Commodities: A Place to Step Back From Risk

In looking ahead to 2023, the big dynamics of this year are poised to shift and investors will want to look for safety amidst the coming uncertainty. Chief Cross Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's global chief economist. 

Andrew Sheets: And I'm Andrew Sheets, Morgan Stanley's chief cross-asset strategist. 

Seth Carpenter: And on part two of this special two-part episode of the podcast, we're going to focus on Morgan Stanley's Year Ahead strategy outlook. It's Wednesday, November 16th, at 10 a.m. in New York. 

Andrew Sheets: And 3 p.m. in London. 

Seth Carpenter: Andrew, on the first part of this, you spent a bunch of time asking me questions about the outlook for the global economy. I'm going to turn the tables on you and start to ask you questions about how investors should be thinking about different asset prices going forward. There really was a big change this year, we came out of last year with big growth, things slowed down, but inflation surprised everyone to the upside. Central banks around the world started hiking rates aggressively. We've seen massive moves in FX markets, especially in the dollar. Things look very, very different. If you were to say, looking forward from here to the next year, what the biggest conviction call you have in terms of asset allocation, what would it be? 

Andrew Sheets: Thanks, Seth. It's that high grade bonds do very well. You know, I think this is a backdrop where 2022 was defined by surprisingly resilient growth, surprisingly high inflation, and surprisingly hawkish monetary policy relative to where I think a lot of investors thought the year would start. And, you know, if I think about 2023 and what you and the economics team are forecasting, it's big shifts to all three of those dynamics. It's much softer growth, it's softer inflationary pressure. And it's central banks pausing their tightening cycles and then ultimately easing as we look further ahead. So, you know, 2022 is exceptionally bad for high grade bonds, investment grade rated bonds, whether they're governments or mortgages or securitized bonds or municipals. So as the economy slows, as investors are looking for some safety amidst all that economic uncertainty, we think high grade bonds will be the place to be. 

Seth Carpenter: What is it that's so special about investment grade bonds as opposed to, for example, high yield bonds? And what is it about fixed income securities instead of equities that you think is so attractive? 

Andrew Sheets: Yeah. Thanks, Seth. So I do think there's an important distinction here because, you know, if I think about a lot of different assets in the market, I think there are a lot of assets that are primarily concerned at the moment with rate uncertainty or policy uncertainty. When will the ECB finally stop hiking rates? When will the Fed finally stop hiking rates? How high will Fed funds go? Now there's another group of assets, and I think you could put the S&P 500 here, U.S. high yield bonds here that are concerned about those questions of interest rates. Obviously, interest rates matter for these markets, but those markets are also concerned about the economic slowdown and how much will the economy slow. So I think when people look into the year ahead, what you want to focus on are assets that are much more about whether or not rate uncertainty falls than they are about how much will the economy decelerate. So we think of high grade bonds as a perfect example of an asset class that cares quite a bit about interest rate uncertainty while being a lot less vulnerable to the risk that the economy slows. And I think emerging market assets are also an example of an asset class that's really sensitive, maybe more sensitive to the question of how high will the Fed hike rates? And just given where it's currently priced, given how much it's already declined this year, might be a lot less sensitive of that question of, you know, whether or not the U.S. goes into recession or whether or not Europe goes into recession. So good for high grade bonds and then we think good for emerging market assets. 

Seth Carpenter: Okay. That makes a lot of sense. High grade bonds, fixed income, obviously, you talked a little bit about where some of the risks are. And whenever I think about fixed income securities and I think about risk, how are you advising clients to think about market-based risks around the world as we're going into the next year?  

Andrew Sheets: I think you a point that you and your team have made that central banks, especially the Fed, are very aware of the liquidity risks around quantitative tightening and might modify it if they felt it was starting to lead to less functional markets. I think that's important. I think if that's our assumption, then investors shouldn't avoid these markets simply because there's a possibility that they could have a more liquidity challenge backdrop. Secondly, and I think this is also an important point, while central banks are going to be backing away from the government bond markets, we think there's a good chance that households and other investors will be moving towards these markets. So, you know, we think that there's actually some pretty good potential for households to do a little bit of reallocation, to have less money in equities, to have a little bit more money in bonds, and that the much higher yields that these households are seeing could be a catalyst for that. 

