Investors were caught off guard last week when the Taiwanese dollar surged to a multi-year high. Our strategists Michael Zezas and James Lord look at what was behind this unexpected rally.

Read more insights from Morgan Stanley.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy.

James Lord: And I'm James Lord Morgan Stanley's, Global Head of FX and EM Strategy.

Michael Zezas: Today, we'll focus on some extreme moves in the currency markets and give you a sense of what's driving them, and why investors should pay close attention.

It's Thursday, May 8th at 10am in New York.

James Lord: And 3pm in London.

Michael Zezas: So, James, coming into the year, the consensus was that the U.S. dollar might strengthen quite a bit because the U.S. was going to institute tariffs amongst other things. That's actually not what's happened. So, can you explain why the dollar's been weakening and why you expect this trend to continue?

James Lord: I think a big factor for the weakening in the dollar, at least in the initial part of the year before the April tariff announcements came through, was a concern that the U.S. economy was going to be slowing down this year. I mean, this was against some of the consensus expectations at the beginning of the year.

In our year ahead outlook, we made this call that the dollar would be weakening because of the potential weakness in the U.S. economy, driven by slow down in immigration, limited action on fiscal policy. And whatever tariffs did come through would be kind of damaging for the U.S. economy.

And this would all sort of lead to a big slowdown and a kind of end to the U.S. exceptionalism trade that people now talk about all the time. And I think since April 1st or April 2nd tariff announcements came, the tariffs were so large that it raised real concerns about the damage that was potentially going to happen to the U.S. economy.

The sort of methodology in which the tariff formulas were created raised a bit of concern about the credibility of the announcements. And then we had this constant on again, off again, on again, off again tariffs. That just created a lot of uncertainty. And in the context of a 15-year bull market of the dollar where it had sucked enormous amounts of capital inflows into the U.S. economy. You know, investors just felt that maybe it was worth taking a few chips off the table and unwinding a little bit of that dollar risk. And we've seen that play out quite notably over the last month. So, I think it's been, yeah, really that those concerns about growth but also this sort of uncertainty about policy in general in the context of, you know, a big bull run for the dollar; and fairly heavy valuations and positioning. Those have been the main issues, I think.

Michael Zezas: Right, so we've got here this dynamic where there are economic fundamental reasons the dollar could keep weakening. But also concerns from investors overseas, whether they're ultimately founded or not, that they just might have less demand for owning U.S. dollar denominated assets because of the U.S. trade dynamic. Now it seems to me, and correct me if I'm wrong, that there was a major market move in the past week around the Taiwanese dollar, which reflected these concerns and created an unusually large move in that currency. Can you explain that dynamic?

James Lord:  Yeah, so we've seen really significant moves in the Taiwan dollar. In fact, on May 2nd, the currency saw its largest one-day rally since the 1980s, and over two days gained over 6.5 percent, which for a Taiwan dollar, which is pretty low volatility currency usually, these are really big moves. So in our view, the rally in the Taiwan dollar, and it was remarkably big. We think it's been mostly driven by Taiwanese exporters selling some of their dollar assets with a little bit of foreign equity inflow helping as well. And this is linked back to the sort of trade negotiations as well.

I mean, as you know, like one of the things that the U.S. administration has been focused on currency valuations. Historically, many people in the U.S. administration believe the dollar is very strong. And so there has been this sort of issue of currency valuations hanging over the trade negotiations between the U.S. and various Asian countries. And local media in Taiwan have been talking about the possibility that as part of a trade negotiation or trade deal, there could be a currency aspect to that – where the U.S. government would ask the Taiwanese authorities to try to push Taiwan dollar stronger.

And you know, I think this sort of media reporting created a little bit of a -- well, not just a little, a significant shift from Taiwanese exporters where they suddenly rush to sell their dollar deposits in to get ahead of any possible effort from the Taiwanese authorities to strengthen their currency. The central bank is being very clear on this.

We should have to point this out that the currency has not been part of the trade deal. And yet this hasn't prevented market participants from acting on the perceived risk of it being part of the trade talks. So, you know, Taiwanese exporters own a lot of dollars. Corporates and individuals in Taiwan hold about $275 billion worth of FX deposits and for an $800 billion or so economy, that's pretty sizable. So we think that is that dynamic, which has been the biggest factor in pushing Taiwan dollar stronger.

Michael Zezas: Right, so the Taiwan dollar is this interesting case study then in how U.S. public policy choices might be creating the perception of changes in demand for the dollar changes in policy around how foreign governments are supposed to value their currency and investors might be getting ahead of that.

Are there any other parts of the world where you're looking at foreign exchange globally, where you see things mispriced in a way relative to some of these expectations that investors need to talk about?

James Lord: We do think that the dollar has further to go. I mean, it's on the downside. It's not necessarily linked to expectations that currency agreements will be part of any trade agreement. But, we think the Fed will need to cut rates quite a bit on the back of the slow down in the U.S. economy. Not so much this year. But Mike Gapen and Seth Carpenter, and the U.S. economics team are expecting to see the Fed cut to around 2.5 per cent or so next year. And that's absolutely not priced. And, And so I think as this slowdown – and, this is more of a sort of traditional currency driver compared to some of these other policy issues that we've been talking about. But if the Fed does indeed cut that far, I do think that that's going to put some meaningful pressure on the dollar. And on a sort of interest rate differential perspective, and when we look at what is mispriced and correctly priced, we see the Fed as being mispriced, but the ECB is being quite well priced at the moment.

So as that weakening downward pressure comes through on the dollar, it should be reflected on the euro leg. And we see it heading up to 1.2. But just on the trade issue, Mike, what's your view on how those trade negotiations are going? Are we going to get lots of deals being announced soon?

Michael Zezas: Yeah, so the news flow here suggests that the U.S. is engaged in multiple negotiations across the globe and are looking to establish agreements relatively quickly, which would at least give us some information about what happens next with regard to the tariffs that are scheduled to increase after that 90 day pause that was announced in earlier in April. We don't know much beyond that.

I'd say our expectation is that because the U.S. has enough in common in terms of interests and how it manages its own economy and how most of its trading partners manage their own economies – that there are trade agreements, at least in concept. Perhaps memorandums of understanding that the U.S. can establish with more traditional allies, call it Japan, Europe, for example, that can ultimately put another pause on tariff escalation with those countries.

We think it'll be harder with China where there are more fundamental disagreements about how the two countries should interact with each other economically. And while tariffs could come down from these very, very high levels with China, we still see them kind of settling out at still meaningful substantial headline numbers; call it the 50 to 60 per cent range. And while that might enable more trade than we're seeing right now with China because of these 145 per cent tariff levels, it'll still be substantially less than where we started the year where tariff levels were, you know, sub 20 per cent for the most part with China.

So, there is a variety of different things happening. I would expect the general dynamic to be – we are going to see more agreements with more counterparties. However, those will mostly result in more pauses and ongoing negotiation, and so the uncertainty will not be completely eliminated. And so, to that point, James, I think I hear you saying that there is potentially a difference between sometimes currencies move based on general policy uncertainty and anxieties created around that.

James Lord: Yeah, that's right. I think that's safer ground, I think for us as currency strategists to be anchoring our view to because it’s something that we deal with day in, day out for all economies. The impact of this uncertainty variable. It could be like, I think directionally supports a weaker dollar, but sort of quantifying it, understanding like how much of that is in the price; could it get worse, could it get better? That's something that's a little bit more difficult to sort of anchor the view to. So, at the moment we feel that it's pushing in the same direction as the core view. But the core view, as you say, is based around those growth and monetary policy drivers.

