Morgan Stanley Outlook 2023: key considerations for Australian Investors
2022 has been a difficult year for investors. If the year ended today, 2022 would be the first year that US stocks and long-term bonds are both down more than 10% in the last 150 years - and both markets are down much more than 10%.
Figure 1: Underperformance
in both bonds and equities is rare – 2022 was unprecedented
Morgan Stanley expects 2023 to be different for both the economy and markets. On the one hand both economic growth and inflation will be lower, but on the other hand cross-asset returns - especially in fixed income - will be much more appealing. In particular, more attractive starting valuations largely due to this year’s poor performance are a significant component.
Macro Backdrop (i): Weaker growth
In 2023 we forecast global GDP growth to slow further to 2.2%Y, but with a notable divergence across economies. In particular, we expect DM economies to moderate further, with the euro area and the UK both in recession, while the US is expected to closely avoid this scenario. In contrast, EM economies are better placed moving forward, particularly once the Fed reaches its peak rate, and the US dollar eases. Most EM central banks should start to gradually lower rates once external inflationary pressures subside, paving the way for a modest rebound in growth from a soft base. In 2024, we see a broad-based, though modest acceleration, as disinflation allows central banks to gently ease policy.
Figure 2: Central bank tightening is restraining global GDP
More specifically, for the US, Morgan Stanley’s forecast of 0.5%Y growth (0.3% 4Q/4Q) in 2023 reflects the cumulative effects of monetary tightening and recessionary global demand. In response to changes in interest rates, residential investment is likely to continue to contract throughout 2023 - before growing again in 2024. Personal consumption is expected to be the weakest in 1Q23, weighed down by weak spending on durable goods. In particular, uncertainty over the outlook has been leading companies to slow hiring, while lean payrolls and difficulty in filling skilled positions has not supported significant layoffs. Net job gains have slowed markedly over the year and, together with a modest rise in labor force participation, we expect an increase in the unemployment rate to 4.3% in 4Q23 - and remaining there in 2024. We expect the Fed to begin a gradual process of normalizing policy in December 2023, as core PCE inflation falls back below 3%Y. In 2024, lower interest rates will likely encourage a rebound in GDP growth to 0.9%Y (1.4% 4Q/4Q). Morgan Stanley’s growth forecast is 30bp above consensus for 2023, but 60bp below for 2024, reflecting our view of a soft landing and tepid rebound. In comparison, currently the consensus view is a harder landing and stronger rebound.
In China, starting from a very weak 3.2%Y in 2022, we see a very modest recovery, led by private consumption and in particular services. In 2023, we forecast 5.0%Y growth, with most of that occurring in 2H23 when the economy is expected to fully reopen following the potential repeal of Covid-zero policies early in the year. Meanwhile, the property sector is likely to pose a milder drag to growth upon more concerted easing efforts, with sales and home completions likely to rebound towards mid-2023. On the other hand, we expect manufacturing investment to soften as slowing global growth implies weaker exports. In 2024, further stabilization in the property sector (with a fledgling recovery in new starts) and a mild rebound in exports should allow full-year growth to remain firm. Beyond the cyclical rebound, we expect economic growth to slow to 4.4%Y in 2024 as the longer-run transition to slower, more sustainable growth continues. Our forecasts are currently in line with consensus for 2023 but below consensus for 2024.
Faced with strong inflation pressures, especially food and energy prices, we believe that the euro area will likely enter a recession in 4Q22 as consumer purchasing power is eroded. Growth is forecast at -0.2%Y in 2023, and only picks up to 0.9%Y in 2024. The European economy is likely to continue to face headwinds for a couple of years as it addresses energy infrastructure amid tight monetary policy. In the UK, we expect the cumulative shocks from surging inflation, fiscal austerity, euro area recession, and sharply tighter monetary policy to result in the UK economy beginning to contract on a quarter-over-quarter basis – which started in 3Q of this year. This recession will likely continue into 2023, partly due to the impact to disposable income from high energy prices which will be felt most acutely in winter. We see GDP contracting by 1.5%Y in 2023 and only recovering modestly in 2024 (0.5%Y).
