Morgan Stanley IM: Underpromise and Overdeliver

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As the banking turmoil from March entered the rearview mirror, all eyes turned to the U.S. debt ceiling. Once a deal became imminent, that uncertainty subsided and all eyes turned back to the economic data. The U.S. did not disappoint, further pushing off to the future recession and Fed rate cuts.

Coming into May, the scene was set for a weakening U.S. economy relative to the Euro-area and China, but economic and labour market data came in stronger than expected. Employment data surprised to the upside for the 13th month in a row (only to be surpassed with data released in early June). Other labour market data prints, including JOLTS[1], ADP and initial jobless claims, were also on the stronger side. In Europe, the markets were confronted with downside surprises in both headline and core inflation and slowing growth expectations. In China, data also came in weaker than expected, disappointing China bulls, with May PMIs confirming the economy’s weakness and the economy showing a continued drag from the property sector.

Developed market central banks continued to raise policy rates to fight recalcitrant inflation. This drove global yields materially higher, with the 10-year U.S. Treasury up 22 basis points (bps), and credit spreads wider. Stronger U.S. data, a somewhat hawkish Fed and lower than expected eurozone inflation supported U.S. dollar strength, reversing course from the first quarter. Credit markets are still worried about tighter lending conditions due to the U.S. regional banking problems, with the Fed’s senior loan survey showing recession-like conditions. By the end of the month, however, sentiment did improve, tightening spreads from their intra-month wides. The U.S. agency mortgage market continued to experience wider spreads as the spectre of bank and Fed selling hurt confidence. The stronger U.S. economy and more hawkish Fed also negatively impacted Emerging Market Debt (EMD) as the U.S. dollar outperformed most EM currencies.

¹ Job Openings and Labor Turnover Survey (U.S. Bureau of Labor Statistics)

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^{There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.}