So, best practice here is let's keep continuing to anchor to the fundamentals in our investment view, but sort of recognize that there are substantial bands of uncertainty that are driven by U.S. policy choices and by investors' perceptions of what those policy choices could mean.

Michael Zezas: So, James conversations like this are extremely helpful to our audience. We'll keep tracking this carefully. And so, I just want to say thank you for taking the time to talk with us today.

James Lord: I really enjoyed it. Looking forward to the next one.

Michael Zezas: Great. And thank you for listening. If you enjoy the podcast, please leave us a review wherever you listen to the podcast and share Thoughts on the Market with a friend or colleague today.

The traditional correlations between some asset classes went haywire in April. Our analysts Serena Tang and Vishy Tirupattur discuss whether, in this environment, investors still consider U.S. Treasuries and the U.S. dollar to be reliable ports in a storm. 

Read more insights from Morgan Stanley.

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Serena Tang: Welcome to Thoughts on the Market. I'm Serena Tang, Morgan Stanley's Chief Cross Asset Strategist.

Vishy Tirupattur: And I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.

Serena Tang: Today's topic, how investors' perceptions of safe havens are evolving, the impact on correlation between asset classes, and what all this means for your portfolio.

It's Wednesday, May 7th at 10am in New York.

April was a really challenging month, and some market moves were highly unusual. There was also a lot of investor concern whether U.S. Treasuries would continue to be a safe haven. In fact, this became one of the biggest market debates over the last few weeks.

Vishy, let's start here. Prior to this recent sell off, foreign investors looked at U.S. assets as a safe haven. Why is that? And is it still the case now after this turbulent month?

Vishy Tirupattur: So, Serena, if you just step back and look at it, U.S. enjoyed positive growth differentials and positive yield differentials with developed markets in the rest of the world. On top of that, there was a consistent policy – not necessarily infallible policy – but there's a consistent policy with a clear sense of demarcation between the executive and the central bank.

All of this meant U.S. was a very attractive destination for foreign investor flows. Not only during periods of normalcy where U.S. equities really attracted inflows and performed really well, but also during the periods of economic stress; where even periods where the stress was coming from the U.S. itself, such as the Global Financial Crisis. This correlation between bonds and stocks held and U.S. Treasuries were the safe haven asset as the single largest and most liquid, and highly negatively correlated asset with risk assets. So that really worked.

What we are now seeing is that growth differential I talked about may no longer be holding. You know, for these [20]25 and [20]26 U.S. and euro area growth basically will converge – and if our economists’ expectations are right, in 2026, euro area will be growing at a faster pace than the U.S.

So, growth differential argument is fading. And there are some questions about the continued Fed independence. So put all these things together. Some investors are beginning to question whether U.S. assets will continue to be safe haven assets.

So let me come back to you Serena. There've been some recent market moves that have been extremely unusual. That's what created all this debate. In some of – a few days in April, during the periods of sell off, we had both stocks and bonds selling off. And it felt like cross-asset correlations have gone totally haywire.

So, can you talk a little bit about which correlations have changed? Which correlations have held up in these sell off?

Serena Tang: What was highly unusual, and I think reflects part of the debate on U.S. as a safe haven, is the correlation between U.S. equities and the dollar. It is very high at the moment, about sort of two standard deviation above the five-year average. While it's not unheard of for FX stocks correlation to be high, it is usually more associated with EM or emerging markets rather than DM or developed markets. As a means, investors now require higher risk premium for holding the equities, which is a risk asset; but also holding the dollar, which again, traditionally is not thought of as a risk asset.

Vishy Tirupattur: So, Serena, how did the correlation between bonds and stocks hold up in this period?

Serena Tang: Surprisingly, the correlation have really, really held up. Stocks and bond return correlation turned very negative during the sell off that we saw, which means that equity losses were actually offset by bond returns. Now, this isn't entirely true across the curve. You saw 2 Year Treasuries being a much effective diversifier than say the 30 Year Treasury. But all in all, I think it means bonds still work as a diversifier.

Now on this point Vishy, how do you think policy will impact asset correlations we've been talking about, as well as the perception of U.S. assets as a safe haven.

Vishy Tirupattur: So, as I said before, positive growth differentials fade, and we have negative growth differential. And if there are continued questions about the Fed's independence, so some of the attraction of U.S. assets, particularly U.S. Treasuries as a safe haven asset, will be challenged. But that challenge hits the practical reality of the size and the scale of the safe haven assets.

So, if you look around, if you add the comparably rated European government bond market and compare that to the U.S. government bond market, the U.S. market is about 10 times as larger. So, more scale, more liquidity, and the ability to deploy capital during the periods of stress is clearly more in the U.S.

So, this is what I would say. The status of U.S. dollar as the global reserve currency and U.S. Treasuries as the global safe haven asset have taken a bit of a ding, but not gone away.

Serena Tang: Vishy, thanks so much for taking the time to talk.

Vishy Tirupattur: Great speaking with you, Serena, as always.

Serena Tang: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

With the May FOMC meeting in progress, our analysts Matt Hornbach and Michael Gapen offer perspective on U.S. economic projections and whether markets are aligned.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist.

Matthew Hornbach: Today we're talking about the Federal Open Market Committee Meeting underway, and the path for rates from here.

It's Tuesday, May 6th at 10am in New York.

Mike, before we talk about your expectations for the FOMC meeting itself, I wanted to get your take on the U.S. economy heading into the meeting. How are you seeing things today? And in particular, how do you think what happened on April 2nd, so-called Liberation Day, affects the outlook?

Michael Gapen: Yeah, I think right now, Matt, I would say the economy's still on relatively solid footing, and by that I mean the economy had been moderating. Yes, the first quarter GDP print was negative. But that was mainly because firms were frontloading a lot of inventories through imports. So imports were up over 40 percent at an annualized pace in the quarter. A lot of that went into inventories and into business spending. That was just a mechanical drag on activity.

And the April employment report, I think, showed the same thing. We're now averaging about 145,000 jobs per month this year. That's down from about 170,000 per month in the second half of last year. So the hiring rate is slowing down, but no signs of a sudden stop. No signs in layoffs picking up. So I'd say the economy is on fairly solid footing, and the labor market is also on fairly solid footing – as we enter the period now when we think tariffs will have a greater effect on the outlook.

So you asked, you know, Liberation Day. How does that affect the outlook? Right now we'd say it puts a lot of uncertainty in front of us. on pretty solid footing now. But Matt, looking forward, we have a lot of concerns about where things may go and we expect activity to slow and inflation to rise.

Matthew Hornbach: That's great background, Mike, for what I want to ask you about next, which is of course the FOMC meeting this week. We won't get a new set of economic projections from the committee. But if we did, what do you think they would do with them and how would you assess the reaction function one might be able to tease out of those economic projections?

Michael Gapen: You're right, we don't get a new set of projections, but New York Fed President John Williams did provide some indication about how he adjusted his forecast, and John tends to be one of the – kind of a median participant.

He tends to be centrist in his thinking and his projection. So I do think that that gives us an indication of what the Fed is thinking; and he said he expects GDP growth to slow to somewhat below 1 percent in 2025. He expects inflation to rise to 3.5 to 4 percent this year, and he said the unemployment rates likely to move between 4.5 and 5 percent over the next year. And those phrases are really key. That's the same thing, Matt, as you know, we are expecting for the U.S. economy and I do think the Fed is thinking of it the same way.

Matthew Hornbach: So one final question for you, Mike. In terms of this meeting itself, what are you expecting the Fed to deliver this week? And what are the risks you see being around that expectation; you know, that might catch investors off guard?