For Japan, we also expect growth to slow but to remain above potential growth. With the normalization of economic activities under the 'living with Covid' policy, we expect private consumption to remain resilient. Our growth forecast for 2023 (1.2%Y) is below consensus, reflecting weak exports, but still above potential growth. For 2024, we expect growth to pick up to 1.6%Y given a likely rebound in exports.
In Australia, we expect 2023 growth to slow sharply to 2.1%Y on the back of policy tightening, slower business investment, and housing market weakness which includes sharp house price declines. The first indicators should be in residential construction and discretionary consumption, as the savings rate troughs in 2Q23 and begins to rise thereafter. We expect GDP growth in 2024 to remain below trend (1.6%Y), although the pace should improve sequentially throughout the year.
Macro Backdrop (ii): Cooler inflation
Slower growth is a function of tighter monetary policy. The last 12 months have seen:
(i) the largest change in the Fed funds rate since 1981 and the ECB target rate since the eurozone was created; as well as,
(ii) the broadest tightening of global central bank policy since at least 1980.
This tightening has been aggressive as inflation has kept exceeding expectations. Going forward, we expect this to change. Morgan Stanley’s economists forecast core inflation to moderate across both EM and DM, allowing the global tightening cycle to pause, then reverse.
The key drivers of this inflation moderation are as follows:
In the US, core goods prices will likely show outright declines as used car prices fall, excessive goods consumption moderates and high i. inventories invite discounting. Trends in shelter look more balanced as rates on new leases slow. ii. In the eurozone, large base effects in food and energy should reverse, while Morgan Stanley expectations of a recession should result in the easing of core price pressures.
iii. Inflation in EM should generally improve, while inflation in DM Asia is already more muted.
Figure 3: Global inflation expected to decelerate moving forward.
Less core inflation finally accommodates central banks to pause (and then reverse) the tightening cycle. For the US, we expect headline CPI inflation to fall to 3.3%Y in 2023 (1.9% 4Q/4Q), below consensus: For core CPI, we forecast 2.6% 4Q/4Q in 2023 and 2.5% 4Q/4Q in 2024. Regarding core PCE - the Fed’s preferred measure - we forecast 2.9% 4Q/4Q in 2023 and 2.4% 4Q/4Q in 2024. New rents are in decline and vacancy rates are up – an indication that shelter inflation will slow, though it will likely remain a persistent driver of above-target inflation for the next two quarters. On balance, we see deflation in core goods, not just disinflation, and in particular we look for vehicle prices, both new and used, to fall between 5% and 10% through to the end of 2023. Finally, a reset in medical services prices exerts a steady drag on core inflation in 2023.
Figure 4: Inflation pressures have peaked in the US
In Australia, we expect inflation to ease from its 8%Y peak through 2023 - initially from the more volatile contributors (fuel, food, construction), and then broadening out as demand slows. However, we still expect inflation to remain above target through the year (3.6%Y by end-2023), only retreating to the RBA's target band by 1Q24. Core inflation is expected to remain somewhat stickier, falling to 3.9%Y by end-2023 and 2.5%Y by end-2024.
Figure 5: Australian inflation set to peak later this year in both headline and core terms
Macro Backdrop (iii): Policy pause
DM rates are set to plateau in 2023, with terminal rates expected in most major DM economies in 1Q, and rate cuts are only expected in 4Q or later. Japan and China are the clear outliers given these central banks have not started hiking rates, and we do not think that inflation pressures will create a significant shift in these countries over the forecast period.
Figure 6: DM policy rates to pause their rise, then reverse over 2023-24
In 2022, continued upside surprises to US inflation has led to higher expectations for the policy path: In our forecast, job growth and spending are expected to continue to step down, and inflation is likely to come off its peak in the current quarter. In response, the Fed is expected to reduce the pace of rate hikes to 50bp in December and deliver a final 25bp hike in January 2023 for a peak rate of 4.625% (range of 4.5-4.75%). As inflation moderates over the course of next year, and as job growth falls well below the replacement rate, the Fed is expected to gain conviction to begin normalizing the policy rate back towards a neutral stance, with 25bp cuts likely per meeting and which are forecast to begin in December 2023. Morgan Stanley believes at this stage that quantitative tightening (QT) will likely continue at its current pace through the second quarter of 2024. This implies the two Fed tools - i.e. rates and QT - move in opposite directions for a time. However, QT might end earlier if the economy goes into recession, with the Fed potentially contemplating significant rate cuts of 100bps or more in this scenario. Similarly, if markets were dysfunctional - like in March 2020 or the recent episode in the UK Gilt market - we would expect QT to end, at least temporarily.
