Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income and Thematic Research.
Vishy: And I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.
Zezas: And on this episode of Thoughts on the Market, we'll talk about the recent market volatility and what it means for fixed income investors.
It's Wednesday, August 7th at 10am in New York.
Vishy, on yesterday's show, you discussed the recent growth of money market funds. But today I want to talk about a topic that's top of mind for investors trying to make sense of recent market volatility. For starters, what do you think tipped off these big moves across global markets?
Vishy: Mike, a confluence of factors contributed to the volatility that we've seen in the last six or seven trading sessions. To be clear, in the last few weeks, there have been some downside surprises in incoming data. They were capped off by last Friday's US employment report that came in soft across the board. In combination, that raised questions on the soft-landing thesis that had been baked into market prices, where valuations were already pretty stretched. And this one came after a hawkish hike by Bank of Japan just two days prior.
While Morgan Stanley economists were expecting it, this hike was far from consensus going in. So, what this means is that this could lead to a greater divergence of monetary policy between the Fed and the Bank of Japan. That is, investors perceiving that the Fed may need to cut more and sooner, and that Bank of Japan may need to hike more; in both cases, more than expected.
As you know, when negative surprises show up together, volatility follows.
Zezas: Got it. And so last week's soft US employment data raises the question of whether the Fed's overtightened and the US economy might be weaker than expected. So, from where you sit, how does this concern impact fixed income assets?
Vishy: To be clear, this is really not our base case. Our economists expect US economy to slow, but not fall off the cliff. Last Friday's data do point to some slowing, on the margin more slowing than market consensus as well as our economists expected. And really what this means is the markets are likely to challenge our soft-landing hypothesis until some good data emerge. And that could take some time. This means recent weakness in spread products is warranted, and especially given tight starting levels.
Zezas: So, it seems in the coming days and maybe even weeks, the path for total fixed income market returns is likely to be lower as the market adjusts to a weaker growth outlook. What areas of fixed income do you think are best positioned to weather this transition and why?
Vishy: We really need more data to confirm or push back on the soft-landing hypothesis. That said, fears of growth challenges will likely build in expectations for more Fed cuts. And that is good for duration through government bonds.
Zezas: And conversely, what segments of fixed income are most exposed to risk?
Vishy: In one way or the other, all spread products are exposed. In my mind, the US corporate credit market recession risks are least priced into high yield single B bonds, where valuations are rich, and positioning is stretched.
Zezas: So clearly the recent market volatility has affected global markets, not just the US and Japan. So, what are you seeing in other markets? And are there any surprises there?
Vishy: Emerging market credit. In emerging market credit, investment grade sovereign bonds will likely outperform high yield bonds, causing us to close our preference for high yield versus investment grade. It is too soon to completely flip our view and turn bearish on the overall emerging market credit index.
We do see a combination of emerging market single name CDSs as an attractive hedge. South Africa, Colombia, Mexico, for example.
Zezas: So finally, where do we go from here? Do you think it's worth buying the dip?
Vishy: Our message overall is that while there have been significant moves, it is not yet the time to buy on dips.
Zezas: Well, Vishy, thanks for taking the time to talk.
Vishy: Great speaking with you, Mike.
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