Our Head of Corporate Credit Research and Global Chief Economist
explain why they’re watching the consumer savings rate, tariffs
and capital expenditures.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Seth Carpenter: And I'm Seth Carpenter,
Morgan Stanley's Global Chief Economist.
Andrew Sheets: And today on this special
episode of the podcast, we'll be discussing what could cause our
optimistic view on the economy and credit to go wrong.
Andrew Sheets: It’s Friday, Oct
11th at 4pm in London.
Seth Carpenter: And as it turns out, I'm in
London with Andrew.
Andrew Sheets: So, Seth you and your global
economics team have been pretty optimistic on the economy this
year. And have been firmly in the soft-landing camp. And I think
we’ve seen some oscillation in the market's view around the
economy over the course of the year, but more recently, we've
started to see some better data and increasing confidence in that
view.
So, this is actually maybe the perfect opportunity to talk about
– well, what could go wrong? And so, what are some of the factors
that worry you most that could derail the story?
Seth Carpenter: We have been pretty
constructive all along the whole hiking cycle. In fact, we've
been calling for a soft- landing. And if anything, where we were
wrong with our forecast so far is that things have turned out
even better than we dare hoped. But it's worth remembering part
of the soft-landing call for us, especially for the US is that
coming out of COVID; the economy rebounded employment rebounded,
but not proportionally. And so, for a long time, up until
basically now, US firms had been operating shorthanded. And so,
we were pretty optimistic that even if there was something that
caused a slowdown, you were not going to see a wave of layoffs.
And that's usually what contributes to a recession. A slowdown,
then people get laid off, laid off people spend less, the economy
slows down more, and it snowballs.
So, I have to say, there is gotta be just a little bit more risk
because businesses basically backfilled most of their
vacancies. And so, if we do get a big slowdown for some reason,
maybe there's more risk than there was, say, a year ago. So, what
could that something be is a real question. I think the first one
is just -- there's just uncertainty.
And maybe, just maybe, the restraint that monetary policy has
imparted -- takes a little bit longer than we realized. It's a
little bit bigger than we realized, and things are slowing down.
We just haven't seen the full force of it, and we just slowed
down a lot more.
Not a whole lot I can do about that. I feel pretty good. Spending
data is good. The last jobs report was good. So, I see that as a
risk that just hangs over my head, like the sword of Damocles, at
all times.
Andrew Sheets: And, Seth, another thing I
want to talk to you about is this analysis of the economy that we
do with the data that's available. And yet we recently got some
pretty major revisions to the US economic picture that have
changed, you know, kind of our basic understanding of what the
savings rate was, you know, what some of these indicators are.
How have those revisions changed what you think the picture is?
Seth Carpenter: So those benchmark revisions
were important. But I will say it's not as though it was just a
wholesale change in what we thought we understood.
Instead, the key change that happened is we had information
on GDP -- gross domestic product -- which comes from a lot of
spending data. There's another bit of data that's gross domestic
income that in some idealized economic model version of the
world, those two things are the same -- but they had been really
different. And the measured income had been much lower than the
measured gross domestic product, the spending data. And so, it
looked like the saving rate was very, very low.
But it also raised a bit of a red flag, because if the savings
rate is, is really low, and all of a sudden households go back to
saving the normal amount, that necessarily means they'd slow
their spending a lot, and that's what causes a downturn.
So, it didn't change our view, baseline view, about where the
economy was, but it helped resolve a sniggling, intellectual
tension in the back of the head, and it did take away at least
one of the downside risks, i.e. that the savings rate was
overdone, and consumers might have to pull back.
But I have to say, Andrew, another thing that could go wrong,
could come from policy decisions that we don't know the answer to
just yet. Let you in on a little secret. Don't tell anybody I
told you this; but later this year, in fact, next month, there's
an election in the United States.
Andrew Sheets: Oh my goodness.
Seth Carpenter: One of the policies that we
have tried to model is tariffs. Tariffs are a tax. And so, the
normal way I think a lot of people think about what tariffs might
do is if you put a tax on consumer goods coming into the country,
it could make them more expensive, could make people buy less,
and so you'd get a little bit less activity, a little bit higher
prices.
In addition to consumer goods, though, we also import a lot of
intermediate goods for production, so physical goods that are
used in manufacturing in the United States to produce a final
output. And so, if you're putting a tax on that, you'll get less
manufacturing in the United States.
We also import capital goods. So, things that go into business
CapEx spending in the United States. And if you put a tax on
that, well, businesses will do less investment spending. So,
there's a disruption to actual US production, not just US
consumption that goes on. And we actually think that could be
material. And we've tried to model some of the policy proposals
that are out there. 60 per cent tariff on China, 10 per cent
tariff on the rest of the world.
None of these answers are going to be exact, none of these are
going to be precise, but you get something on the order of an
extra nine-tenths of a percentage point of inflation, so a pretty
big reversion in inflation. But maybe closing in on one and a
half percentage points of a drag on GDP – if they were all
implemented at the same time in full force.
So that's another place where I think we could be wrong. It could
be a big hit to the economy; but that's one place where there's
just lots of uncertainty, so we have to flag it as a risk to our
clients. But it's not in our baseline view.
Seth Carpenter: But I have to
say, you've been forcing me to question my optimism, which
is entirely unfair. You, sir, have been pretty bullish on
the credit market. Credit spreads are, dare I say it, really
tight by historical standards.
And yet, that doesn't cause you to want to call for mortgage
spreads to widen appreciably. It doesn't call for you to want to
go really short on credit. Why are you so optimistic? Isn't there
really only one direction to go?
Andrew Sheets: So, there are kind of a few
factors the way that we're thinking about that. So, one is we do
think that the fundamental backdrop, the economic forecast that
you and your team have laid out are better than average for
credit -- are almost kind of ideal for what a credit investor
would like.