In Australia, we expect the RBA to continue with its slower pace of rate hikes (25bp a month) until it is confident it has moved into moderately restrictive territory. There are several signposts it is likely focusing on to confirm this - in particular: i) above the modelled neutral rate of ~3.1%; ii) signs that inflation has peaked and is easing; and iii) increasing slack in the labor market. We expect that these signposts will be sufficiently clear by 2Q23, and therefore the RBA will likely have rates on hold from April and at a terminal rate of 3.6%. Once on hold, the RBA is expected to assess the disinflationary impact of its hikes and by 1Q24 this should be sufficient to move rates to less restrictive. Morgan Stanley expects the reduction of rates to be by 100bp to leave the cash rate at 2.6% by end-2024.
Macro Backdrop (iv): Where are we in the cycle?
For markets, this presents a very different backdrop. 2022 was marked by resilient growth, high inflation, and hawkish policy. 2023 will likely see weaker growth, disinflation, and rate hikes end/reverse - and all with very different starting valuations.
Yet one debate looms large: Should investors focus on the fact that a 'hot' economy slowing (the ‘downturn’ regime of Morgan Stanley cycle indicator) tends to be tough for cyclical assets like equities and high yield (see Figure 7)? Or should they focus on the 'end of central bank hiking', which has historically brought relief (see Figure 8)?
Figure 7: Morgan Stanley cycle indicator is about to enter the downturn phase, which is historically negative for risk assets…
Figure 8: …but we also forecast US rate hiking to end soon, whereby both stocks and bonds tend to do well after the 'last' Fed hike
The tension between 'slower growth is bad' and 'the end of hiking is good' often comes down to how bad the slowdown is. If a recession can be avoided (Morgan Stanley’s US base case), a downturn from ‘hot’ conditions has mattered less (like in 1995). If a recession arrives, the ‘end of hiking’ is much less helpful (like in 2000).
Importantly, this tension doesn’t matter as much to high-quality bonds, which outperform more consistently when the Fed stops hiking. High grade bonds performed well in both 1995 and 2000.
Cross Asset Investment Implications
In the US, we expect Treasury yields to move lower gradually over 2023, led by declining 2-year yields. We see 10-year Treasury yields trading around 3.75% by the middle of 2023, and around 3.50% by the end of 2023. A conclusion of the Fed hiking cycle by the January Federal Open Market Committee (FOMC) meeting and moderating inflation, alongside a soft landing for the US economy, will likely drive yields lower gradually. Morgan Stanley’s Fixed Income Strategy team sees the 2s10s and 2s30s curves steeper than forwards by year-end, but see this trend concentrated in 2H, and thus it is too early to position for a steepening of the curve. Real yields are expected to be slightly higher than nominal yields, with breakevens remaining stable to slightly higher as the hiking cycle comes to a close.
As we highlighted in our recent note on Fixed Income risks are asymmetrical and skewed to the downside currently regarding government bond yields. We see a wide dispersion for yields in the bull and bear cases, with a skew towards lower yields in the bull case for US Treasuries. The gap between the bull and bear cases increases significantly towards the end of 2023, with 10-year yields ending 2023 at 2.10% in Morgan Stanley’s bull case and 4.50% in the bear case, versus 3.50% in the base case. The skew favouring the bull case for US Treasuries reflects Morgan Stanley’ bear case for the economy. In this scenario, the Fed is seen cutting rates sharply to near 1% - after lifting rates to as high as 6% earlier in 2023 - versus delivering only a couple of additional hikes in the bear case.