Michael Gapen:

I think the Fed's main message this week will be that they're prepared to wait, that they think policy's in a good spot right now. They think inflation will be rising sharply, that the tariff shock is a lot larger than they had anticipated earlier this year. And they will need time to assess whether that inflation impulse is transitory, or whether it creates more persistent inflation. So I think what they will say is we're in a good position to wait and we need clarity on the outlook before we can act.

In this case, we think acting means doing nothing. But acting could also mean cutting if the labor market weakens. So I think there'll be worried about inflation today, a weak labor market tomorrow. And so I think risks around this meeting really are tilted in the direction of a more hawkish message than markets are expecting at least vis-a-vis current pricing. I think the market wants to hear the Fed will be ready to support the economy. Of course, we think they will, but I think the Fed's also going to be worried about inflation pressures in the near term. So that, I think, might catch investors off guard.

So Matt, what I think might catch investors off guard may be a little misplaced. I'm an economist after all. You're the strategist, you're the expert on the treasury market and how investors may be perceiving events at the moment. So the treasury market had quite the month since April 2nd. For a moment U.S. treasuries didn't act like the safe haven asset many have come to expect. What do you think happened?

Matthew Hornbach: So, Mike, you're absolutely right. Treasury yields initially fell, but then spent a healthy portion of the last month rising and investors were caught off guard by what they saw happening in the treasury market. I've seen this type of behavior in the treasury market, which I've been watching now for 25 years. I've seen this happen twice before in my career. The first time was during the Great Financial Crisis, and the second time I saw it was in March of 2020. So, this being the third time you know, I don't know if it was the charm or if it was something else, but treasury yields went up quite a bit.

I think what investors were witnessing in the treasury market is really a reflection of the degree of uncertainty and the breadth with which that uncertainty, traversed the world. Both the Great Financial Crisis and the initial stage of the pandemic in March of 2020 were events that were global in nature. They were in many ways systemic in nature, and they were events that most investors hadn't contemplated or seen in their lifetimes. And when this happens, I think investors tend to reduce risk in all of its forms until the dust settles. And one of those very important forms of risk in the fixed income markets is duration risk.

So, I think investors were paring back duration risk, which helped the U.S. Treasury market perform pretty poorly at one moment over the past month.

Michael Gapen: So Matt, one aspect of market pricing that stands out to me is how rates markets are pricing 75 basis points of rate cuts this year. And just after April 2nd, the market had priced in about 100 basis points of cuts.

How are you thinking about the market pricing today? Matt, as you know, it differs quite a bit from what we think will happen.

Matthew Hornbach: Yeah. This is where, you know, understanding that market prices in the interest rate complex reflect the average outcome of a wide variety of scenarios; really every scenario that is conceivable in the minds of investors. And, of course, as you mentioned, Mike depending on exactly how this year ends up playing out there, there could be a scenario in which the Federal Reserve has to lower rates much more aggressively than perhaps even markets are pricing today.

So, the market being an average of a wide variety of outcome will find it really challenging to take out all of the rate cuts that are priced in today. Or said differently, the market will find it challenging to price in your baseline scenario. And ultimately, I think the way in which the market ends up truing up to your projections, Mike, is just with time.

I think as we make our way through this year and the economic data come in, in-line with your baseline projections, the market will eventually price out those rate cuts that you see in there today. But that's going to take time. It's going to take investors growing increasingly comfortable that we can avoid a recession at least in perception this year before, you know, on your projections, we have a bit of a slower economy in 2026.

Michael Gapen: Well, it definitely does feel like a bimodal world, where investor conviction is low. Matt, where do you have conviction in the rates market today?

Matthew Hornbach: So, the way we've been thinking about this environment where we can avoid a recession this year, but maybe 2026 the risks rise a bit more. We think that that's the type of environment where the yield curve in the United States can steepen, and what that means practically is that yields on longer maturity bonds will go up relative to yields on shorter maturity bonds. So, you get this steepening of the yield curve. And that is where we have the highest conviction; in terms of, what happens with the Treasury market this year is we have a steeper yield curve by the time we get to December.

Now part of that steepening we think comes because as we approach 2026 where Mike, you have the Fed beginning to lower rates in your baseline, the market will have to increasingly price with more conviction a lower policy rate from the Fed. But then at the same time, you know, we probably will have an environment where treasury supply will have to increase.

As a result of the fiscal policies that the government is discussing at the moment. And so you have this environment where yields on longer maturity securities are pressured higher relative to yields on shorter maturity treasuries.

So, with that, Mike, we'll wrap our conversation. Thanks so much for taking the time to talk.

Michael Gapen: It's been great speaking with you, Matt.

Matthew Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

Morgan Stanley Research analyst Mark Schmidt and Investment Management’s Craig Brandon discuss the heightened uncertainty in the U.S. municipal bonds market.

Read more insights from Morgan Stanley.

For a full list of episode disclosures click here.

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Mark Schmidt: Welcome to Thoughts on the Market. I'm Mark Schmidt, Morgan Stanley's Head of Municipal Strategy.

Craig Brandon: I'm Craig Brandon, Co-Director of Municipal Investments at Morgan Stanley Investment Management.

Mark Schmidt: Today, let's talk about the biggest market you hardly ever hear about – municipal bonds, a $4 trillion asset class.

It's Monday, May 5th at 10am in Boston.

Mark Schmidt: If you've driven, flown, gone to school or turned on a tap, chances are munis made it happen. Although munis are late cycle haven, they were not immune to the latest bout of market volatility. Craig, why was April so tough?

Craig Brandon: So, what we say in April, it was sort of the trifecta of things that happened that were a little different than other asset classes. The first thing that happened is we saw a significant increase in treasury rates – and munis are generally correlated to treasuries. We're a very high-quality asset class, that's viewed as a duration asset class. So, one thing we saw were rates going up. When we see rates going up, you generally see money coming out of the market, right? So, I think investors were a little bit impacted by the higher rates, the correlation to treasuries, the duration, and saw some flows out of the market.

Secondly, what we saw is conversation about the tax exemption in Washington D.C. What that did is it caused muni issuers to pull their issuance forward. So, if you're an infrastructure issuer, you are issuing bonds in the next year to year and a half; you're going to pull that forward because if there's any risk of loss of the tax exemption, you want to get these bonds issued today. So that's basically what drives technicals. It's supply and demand. So, what we saw was a decrease in demand because of higher rates; an increase in supply because of issuance being pulled forward.

And the third part of the trifecta we refer to is the conversations about the economy. So, I would put that, it's sort of a distant third, but there's still conversations about maybe credit weakness driven by a slowing economy.

Mark Schmidt: Craig, your team has been through a lot of tough market cycles. Given your experience, how did the most recent selloff compare? And why was it not like 2008?

Craig Brandon: I started my career back in 1998 during the long-term capital management crisis. I lived through 2008. I lived through the COVID crisis, and you know, really when I look at the crisis in 2008 – no banks went out of business three weeks ago, right? In 2008 we were really sitting on a trading desk wondering where this was going to end.

You know, we had a number of meetings with our staff, over the last couple weeks explaining to them why it was different and how. Yes, there was some volatility here, but you could see that there was going to be an end to this, and this was not going to be a permanent restructuring of the market. So, I think we felt comfortable. It was very different than 2008 and it really felt different than COVID.

Mark Schmidt: That's reassuring. But with economic growth set to slow sharply, how does your credit team think the fiscal health of America's state and local governments will hold up?

Craig Brandon: Well, remember state and local governments, and when we're talking about munis, we're also talking about other infrastructure asset classes like water and sewer bonds. Like, you know, transportation, bonds, airports. We're talking about toll roads.

