Morgan Stanley & Co.’s (MS & Co.) economists see global growth broadening, with reacceleration in the US, upward revisions to Euro Zone forecasts and an intact Japanese recovery. They see inflation for the G3 economies bottoming imminently and then picking up, as growth improves and unusually large distortions from oil prices roll out of the year-over year comparison. MS & Co.’s forecast for global inflation has slightly increased since the 2015 outlook was first published, to 3.1% from 3.0%; the 2016 CPI forecasts are materially above consensus in the Euro Zone and Japan (see table). Together, these trends support a shift in market focus toward inflation and away from deflation as the year progresses.
Broader growth and better inflation present a constructive backdrop, although one that’s not without risks. With the new growth and inflation profile, it also appears that the Federal Reserve’s rate hike will be earlier, in December 2015, rather than in March 2016. Asset valuations are not cheap. Emerging market economies still need to adjust and corporate America is getting more aggressive. Liquidity in many corners of the market is dreadful.
For now, however, we see these risks as manageable and see both risk premiums and our economic story supporting a “reflationary” theme. We remain overweight equities versus bonds, believe higher inflation and low term premiums will lead to steeper yield curves and expect spreads to tighten. Many of our micro themes, from being overweight financial and energy stocks globally to expecting some of the best risk-adjusted credit returns in floating rate assets, also grow out of this view.
Let’s start with better growth, which admittedly has long seemed just over the horizon. Our expectation of a stronger second half has several drivers. US growth, which stumbled in the first quarter due to a strong dollar and heavy energy disinvestment, should improve as these headwinds moderate. Euro Zone growth is tracking better than our previous forecasts, with a weaker euro and improving loan growth still working through the system. Japan is on track for its strongest nominal growth since 1991, and China’s recent easing measures in the local housing market could help to support consumer demand in the second half.
As growth recovers, so should inflation. Part of this is simple math. Energy accounts for some 11% of headline inflation in Europe and 7.5% in the US and, by late autumn, it should no longer be falling substantially on a year-on-year basis. A big negative number falling out of an average helps to raise what’s left. In our view, G3 government bond yields, breakeven inflation and Fed funds futures currently price in little inflation premium. The financial media was happy to trumpet the deflation narrative in the first quarter despite much of it being oil related. We suspect the story will reverse as headline inflation starts to move higher. What’s more, the rise isn’t all about oil.
In Europe, wage settlements and capacity utilization are rising, while services inflation has begun to tick higher. US wages should be rising at a faster pace by September. Wage growth in Japan is running at its strongest levels since 1998, and should continue to climb (on our forecasts) as the labor market tightens further. Markets excel at extrapolation, and this sounds like a good enough excuse.
A Change to Our Fed Call
Having long assumed that the Fed would wait until 2016 to raise rates, we now expect the first hike in December. This is roughly in line with market pricing and puts the start of the hiking cycle firmly in this calendar year. Once the Fed starts, we expect an alternating series of hikesand reductions in mortgage-backed securities holdings at each meeting, for a total of 150 basis points of hikes between now and year-end 2016.
Are markets prepared? We think the answer varies. US investment grade, high yield and emerging market credit have given up all spread tightening since late 2013. Currency volatility is back above its long-run average. US stocks have gone nowhere in four months. Moreover, the history of previous hiking cycles is anything but conclusive. US credit rallied into the 1994 hike and sold off after, but did the opposite in 2004. Looking at three Fed hiking cycles since 1986, credit, equity and Treasury total returns before and after the hike are mixed (see table). On average, however, returns before the first rate hike have been positive more often than negative.
Hiking cycles are hardly harbingers of doom, and it is notable that MS & Co.’s interest rate strategists see the US having one of the best-behaving rate markets through year end. Conversely, we see emerging markets as more exposed versus prior cycles, which is one reason we remain cautious on their currencies and stocks.