Similarly in the euro area, Morgan Stanley forecasts a gradual decline in 10-year Bund yields in 1H23 after the peak posted at 2.50% in October. The decline in eurozone HICP inflation below 5%Y mid-year and significantly lower-than-expected 2023 eurozone GDP growth will likely warrant a lower ECB terminal rate than market expectations. The lower path of short-term rates and the decline in inflation is expected to more than offset the negative impact of ECB QT, pushing Morgan Stanley’s Bund model fair value close to 1.50% by late 2023. We forecast the 10-year Bund yield at 1.60% in 2Q23 and 1.50% in 4Q23.
In Australia, we see short-end yields remaining relatively resilient around 3% through 2023 as the RBA signals an intention to assess the cumulative impact of the hikes it has already delivered, in turn constraining market pricing for the local terminal rate. Local domestic growth and inflation hold up relatively well despite further housing market softening, limiting term premium compression. Morgan Stanley expects the Australian 10-year yield to end 2023 around 3.35%.
With slowing growth and the end of rate hiking, we believe investors
should be overweight high-quality bonds on a cross-asset basis. We expect IG
spreads to hold recent ranges and tighten marginally in 2H23. However, healthy
all-in yields should translate into positive excess and total returns across
all regions. We see room for further spread widening in HY and Loans but
maintain that HY index spreads are unlikely to test prior cycle wides - even in
a mild recession. Leveraged loans remain fundamentally vulnerable until the rates’ and earnings’ paths become clearer.
Figure 9: Year-to-date repricing in Europe and Asia has been sharper than in the US
IG over leveraged credit, HY over loans: We expect US IG spreads to trade in a broad but well-defined range of 140-170bp, centred on current spread levels and in line with our 12-month forward forecasts. Concerns of a recession/earnings uncertainty are likely to take spreads towards the wider end of this range in 1H23. However, we believe that a full repricing to 'normal' recession levels is unlikely given limited downgrade pressures, record-low US dollar prices and attractive all-in yields. As growth stabilizes alongside inflation in 2H23, we expect spreads to compress back towards our target.
We expect HY to be a clear underperformer versus IG in both total and excess returns (beta-adjusted) in 2023. In addition to more dispersion around earnings, HY markets face the challenge of companies approaching the refinancing window - leading up to a maturity wall in late 2024/2025. Our spread target is 100bp wider than current levels, generating modestly negative excess returns, but positive total returns on the back of lower yield projections. Within leveraged credit, we retain a preference for HY over Loans. While our base case projection for loan total returns is higher, we see significantly more spread downside (beta-adjusted) if there is a deeper/longer recession.
In Australia, we expect a similar path for Credit, with spreads likely to widen as economic growth decelerates. We maintain a preference for IG Fixed Income, given high quality, attractive carry (~4.8% yield to maturity), and price upside from falling government bond yields. This preference is over floating rate credit which will likely see a more pronounced widening in spreads (for lower grade instruments) whilst not benefitting from the offset from falling yields. We find the combination of Fixed Income IG credit and cash more appealing than floating rate credit on a risk-adjusted basis.
Morgan Stanley believes that the US dollar is in its last leg higher and should peak this quarter, to be followed by a decline through 2023. This will likely bring the DXY to 104, which would reverse roughly half of the US dollar strength observed in 2022. A moderation in global inflation measures, and against particularly bearish consensus expectations, should support risk-sensitive currencies. However US dollar weakness is also expected to be moderated by relatively elevated US interest rates and lethargic growth, particularly outside the US.
As investors discount the probability of a "hard landing" in the US (as well as in other economies including Australia) we expect the US dollar to decline broadly - particularly relative to the currencies of commodity-exporting currencies like the Australian dollar. However, Australia's economic growth outlook also looks brighter than other DM economies, which should boost the Australian dollar more broadly. In this context, we expect the Australian dollar to gain over the course of 2023 given receding price pressures allowing key central banks to slow or halt their tightening.
In 2022 year-to-date, the Bloomberg Commodity index has outperformed the MSCI World equity index significantly for a second consecutive year. History suggests that this is not common. In addition, the last time three years of consecutive commodities outperformance over equities eventuated was in 1976-79. However, with China reopening, the eventual end of rate hikes, and a US dollar peak all likely to occur in 2023, these factors may turn into a meaningful tailwind for commodities.
Morgan Stanley expects Brent to rally to US$110/bbl if demand recovery continues, spare capacity erodes rapidly, and the capex response is broadly absent. European gas and LNG markets are likely to remain tight and will likely support the price recovery from current levels.