They went into this with a very strong balance sheet, right? Remember, there was a lot of infrastructure money spent by the federal government during COVID to give issuers money to make it through COVID. There's still a lot of money on balance sheets. So, what we do is we're going into this crisis with a lot of cash on balance sheets, allowing issuers to be able to withstand some weakness in the economy and get through to the other side of this.

Mark Schmidt: Not only do state and local governments have a lot of cash, but they're just not that impacted by tariffs, right? So why did muni yields perform worse than U.S. treasuries over the past couple of weeks?

Craig Brandon: Right. It really… We're technically driven, right? The U.S. muni market is more retail driven than some other asset classes. Remember – investment grade corporates, treasury bonds, there's a lot of institutional buyers in those markets. In the municipal market, it's primarily retail driven.

So, when you know, individual retail investors get nervous, they tend to pull money out of the market. So, what we saw was money coming out of the market. At the same time, we saw an individual increase in more bonds, which just led to very weak technicals, which when we see that it eventually reverses itself.

Mark Schmidt: Now I almost buried the lede, right? Why invest in munis? Well, they're great credit quality, but they're also tax free. In fact, muni bonds have been exempt from federal taxes for over a century. You have a lot of experience putting together tax bills, and right now people are worried about tax reform. Do you think investors should be concerned?

Craig Brandon: Listen. I'm not really losing a lot of sleep at night over the tax exemption. And I think there's other, you know, issues to worry about. Why do I say that?

As you mentioned Mark, I spent the early years of my career working for the New York State Assembly Ways and Means Committee. I spent seven years negotiating budgets and what that did is it gave me a window – into how, you know, not only state budgets, but the federal budget gets put together.

So, what it also showed me was the relationship between state and local elected officials and your representatives in Congress and your representatives in the Senate. So, I know firsthand that members of Congress and members of the Senate in Washington have very close relationships with members of the state legislatures, with governors, with mayors, with city council members, with school board members – who are all delivering the message that significantly higher financing costs that could potentially happen from the loss of the exemption, could be meaningful to them.

And I think members of Congress and members of the Senate and Washington get it. They understand it because they were all there when it happened. The last time the muni exemption came under fire was back in 2012; and in 2012, a lot of members of Congress were in the state legislature back then, so they understand it.

Mark Schmidt: That's reassuring because right now, tax equivalent yields in the muni market are 7 to 8 per cent. That's equal to or greater than the long run rate of return on the stock market. So, whether to invest in the muni market seems pretty straightforward. How to invest in the muni market? Well, with 50,000 issuers, that's a little complicated. How do you recommend investors get exposure to tax-free munis right now?

Craig Brandon: Well, and that is a very common question. The muni market can be very confusing because there are just so many bonds out there. You know, over 50,000 issuers, there's over a million individual CUSIPs in the muni market.

So as an individual investor, where do you start? There's different coupon structures, different call structures, different maturity structures, ratings. There's so many different variables that go into a decision in investing in muni bonds.

I can make an argument that you could probably mimic the S&P 500 with 500 different stocks. But most muni indices are over 50,000 constituents. It's very difficult to replicate the muni market by yourself, which is why a lot of people, you know, they let professional money managers, do the investing for them. Whether you're looking at mutual funds, whether you're looking at separately managed accounts, whether you're looking at exchange traded fund ETFs, there's a lot of different ways to get exposure to the muni market. But with the huge amount of choices you have to make, I think a lot of individual investors would just let a professional with the experience do it.

Mark Schmidt: And active managers let you customize portfolios to your unique tax situation and risk tolerance. So, Craig, a final question for you. How do munis fit into a diversified portfolio?

Craig Brandon: Munis are generally the stable part of most people's portfolios. Remember, you don't have a choice of whether you're going to pay your taxes or not. You have to pay your taxes, you have to pay your water bill, you have to pay your power bill. You have to pay tolls on highways. You have to pay airport fees when you buy an airline ticket, right?

It's not an option. So, because the revenue streams are so stable, you see most muni bonds rated AA or AAA. The default rate for rated munis is significantly below 1 per cent. It's something in the ballpark of about 0.2 per cent*. So, with such a low default rate – listen, we're technically driven, as I said. You see ups and downs in the market. But over a longer period of time, munis can give you generally stable returns, tax exempt income over the long term, and they're one of the more stable asset classes that you see in your overall portfolio.

Mark Schmidt: That sounds boring, and I mean that in the best possible way. Craig, thanks so much for your time today.

Craig Brandon: Thanks, Mark, happy to be here

Mark Schmidt: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

*“US Municipal Bond Defaults and Recoveries, 1970-2021” – Moody’s Investor Services

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Despite news that the UK economy is set to slow due to uncertainty around US trade policy, our analysts Andrew Sheets and Bruna Skarica explain why they have a more optimistic outlook.

Read more insights from Morgan Stanley.

----- Transcript -----

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Bruna Skarica: And I'm Bruna Skarica, Chief UK Economist at Morgan Stanley.

Andrew Sheets: Today we're going to talk about the United Kingdom and why, despite a downbeat outlook by many in the market, we remain more optimistic.

It's Friday, May 2nd at 2pm in London.

Bruna, it's great to talk to you again about the UK and not just because this is an unusual day in London where it's sunny and warm, and at the moment warmer than Los Angeles. You know, when discussing the UK, I do think you kind of need to take a step back. This is a country and an economy that's had a tough number of years where growth has been sub-trend, inflation's been higher, and a lot of assets have traded at a discount.

So maybe just to give some context, talk to us a little bit about the last couple of years in the UK and the challenges the economy has faced.

Bruna Skarica: Indeed, Andrew, I do think it's important to take a step back to appreciate just the amount of supply side shocks the UK has seen in recent years. First, between 2016 and 2020, of course, the country had to navigate Brexit negotiations. The elevated uncertainty kept a lid on business CapEx. In 2020, of course, as the rest of the world, we saw the lockdown and the pandemic. What followed were supply chain disruptions, and then, the European energy shock in 2022. I do want to zoom in on this final point because in its scale, the natural gas price surge in the UK was twice more of a hit to growth compared to the 1970s oil price shock.

We've also seen a fair share of volatile market moves, most notably around the mini budget in the autumn of 2022. On top of all of this, the Bank of England into these supply side shocks had to hike interest rates to cap the inflation surge. And they went to above 5 per cent and have recently been relatively slower in reducing policy restrictiveness than most of its peers.

So, when you tally all these factors up, it's really no surprise that the UK has seen an exceptionally weak post COVID recovery.

Andrew Sheets: And that's continued right into this year. You know, I remember a lot of conversations with global investors heading into 2025, and again, the sentiment around the UK was kind of downbeat. Growth was pretty soft. Inflation was still high. Because inflation was high, interest rates here were still quite high. And so, you really had this, you know, unattractive mix of weak growth, high inflation, tight monetary policy. And then you could throw onto that, this uncertainty around the U.S. and trade. And you had a Trump administration that was adopting a more adversarial policy towards trade and towards Europe, which the UK was getting caught up in.

So, you know – again, did I miss any of the challenges that the UK was facing, entering this year?

Bruna Skarica: No, I think that's a great summary. First, at the end of last year, of course, the government faced some pretty tough decisions in the October budget, and they hiked a tax – a payroll tax really – in order to balance the books, which created somewhat subdued sentiment around the labor market this year.

Now the labor market has been soft in the UK at the start of this year, but it did hold up a little bit better perhaps than the expectations from the end of last year. At the start of the year, we also saw the energy inflation forecast rise. So, that led to a more cautious tone by the Bank of England in February and March, as you mentioned. And now on the trade front, although we have a small manufacturing sector, we are a small open economy, we're a big beta to global growth dynamics.

