Welcome to Thoughts on the Market.
I'm Seth Carpenter, Morgan Stanley's global chief economist.
And I'm Serena Tang, Morgan Stanley's chief global cross-asset strategist.
Yesterday, Serena, we discussed our views on the global economy.
And today I'm going to turn the tables on you and start asking you questions about our market outlook and how to invest across regions and across asset classes.
It's Tuesday, November 18th at 10 a.m. in New York.
All right, Serena.
In 2025, global markets rode some significant volatility driven by tariffs, policy uncertainty.
Things went up, they went down.
Equities ultimately outperformed bonds as rate cuts began, but cross-asset strategy depended so much on identifying correlations opportunities, all in a world that is still adapting to the new geopolitical dynamics and what seemed like evolving rules.
So with that backdrop, could you just broadly...
Tell us what the investment strategy should be in 2026.
We think 2026 will be a strong year for risk assets, as you have unusually pro-cyclical policy mix that's supportive of earnings.
And that frees up markets to shift the focus from global macro concerns, which of course have dominated this year, to more micro asset-specific narratives, particularly those related to AI, CapEx investment.
And I think such a constructive environment really calls for a risk-on tilt.
We recommend equities over credit and government bonds with a preference for U.S. assets.
Okay.
I think last year we had some preference, at least for U.S. equities.
Are there any other big rotations versus more of the same that you really want to highlight for folks?
In terms of, I think, the strategy outlook itself, a big shift has been what we think drive investor focus the most.
Our strategy mid-year outlook had focused heavily on global macro risks, right?
Especially those emanated from trade tensions, which you alluded to earlier.
I think this time around, as the distribution of outcomes on tariffs has become a bit narrower, it's very much more about asset-specific stories.
And yes to your point about being bullish on US equities.
We've maintained that view this time around and believe that US equities can generally do better than the rest of the world.
As you know, Mike Wilson, our colleague and chief US equity strategist.
He has a price target of 7800 for the SP 500 index, beating the expected returns from other regional equities by quite a bit.
So that's not changed.
But I think with this backdrop of pro-cyclical policy combo lifting US earnings, they've also turned more bullish equities on high-yield corporate credit.
That is bonds which are riskier.
I think, very much like US equities.
We believe that the asset class can benefit from the combination of monetary deregulation policy.
But there is also a very interesting technical component there, which is, as we expect, a surge in investment-grade issuance to fund AI-related CapEx.
I think the high-yield market will be more insulated from this, which means outperformance versus higher quality corporate bonds.
Got it.
Okay so, as you're coming up with these strategies and these recommendations, in lots of ways it just relies on forecasting.
And I have to say I'm sympathetic to how hard forecasting is, especially when it comes to the future.
In our economic forecast we also included a bunch of different alternate scenarios, because I just see that much uncertainty in the global economy.
So, with that as a backdrop, Nothing is for sure, but where, would you say, your highest conviction calls are when it comes to investing in 2026?
Well, as I mentioned, we like U.S. equities and that remains a very high conviction call for us.
Sort of dug through the details of that already.
And so I want to turn to our other high conviction view, which is curve steepening.
We see pretty material U.S.
Treasury curve steepening over the next year.
I think even as a macro strategist, I actually expect yields, at least in the back end, to be mostly range bound.
And this steepening will be very much driven by what happens in the two-year point.
I think as markets continue to, we think underprice future Fed easing and growth slowdown tail risks.
So that's super helpful in terms of the places where you're convicted.
Let me be perhaps a little bit unfair because nothing is in fact certain.
And so if there are things that we feel pretty sure about, there have got to be things where we're either not sure or parts of the market that really pose the most risk.
So if I asked you then, where do you see the biggest risk for investors and markets next year?
What would you say?
So one of them really is AI investment cycles. abruptly ending.
And then this has been a topic of huge debate in all of the investor meetings that we've had over the last several weeks.