With demand still uncertain, we focus on the supply side in base metals. Currently, Morgan Stanley’s order of preference is: aluminium, zinc, lead, copper, nickel. Aluminium is our top pick as supply continues to tighten against an uncertain demand backdrop, while prices have been moving up from the 50th percentile of the cost curve, which has normally been a floor. We are more cautious on copper and expect the market to move into oversupply in 2023 - including both the concentrate and refined metal markets. However, copper is our most preferred metal over the medium-term owing to a lack of investment and growing energy transition demand.
Gold prices have moved lower with a stronger US dollar and rising rates, but still look overvalued versus real and nominal yields. Morgan Stanley forecasts further weakness ahead.
We are particularly positive on iron ore prices. A sequential recovery in China's steel output in 1H23, along with seasonally weaker supply, will likely result in similar 1H market tightness as seen in 2021/22 - pushing iron ore back towards US$125/t. Coal will likely stay higher for longer, but prices should gradually trend lower as the coal market rebalances slowly.
While the year-end 2023 base case price target of 3,900 is roughly in line with where the S&P 500 is currently trading, Morgan Stanley believes it won’t be an uneventful year for US equities. We believe 2023 bottom-up US consensus earnings are materially too high. Morgan Stanley recently revised 2023 US EPS forecasts another 8% lower to US$195 in the base case, reflecting worsening output from our leading earnings models. Currently Morgan Stanley is around 16% below consensus regarding 2023 EPS in the base case and down 11% from a year-over-year growth standpoint. After what is left of this current tactical rally, we see the S&P 500 discounting the 2023 earnings risk in 1Q23 and via a ~3,000-3,300 price trough. We believe this will occur in advance of the eventual trough in EPS, which is typical for earnings recessions. While we see 2023 as a very challenging year for earnings growth, 2024 should see a strong rebound where positive operating leverage returns - i.e., the next boom. US equities should begin to process that growth reacceleration well in advance and rebound sharply to finish the year at 3,900 in our base case. Bear/Base/Bull price skew: 3,500/3,900/4,200.
Figure 10: US equities are expected to dip around Q1 2023 before
recovering back to current levels
For Australian equities, Morgan Stanley’s price target for the ASX200 is set at 7200, marginally higher than previously (7150). This is using a 14.5x multiple outlook in line with the long-run average and assuming some downside to aggregate earnings. Our bear case links to stubbornly high inflation as well as continued aggression in policy tightening - leading to expected downside to 5900. Morgan Stanley’s bull case reflects moderating inflation, stronger underlying economic growth with a re-rating to 15.0x and upside to 8100.
On the earnings side, earnings levels are materially higher owing to base effects, commodity boosts and Industrial resilience. Currently minimal EPS growth is reflected in the consensus outlook and also Morgan Stanley strategists’ models suggest downside risk. The valuation de-rating has occurred but investors should now brace for the impact from the lagged effects of an aggressive tightening cycle. Morgan Stanley has a preference for Energy, Healthcare, Diversified Miners and Global growers (at a reasonable price – GARP). We move equal weight on REITs and underweight Banks, Housing and the Consumer sectors.
In Europe, we expect an earnings downgrade cycle to commence soon and forecast a 10% EPS decline in 2023 (overall Morgan Stanley are currently around 14% below consensus for December 2023), with an economic recession driving down top-line demand, In addition, the delayed impact of this year’s cost increases is expected to hit margins significantly. Morgan Stanley’s margin lead indicator is pointing to a year-on-year decline in profitability on a par with that was seen in the global financial crisis. Even adjusting for a weak EPS profile, Morgan Stanley’s base case 12-month index target does only currently offers around 3% upside potential as we see scope for a next 12 month P/E re-rating from 11.5x to 13.3x. This will likely occur on the back of lower inflation, lower bond yields and a conclusion of the rate-hiking cycle. However, and in-line with US equities, Morgan Stanley’s modelling points to reasonable upside by December 2023. However, we are concerned that markets have further to fall in the short term as none of the key indicators that Morgan Stanley track are signalling a trough at this point.