I would just like to mention here that one of the real bright spots of the UK economy in recent years have been services exports to the U.S., the kind of high-value-added white-collar services exports, which rose between 2019 and 2023 by 50 per cent. Now with the growth in the U.S. slowing and obviously the Euro area as well, UK growth will be affected too this year. We actually took our growth forecast down by around 30 basis points in our latest GDP revisions.

Andrew Sheets: But Bruna, we're here to talk about the future and you know, I do think it's fair to say that going forward we think this picture is starting to look better. So, let's jump right into that. Across a number of specific points. Why do we think the UK story could look better as you look ahead?

Bruna Skarica: Absolutely. I mean, the last point that I mentioned, I do think I want to put it in context. The trade related revisions in the UK are still less than what our colleagues in the euro area and the U.S. had undertaken in recent months on the back of the U.S. trade policy shifts. So, the UK does look a little bit like a relative winner there.

Second, we now think that inflation can come down faster than both the Bank of England and the market expected at the beginning of the year. Commodities prices will do a fair bit of heavy lifting this year, but we do think that next year in particular, domestically generated inflation could slow fairly sharply as wage growth sticks around 3 to 3.5 per cent, which we think is fairly inflation target consistent.

This all means the Bank of England should be able to cut more than the markets expect. We anticipate 125 basis point worth of cuts between May and November, and we think the terminal rate could fall to as low as 2 ¾. So, we think the neutral rate in the UK is between 2.5 to 3.5 per cent, and we do think the market still has a bit of adjustment to do in the sense of the pricing of the terminal rate one and two years ahead.

The third point around fiscal policy I think is quite interesting. Fiscal policy has been in great focus in the UK in recent years. We had a big fiscal event in October. We had another fiscal event just now in March. The borrowing increase was less than what the market expected. Deficit projections are such that we are expecting deficit to fall from around 4.8 per cent this year to 3 per cent over the course of the next three years, and for debt to GDP ratio to remain at around 100 per cent of GDP. I would perhaps contrast that with France where our economist is expecting the deficit to remain north of 5 per cent over the course of the next two years.

Finally, an important point to make is that the UK government amid trade shifts in the U.S. is looking for a closer relationship with the EU, or rather a trade reset with the EU. EU remains our closest trading partner and in the aftermath of Brexit, the current government has an ambition to improve trading in food and goods; and also to ensure that the UK is part of the European Defense Program, which would allow UK defense companies to partake in the defense and security path that the European Union presented in recent weeks. There is a summit being held on May 19th, and obviously the trade and corporation agreement is coming up for revision in 2026.

So, we do think those relations between UK and the EU could become somewhat closer over the course of this year and next.

But now a question from me, which is, what does all this mean on the strategy side? UK assets have obviously been quite unloved in recent years. Do you think that's about to change?

Andrew Sheets: So again, I think it's pretty interesting that markets are anticipatory, and I think markets are pretty smart here. So, you've already seen the British pound, the currency do quite well. This year it's up against the dollar. You've seen the UK stock market do quite well. It's up about 5 per cent this year, despite the S&P 500 being down quite significantly.

So, you're already seeing, I think, some signs that investors are warming up to the UK and you know, I do think that if our expectations play out, that could continue. You know, UK stocks do tend to be concentrated and slower growing, less exciting sectors. But their valuations are also less demanding. You know, the U.S. Stock Index trades at about 21 times next year's earnings. The UK stock market trades a little bit under 13 times next year's earnings.

And I also think it's really important that if the Bank of England does cut interest rates more than the market expects, which again, as you discussed, is one of our expectations here at Morgan Stanley, that could be pretty supportive for the UK bond market, which continues to offer pretty high yields.

Bruna, thanks for joining me for this conversation. It's always great to catch up with you.

Bruna Skarica: My pleasure, Andrew. Thank you for the invite.

Andrew Sheets: And thanks for listening. If you enjoyed the show, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our Chief Korea and Taiwan Economist Kathleen Oh discusses Korea's recent pension reform and its implications for the country's rapidly aging population.

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----- Transcript -----

Welcome to Thoughts on the Market. I’m Kathleen Oh, Morgan Stanley’s Chief Korea and Taiwan Economist. Today I’ll revisit Korea's demographic emergency and how the recent pension reform is trying to address it.

It's Thursday, May 1st, at 4pm in Hong Kong.

Some of you may remember that I came on the show last fall to talk about the crisis-level demographic challenges in Korea. Korea officially became a super-aged society at the end of 2024. This means that more than 20 per cent of the population is 65 or older.

In the face of its rapidly aging population and a fertility rate that has hit rock bottom, Korea is taking decisive action finally. The national assembly recently passed a landmark pension reform bill to amend the National Pension Act. This measure marks the first major change to its pension system in 18 years. And it’s supposed to improve the pension fund's financial sustainability to prepare for a rapidly aging population that will only accelerate from here.

The amendments include raising pension contribution rates and adjusting the income replacement ratio to 43 per cent. These changes aim to delay the depletion of the fund to 2064 to 2071, in an upside scenario. Without this reform, the fund would have been depleted by 2055, just 30 years later.

This reform avoids having to sell the fund's financial assets by delaying depletion. It also assures pension-holders of the stability of future pension assets. And, last but not least, it increases the pension fund's capacity for financial investments, which could lead to higher returns.

This is the first step towards making legislative, and therefore more structural changes to respond to the reality of a super-aged society. Moreover, it kicks off a sweeping reform agenda that includes the pension program, labor market, education system, and capital markets.

It’s also notable because the center-left Democratic Party of Korea and the conservative People Power Party were able to show bipartisan support and a public consensus to reach a deal, especially during the recent tumultuous political events that took place in Korea.

That said, the reform also has some potentially negative economic impacts. Higher pension contributions could squeeze households' disposable income, putting mild but additional downward pressure on aggregate consumption and savings. Especially considering that as people age, they tend to consume less – and this can lead to a structural slowdown in private consumption.

Despite Korea's challenges with an aging population, we're cautiously optimistic about its future – especially because [of] the recent rebound in the country's fertility rate. After marking a drop every year since 2015, it rebounded to 0.75 in 2024. While still far below the ideal replacement ratio of 2.1, this rebound is a small but certainly a positive sign.

Looking ahead, Korea's working population is expected to decrease by 50 per cent in the next 40 years unless the country ensures a dramatic rebound in the fertility rate to 1.0 or higher by 2030. In the meantime, we expect further adjustments to the pension reform bill, we expect further discussions around lifting of retirement age, along with the labor market reform next in line on the economic front. The Korean government will continue to execute on its demographic policy agenda.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our analysts Michael Zezas and Rajeev Sibal unpack the significance of a little-discussed clause in the Trump administration’s tariff policy, which suggests investors should think less about countries and more about products.

Read more insights from Morgan Stanley.

----- Transcript -----

Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy.

Rajeev Sibal: And I am Rajeev Sibal, Senior Global Economist.

Michael Zezas: Today we look through the potential escalation and de-escalation of tariff rates and discuss what the lasting impact of higher tariffs will be for companies and the economy.

It's Wednesday, April 30th at 11am in New York.

Rajeev Sibal: And 4pm in London.

Michael Zezas: Last week during a White House News conference, President Trump announced that tariffs on goods from China will come down substantially, but it won't be zero. And this was after U.S. Treasury Secretary Scott Bessent made comments about high tariffs against China being unsustainable, according to some news reports.

Now, some of this has been walked back, and there's further discussion of challenging negotiations with China and potential escalations if those negotiations don't go well. Meanwhile, Canadian voters elected a Liberal government, led by Mark Carney yesterday. That federal election played out against the backdrop of the U.S. proposing higher tariffs on its northern neighbors.

