Our Global Head of Fixed Income Research Andrew Sheets outlines what could potentially go wrong and disrupt markets’ optimism this summer.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley. 

Today, discussing three things that could disrupt a quiet summer. 

It’s Wednesday, July 8th at noon in New York. 

As markets turn the page toward the second half of the year, there are lots of reasons for optimism. Global growth remains solid. Earnings growth is strong, and broadening across more companies. Capital markets remain open and deal activity is robust. We continue to think that the best analogy for current conditions is something like 1997 through 1998 or 2005 through 2006 – periods where corporate aggression was increasing, and had further to go, leading to equities outperforming credit. 

Even more immediately, July also happens to be one of the best months of the year for markets. And while one should never base their entire investment strategy on how far the earth has travelled around the sun, this month has been the best month for the U.S. High Yield returns, by far, over the last 15 years. The last time the S&P 500 fell in the month of July was 2014. 

So given all that, what could go wrong? Well, here are three things that are on our mind. 

First, a key part of our most optimistic view is that U.S. inflation will be lower than the Federal Reserve expects in the second half of this year, leading them to leave interest rates unchanged, rather than raise rates as the market expects. 

The risk is that this assumption is just wrong, perhaps soon. There is certainly an argument that, if the Fed is worried about inflation, it shouldn’t wait to act, and the market is currently placing roughly 1-in-3 chance that the Fed hikes rates on July 29th. If that happens – and again, our base case is it does not – it could drive volatility. 

Second is earnings season, which kicks off next week. While the general trend of earnings is important, the bigger focus is likely to be on the results of large U.S. tech companies, and in particular, how much they plan to spend building out AI infrastructure. 

Over the last several quarters, almost like clockwork, these spending estimates have been revised higher and higher. And that has helped boost confidence in AI – as the spending is a sign that the technology holds promise – as well as boosting the broader earnings outlook; since all of this spending is becoming other company’s revenue. 

Our base-case remains that this AI spending cycle has further to run, with capex from the major U.S. hyperscalers rising from over $800bn of spending this year to roughly $1.2 trillion of spending next year. 

But the risk would be that second quarter earnings now show more hesitation to spend, maybe because the share prices of some of these big spenders have been recent underperformers. And given how much the current growth and earnings story is linked to AI, and how popular AI exposure is with investors, that would create a risk. 

Finally, there’s Iran. Our base case assumes a gradual renormalization of flows through the Strait of Hormuz, and we forecast Brent oil at about $75/bbl in 12 months time, which is pretty similar to current levels. But as of this recording there were reports of renewed hostilities, and the ceasefire may be fragile. 

The U.S. has already drawn down its Strategic Petroleum Reserve to its lowest-ever levels, potentially reducing some ability to absorb shocks if the conflict re-escalates. 

Historically, July tends to be strong, and markets have a number of helpful tailwinds at their back. But an unexpected rate hike, an unexpected reduction in Hyperscaler Capex, and a resumption of the Iran conflict are three factors that are not in our base-case – and could disrupt that. 

Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. Also tell a friend or colleague about us today.