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Optimism around the new tax law is propelling U.S. equities to record highs, but bond markets are signaling risk. Here’s what to watch.
Markets may seem calm following recent policy headlines, but for Michael Zezas, our Global Head of Fixed Income Research and Public Policy Strategy, investors may need to...
Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy.
Today: Why there's no summer slowdown yet for U.S. policy catalysts for the financial markets.
It's Friday, July 18th at 8am in New York.
The past week and a half has seen many major policy, events and headlines relevant to the outlook for financial markets. This includes more speculation by the U.S. administration over leadership at the Fed, more information about the deficit impact of the new fiscal bill, and – perhaps most tangibly – announcements of new tariffs that, if they take effect, will be a meaningful step up from already elevated levels.
It would all suggest a weaker growth outlook and less overseas demand for U.S. assets. Yet major financial markets seem to have shrugged it all off. The S & P and the U.S. dollar are up about 1 percent over that time, and Treasury yields are modestly higher.
So, what's going on? Two possibilities to consider, and it implies investors should pay more attention than they may be inclined to this summer.
First, when it comes to the impact of tariffs on the economy, it's possible we're dealing with a delayed impact. The effective average U.S. tariff rate shot up from 3 to 4 percent earlier this year to 13 percent, and if recent announcements go through, that could exceed 20 percent. That's a major escalation in costs for U.S. companies and consumers and something our economists argue takes growth down to 1 percent and elevates the possibility of a recession.
But our economists also point out that we may not be experiencing these cost increases quite yet. History suggests several months of lag between implementation and economic impact as companies leverage existing lower cost inventory before making tough decisions on pricing and managing their own costs.
That means hard economic data likely does not yet tell us about the impact or lack thereof of tariffs, but that may change in the coming months.
Second. It's also possible that the recent announcements of tariff increases don't tell us the whole story. As my colleagues in our equity strategy team point out, corporate America's cost base is most sensitive to the U.S.' largest trading partners – China, Mexico, Canada, and Europe. As we've discussed in prior episodes, we see tariff rate increases as likely on all these trading partners as tough negotiations continue.
However, the details will matter greatly if rates are increased, but with a healthy dose of exceptions or quotas. Even if they diminish over time, then the real impact could be significantly blunted. In that case, markets would resume taking cues from other factors such as earnings revisions and forward-looking expectations around AI driven productivity.
So bottom line, market movements suggest investors are assuming benign U.S. policy outcomes. But there's plenty of developments to track in the coming weeks and months to test if those assumptions will hold. Trade policy details and hard economic data are key among them.
Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review, and tell your friends about the podcast. We want everyone to listen.
The dollar’s bearish run is likely to affect U.S. equity markets. Michelle Weaver, our U.S. Thematic & Equity Strategist, and David Adams, our Head of G10 FX Strategy, di...
Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver, U.S. Thematic and Equity strategist at Morgan Stanley.
David Adams: And I'm Dave Adams, head of G10 FX Strategy here at Morgan Stanley.
Michelle Weaver: Our colleagues were recently on the show to talk about the impact of the weak dollar on European equities. And today we wanted to continue that conversation by looking at what a week U.S. dollar means for the U.S. equity market.
It's Thursday, July 17th at 2pm in London.
Morgan Stanley has a bearish view on the U.S. dollar. And this is something our chief global FX strategist James Lord spoke about recently on the show. But Dave, I want to go over the outlook again, since Morgan Stanley has a really differentiated view on this. Do you think the dollar will continue to depreciate during the remainder of the year?
David Adams: We do, and we do. We have been dollar bears this whole year, and it has been very out of consensus. But we do think the weakness will continue and our forecasts remain one of the most bearish on the street for the dollar.
The dollar has had its worst first half of the year since 1973, and the dollar index has fallen about 10 percent year to date, but we think we're at the intermission rather than the finale. The second act for the dollar weakening trend should come over the next 12 months as U.S. interest rates and U.S. growth rates converge to that of the rest of the world. And FX hedging of existing U.S. assets held by foreign investors adds further negative risk premium to the dollar. The result is that we're looking for yet another 10 percent drop in the dollar by the end of next year.
Michelle Weaver: That's really interesting and a differentiated view for Morgan Stanley. When I think about one of the key themes that we've been following this year, it's the multipolar world or a shift away from globalization to more localized spheres of influence. This is an important element to the dollar story.
How have tariffs impacted currency and your outlook?
David Adams: Tariffs play a key role in this framework. Tariffs have a positive impact on inflation, but a negative impact on U.S. growth. But the inflation impact comes faster and the negative impact on growth and employment that comes a bit later. This puts the Fed in a really tough spot and it's why our economists are pretty out of consensus in calling for both no cuts this year, and a much faster and deeper pace of cuts in 2026.