A Cycle Intact
We continue to expect that this cycle will be a long one—perhaps the longest global expansion in recent memory. It should be unusually long because it has been unusually weak, followed an unusually severe downturn, and is unusually unsynchronized on a global basis. More tangibly, we do not think it yet possesses the level of optimism or hubris we’d associate with “late cycle” behavior, which is a message we see borne out in our cycle indicators. The disjointed nature of the current cycle makes it easy to find indicators that make conditions look particularly good (or bad), depending on one’s point of view. We think the most fair and least emotional approach is to focus on a broad array of measures. Our cycle indicators are designed for this, and neither the cycle nor the broader measure that incorporates Europe and Japan is at extremes (see chart).
Yes, US mergers-and-acquisitions volume is near previous-cycle highs, but other measures, from US consumer confidence to corporate loan growth, are far more normal. Global activity, meanwhile, is still well short of the intensity that made the downturns of 2000 and 2008 so severe. All contribute to our view that the global expansion has further to go.
Valuation: How Extreme?
Levels of activity may not be extreme, but what about valuations? Asset prices are routinely described as being “manipulated” and “inflated” by central bank policy and, although these charges have been leveled for several years, they need to be addressed. Specifically, how far has recent central-bank policy pushed valuations from their 20-year averages? Look at the past 20 years, and most are in the middle of the range. Price/earnings and price/book ratios for the MSCI All Country World Index (MSCI ACWI) are below their 20-year medians, while the same measures for the S&P 500 have been richer about 40% of the time over the same period. Credit spreads in US investment grade and high yield credit are pretty average over this range. Government bond valuations, in contrast, look highly distorted by central bank policy, which is one reason we are underweight.
We continue to believe that the market could “melt up”—that is, trade to richer, more ill-advised valuation—before it “melts down.” The upside left in our cycle indicators is one reason for this, as is the gap between US nominal growth and bond yields, a measure frequently cited by our currency strategists. When long-term rates are below nominal GDP, growth-sensitive assets are attractive relative to their financing costs, and asset booms are common. We saw that in the 1997-to-1999 and 2003-to-2007 periods, which ended at valuations higher than those of today.
Morgan Stanley Developed Market Cycle Indicator: The Morgan Stanley Developed Market Cycle Indicator measures the deviation from historical norms for macro factors including employment, credit conditions, corporate behavior and the yield curve in developed market countries.
Morgan Stanley US Cycle Indicator: The Morgan Stanley US Cycle Indicator measures the deviation from historical norms for macro factors including employment, credit conditions, corporate behavior and the yield curve in the US.
MSCI All Country World Index: The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets.
MSCI Europe Index: This index captures large, mid and small cap representation across 16 Developed Markets countries in Europe. With 1,372 constituents, the index covers approximately 99% of the free float-adjusted market capitalization across the Developed Markets countries of Europe.
S&P 500 Index: The Standard & Poor's (S&P ) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.
International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk.
Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security's underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.
Principal is returned on a monthly basis over the life of a mortgage-backed security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMO's average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMO's average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMO's market price to fall. Some MBS/CMOs may have "original issue discount" (OID). OID occurs if the MBS/CMO's original issue price is below its stated redemption price at maturity, and results in "imputed interest" that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.
Investing in foreign marketsv entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Credit ratings are subject to change.
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.
The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material.
This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein.
The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.
This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material.
Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.
This material is disseminated in Australia to "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813).
Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the material in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities.
If your financial adviser is based in Australia, Dubai, Germany, Italy, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Dubai: Morgan Stanley Private Wealth Management Limited (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA; Germany: Morgan Stanley Private Wealth Management Limited, Munich branch authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Bundesanstalt fuer Finanzdienstleistungsaufsicht; Italy: Morgan Stanley Bank International Limited, Milan Branch, authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, the Banca d'Italia and the Commissione Nazionale per Le Societa' E La Borsa; Switzerland: Bank Morgan Stanley AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom.
Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.
This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC.
Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.
This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC.
© 2015 Morgan Stanley Smith Barney LLC. Member SIPC.