Macro Trends and Dollar Depreciation Insights

Morgan Stanley’s midyear outlook defied the conventional view in a number of ways. Our analysts Serena Tang and Vishy Tirupattur push back on the pushback to their conclusions, explaining the thought process behind their research. 

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Serena Tang: Welcome to Thoughts on the Market. I'm Serena Tang, Morgan Stanley's Chief Cross-Asset Strategist

Vishy Tirupattur: And I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.

Serena Tang: Today's topic, pushback to our outlook.

It's Friday, June 6th at 10am in New York.

Morgan Stanley Research published our mid-year outlook about two weeks ago, a collaborative effort across the department, bringing together our economist views with our strategist high conviction ideas. Right now, we're recommending investors to be overweight in U.S. equities, overweight in core fixed income like U.S. treasuries, like U.S. IG corporate credit. But some of our views are out of consensus.

So, I want to talk to you, Vishy, about pushback that you've been getting and how we pushback on the pushback.

Vishy Tirupattur: Right. So, the biggest pushback I've gotten is a bit of a dissonance between our economics narrative and our markets narrative. Our economics narrative, as you know, calls for a significant weakening of economic growth. From about – for the U.S. – 2.5 percent growth in 2024 goes into 1 percent in 2025 and in 2026. And Fed doesn't cut rates in 2025, and cuts seven times in 2026.

And if you look at a somewhat uninspiring outlook for the U.S. economy from our economists – reconciling an uninspiring economic outlook on the U.S. economy with the constructive view we have on U.S. assets, equities, credit, treasuries – that's been a source of contention.

So how do we reconcile this? So, my pushback to the pushback is the following; that they are different plot lines across different asset classes. So, our economists have slowing of the economy – but not an outright recession. Our economists don't have rate cuts in 2025 but have seven rate cuts in 2026.

So, if you look at the total number of rate cuts that are being priced in by the markets today, roughly about two rate cuts in [20]25, and about between two and three rate cuts in 2026, we expect greater policy easing than what's currently priced in the markets. So that makes sense for our constructive view on interest rates, and in government bonds and in duration that makes sense.

From a credit point of view, we enter this point with a much better credit fundamentals in leverage and coverage terms. We have the emergence of a total yield-based buyer base, which we think will be largely intact at our expectations, and you layer on top of that – the idea that growth slows but doesn't fall into recession is also constructive for higher quality credit. So that explains our credit view.

From an equities view, the drawdowns that we experienced in April, our equity strategists think marks the worst outcomes from a policy point of view that we could have had. That has already happened. So looking forward, they look for EPS growth over the course of the next 12 months. They look for benefits of deregulation to kick in. So, along with that seven rate cuts, get them to be comfortable in being constructive about their views on equities. So all of that ties together.

Serena Tang: And I think what you mentioned around macro not being the markets is important here. Because when we did some analysis on historical periods where you had low growth and low inflation, actually in that kind of a scenario equities did fine. And corporate credit did fine. But also, in an environment where you have rather unencouraging growth, that tends to map onto a slightly risk-off scenario. And historically that's also a kind of backdrop where you see the dollar strengthen.

This time out, we have a very out of consensus view; not that the dollar will weaken, that seems quite consensus. But the degree of magnitude of dollar weakening. Where have you been getting the most pushback on our expectations for the dollar to depreciate by around 9 percent from here?

Vishy Tirupattur: So, the dollar weakness in itself is not out of consensus, largely driven by narrowing of free differentials; growth differentials. I think some of the difference between the extent of weakness that we are projecting comes from the assessment on the policy and certainty. So, the policy uncertainty adds a greater degree of risk premia for taking on U.S. assets.

So, in our forecast, we take into account not only the differentials in rates and growth, but also in the policy uncertainty and the risk premia that the investors would demand in the face of that kind of policy uncertainty. And that really explains why we are probably more negative on the outcome for U.S. dollar than perhaps our competition.

Serena Tang: The risk premium part, I think bring us to one of the biggest debates we've been having with investors over, not just the last few weeks, but over the last few months. And that is on U.S. exceptionalism. Now clearly, we have a view that U.S. assets can outperform over the next six to 12 months, but why aren't we factoring in higher risk premium for holding any kind of U.S. assets? Why should U.S. assets still do well?

Vishy Tirupattur: So, as I said earlier, we are calling for the economy to slow without tipping into recession. We are also calling for greater amount of policy easing than what is currently priced in the markets. Both those factors are constructive.

So, I think we also should keep in mind the sheer size of the U.S. markets. The U.S. government bond markets, for example, are 10 times the size of comparably rated European bond markets, government bond markets put together. The U.S. equity markets is four-five times the size of the European equity markets. Same thing for investment grade corporate credit bonds. The market is many, many times larger.

So, the sheer size of the U.S. assets makes it very difficult for a globally diversified portfolio to substantially under-allocate to U.S. assets. So, what we are suggesting, therefore, is that allocate to U.S. assets, where there are all these opportunities we described. But if you are not a U.S. investor, hedge the currency risk. Not hedging currency risk had worked in the past, but we are now saying hedge your currency risk.

Serena Tang: And the market size and liquidity point is interesting. I think after the outlook was published, we had a lot of questions on this. And I think it's underappreciated, how about, sort of, 60 percent of liquid, high quality fixed income paper is actually denominated in U.S. dollars. So, at the end of the day, or at least over the next six to 12 months, it does seem like there is no alternative.

Now Vishy, we've talked a lot about where we are getting pushback. I think that one part of the outlook where – very little discussed because very highly consensus – is credit. And the consensus is credit is boring. So how do you see corporate credit, and maybe securitized credit, fit into the wider allocation views on fixed income?

Vishy Tirupattur: Boring is good for a fixed income investor perspective, Serena. Our expectation of rate cuts, slowing growth but not going tipping into recession, and our idea that these spreads are really not going very far from where they are now, gets us to a total return of about over 10 percent for investment related corporate credit.

And that actually is a pretty good outcome for credit investors. For fixed income investors in general that calls for continued allocations to high quality credit, in corporate credit as well as in securitized credit.

Serena Tang: So just to sum up, Morgan Stanley Research has very differentiated view this time around on how many times the Fed can cut, which is a lot more than what markets are pricing in at the moment, how much yields can fall, and also how much weakening in the U.S. dollar that we can get. We are recommending investors to be overweight U.S. equities and overweight U.S. core fixed income like U.S. treasuries and like U.S. IG corporate credits. And as much as we're not arguing [that] U.S. exceptionalism can continue on forever, over the next six to 12 months, we are constructive on U.S. assets.

That is not to say policy uncertainty won't still create bouts of volatility over the next 12 months. But it does mean that during those scenarios, you want to sell U.S. dollars rather than U.S. assets.

Vishy, thank you so much for taking the time to talk.

Vishy Tirupattur: Great speaking with you, Serena.

Serena Tang: And for those tuned in, thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.