Credit likes moderation. We're forecasting a lot of moderation.
And, also kind of the supply and demand dynamics of the market.
What we call the technicals are better than average. There's a
lot of demand for bonds. And companies, while they're getting a
little bit more optimistic, and a little bit more aggressive,
they're not borrowing in the kind of hand over fist type of way
that usually causes more problems. And so, you should have richer
than average valuations.
Now, in terms of, I think, what disrupts that story, it could be,
well, what if the technicals or the fundamentals are no longer
good? And, you know, I think you've highlighted some scenarios
where the economic forecasts could change. And if those forecasts
do change, we're probably going to need to think about changing
our view. And that's also true bottom up. I think if we started
to see Corporates get a lot more optimistic, a lot more
aggressive. You know, hubris is often the enemy of the bond
investor, the credit investor.
I don't think we're there yet, but I think if we started to see
that, that could present a larger problem. And both, you know,
fundamentally it causes companies to take on more debt, but also
kind of technically, because it means a lot more supply relative
to demand.
Seth Carpenter: I see. I see. But I wonder,
you said, if our outlook, sort of, doesn't materialize, that's a
clear path to a worse outcome for your market. And I think that
makes sense.
But the market hasn't always agreed with us. If we think back not
that long ago to August, the market had real turmoil going on
because we got a very weak Non Farm Payrolls print in the United
States. And people started asking again. ‘Are you sure, Seth?
Doesn't this mean we're heading for a recession?’ And asset
markets responded.
What happened to credit markets then, and what does it tell you
about how credit markets might evolve going forward, even if, at
the end of the day, we're still right?
Andrew Sheets: Well, so I think there have
been some good indications that there were parts of the
market where maybe investors were pretty vulnerably positioned.
Where there was more leverage, more kind of aggressiveness in how
investors were leaning, and the fact that credit, yes, credit
weakened, but it didn't weaken nearly as much -- I think does
suggest that investors are going to this market eyes wide open.
They're aware that spreads are tight. So, I think that's
important.
The other I think really fundamental tension that I think credit
investors are dealing with -- but also I think equity investors
are -- is there are certain indicators that suggest a recession
is more likely than normal. Things like the yield curve being
inverted or purchasing manager indices, these PMIs being below
50.
But that also doesn't mean that a recession is assured by
any means. And so, I do think what can challenge the market is a
starting point where people see indicators that they think mean a
recession is more likely, some set of weak data that would seem
to confirm that thesis, and a feeling that, well, the writing's
on the wall.
But I think it's also meant, and I think we've seen this since
September, that this is a real, in very simple terms, kind of
good is good market. You know, I got asked a lot in the aftermath
of some of the September numbers, internally at Morgan Stanley,
'Is it, is it too good? Was the jobs number too good for credit?'
And, and my view is, because I think the market is so firmly
shifted to ‘we're worried about growth,’ that it's going to take
a lot more good data for that fear to really recede in the market
to worry about something else.
Seth Carpenter: Yeah, it's funny. Some
people just won't take yes for an answer. Alright, let me, let me
end up with one more question for you.
So when we think about the cycle, I hear as I'm sure you do from
lots of clients -- aren't we, late cycle, aren't things coming to
an end? Have we ever seen a cycle before where the Fed hiked this
much and it didn't end in tears? And the answer is actually yes.
And so, I have often been pointing people to the 1990s.
1994, there was a pretty substantial rate hiking cycle that
doesn't look that different from what we just lived through. The
Fed stopped hiking, held out at the peak for a while, and then
the economy wobbled a little bit. It did slow down, and they cut
rates. And some of the wobbles, for a while at least, looked
pretty serious. The Fed, as it turns out, only cut 75 basis
points and then held rates steady. The economy stabilized and we
had another half decade of expansion.
So, I'm not saying history is going to repeat itself exactly. But
I think it should be, at least from my perspective, a good
example for people to have another cycle to look at where things
might turn out well with the soft landing.
Looking back to that period, what happened in credit markets?
Andrew Sheets: So, that mid-90s
soft-landing was in the modern history of credit -- call it the
last 40 years -- the tightest credit spreads have ever been. That
was in 1997. And they were still kind of materially tighter from
today's levels.
So we do have historical evidence that it can mean the market can
trade tighter than here. It's also really fascinating because the
1990s were kind of two bull markets. There was a first stage
that, that stage you were suggesting where, you know, the Fed
started cutting; but the market wasn't really sure if it was
going to stick that landing, if the economy was going to be okay.
And so, you saw this period where, as the data did turn out to be
okay, credit went tighter, equities went up, the two markets
moved in the same direction.
But then it shifted. Then, as the cycle had been extending for a
while, kind of optimism returned, and even too much optimism
maybe returned, and so from '97, mid-97 onwards, equities kept
going up, the stock market kept rallying, credit spreads went
wider, expected volatility went higher. And so, you saw that
relationship diverge.
And so, I do think that if we do get the '90s, if we're that
lucky, and hopefully we do get that sort of scenario, it was
good in a lot of ways. But I think we need to be on the watch for
those two stages. We still think we're in stage one. We still
think they're that stage that's more benign, but eventually
benign conditions can lead to more aggressiveness.
Seth Carpenter: I think that's really fair.
So, we started off talking about optimism and I would like to
keep it that you pointed out that the '90s required a bit of good
luck and I would wholeheartedly agree with that.
So, I still remain constructive, but I don't remain naive. I
think there are ways for things to go wrong. And there is a ton
of uncertainty ahead, so it might be a rocky ride. It's always
great to get to talk to you, Andrew.
Andrew Sheets: Great to talk to you as
well, Seth.
And thanks for listening. If you enjoy the show, leave us a
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