Morgan Stanley’s In-Depth Report – Executive Summary for Australian Investors

// ULTRA-CONDENSED SUMMARY // Purpose: Connect market events to investor portfolio implications. Monthly review. // Provider: Morgan Stanley // Scope: Bonds, Equities, Alternatives, Transition* (*cash, cash equivalents, liquid short-duration assets like short-dated Treasuries for asset class transition). // Content Style: Investment ideas, focus areas, asset allocation outlook, economic/asset class data review via charts. // Data Disclaimer: Informational use only. Data as of May 20-22, 2025, unless specified. Views are Portfolio Solutions Group’s at time of writing, subject to change. Not investment/research recommendation. Forecasts/estimates based on current market conditions, subject to change, may not come to pass. Past performance not indicative of future results. // ASSET ALLOCATION LEGEND (SYMBOLS): // — : High conviction underweight // – : Underweight // = : Neutral // + : Overweight // ++ : High conviction overweight // SECTION: KEY THEMES FOR JUNE 2025 (TOP IDEAS – General Market Commentary) // 1. A New Fed Policy Framework: // – Focus Shift: Chairman Powell (May Fed conference) indicated next policy framework review will weight “shortfalls” more heavily than “deviations” from inflation target and full employment estimate (dual mandate). This is a change from the 2020 policy review. // – Implication 1 (Policy Reactivity): Fed policy may become less reactive to deviations from dual mandate objectives, aiming for a more robust policy reaction function. // – Implication 2 (Average Inflation Targeting – AIT): Powell might revisit AIT. Fed could tolerate above-target inflation if the preceding period was below target (meeting target “on average”). Same logic for unemployment rate. // – Market Interpretation: Fed could cut rates sooner, even with inflation above target, especially if there’s a risk of a sharp rise in unemployment. Signifies a more robust and less rigid framework. // – Implication 3 (Yield Curves): Potential for steeper yield curves and underperformance of long-duration assets. Term premia should increase. Long-term yields could fall in absolute terms, but possibly not as much as before the framework change. // – Implication 4 (Equities): Supportive for equity assets. Near-term read is Fed more apt to lower policy rates for stimulus (risking higher inflation). This should support earnings and multiples, provided inflation doesn’t spin out of control. // 2. Tariffs: Policy, Strategy, and Process: // – Administration’s View: Tariff policy needs a rational thesis, not just reactions to headlines. // – Three Components of U.S. Tariff Policy: // 1. Reduce the trade deficit. // 2. Reduce non-tariff barriers (NTBs). // 3. Coercive policy objectives with trading partners to counter China’s policies. // – Key Drivers: While much focus is on the measurable trade deficit, the hard-to-quantify NTBs and coercive objectives might be the main drivers putting trade agreements within reach. // – Market Outlook: Markets may not fully appreciate this and risk being surprised to the upside. // SECTION: THE PORTFOLIO SOLUTIONS GROUP – OUR TOP 4 IDEAS // 1. Rebalancing Equity Exposure: // – Context: Trade deal between U.S. and U.K. seen as a first domino for deals with allied partners. U.S.-China deal significantly reduced recession risks. // – Impact: Increasing both earnings and multiples from previous levels. // – Action: Rebalanced by increasing equity exposures, not just in the U.S. but also Europe. // – Conviction: Europe is the highest conviction overweight (++). // 2. Adding European High Yield (HY): // – Rationale: Reduction in global growth risks (from recent trade deals) should also reduce default risks, making lower-quality credit more attractive. // – For U.S. Dollar (USD) Investors: Can buy European Union (EU) HY and pick up significant additional yield by adding FX carry. // – Market Dynamics: Increased demand for EU credit should support the underlying asset itself and boost euro-based investors. Fiscal stimulus and ECB rate cuts are also supportive. // 3. Considering U.S. Loans Exposure (Managing Duration Risk): // – Context: Recession risks receding. // – Preference: Bank loans over traditional U.S. HY due to the floating-rate nature of loans over traditional fixed-duration HY. // – Valuation Note: Loan spreads have tightened recently, creating less of a valuation tailwind and balancing