Morgan Stanley’s ‘Five Cs’ That Will Shape 2018

Morgan Stanley said the global growth cycle will stay stronger for longer in 2018, based on its confidence on five critical factors.

These are:

• A pick-up in investments.
• A gradual rise in core inflation.
• Steady withdrawal of easier monetary policies.
• Contained financial stability risks in the U.S.
• A moderate slowdown in China.

Calling its five key base-case assumptions as ‘5 Cs’, the bank, in a report published recently, explained how it expects these factors to play out next year...

Capex Cycle

Global GDP growth is expected to rise in 2018 as investment growth, which has started to pick up from multi-year lows in the last four quarters, will continue to accelerate, Morgan Stanley said. Rising capacity utilisation and a pick-up in wage growth will support the capex cycle in the developed markets. Stronger consumption growth and a steady rise in exports would improve capacity utilisation in emerging markets, supporting private capex.

Core Inflation

Core inflation is expected to rise in the developed markets driven by tighter labour markets and as the transitory impact of idiosyncratic factors fades gradually. Morgan Stanley has factored in an above-consensus acceleration in core inflation in the euro area and Japan starting June next year. While core inflation is expected to pick up, the bank doesn’t see it overshooting central bank targets of around 2 percent.

• The U.S. core personal consumption expenditure to rise to an average 1.7 percent in the quarter ending December 2018 from an estimated 1.5 percent in the year-ago period.
• Core inflation in the euro area to increase to 1.6 percent from 0.9 percent.
• Core inflation in Japan to rise to 1.0 percent from 0.2 percent.

Central Banks’ Role

Developed markets should move towards less expansionary policies, led by the U.S. Federal Reserve. The Fed is expected to raise policy rates by 75 basis points (three-quarters of a percentage point) in 2018 while shrinking its balance sheet as planned. The European Central Bank is also likely to end quantitative easing and the Bank of Japan will adjust its 10-year yield target in the third quarter.

Yet, monetary policy stance will remain accommodative as real interest rates stay below the natural rate—the stable long-term sustainable rate— in both the euro area and Japan. U.S. real rates are seen rising above the natural rate only in the first quarter of 2019. A pick-up in productivity and stronger investment growth will partly offset the headwinds from central banks moving towards less expansionary policies.

Also Read: Global Growth Will Hold Up Stronger For Longer, Says Morgan Stanley’s Chetan Ahya

Corporate Credit Risks In U.S.

Given the the past two cycles in the U.S., financial stability risks pose a bigger threat than price stability risks. The impact of Fed rate hikes on the corporate interest rate coverage ratio is expected to be moderate. Despite having declined, the ratios—a measure of companies’ ability to service debt—still remains high by historical standards. With the share of (second lowest) BBB-rated debt in overall investment grade rising from 37 percent in end-2008 to 50 percent now, overall financial conditions are expected to tighten as credit spreads widen in the context of rate hikes.

China Factor

While there are concerns that Chinese policy makers’ actions to contain financial risks and improve the quality of growth could lead to a deeper slowdown, Morgan Stanley doesn’t expect at rerun on 2013-2015 when the growth had declined, saying that the pace of tightening will be gradual. A combination of four factors including sustained strength in exports growth, improvement in consumption supported by better wage growth, a healthier state of inventory in the property market and an improvement in industrial sector profits supported by cumulative capacity cuts will offset the tightening measures.

Market Strategy

• Sees a more challenging market backdrop as the year progresses, inflation rises and financial conditions become less supportive.
• There will be an opportunity to reduce risk later in the first quarter of next year.
• Prefers developed market equities, emerging markets fixed income and U.S. treasury bonds within developed market bonds.
• Cautious on U.S. high-yield corporate bonds, given rich valuations and cycle risks.