Morgan Stanley IM: No Easy Fix

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After a sustained rally over the summer, both the U.S and Europe sold off, with the S&P 500 (TR) (USD) down 4.1% and MSCI Europe (TR) (EUR) -4.9%¹. Japanese equities appear to offer some defensiveness, as the MSCI Japan (TR) (JPY) returned 1.1%¹. The MSCI Emerging Markets Index (USD) returns also proved more defensive, marginally up 0.5%¹. Energy was once more the top performing sector over the month, as the MSCI ACWI Energy (USD) returned 2.4%¹. However, after much of the year significantly above $100 a barrel, there was some relief as oil finally moved below this, with WTI ending the month $90.1bbl and Brent $96bbl¹. As markets sold off, the VIX index began creeping back up, reaching 26 by month end².

The selloff can partly be attributed to the continuing conundrum faced by central banks, including the Federal Reserve (the Fed), European Central Bank (ECB) and the Bank of England (BoE). They must hike enough to control inflation, but with the risk of pushing their economies into a recession. At Jackson Hole, Federal Reserve Chairman, Jerome Powell re-iterated the Fed’s hawkish resolve, stating that even if softening labour markets and slower growth were to bring some pain, “failure to restore price stability would mean far greater pain”³.

Hard landing in the U.S.?

However, there are a number of factors which could help the U.S. avoid a hard landing in 2022. Capital expenditure (capex) is better supported compared with previous cycles, given healthy credit demand. Pent-up demand and the need for energy investment should also support capex. Capex may be front-loaded too, as the tax advantage of depreciating 100% in one year – part of Trump’s Tax Cuts and Jobs Act 2017 - starts to decrease annually from 2023. Moreover, though U.S. consumers are seeing inflation erode their personal income in real terms and savings rates have fallen to their lowest level since 2008 (i.e. from a pandemic high of 26% to 5.1%⁴, they still have a higher stock of personal savings compared to pre-pandemic levels, which can cushion spending. Whilst consumers are leveraging up, again this is not as pronounced as previous cycles, since leverage levels have been in decline since 2008’s Global Financial Crisis. The housing market, despite its current strength, is one of the main vectors which could help the Fed bring inflation under control, given mortgages’ sensitivity to rate rises.

That said, if inflation does not come down the Fed may have to act more aggressively than market participants currently anticipate, to prevent it becoming entrenched. Combine this with the time it takes for hikes to take effect, if it then turns out that the policy is too aggressive, it may be too late for the Fed to reverse its actions and avoid a hard landing.

The long winter

We are in an energy crisis caused by supply shortages. Therefore, government measures to cushion the blow to consumers are likely to support demand, in turn leading to higher prices, in a self-defeating cycle. As high energy prices exacerbate inflation, the only way central banks can act is by supporting currencies and suppressing activity enough to avoid an entrenchment of inflationary expectations. In this context, Europe is lagging in its hiking cycle and has a higher exposure to Russian gas supply, so may be more vulnerable to recessionary risks. Whilst the region has for now been able to remain on track to achieve its storage fill targets through gas supplies from UK pipelines, as we move into winter, this could come under pressure as temperatures drop. Unless supply is restored, only demand destruction can resolve the demand-supply mismatch. Again, there is no easy solution to this conundrum.

Investment implications

We maintain a cautious equity exposure and reduced duration in light of the increasing pressure on Central Banks to prevent inflation expectations from de-anchoring. Against this backdrop, we made the following tactical changes to our views:

U.S. 10-Year Treasuries

We moved from neutral to underweight U.S. 10-Year Treasuries, moving to short-dated T-Bills to reduce duration.

U.S. High Yield

We increased our underweight to U.S. High Yield and added to our short-dated T-Bills. Recently, U.S. High Yield spreads have tightened significantly, with many market participants forecasting the Fed will soon reach the terminal rate and rate cuts should commence in 2023, with economic growth remaining positive. In contrast, we believe these scenarios are mutually exclusive and look for a higher terminal rate and no significant cuts to the Fed funds rate in 2023, unless there is a deep recession in the U.S.. U.S. High Yield remains expensive compared to U.S. Investment Grade, but this pricing should turn as Fed tightening impacts lower quality borrowers negatively.

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.

Tactical Positioning

We have provided our tactical views below:

^{Source: MSIM GBaR team, as of 31 August 2022. For informational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The tactical views expressed above are a broad reflection of our team’s views and implementations, expressed for client communication purposes. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. The signals represent the GBaR team’s view on each asset class. A negative signal indicates a negative or underweight relative view, a positive signal indicates a positive or overweight relative view. Light blue indicates the tactical view before the change, with dark blue indicating the view as of 31 August 2022.}

¹ Bloomberg, 1-month returns, as of 31 August 2022. TR is total return, bbl is barrel of oil.
² Bloomberg, 31 August 2022.
³ Monetary Policy and Price Stability, Chair Jerome H. Powell, 26 August 2022. Board of Governors of the Federal Reserve System www.federalreserve.gov/newsevents/speech/powell20220826a.htm
⁴ US Real Personal Income is -3.4%, with Personal Saving Rate at 5.1% vs 8.7% long term median (based on YoY 3month moving average). U.S. Bureau of Economic Analysis (BEA), MSIM, 30 August 2022.

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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.