risk/reward towards default risks. // – Rate Sensitivity: While HY is typically less rate-sensitive, loans offer additional reduction in rate sensitivity, especially relevant given potential Fed policy framework changes. // 4. Overweight Indian Equities: // – Background: India experienced two quarters of a self-inflicted economic slowdown and corporate earnings downgrade cycle (since 4Q24), driven by tight domestic fiscal and monetary policy. // – Recent Developments: Reserve Bank of India (RBI) shifted to an accommodative policy stance (cutting interest rates) as growth risk rose (U.S. trade policy uncertainty) and inflation moderated to a multi-year low. // – Current State: Encouraging signs of the domestic cycle bottoming have emerged based on recent data. // – Risk Profile: While U.S. tariffs remain a risk, India is relatively insulated due to low goods export exposure to the U.S. and a largely domestic-oriented economy. // SECTION: TOP THEMES (Detailed Observations with Data Points & Charts Summary) // 1. Soft Data Disappointment vs. Hard Data Resilience: // – Observation: Record policy uncertainty has cast doubt on economic growth prospects. This uncertainty led to negative trends in “soft” data (sentiment surveys, PMIs), while “hard” data (measures of actual economic activity) continued to surprise positively. // – Expectation: These trends are expected to eventually reconverge; timing, direction, and magnitude will determine asset price paths. // – Chart: “Economic Data Weakness Has Been Contained to Soft Measures Like Surveys and Business Cycle Indicators” (Bloomberg U.S. economic surprise by economic sector). (Source: Bloomberg, MSIM. As of May 20, 2025) // 2. Peak Tariff De-escalation?: // – Event: May 12th temporary pause/reduction of tariffs on China. // – Impact: Overall average effective tariff rate (Yale Budget Lab est.) fell by over 10% to 17.8% (pre-substitution basis). // – Outlook: With the China de-escalation being more significant than market expectations, further reductions seem less likely. // – Chart: “Following the Recent Trade Deal With China, Have We Reached Peak Tariff De-escalation?” (Average pre/post-substitution effective tariff rate (%), Yale Budget Lab). (Source: Bloomberg, Yale Budget Lab, MSIM. As of May 20, 2025) // 3. De-escalation & “Risk-On” Market Trends: // – Catalyst: Reciprocal tariffs delay announced on April 9th. // – Market Internals: Signaled risk-on trends: // – Cyclicals (ex-energy) outperformed Defensives. // – High-volatility factor outperformed low-volatility (sector-neutral basis). // – Tariff “exposed” basket of stocks outperformed tariff “resilient” basket. // – Chart: “The “Risk-On” Trade Has Returned Since Early April, with De-escalation in Trade Tensions a Key Catalyst” (YTD cumulative performance for key pair trades). (Source: Bloomberg, MSIM. As of May 20, 2025) // 4. Payroll Gains Driven by Public Sector: // – Trend: Over the past three years (since 2022), the majority of payroll job gains have been in the public sector (government, education, health services). // – Consequence: Resulted in a crowding out of private sector employment. // – Outlook: Remains to be seen if new administration’s policies can lead to a reconvergence, which would be positive for labor productivity and inflation. // – Chart: “Public Sector Employment Has Exploded Since 2022, Resulting in a Crowding Out of the Private Sector” (Cumulative growth in total payrolls since 12/31/2022). (Source: Bloomberg, MSIM. As of April 30, 2025) // 5. Mapping Total Fiscal Impulse from Reconciliation: // – Context: Budget process ongoing, but bill from House reconciliation suggests more near-term fiscal tailwinds than expected. // – Focus: Core focus is extending tax cuts set to expire at the end of the year. // – Structure: Bill structured with front-loaded benefits and backend-weighted costs. // – Chart: “Estimated Fiscal Impulse from Reconciliation Shows a Front-Loading of Stimulus” (Net fiscal impulse from reconciliation legislation). (Source: Bloomberg, Don Schneider (Piper Sandler), MSIM. As of May 16, 2025) // 6. Global Bond Yields Rising (Not Unique to U.S.): // – Observation: Long-duration assets are being repriced globally. // – U.S. Context: U.S. long-dated bond yields have risen less than in other major regions thus far in 2025. // – Japan Example: Japanese 30-year bond yields have risen to historic levels. // – Charts: “Japanese Bond Yields Have