Morgan Stanley IM: The headwinds and tailwinds dominating the next half of 2024

A weakening dollar, downturn in equities, and commanding fiscal policy could steer markets for the rest of the year, writes Jim Caron

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By Jim Caron, CIO of the portfolio solutions group at Morgan Stanley Investment Management

Despite already having had to navigate a number of market moving events in 2024 such as interest rates, inflation and the US presidential election, there is more excitement to come.

There are a number of compelling opportunities across the investment landscape to look out for over the next half of the year, including in fixed income, alternatives and pockets of the equity market.

Fiscal policy dominance

One of the most commonly asked questions we get from clients with respect to markets is simply, ‘what keeps you up at night’?  What they are really asking is which market risk worries us most, and my answer is straight forward: the potential dominance of fiscal policy over monetary policy.

Over the next six months, we expect this fiscal dominance will start to take root, controlling the narrative and significantly impacting the market into the US election, alongside fiscal policy related to taxes and spending playing a role well into 2025.

Over the last few years, we have been fortunate that fiscal largesse has not yet unanchored inflation expectations. However, the next six to eighteen months will be critical in determining whether that is in fact the case.

Weakening US dollar

Compounding this theme, the US government’s spending, debt levels, high interest payments and twin deficits have raised concerns about the valuation of the US dollar and its stability as a global reserve currency.

Now economic activity is showing strength beyond the US’s borders, we find a less compelling case for US economic growth to continue outperforming the rest of the world. The risk-reward balance is tipping away from the dollar, making it an opportune time to explore international currencies and assets.

A downturn in equities

The forward price to earnings (P/E) for the S&P 500 stands at 20.5x, up from 19.7x at the beginning of the year. Both justify a year-end for the S&P 500 closer to 6,000 than 5,000 while using 2025 estimates.

But historically, the market has a decline of around 10% at least once a year. The last one was in the fall of 2023, so the market is due another.

Based on year-over-year inflation comparisons getting tougher, we suspect that the current declining trajectory could become more challenging starting this summer.

A Fed that seems less dovish would disappoint the market. And if the Fed were to cut rates in conjunction with some weaker economic data, then you’ll likely hear that scary word – “stagflation.”

That said, re-election years are normally good for stocks for reasoning that certainly applies this year as well.

Presidents running for re-election prime the economy with fiscal spending. That has direct implications for sectors we favour.

The Infrastructure Act, for example, should benefit the industrials and materials sectors, while the Chips Act is likely to help semiconductors and equipment. Our focus is now on the areas where the US government is spending the money.

Emerging market debt

Emerging markets debt (EMD), offers compelling value at current levels based on the combination of the macro environment, valuations, investor flows and a number of exciting individual reform stories that are the hallmark of the asset class.

The macro environment is currently characterized by a relatively rich US dollar post-peak tightness in global monetary policy and better overall fundamentals in emerging markets  than developed markets.

Should interest rates and growth ease off, the rationale for the US dollar to weaken would become quite strong. While EMD does not necessarily need a weaker dollar to perform well, the absence of persistent strength is likely to support the asset class.

Valuations across EMD therefore appear attractive. Hard and local currency segments offer meaningful value outright, especially when compared with most areas of the DM fixed income market.

Bank loans and CLOs

Bank loans and collateralized loan obligations (CLOs) have yields that are currently twice that of core bond market proxies and about equal to long-term stock market results.

Loans are anti-bond in structure (no duration coupons float) and can complement portfolios across a spectrum of use cases: Higher coupons than investment grade bonds; larger and more liquid companies than present in private credit; trading cheap relative to the 60/40.

Though we see sunny skies for credit, loans can act as an umbrella for portfolios if rainy days arrive, but won’t hurt your day at the beach if they don’t!

The alternative route

Last but by no means least, we should not forget the rise of alternatives, with the asset class continuing to undergo an encouraging transformation across their market valuations and prospects for return generation.

A clear sequence has emerged that was initially triggered by the sharp shift in the interest rate regime in 2022. The early beneficiary of this unique change in market conditions was private credit, where early performance improvements were also observed in the hedge funds space.

Now, we believe this transformation will extend further across alternatives and see compelling opportunities emerging across the alternative equity markets, including private equity and real estate.