Lisa Shalett, our CIO for Wealth Management, and our Head of
Corporate Credit Research discuss how to forecast expected
returns over the long term, and whether historic cycles can help
make sense of the market environment today.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Lisa Shalett: And I'm Lisa Shalett, Chief
Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: And on part one of this
special episode of the podcast, we'll be discussing long run
expected returns across markets, how we think about cross asset
correlations and portfolio construction, and what are the special
considerations that investors might want to have in mind in the
current environment.
It's Friday, May 3rd at 4pm in London.
Lisa Shalett: And it's 11am here in New
York City.
Andrew Sheets: Lisa, you and I are both
members of Morgan Stanley's Global Investment Committee, which
brings together nine of our firm's market, economic, and
portfolio management thought leaders to provide a strategic
framework for advice that we give to clients.
Andrew Sheets: I wanted to touch on a
unique aspect of that process because, you know, we're talking
about estimating returns over different horizons for markets. And
I think there's something that's kind of unique about that
challenge. I mean, I think in most aspects of life, it's probably
safe to say that the next decade is more uncertain than the next
six months or next year. But when we're thinking about asset
class returns, it's not quite as simple as that.
Lisa Shalett: Not at all. And very often
this is where our understanding of history needs to play a big
part. When we think about the future, what are the patterns that
we think might be persistent? And therefore, encourage us to
think about long run trends and mean reversion. And what dynamics
might actually be disconnected, or one offs that are
characteristic of maybe structural change in the economy or
geopolitics or in policymaking stance.
Andrew Sheets: How have these latest
capital market assumptions changed over the last year?
Lisa Shalett: I think one of the most
profound changes has been our willingness to embrace the idea
that, in fact, we are in a higher for longer inflation regime.
And that has a couple of implications. The first has to do,
of course, with nominal returns. A higher inflation environment
suggests that nominal returns are actually likely to be
higher. The second really has to do with where we are in the
cycle and its implications for correlations. We've been
through periods most recently, where stocks and bonds were, in
fact, anti-correlated; or there was a diversifying property, if
you will to the 60 40 portfolio. Most recently, as inflation and
level of interest rates has had profound importance to both stock
valuations and bond valuations, we have found that these
correlations have turned positive. And that creates a imperative,
really, for clients to have to look elsewhere beyond cash, bonds,
and stocks to get appropriate diversification in their
portfolios.
Andrew Sheets: Well, it's been less than a
month since we updated our strategic recommendations. We've
recently also published an update to our tactical asset
allocation recommendations. So, Lisa, I guess I have two
questions. One is, how do you think about these different
horizons, the strategic versus the tactical? And can you also
summarize what's changed?
Lisa Shalett: Sure. You know, we very often
talk to clients about the tactical horizon as being in the 12 to
18-month time frame.
In our most recent adjustment, we moved from what had been
roughly a, year old underweight in US large cap stocks, and we
neutralized that, kind of quote unquote, back to benchmark. So,
we added some exposure, and we funded that exposure by selling
out of two other positions; one that we had had in both small cap
value and small cap growth, as well as a position we had, that we
had put on as a hedging oriented position and long duration
treasuries.
Now, some might say well, given the move in interest rates, is
now the right time to take that hedge off? Our decision was
basically premised on the fact that we're just not seeing the
value in holding duration today given the inversion of the yield
curve, and we're not getting paid for the risk of duration. And
so, you know, we thought redeploying into those large cap stocks
was prudent.
Now, the other rationale, really has to do with
earnings achievability. A lot of our thoughts were premised early
in the year on this idea of a soft landing -- and a soft landing
that would include deceleration in top line growth. And so, we
were skeptical that could produce what consensus was looking for,
which was a 10 to 11 per cent bottom line in 2024.
As it turns out, it looks like, nominal GDP in the US is going to
continue to persist at levels above 5 per cent, and that kind of
tailwind, suggested that our skepticism would prove too
conservative; and that, in fact, in a, 10 per cent bottom line
could be achievable -- especially if it were being driven by
manufacturing oriented companies who are seeing a pick up from
global growth.
Andrew Sheets: Lisa, maybe if I could just
ask you kind of one more question related to some of these
longer-term assumptions, you know, I imagine you get some
skepticism to say, ‘Well, you know, is the market of today really
comparable to, say, the stock market of 30 or 40 years ago? Can
we really use metrics or mean reversion that's worked in the past
when, you know, the world is different.’
Lisa Shalett: Yeah, no, that, that's a
fantastic question. I mean, some of the bigger variables in the
world that we look at have shown over very long periods of time
tendencies to cycle, whether those are things around the
business cycle, valuations, cost of capital. Those
are the types of variables that over long periods of time tend to
mean revert. Same thing volatility. There tend to be long term
characteristics. And the history book is pretty convincing that
even if sometimes mean reversion is delayed, it ultimately plays
out.
But we do think that there are elements that we need to continue
to question, right. One of them is, you know, has
monetary policy and central bank intervention fundamentally
changed the rules of the game? Where central banks implicitly or
explicitly are managing market liquidity as much as they are
managing cost of capital; and as a result, the way markets
interact with the central bank and the guidance -- is that
different?
A second, factor has to do with market structure, right? And in a
world where market prices were really being determined almost
exclusively by fundamentals, right? There was this constant
rotational shift between growth style and value style and where
value could be determined in the market. As we've moved to a
market that is increasingly driven by passive flows; there's a
question that many market participants have raised about whether
or not markets have gotten more inefficient because price
discovery is actually, in the short run, not what's driving
prices, but rather flows; passive flows are driving prices.
And so, you know, how do we account for these leads and lags in
prices being actually remarked to fundamentals? So those are at
least two of the things that I know we are constantly tossing
around as we think about our methodologies and capital market
assumptions.
Andrew Sheets: That was part one of my
conversation with Lisa Shalett, Chief Investment Officer for
Morgan Stanley Wealth Management.
Look out for part two of our conversation, where we'll be
discussing the impact of higher interest rates on asset classes.
And how investors should think about an unusually concentrated
stock market.
Andrew Sheets: As a reminder, if you enjoy
Thoughts in the Market, please take a moment to rate and review
us wherever you get your podcasts. It helps more people find the
show.
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