Risen to Historic Levels” (U.S. 30-year yield vs. Japan 30-year yield). “U.S. Bond Yields Have Risen Least in 2025” (YTD cumulative change in bps for various regions). (Source: Bloomberg, MSIM. As of May 20, 2025) // 7. Municipals: Higher Yields and a Steeper Curve: // – Trend: Longer-dated yields in the municipal market moved higher in May (continuation of YTD trend). // – Cause: Heavy supply in recent months. // – Impact: Muni curve has (bear) steepened, to a greater degree than U.S. Treasuries (USTs). // – Result: Attractive Muni/UST ratios out on the curve. // – Chart: “Muni/UST Ratios Look Attractive Farther Out on the Curve” (Muni/UST ratios across selected curves, 12/31/24 and present). (Source: Bloomberg, MSIM. As of May 21, 2025) // SECTION: TOP IDEAS (Reiteration/Expansion with Chart Summaries) // 1. Overweight European High Yield Credit: // – Rationale: Reduced global growth risks (from positive trade negotiations) should reduce default risks, making lower-quality credit attractive. // – USD Investor Benefit: European HY credit attractive for USD-based investors due to an additional ~2.4% yield pickup from hedging EUR exposure back to USD. // – Chart: “European HY Credit Offers the Highest Yield on USD-Hedged Basis” (Yield decomposition across major credit asset classes: EU HY (hedged), US HY, EM HY, US IG Corp, EU IG Corp, US Loans). (Source: Bloomberg, MSIM. As of May 22, 2025) // 2. Overweight Indian Equities: // – Context: India’s economic/earnings slowdown (since 4Q24) due to tight domestic policy. RBI shifted to accommodative stance. Signs of bottoming. Low vulnerability to U.S. trade policy. // – Chart: “Indian Equity Returns Have Historically Been Positive When Financial Conditions Ease” (India financial conditions (LH) vs. MSCI India rolling 6M return (2-month lag, RH)). (Source: Bloomberg, Goldman Sachs, MSIM. As of May 21, 2025) // 3. Considering Loans Exposure: Managing Duration Risk: // – Rationale: Loan spreads tightened, but rate sensitivity reduction from bank loans is attractive, especially with potential Fed policy changes. Loans show low correlations to traditional fixed income. // – Charts: // – “Loans Have High Yields and Near-Zero Duration” (Yield-to-worst (%) vs. duration for various fixed income assets). // – “Negative Correlation to Core Bond Allocations” (10-year correlation of loans to USTs). (Source: Bloomberg, MSIM. As of May 22, 2025) // 4. Real Estate Fundamentals Continue to Improve: // – Context: Real estate repriced (higher rates, oversupply, demand destruction). Long-term operating outlook markedly improving (future supply decreasing, demand destruction stabilizing). // – Opportunity: Entry pricing meaningfully lower, providing margin of safety and interesting access point. // – Charts: // – “U.S. Cap Rates Have Stabilized” (Real estate sector cap rates (%)). // – “…and Asset Valuations Are Below Replacement Cost” (Residential price index (LH), construction as % of inventory (RH)). (Source: CoStar, Bloomberg, Bureau of Labor Statistics. As of Dec 31, 2024) // SECTION: ASSET ALLOCATION (Portfolio Solutions Group – Representative Allocations & Views) // Framework: Current allocation | Change from previous | Symbol (– to ++) // Disclaimer: Informational. Does not constitute offer/recommendation. Tactical views are broad reflection. Individual allocations may differ. Does not address specific investor needs. Signals represent PSG view. // Overall Asset Allocation: // – Bonds – Duration: = (Neutral) // Commentary: 10-year yields (~4.50%) in middle of conceptual range. Recent tariff de-escalation (China-U.S.) removed growth headwinds, reduced recession risks. // – Bonds – Credit: = (Neutral) // Commentary: Spreads tightened, below medium/long-term averages. View spreads as asymmetrically exposed to negative news, limited upside. // – Equities – Risk Level: = (Neutral) // Commentary: Risks balanced. Tariff de-escalation eases headwinds, reduces recession risk. Equities still face trade negotiation headlines, tariff price pressure, eventual growth deceleration. // – Alternatives – Private Markets: = (Neutral) // Commentary: Private equity: constrained distribution activity since 2022. Expect higher dispersion (capital markets, company/asset performance, manager success). Valuations offer fair entry. Importance of European exposure & EM (e.g., India). // – Alternatives – Private Credit: (No explicit rating symbol in summary table, narrative