Seth Carpenter: We're sitting here having a conversation, looking around the world. One of the natural topics to get on to if you're thinking globally is about currencies and exchange rates. How should we be thinking about where currency markets will be going from here forward into next year? What's the outlook for different currencies? Is there a set of currencies that might outperform? Are there ones where investors still need to be very wary? 

Andrew Sheets: Yeah. So I think when talking about currencies, we have to start with the dollar, which in some ways is the benchmark against which everything else is measured. And you know, our foreign exchange strategists do think the dollar has peaked. Looking into next year, if we see slower growth, less inflation, less hawkish policy, you know, we think that will be less good for the dollar, maybe even negative for the dollar. So we see the dollar peaking and declining over the course of 2023. We think the euro does better, as we do think investors will look to reengage in European assets next year and so investment flows can be more supportive. We do think some of the more cyclical currencies, things like the Australian dollar and New Zealand dollar can do a little bit better as the market gets maybe a little bit more optimistic about better Chinese growth next year. And we think some of the large EM currencies can also outperform relative to their forward. 

Seth Carpenter: That makes a lot of sense. I guess the other point that you and I discussed in the first part of this podcast is about inflation and how commodity prices have factored into the evolution of inflation over the past couple of years. How should we be thinking about commodities for investors going into 2023 as a place to step back from risk? What do you think? 

Andrew Sheets: So commodities were an asset class that we liked at this time last year when we wrote our 2022 outlook. It was an asset class that we were overweight and we maintained that position through this year. But I think that picture is changing a little bit. You know, first, the attractiveness of other asset classes is now better because those other asset classes have fallen a lot relative to commodities over the course of 2022. And, you know, commodities are an asset class that can be sensitive to when growth actually slows. They tend to be less anticipatory. And so they've held up well, I think even as other asset classes have become more worried about the prospect of a recession. And so if the odds of a recession are rising, even if they're not the base case in the US and then they are the base case in Europe, maybe that presents a little bit more danger. But that needs to be balanced against the fact that commodities do have a number of attractive properties. They provide a hedge against inflation and some commodities, especially energy commodities, pay a quite high carry or a quite high yield for holding them, buying them on a forward basis and holding them to maturity. In the case of oil, we think prices will come in well ahead, more than 20% ahead of where kind of the market is implying the price next year. So it's a more nuanced story. It's a story where we think energy continues to outperform metals within the commodities complex, but more of a relative value story than a directional story for the year ahead. 

Seth Carpenter: So what I'm taking away from what you've told me so far, that if a shift to a year of fixed income, maybe the dollar has peaked, and then a more nuanced story when it comes to commodities, what would you leave our listeners with as a closing story? Where would you want to wrap things up in terms of leaving our listeners with advice? Where do they need to be the most cautious? And are we going to go into a year where volatility finally comes down from the sort of tumult that we've seen this year? 

Andrew Sheets: So I think this idea that we might not have an all clear on recession risk in the US kind of well into the start of 2023, the idea that Europe will be in recession at the start of 2023, I think that makes us a little bit cautious to buy cyclical assets here and I think that applies to things like metals, copper, that applies to high yield bonds and loans. And then we think the S&P 500 will also be tricky. So we think the S&P 500 is probably worse risk reward than other asset classes. It doesn't fall over the course of the year on our forecasts, but it has a very choppy range. And when we think about sector and style, I think it's being open to having different preferences depending on where you're looking. And we think EM assets will be on the leading edge of any recovery. That is where we're more favorable towards early cycle sectors like tech and tech hardware. You know, in Europe you're kind of in the middle. That's where we like banks and energy kind of deep value sectors that have quite high dividend yields. And in the US we're more defensive. But you know, something that links all of those themes is that both US defensive, equities, banks and energy in Europe, and tech and semis and Asia, they're all quite high yielding sectors. And so we do think this is a backdrop where the idea of gaining income is not just about high grade bonds, that there are a lot of different pockets of the market where, you know, this is a year to look for the more solid income candidate and income strategy on a cross asset basis. You know, don't swing for the fences yet in terms of buying cyclicality, and we think we'll wait for a better opportunity to do that as we move into 2023. 

Seth Carpenter: All right, Andrew. Well, I have to say, that was a great summary at the end. I really appreciate you taking the time to talk. 

Andrew Sheets: Great speaking with you, Seth. 

Seth Carpenter: And thank you to our listeners. If you enjoy thoughts on the market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.