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May 05, 2023

The inflation and recession duality

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May 05, 2023

The inflation and recession duality


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The inflation and recession duality

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May 05, 2023

 
 

Global equities continued their positive trajectory in April, with the S&P 500 Index returning 1.6%1. In local currency terms, the MSCI Europe Index and MSCI Japan Index each returned 2.7%1. In contrast, the MSCI Emerging Markets (USD) fell 1.1%1 with the MSCI China Index being one of the top detractors for the month, returning -3.3%1 due to earnings downgrades and US-China tensions. The majority of S&P 500 companies reported better-than-expected first quarter earnings, leading to an upward revision in the earnings projections for the entire year. However, with only a handful of names driving majority gains, the sustainability of this rally comes into question. Bond yields were range bound across the month, although they remained volatile within the range, with US 10-Year yield between 3.3%2 and 3.6%2. Overall, the US 10-Year yield slightly fell from last month, ending the month at 3.4%2. The VIX index also remained range bound, falling to 17.03 by month end.

 
 

US headline inflation slowed for the ninth consecutive period to 5.0%4 in March 2023, coming in below market forecasts of 5.2%5 and the lowest since May 2021. The Federal Open Market Committee (FOMC) announced a rate hike of 25 basis points6 after its May meeting. This brings the target range to 5.25%6, the highest since 2007. However, the language seemed softer than last time with no indication of a further hike. The US jobs market is still tight, but cooling slowly, re-enforcing the prospect that the Federal Reserve may be done with further rate hikes for the time being. However, if inflation becomes de-anchored, they likely will be quick to hike again.

Meanwhile in Europe, the UK remains the only western European country with double-digit inflation at 10.1%7. Higher-than-expected core inflation and continued labour market tightness is forcing the Bank of England (BoE) to keep policy tight. Eurozone inflation was relatively better at 6.9%8, falling sharply as plunging energy prices continue to ease pressure on the cost of living. With inflation still very high, especially compared to the US and long-term targets, we expect more work from the European Central Bank (ECB) and BoE.

After the turmoil in the banking sector in recent weeks, credit spreads appear to have calmed and smaller bank risks seem to be fading. That said, tighter lending conditions are likely to linger. However, the surprising strength, acceleration and positive momentum from the first quarter is likely to make it difficult for the economy to decelerate enough to produce a continuous negative growth rate in the second quarter.

Investment Implications
The overall effects of central bank tightening have yet to be fully felt, even though the risk of a recession in the short term appears to have diminished. This implies that despite the recent improvement in data, balanced portfolio diversification remains crucial in the face of significant volatility. Bearing this in mind, we made the following tactical changes in April:

Oil and Global Energy equities
We trimmed our exposure to energy equities by closing out our US energy equities exposure, as we see less upside for oil prices after recent rises, in turn leaving less upside for US energy which has a higher beta to oil prices.

MSCI China equities
We reduced the overweight to MSCI China equities as positive earnings revisions have stalled, despite the reopening impetus. Moreover, elevated risk premium due to continued US-China tensions weaken near-term conviction.

US small cap equities
We added an overweight to US small cap equities during April, as relative valuations compared to US large cap are at historically attractive levels. Furthermore, bearish consensus and an overreaction of US small caps to the recent banking instability, are also supportive factors.

EUR high yield
We closed our EUR high yield overweight as we expect intensifying refinancing and economic headwinds to tilt risks towards wider spreads over coming months. A lack of capital availability and higher fundraising costs are likely to disproportionately impact riskier firms.

Global asset-backed securities (ABS)
On closing our EUR high yield overweight, we allocated the proceeds to our existing Global ABS overweight to increase our exposure to high quality yield. We remain confident in the allocation given limited exposure to commercial real estate and our expectation that US mortgage credit performance is unlikely to come under substantial pressure, even in a recessionary scenario.

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. Previous view is as of 31 March 2023 and current view is as of 30 April 2023. 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.

 
 

1 Bloomberg, 1-month returns, local currency unless otherwise stated, as of 30 April 2023.
2 Bloomberg, 3.3% on 5 April 2023, 3.6% on 19 April 2023 and 3.4% on 30 April 2023.
3 Bloomberg, 30 April 2023.
4 Bureau of Labor Statistics, Consumer Price Index Summary, 12 April 2023, before seasonal adjustment.https://www.bls.gov/news.release/cpi.nr0.htm
5 Morningstar, https://www.morningstar.com/articles/1149028/markets-brief-march-cpi-report-forecasts-show-inflation-still-running-high
6 https://https://www.federalreserve.gov/newsevents/pressreleases/monetary20230503a.htm
7 CPI 12-month rate as of March 2023. https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/march2023
8https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Inflation_in_the_euro_area as of March 2023.

 
andrew.harmstone
 
jim.caron
Chief Investment Officer
Portfolio Solutions Group
 

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RISK CONSIDERATIONS

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.

INDEX DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

Consumer Price Index: The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.

MSCI China Index: This free-float adjusted capitalization-weighted index is designed to measure the performance of China-based equities.

MSCI Europe Index: The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe.

MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries. With 1,417 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Japan Index: The MSCI Japan Index is designed to measure the performance of the large and mid-cap segments of the Japanese market.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalisation US stocks.

VIX ©: This is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.

DISCLOSURES

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

A separately managed account may not be appropriate for all investors. Separate accounts managed according to the particular Strategy may include securities that may not necessarily track the performance of a particular index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required.

For important information about the investment managers, please refer to Form ADV Part 2.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

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Past performance is no guarantee of future results. Charts and graphs provided herein are for illustrative purposes only.

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