The results for me in FX land is that the market is underestimating just how low the Fed will go and just how low U.S. rates will go. In general, tariffs play a big role in helping to generate this rate convergence, and rate differentials are a fundamental driver of currencies. The more that U.S. rates are going to fall, the more likely it is that the dollar keeps falling too.
Michelle Weaver: Tariffs have certainly impacted heavily on our view for the U.S. equity market and it, it's something that no asset class is, is not impacted by really given the volatility and the magnitude of the move we've seen this year.
Are foreign investors hedging more?
David Adams: We do think they've started hedging more, but the bulk of the move is really ahead of us. Foreign investors own a massive amount of U.S. assets. European investors alone own $8 trillion of U.S. bonds and stocks, and that's only about a quarter of total foreign ownership of U.S. assets.
Now when foreign investors buy U.S. assets, they have to sell their currency and buy the dollar. But at some point, you're going to have to bring that money back, so you're going to have to sell the dollar and buy back your home currency again. If the dollar rises over this period, you've made a gain, congratulations. But if it falls, you've made a loss.
Now a lot of foreign investors will hedge this currency risk, and they'll use instruments like forwards and options to do so. But in the case of the U.S., we found that a lot of foreign investors really choose not to hedge this exposure, particularly on the equity side. And this reflects both a view that the dollar would appreciate. So, they want to take that gain, but it also reflects the dollar's negative correlation to equities.
So, what's changing now? Well, a lot of investors are starting to rethink this decision and add those FX hedges, which really means dollar selling. Now, there's a lot of factors motivating their decision to hedge. One, of course is price. If U.S. rates are going to converge meaningfully to the rest of the world – like we expect – that flattens out the forward curve and makes those forwards cheaper to buy to hedge.
But the breakdown in correlations that we've seen more broadly, the uptick in policy volatility and uncertainty, and the sell off in the dollar that we've already seen year to date, have all increased the relative benefit of FX hedging.
Now, Michelle, I often get asked the question, that's a nice story, but is hedging actually picking up? And the answer is yes. The initial data suggests that hedging has picked up in the second quarter, but because of the size of U.S. asset holdings and given how much it was initially unhedged, we could be talking about a significant long-term flow. We have a lot more to go from here.
We estimated that just over half of Europe's $8 trillion holdings are unhedged. And if hedge ratios pick up even a little bit, we could be talking about hundreds of billions of dollars in flow. And that's just from Europe.
But Michelle, I wanted to ask you. What do you think a weaker dollar means for U.S. companies?
Michelle Weaver: The weaker dollar is a substantial underappreciated tailwind for U.S. multinational earnings, and this is because these companies sell products overseas and then get paid in foreign currency. So, when the dollar's down, converting that foreign revenue back into dollars, gives them a nice boost, something that domestic only companies aren't going to benefit from. And this is called the translation effect.
Recently we've seen earnings revisions breadth, essentially a measure of whether analysts are getting more optimistic or pessimistic start to turn up after hitting typical cycle lows. And based on our house view for the dollar, there's likely more upside ahead based on that relationship for revisions over the next year.
David Adams: Interesting. Interesting. And is this something you're hearing about from companies on things like earnings calls?
Michelle Weaver: No, this dynamic isn't being highlighted much on earnings calls. Typically, companies talk about foreign exchange effects when the dollar's strengthening and provides a headwind for corporate earnings. But when we're in the reverse scenario like we are now with the dollar weakening and getting a boost to earnings, we tend to not hear as much discussion, which is why I called this an underappreciated tailwind.
And according to your team's forecast, we still have a substantial amount of weakening to go and thus a substantial amount of benefit for U.S. companies to go.
David Adams: Yeah, that makes sense. And who do you think benefits most from this dynamic? Are there any sectors or investment styles that look particularly good here?
Michelle Weaver: So generally, it's the large cap companies that stand to gain the most from this dynamic, and that's because they do more business overseas. If we look at foreign revenue exposure for different indices, around 40 percent of the S & P 500’s revenue comes from outside the U.S., while that's just 22 percent for the Russell 2000 small cap index. But the impact of a weaker dollar isn't the same across the board.
Foreign revenue exposure and earnings revision sensitivity to the dollar vary quite a bit, when we look at the sector and the industry group level. From a foreign
revenue exposure perspective, Tech Materials and Industrials have the highest foreign revenue exposure and thus can benefit a lot from that dynamic we've been talking about. When we look from an earnings revisions perspective, Capital Goods, Materials, Software and Tech Hardware have the most earnings revisions, sensitivity to a weaker dollar, so they could also benefit there.
David Adams: So, I guess this brings us to the million-dollar question that all of our listeners are asking. What do we do with this information? What does this mean for investors?
Michelle Weaver: So as the dollar, continues to weaken, investors should keep a close eye on the industries and companies poised to benefit the most – because in this multipolar world, currency dynamics are not just a macro backdrop, but an important driver of earnings and equity performance.
Dave, 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.
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