Figure 11: Pauses in Fed hiking cycles are positive for stocks, while cuts are negative if they coincide with recessions.
For Japan, we retain a constructive view moving into 2023, with expected earnings upgrades and resilient local currency returns. These will likely be driven by stable domestic growth/inflation/policy, a sharply weaker JPY, and improving corporate governance. The international reopening from last month should help to capitalize on a hyper-competitive JPY, while incremental capex re-shoring should help to insulate Industrials from the global slowdown. Morgan Stanley expects only an incremental Bank of Japan (BoJ) policy pivot, with YCC moving to the 5-year point and a modest curve steepening - leaving our USD/JPY forecast at 140 for end-2023. For Australian dollar based investors, we no longer recommend hedging FX exposure given the expected downside skew to AUD/JPY scenarios over 2023.
Our key overweigh in equities is EM, following Morgan Stanley’s upgrade in October. We see next year as a much more favourable one for Asia/EM equities, following the longest bear market in the history of the MSCI EM index. Morgan Stanley's 2023 global macro and strategy outlooks are particularly conducive to a recovery in EM equities. Of note, US inflation is expected to moderate quicker than consensus, allowing the Fed to finish hiking in January. MSCI EM-weighted policy rates are forecast to peak at 5% in 2Q23, with 74% of the aggregate rate hikes already implemented, while economic growth picks up from 2Q23, assisted by China’s reopening. EM FX is forecast to recover against the US dollar (for around 7% forecast total returns to 4Q23), while EM sovereign credit is expected to deliver around 14% total returns.
Morgan Stanley sees the MSCI EM earnings downgrade cycle nearing completion, with 12 month forward estimates expected at US$77 in 2022, down around 24% from a peak of US$101 in February 2022. In 2023 we expect around a 10% rebound, versus consensus expectations of just 3% growth. Even holding valuations around current levels (~28th percentile of 10 year history), we still see around 12% price upside for MSCI EM in Morgan Stanley’s base case.
Regarding Chinese equities, we note they have fallen from a 43% weight to 28% over the past two years, a period where we have generally been cautious. From here we see the potential for Chinese equities to participate in an EM rally, but we retain an equal-weight stance for now. The range of possible outcomes is wide, with a bull case entailing gradual institutionalization of a transparent and supportive business environment for major private corporations. This is turn would facilitate ROE to rebound and re-install investor confidence in China's long-term potential growth. The bear case implies that the market loses confidence in earnings-based valuation approaches and switches to focusing on asset valuation (price/book at or below 1.0x) and dividend yield support (around 5%) amid ongoing regulatory pressure domestically and deteriorating geopolitical risks.
In our Australian multi-asset portfolios we remain underweight Equities
in the short term as we expect the macro environment to deteriorate further
before improving. Having said that, this bear market is “long in the tooth” and
we are seeing tactical opportunities emerging in EM and Japan. The case is more
mixed for Europe, whilst the US remains the least attractive given relatively high
valuations compared to bonds and other geographic markets. Elevated US earnings downgrade risks remain for 2023. Australia will continue to benefit from its defensive quality attributes. Low valuations and favourable dividend yields are appealing and we therefore remain overweight.
We continue to build our fixed income allocation. We recommend government bonds where we focus on the back end of the curve. We have a residual allocation to IG credit. Despite a solid outlook based on resilient fundamentals, we believe spreads are too tight currently – particularly due to our expectation of a marked economic deceleration next year. We stay underweight in the short term, but look to rebuild in the second half of the year when the equity market is expected to turn and central banks start moving towards monetary easing. For the same reasons we currently have no allocation to sub-IG bonds.
Finally, we remain positive on Alternative assets. Our preference for hedge funds over unlisted assets (in growth alternatives) is retained. In particular, whilst hedge fund managers will continue to benefit from dislocated markets and high volatility, we are concerned about a wave of negative revaluation in the private equity and private real estate markets – particularly on the back of: i) a very different interest rate environment; and ii) a downgraded economic outlook.
Alexandre is the Head of Research and Investment Strategy for Morgan Stanley Wealth Management Australia. Since arriving at Morgan Stanley, he has developed Wealth Management’s multi-asset investment approach which was recognized by the Institute...