only) // Commentary: Favor non-cyclical corporate lending. Increased supply for opportunistic/special situation lenders with flexible debt strategies. // – Alternatives – Hedge Funds: = (Neutral) // Commentary: Macro environment disruptive for many alpha themes. High conviction in relative value strategies for intra-market dispersion. // – Alternatives – Commodities: = (Neutral) // Commentary: Energy: geopolitical upside risks balanced by high spare capacity (e.g., crude), limiting upside absent physical disruptions. Precious metals: potential structural tailwinds. // – Transition – Cash/Short Duration: – (Underweight) // Commentary: Remain underweight cash and short duration instruments. // SECTION: GLOBAL FIXED INCOME (Detailed Views) // Bonds (Sovereign/Quasi-Sovereign): // – U.S. Treasuries (USTs): = (Neutral) // Commentary: ~4.50% 10-year yield in middle of conceptual range. Tariff de-escalation reduced downside recession risks. // – Inflation Linked Bonds: + (Overweight) // Commentary: Some value, particularly longer sections of curve (5Y/5Y inflation 2.29%). Recent House budget reinforces this. // – Eurozone Govt. Bonds: = (Neutral) // Commentary: Germany’s fiscal pivot likely -> higher trading range for European rates vs. post-GFC, even as ECB cuts. // – EM Hard Currency Govt. Bonds: = (Neutral) // Commentary: EMD spreads wider than corporate credit for most of past 15 yrs, but currently much tighter. Investors still get additional spread pickup. Creditworthiness generally improved with weakening USD. // – EM Local Currency Govt. Bonds: = (Neutral) // Commentary: Strong upgrade candidate, actively researching. Higher quality issuers (mostly Asia) not very attractive (very low rates). Other market segments appealing. Recommend very active manager. // Public Credit: // – Municipal Bonds: + (Overweight) // Commentary: Since upgrading Munis to ++ last month, Muni/UST ratios tightened reasonably, strong returns. Still like Munis, but entry point not quite as attractive. // – Investment Grade (IG) Corporate: – (Underweight) // Commentary: Spreads remain tight given market risks. Poor convexity in current environment. // – MBS/ABS: ++ (High Conviction Overweight) // Commentary: Continue high conviction. Yield per unit of credit quality remains attractive. // – High Yield (HY) Corporate: // – U.S. HY: – (Underweight) // – European HY: = (Neutral) (Upgraded view) // Commentary: European HY offers more attractive spreads than U.S. HY (adjusting for ratings differentials). // – Bank Loans: + (Overweight) // Commentary: Recently tightened with broader risk assets. Like high carry & floating rate nature. Want more conviction default cycle peaked or wider spreads before larger overweight. // SECTION: GLOBAL EQUITY (Detailed Views) // Regional Allocation: // – U.S. Equities: = (Neutral) // Commentary: De-escalation with China reduces growth headwinds/recession risk, but U.S. equities still face tariff price pressure & expected growth deceleration. // – Eurozone Equities: ++ (High Conviction Overweight) // Commentary: Growth outlook benefits from: a) more fiscally expansive stance, b) rising real incomes (consumption), c) relatively more supportive financial conditions than U.S. Prefer segments less exposed to tariffs, directly benefiting from nascent fiscal stimulus (e.g., banks, German mid-caps). // – Japan Equities: = (Neutral) // Commentary: Given continued rise in longer-dated yields & potential JPY strength. Constructive on Japan’s structural reforms & longer-term prospects. // – Emerging Markets (EM) Equities: + (Overweight) // Commentary: Tail risk for EM substantially lower after better-than-expected US/China trade deal. Within EM: India upgraded to overweight (+), China maintained at neutral (=). // Style Allocation: // – Growth vs. Value: = (Neutral) // Commentary: Since mid-2022, GvsV trade dictated by high-beta tech exposure (Growth outperforming Value in rising markets, underperforming in falling). Neutral equity view -> neutral GvsV. // – Quality: + (Overweight) // Commentary: Retain preference for Quality given weaker economic growth outlook. // – Large Cap vs. Small Cap: = (Neutral) // Commentary: Lower quality small-caps still best avoided. Prefer mid-caps (exposure in U.S. and Germany). // – Cyclical vs. Defensive Sectors: = (Neutral) // Commentary: Current cyclical exposure remains in Europe, rests more on structural growth drivers. // END OF AI ULTRA-CONDENSED SUMMARY