Morgan Stanley: The U.S. economy is slowing down, not collapsing. Until data confirms this, the market will remain "tense."

In August, the US stock market experienced significant volatility, with growing concerns about a hard landing for the US economy. However, Morgan Stanley still maintains the basic expectation of economic resilience and achieving a soft landing, while also recommending investors to consider hedging tools to address the risks of a hard landing.

So far, global stock markets and fixed income markets have experienced intense volatility in August. In the first few days of the month, the S&P 500 index fell by over 6%, and the Nikkei 225 index saw a sharp decline of 20%. However, both indices have since recovered about half of their losses. The yield on the US 10-year Treasury bond dropped by over 20 basis points but has now returned to early-month levels. Volatility indicators for the stock and interest rate markets, such as the VIX index and MOVE index, have also sharply risen, although they have retreated from recent peaks, they still remain at relatively high levels.

What will happen next? Although risk markets have reversed some losses and US Treasury bonds have erased some gains, Morgan Stanley expects the market to remain tense until new data confirms or denies the soft landing/hard landing scenario for the US economy.

Morgan Stanley Stands Firm on the Basic Expectation of Economic Resilience and Achieving a Soft Landing

Morgan Stanley believes that the core of market volatility lies in the changing market narrative about US economic growth. Despite some downside surprises in recent weeks, such as the latest ISM Manufacturing PMI, the broad weakness in the US employment report two Fridays ago has been the catalyst for recent market volatility, making the risk of an economic hard landing the focus of the market's attention and affecting the Federal Reserve's monetary policy path.

The optimistic expectations before an economic hard landing sharply contrast with the market's previous outlook. The market's expectations for Fed rate cuts this year have changed dramatically, from less than two 25 basis point cuts about a month ago to now expecting over five cuts, with a probability of over two-thirds for a 50 basis point cut at the September meeting.

However, Morgan Stanley still maintains the basic expectation of economic resilience and achieving a soft landing, anticipating that the continued decline in inflation will drive the rate-cut cycle. Rate cuts are expected to begin at the Federal Open Market Committee (FOMC) meeting in September, with three 25 basis point cuts by 2024.

Nevertheless, the market may continue to question the view of a soft landing (meaning the US economy continues to slow down but does not collapse) until some "good data" emerges. Morgan Stanley's Global Chief Economist Seth Carpenter pointed out:

To prompt a change in the Fed's stance, another month of weak labor market data (close to 100,000 new jobs) or continued weakness in manufacturing and service PMIs, along with a significant rise in unemployment claims, would be needed. However, this week's unemployment claims data came in below expectations, and last month's data did not show a broad-based slowdown in the labor market, providing support for the expectation of a soft landing.

Furthermore, the hawkish stance of the Bank of Japan has intensified global market volatility. Last week, Bank of Japan Governor Haruhiko Kuroda significantly shifted to a hawkish tone during a press conference, hinting at the possibility of early consecutive rate hikes. Coupled with concerns about economic growth sparked by the July US employment data, this further increases the likelihood of a rate cut by the Federal Reserve. The hawkish stance of the Bank of Japan implies an increasing policy divergence between the Federal Reserve and the Bank of Japan, triggering a chain reaction in the yen and the widely discussed "arbitrage trade unwinding". Although the crisis PR of the Bank of Japan has calmed the market after Governor Kuroda's hawkish comments, as pointed out by Morgan Stanley's Japan macro and equity strategists Koichi Sugisaki and Sho Nakazawa, approximately 60% of yen arbitrage trades have been unwound.

Morgan Stanley recommends investors to consider hedging tools to address hard landing risks

In the credit market, Morgan Stanley believes that the recent weakness in spread products is reasonable, especially considering their starting yield levels are already low. In the U.S. corporate credit market, high yield Single B bonds have the lowest level of economic recession risk priced in, with these bonds being highly valued and market positions being tight. Morgan Stanley suggests investors hold hedging tools against hard landing risks. For example, using the put spread of High Yield Total Return Swaps (HYTRS) and High Yield Credit Default Swap Index (CDXHY) as reasonable hedging tools.

In terms of emerging market sovereign credit, Investment Grade (IG) bonds may outperform High Yield (HY) bonds, leading Morgan Stanley to stop favoring HY bonds over IG bonds.

Additionally, Morgan Stanley recommends using Emerging Market Credit Default Swaps (CDS) as a hedging tool