider and equity prices lower.
  • BUT FROM WHAT LEVEL? This is the key question. We may get a sell-off in 2H, but perhaps from more elevated levels.
  • Conclusion: It's difficult to forecast the future, but for now, over the nearer term, the risk seems to be higher prices.
• Our asset allocation thus has a more 'risk-on' tilt. Something we started building upon last December. We maintain this bias and are looking to add on dips.

^{Risk Considerations}

^{Diversification does not eliminate the risk of loss. There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.}