 So, Rajeev, amidst all this noise, what seems clear is that tariff levels will end up higher than where we started before President Trump took office. Though we don't exactly know how high they will be. What is it that investors need to understand about the economic impacts of higher tariffs just generically?

Rajeev Sibal: So yeah, we do view that tariffs are going to structurally be higher than they were before the Trump administration. This has been a baseline of our outlook since last year. Now I think the challenge is figuring out where they're going to settle as you've highlighted. We do think that peak tariff was probably a couple weeks ago, when we were at the max pain threshold, vis-a-vis China and the rest of the world. We've since seen the reciprocal tariffs move to 10 per cent for everyone but China.

China's clearly higher than 60 per cent today, but we do think that over time the implied rate to China will start to graduate and come down. If you look at the electronics exemption for example, that's a big step in getting the average tariff rate out of China lower. So, we think we're on a journey. We think we were past peak tariff pain in terms of level. But over the next few months, it's going to take some time and negotiation to figure out where we settle. And we are still looking to kind of our baseline outlook, that had been defined some time ago of a 10 per cent baseline with an elevated level on China, if you will.

Michael Zezas: So, I think this is an important point, that there's a lot of back and forth about tariff levels, which countries are going to be levied on, to what degree, and to what products. But at the end of the day, we think there'll be more tariffs than where we started.

Rajeev, you have a view on where investors should focus, in terms of what tariffs are durable. And maybe at the end of the day it'll be less about countries and more about products. Can you talk us through that?

Rajeev Sibal: You know, on April 2nd when the Trump administration released the fact sheet about tariffs and reciprocal tariffs, there was a small clause in there that I think the market did not pay enough attention to, and which is becoming front and center now.

And in that clause, they identified that a number of tariffs related to Section 232 would be exempted from reciprocal tariffs. And the notion is that country tariffs would evolve or shift into sector tariffs over time. And in the note that we recently published, we highlighted some of the legal mechanisms that may be at play here. There's still a lot of uncertainty as to how things will settle down, but what we do know is that legally speaking, country tariffs are coming through IEEPA, which is the International Emergency Economic Powers Act; whereas section and sector tariffs are coming through Section 232; and some of the other section structures that exist in U.S. trade law.

And so, the experience of 2018 leaned a lot more to these sections than it did to IEEPA. And that was a guiding, I guess, mechanism for us, as we thought about what was happening in the current tariff structure. And the fact that the White House included this carve out, if you will, for Section 232 tariffs in their April 2nd fact sheet was a big lead indicator for us that, over time, there would be an increased shift towards sectors.

And, so for us, we think the market should be focusing more in that direction. As we think about how this evolves over time, now that we've not completely de-escalated, but brought a materially lower tariff level and everywhere in the world except for China. The big variability is probably going to be in the sector tariffs now going forward.

Michael Zezas: So, what sectors do you think are particularly in focus here?

Rajeev Sibal: So, on the April 2nd fact sheet that the White House provided to countries and to the market, they specifically identified steel, aluminum, autos and auto parts as already having Section 232 tariffs. And we know that's true because those investigations had started in a prior Trump administration. And so, kind of the framework was already in place for them to execute those tariffs.

The guidance then suggested that copper, pharmaceuticals, semiconductors, and lumber would also potentially fall under Section 232 tariffs in the future. And then there's been a range of indications as to what might be in play, so to speak, for Section 232.

I know pharmaceuticals is at the top of the list of many investors, as are semiconductors. So, this is our kind of sample list, but we're pretty certain that this will evolve over time. But that's where we're starting.

Michael Zezas: Okay, so pharmaceutical, semiconductors, automobile, steel, aluminum. It's a pretty substantial list. So, if that's the sort of end game landscape here – relatively elevated China tariffs, and then all of these products specific tariffs – what does an investor need to know about a company's options in this world? Can companies just rewire their supply chains around all of this? And you know, ultimately there's some temporary price pain. But once things are rewired around this, that should dissipate. Or are the decisions more difficult than that and that there has to be some cost passed through to the consumer or to the companies themselves – because this is just too many tariffs in too many places?

Rajeev Sibal: Yeah, so I think the latter of your question – the difficulty – is really where we need to be thinking about what's happening here. If you think about the bigger picture, and you go back to the note that we collaborated on earlier in the year called Supply Chain Strain, we highlighted the complexity of moving factors of production and the extreme levels of investment that have required to shift factors of production.

So, companies, if they're going to move a factory from country A to country B, have to make sure that country B has the institutional framework, that it has the capital, it has the labor input, and this is a big, big decision. So, as a company you're not going to make that decision to shift your investment or reconstruct productive facilities in a new country – until you understand the cost benefit analysis. And in order to understand the cost benefit analysis, you really need to know what the sector-based Section 232 tariff looks like in the end.

If we remember back in 2018, the government tried to implement a wide range of tariffs. On average, it took about 250 days for each investigation to be completed. And that's a long timeframe. And so, I think what we're going through now, apart from automobiles and steel and aluminum where that process has kind of already been done, and we kind of have the framework of the tariffs and the new sectors, companies are going to have to wait for this investigation to take place so that they understand what the tariff level is. Because the tariff level is going determine the risk of actually shifting productive facilities. Or if you just kind of absorb the cost because the tariff isn't at a high enough level that it incentivizes the shift.

And so, these are the changes that I think remain an open question and will be the focus of companies over the next few months as their sectors are exposed to tariffs.

Michael Zezas: Right. So, what I think I'm hearing then, and correct me if I'm wrong, is that some of the focus on the China tariffs or the country level specific tariffs in the headlines – about they're moving up, they're moving down – might mask that at the end of the day, we're still dealing with considerably higher tariffs on a broad enough array of products; that it will mean difficult choices for companies and/or higher costs. And so therefore markets are still going to have to price some of the economic challenges around that.

Rajeev Sibal: Yeah, I think that's absolutely right. And we've seen the market try to price some of this stuff at a country level context. But it's been hard. And, you know, even the headline tariff rate in the U.S. is really hard to pin down for the simple reason that we don't know if the Mexican and Canadian trade into the U.S. is compliant or non-compliant, and how that gets counted in the current structure of the tariff regime. And so, as these questions remain outstanding, markets are going to be volatile, trying to figure out where the tariff level is. I think that uncertainty at a country level then shifts to the sector level as we go through these investigations that we've been highlighting.

Autos is a great example. We finished the investigation. We've implemented a Section 232 tariff, and we still don't know what the implied auto tariff rate is because we don't know how many parts in a car are compliant within existing free trade agreements of the United States; and if they're compliant or not really determines what the implied tariff level is for the U.S. And until companies can decide and give forward guidance and understand what their margins look like, I think markets are going to be in this guessing game.

Michael Zezas: Yeah, and that certainly syncs up with our fixed income strategy views. The idea that yield curves will continue to steepen to deal with the uncertainty about U.S. trade policy and demand for dollars, as a consequence. That equity markets might be moving sideways as perhaps we priced in some of the first order effects of tariffs, but not necessarily the second order, potentially non-linear effects on the broader global economy. And unfortunately, the lingering uncertainties that you talk about implementation, they're going to be with us for awhile.

Rajeev Sibal: Yeah, I think that's really fair. And our economics outlook mirrors that as well.

Michael Zezas: Well, Rajeev, thanks for joining us today to help us sort through all of this

Rajeev Sibal: Mike, thanks for having me on the podcast.

Michael Zezas: And to all of you, thanks for listening. If you found this podcast helpful, let us know and share Thoughts on the Market with a friend or colleague today.