Because I think the idea is you have a sharp pullback in investment in the next 12 months, which could trigger a pretty cascading effect.
And of course, that would likely pressure US equities.
I think, given the hyperscalers index weight could, weirdly enough, benefit IG credit by reducing issuance, which has been the main driver of wider spreads in our forecast.
But I think the other risk here actually is if animal spirits run a bit too hot.
Underlying our equities over credit, over rates allocation is some revival in animal spirits, but it's not the kind of irrational exuberance that marks the end of cycle in our view given, I think, there's still rational belief in that policy triumvirate that we touched on earlier that can still be supportive of risk.
But you know, I think if sentiment does overheat, then our allocation tilt towards cyclicals and beta would be wrong.
And historically late cycle expansions, see investment grade outperforming high yield and equities with bonds eventually leading returns.
The last risk I think to our asset allocation is is really the Fed, either the FOMC, not easing further over the next 12 months, or if it changes its reaction function?
And I think both of those will have very different implication of what happens to the front end of the yield curve.
So my question to you, Seth, is what do you see as the probability around both of those scenarios?
Look, with the data that we have before the government shut down, it was clear there was a tension.
Spending by households, spending by businesses was strong.
Employment data were getting weaker and weaker and the Fed has decided to start cutting to err on the side of insulating against further deterioration in the labor market.
So one thing that could upend our forecast is that the real signal is from the spending.
Spending stays strong.
The labor market eventually catches up to the stronger spending and we start to see job gains come back.
If that happens, especially with inflation now running notably above the Fed's target, I just don't really think we're going to get anywhere near the number of rate cuts that we forecast or that are already priced into market.
So you'd have to see a reversal.
How likely is that?
If you can't rule it out, I'd say 20% or something like that, maybe a little bit more.
On the other hand, to the downside.
I wonder if what you're getting at a little bit is there's going to be some turnover in the personnel at the Fed, and do we have to worry about a fundamentally different reaction function from the Fed going forward and cutting rates aggressively, even if the macro considerations don't warrant?
Is that really what you're getting at?
Yes, I think that has been the question on the forefront of investors' minds.
Yeah, I think that's a real question.
The way I look at it is Chair Powell is in charge of the Fed now.
His term goes through May of next year.
And so until we get to the middle of next year, I don't really think there's any fundamental change in how the Fed does business.
But it really does seem like we're going to have a new Fed chair soon. in June of next year.
But even there we got to remember that the committee is a committee and that's how policy is decided.
And so if there was a new chair who really really, really wanted to take policy in a truly unorthodox way, I also don't think that's really feasible over the second half of next year, because there just won't have been that much turnover in terms of the personnel of the Fed.
That's how we're looking at it for now.
I really don't think that latter version of the world is a big risk.
That said, I'm going to throw it back to you because I always have to get the last word.
You talked about asset classes bullish on U.S. equities.
We talked about high-yield bonds.
We talked about some of the risks that markets have to face.
But one thing I didn't hear and we do have a global investor base is about currencies and specifically the dollar.
So this time last year the team made a pretty bold call that the dollar would depreciate a great deal.
And here we are, and the dollar has come off a lot on net over this year.
That's stabilized a little bit.
Maybe not for the whole year because that kind of forecasting is hard for currencies.
But what do you see over the next few months called the next half year for the dollar?
Is it going to continue the trend or do you think we should see a reversal?
So we do think the dollar will continue its trend downwards from here to the middle of next year.
And I know, I know there's been a lot of discussion.
There's been a lot of debate around whether the dollar has basically stopped where we are.
But the thing is Going back to what you mentioned around the path for growth in the US and unemployment in the US.
If we do see softer economic data in the first half of next year, that can drive the dollar downwards.
In fact, we're once again more bearish than consensus on the dollar by the middle of next year.
Got it.
All right, that's super helpful.
Serena, thank you so much for taking the time to talk with me today, and let me ask the questions of you.
Always a pleasure, Seth.
And thank you for listening.
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