Our Global Commodities Strategist Martijn Rats discusses the ongoing volatility in the oil market and potential macroeconomic scenarios for the rest of this year.

Read more insights from Morgan Stanley.

----- Transcript -----

Welcome to Thoughts on the Market. I’m Martijn Rats, Morgan Stanley’s Global Commodities Strategist. Today on the podcast – the uncertainty in the oil market and how it can play out for the rest of the year.

It’s Tuesday, April 29th, at 3pm in London.

Now, notwithstanding the energy transition, the cornerstone of the world’s energy system is still the oil market; and in that market, the most important price is the one for Brent crude oil. Therefore, fluctuations in oil prices can have powerful ripple effects on various industries and sectors, as well as on the average consumer who, of course, pays attention to gasoline prices at the pump. Now with that in mind, we are asking the question: what's been happening in the global oil market recently?

Earlier this month, Brent crude oil prices dropped sharply, falling 12.5 per cent over just two trading sessions, from around 75 dollars a barrel to close to 65 dollar a barrel. That was primarily driven by two factors: first, worries about the impact of trade wars on the global economy and therefore on oil demand, after the Trump administration’s announcement of reciprocal tariffs.

Secondly, was OPEC’s announcement that, notwithstanding all the demand uncertainty that this created, it would still accelerate supply growth, progressing not only with the planned production increases for May; but bring forward the planned production increases for June and July as well. Now you can imagine, when OPEC releases extra production whilst the GDP outlook is weakening, understandably, this weighs on the price of oil.

Now to put things into context, two-day declines of 12.5 per cent are rare. The Brent futures market was created in 1988, and since then this has only happened 24 times, and 22 of those instances coincided with recessions. So therefore, some commentators have taken the recent drop as a potential sign of an impending recession.

Now while Brent prices have recovered slightly from the recent lows, they’re still very volatile as they continue to reflect the ongoing trade concerns, the economic outlook, and also a strong outlook for supply growth from OPEC and non-OPEC countries alike. The last few weeks have already seen unusually large speculator selling. So with that in mind, we suspect that oil prices will hold up in the near-term. However, we still see potential for further headwinds later in the year.

In our base case scenario, we expect that demand growth will slow down to approximately 0.5 million barrels a day year-on-year by the second half of 2025, and that is down from an an initial estimate earlier in the year when were still forecasting about a million barrel a day growth over the same period. Now this slowdown – coupled with an increase in non-OPEC and OPEC supply – could result in an oversupply of the market of about a million barrels a day over the remainder of 2025. Now with that outlook, we believe that Brent prices could eventually drop further down into the low-$60s.

That said, let's also consider a more bearish scenario. Oil demand has never grown continuously during recessions. So if tariffs and counter-tariffs tip the economy into recession, oil demand growth could also fall to zero. In such a situation, the surplus we're currently modeling could be substantially larger, possibly north of 1.5 million barrels a day. Now that would require non-OPEC production to slow down more severely to balance the market. In that scenario, we estimate that Brent prices may need to fall into the mid-$50s to create the necessary supply slowdown.

On the flip side, there's also a bullish scenario where we and the market are all overestimating the demand impact. If oil demand doesn't slow down as much as we currently expect and OPEC were to revert quite quickly back to managing the supply side again, then inventories would still build but only slowly. Now in that case, Brent could actually return into the low-$70s as well.

All in all, we would suspect that the twin headwinds of higher-than-expected trade tariffs and faster-than-expected OPEC+ quota increases will continue to weigh on oil prices in the months ahead. And so we have lowered our demand forecast for the second half of the year to just 0.5 million barrels a day, year-on-year. And we’ve also lowered our prices forecasts for 2026; we’re now calling for $65 a barrel – that’s $5 a barrel lower than we were forecasting before.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our CIO and Chief U.S. Equity Strategist Mike Wilson discusses how market volatility over the last month will affect equity markets as earnings season begins.

Read more insights from Morgan Stanley. 

----- Transcript -----

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. Today, I will discuss what to expect from Equity markets as we enter the heart of earnings season.  

It's Monday, April 28th at 11:30am in New York. 

So, let’s get after it. 

The S&P 500 tested both the lower and upper ends of our 5000-5500 range last week, reinforcing the notion that we remain in a volatile trading environment. Incrementally positive news on a potential tariff deal with China and hope for a more dovish Fed lifted stocks into the end of the week, and the S&P 500 closed slightly above the upper end of our range. While a modest overshoot of 5500 can persist very short-term, a sustainable break above this level is dependent on developments that have yet to come to fruition. 

Those include a tariff deal with China that brings down the effective rate materially; a more dovish Fed; 10-year Treasury yields falling below 4 percent without recessionary risks increasing; and a clear rebound in earnings revisions. Bottom line, until we see clear positive shift in one or more of these factors, range trading is likely to continue with risks to the downside given that we are now at the top end of the range. 

A frequent question we're getting from clients is does the soft data matter for equities or is the market waiting for the hard data to make up its mind in terms of an upside or downside breakout above or below this range? Our view has been consistent that the most important macro data at this stage is from the labor market while the most important micro data are earnings revisions. Equities have already priced a meaningful slowdown in growth relative to expectations.  

What's not priced is a labor cycle or recession. While this risk has been reduced to some extent given the recent, more dovish tone shift on tariffs from the administration, it's far from extinguished. Until we see clear evidence over multiple months that the labor market remains solid, a recession will likely remain a coin toss. One soft data point to pay attention to this week that could move the market is the April ISM Manufacturing data on May 1st. Recall this series accelerated the August 2024 selloff ahead of a soft July payroll report. 

The most important takeaway from an equity strategy perspective is to stay up the quality curve. No matter what the hard data says, we remain in a late cycle backdrop where both quality and large cap relative outperformance should continue. While uncertainty remains higher than usual, defensives should continue to do well. However, given their relative outperformance over the past year, it also makes sense to pick spots in high quality cyclicals that have already discounted a material slowdown in both macro conditions and earnings.  

To be clear, this is not a blanket call on cyclicals; it's a selective, stock-specific one. More specifically, look for quality, cyclical stocks that are more de-risked based on what the stocks are pricing from a forward earnings growth standpoint. See our written research for stock screens. 

And from a global standpoint, we recommend favoring U.S. over international equities at this point as a weaker dollar should benefit U.S. relative earnings revisions, particularly versus Europe and Japan. Furthermore, less volatile earnings growth and a higher quality bias should benefit the U.S. on a relative basis in today's late cycle backdrop. 

Thanks for listening. If you enjoy the podcast, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our U.S. and Asia economists Michael Gapen and Chetan Ahya discuss how tariff uncertainty is shaping their expectations for these economies over the second half of 2025.

Read more insights from Morgan Stanley. 

----- Transcript -----

Michael Gapen: Welcome to Thoughts on the Market. I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist.

Chetan Ahya: And I'm Chetan Ahya, Chief Asia Economist.

Michael Gapen: Today we'll discuss some significant changes to our Asia growth forecast on the heels of tariffs. As well as how the U.S. economy is reacting to the changes in the global trading environment.

It's Friday, April 25th at 8am in New York.

Chetan Ahya: And 8pm in Hong Kong.

Michael Gapen: So, Chetan, since the last time we were both on the show, it appears that we are headed towards at least some de-escalation of trade tensions. Just last week, you wrote in your report that the tariffs on China are too prohibitive for any trade to take place – and that you expected some dialing down of the escalatory action. And this week the administration started to talk about easing tariffs on China significantly.

Considering all the events since April 2nd – and it's felt like a lot of events since April 2nd –where does it leave you in terms of how you are thinking about the outlook?

Chetan Ahya: So, Mike, that's right. You know what we thought was that the current level of tariffs that the U.S. has on China and what China has on the U.S. means that effectively there are no transactions possible

But look, even after those tariff rates are going down, we are still expecting it to be in the range of around 60 per cent. And that would still be relatively high level of tariffs. If I were just to translate this into what it means for the whole region? So, for the whole region, the weighted average tariff will still be around 32 per cent. And remember this number was close to 5 per cent in early January.

So, we are talking about a huge amount of uncertainty related to this tariff path and the tariff level itself is going to remain somewhat high.

And so, with that concern on uncertainty, we are expecting a region's investment growth to be affected significantly, taking down region's growth lower.

Michael Gapen: So, Chetan, I was looking over your growth forecast and noticed that you have a sharp step down in growth from the second quarter of 2025 on. Can you walk us through these revisions in particular?

Chetan Ahya: So yes, we have changed our forecast and what we are now seeing is in terms of growth path is that Asia's overall GDP growth will slow from 4.8 per cent that we saw in fourth quarter of last year, to around 3.6 per cent by fourth quarter of this year.

And for comparable time period, China's growth will slow from 5.4 to 3.7 [per cent]. So that's another meaningful step down for China

Michael Gapen: What do you think Asian economies can do to counteract the impact from tariffs at this point?

Chetan Ahya: So, we expect the policy makers in the region to take up both monetary and fiscal policy easing. But, you know, despite that policy easing effort, you will still see that meaningful growth drag. So, for China, we think it'll be the fiscal policy that will do the heavy lifting. Whereas for Asia ex-China is going to be more monetary policy that will do the heavy lifting.

And in terms of the exact magnitude, we're expecting 50 to 150 basis points depending upon the economy in the region in form of rate cuts. And specifically on China; on the fiscal policy, we expect them to take up about 2.5 per cent of GDP increase in fiscal deficit in form of investment in infrastructure, as well as some programs for supporting consumption spending.

Michael Gapen: So Chetan, it sounds like a lot of monetary and fiscal policy easing and support is coming from the Asian economies. But I guess the bottom line is that you don't think it would be sufficient to fully counteract the impact from tariffs. Is that right?

Chetan Ahya: That's right Mike. And let me come to you now and get your thoughts on how you see the development of the tariffs, et cetera, affecting the U.S. economy. You've already recently characterized your view on the U.S. economy as still living on the edge. What's driving this view?

Michael Gapen: It's a way that we were trying to communicate that, you know, we don't see the economy at the moment, falling into a recession, but we think it's close. If we thought that the effective tariff rate was going to stay where it was -- or where it is -- roughly around 18 per cent, then we would have a much more negative view on the outlook. And we do expect the effective tariff rate to come down for all the reasons that you suggested there. And there's openings for that, to happen. And that's where the conversation has been going in recent days.

And so, I think there's a tension between how much uncertainty can be reduced on one hand. And then on the other hand, how quickly volumes in the economy, activity in the economy may slow. So, I think we're in a window here where – where we are in a race against time to bring the effective tariff rate lower, in order to keep the economy in recovery. So that was really my narrative here where living on the edge, where we're not projecting a recession, but we're close enough to one. That, it’s almost a coin toss. And I think we need to backpedal here relatively quickly, or we could have much more negative effects on the economy.

Chetan Ahya: And Mike, I remember that, in 2018, we did not see this kind of a reaction in the consumer confidence data, but we are seeing that in this cycle. And on top of it, we have this expectation that corporate confidence will also be weighed down by policy uncertainty. So how does this double whammy of weak confidence feature in your forecast?

Michael Gapen: I think the key component or in, in this case two key components for the outlook for the economy – because it's relatively straightforward to try and project or pass through the direct effect of tariffs on consumer spending, real incomes and trade volumes. But what's really hard to understand here is what does a highly uncertain environment do to asset markets and business sentiment?

So, the, the two channels here that you mentioned, consumer confidence and business confidence. These are kind of what might get you spill over effects, and a recession.

So, for the consumer, what we're really focused on here is, yes.  Stated confidence by households is weak, but they're still generally spending. And tariffs affect lower- and middle-income houses more than they do upper income households. So, we're really keyed in on: Do equity markets fall enough? Do we get a negative wealth shock on upper income consumers, where they decide, ‘Hey, I feel less wealthy, therefore I'm going to spend less than save more.’

So, then the business sector delays spending and may even, you know, generate some layoffs; and recessions, as you know, happen when there's a lot of negative feedback loops in the economy. And so, this is what we're worried about.

Chetan Ahya: Another interesting debate, that we as a team are having with the investors is about the Fed policy response. And so, Fed Chair Powell has said that tariffs would generate at least a temporary rise in inflation. How do you think the Fed will handle a tariff induced spike in inflation?

Michael Gapen: So, there has been an evolution in the Fed's thought and thinking around how to handle tariffs. Given the dramatic increase in tariffs,, I think the Fed has to wait and they have to see the actual data come in.

So, in our view, with inflation rising first and activity weakening later, you probably don't get any Fed cuts this year. And the Fed moves to rate cuts in 2026. If we're wrong in the economy, and, and it decelerates, and moves into a recession more quickly than we would anticipate, and the labor market deteriorates rapidly, then the Fed will ease.

But what they're doing here is they're responding to a world where both sides of their mandate are getting worse. And they're going to respond to the one that's more offsides than the other. And in the short run, we think that'll be inflation. So, it means the Fed moves much later than markets currently expect.

Chetan Ahya: In terms of the next set of data points or events that you're watching, uh, which can change your view on the growth outlook – what are you really, looking out for?

Michael Gapen: Well, I think in the very short run, it's looking at all the inflation data and seeing whether or not   the higher tariff rates are getting passed through to the final consumer. We think a little of that will show up in the April inflation data that's due out in the middle of May. That'll be mainly around autos. But then we think the May, June, and July data will begin to show much more increase in goods prices from the tariff pass through. So, we'll be kind of watching that to see whether the inflation impulse is as strong as we think it will be.

Second, I think in the very short run, we'll be watching trade volumes. We'll be watching even, shipping container volumes.

We'll be watching for blank sales where ships skip ports because there's just not any activity or demand. And then finally, I'd say employment, right? Obviously, expansion versus contraction and whether the economy will stay in expansion phase will be dependent on whether employment continues to grow. We'll get an early look on that. For the April employment data in early May. We don't think there'll be much negative imprint on April employment, but as we move into May, June, and July, we could see hiring slow down more rapidly.

So, Chetan, that's what I would point to – just ascertaining the near-term inflation impulse, looking out for any sharp slowdown in trade volumes and whether or not the labor market holds up.

Michael Gapen: Before we close, based on what I just described about the U.S. and also how you're thinking about the tariff situation, how would you differentiate the economies in your part of the world? I only have to deal with one. You have to deal with many. How would you differentiate between economies in your region right now?

Chetan Ahya: So Mike, what we've tried to do is to think about this more from which economies are more trade oriented and which economies are less trade oriented. Because we are aware about the fact that there is going to be an overall trade slowdown for the region. And so, in that context, India and Australia are the ones we think will be, relatively less affected from this trade slowdown and global growth slowdown. Whereas more trade-oriented economies, which is, you know, the likes of Korea, Taiwan, Thailand, Malaysia would be getting more affected.; The reality is that China is facing the maximum amount of tariffs within the region. And therefore we are building in a bit more growth slowdown in case of China, even while its trade orientation is a bit lower than Korea and Taiwan.

Michael Gapen: Chetan, thanks for taking time to talk today.

Chetan Ahya: Great speaking with you, Mike,

Michael Gapen: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.