Morgan Stanley: The market will remain tense for a long time

So far, the performance of global stock and fixed income markets in August has been very volatile. In the first few days of this month, the S&P 500 index fell by more than 6%, and the Japanese Nikkei 225 index recorded a dramatic 20% decline. Both indices have now recovered about half of their losses.

The yield on the 10-year US Treasury bond fell by more than 20 basis points, but has now returned to the levels at the beginning of this month. Volatility indicators for stocks and interest rates - the VIX and MOVE indices - have also sharply risen. Although they have dropped from recent highs, they still remain at elevated levels. At the beginning of this week, we will focus on the debates that have led to the sharp market volatility and how we expect them to unfold in the short term.

In our view, the core of market volatility is the changing market narrative about US economic growth. It is worth noting that our economists' outlook on the prospects has not changed. Despite some downside surprises in data over the past few weeks, such as the latest ISM Manufacturing Purchasing Managers Index, the broad weakness in the US employment report for July has become the latest trigger for the volatility, putting the risk of a hard landing in focus and thereby leading to a change in expectations for the Fed's monetary policy path. This contrasts sharply with the overly optimistic points already priced into the market, which had led to stretched market valuations. The pricing of Fed rate cuts by the market this year has once again undergone a significant change, from less than two 25 basis point cuts a month ago to now over five cuts, with a probability of more than two-thirds for a 50 basis point cut at the September meeting.

Our economists maintain their basic expectation of achieving a soft landing in the economy, expecting that continued decline in inflation will drive the rate-cutting cycle, with the Fed expected to start a total of three 25 basis point cuts this year at the September FOMC meeting. However, the market may continue to challenge the soft landing view (that the US economy will continue to slow down but not collapse) until some "good data" emerges. As Morgan Stanley's Chief Global Economist Seth Carpenter pointed out, another month of weak labor market data (non-farm payrolls dropping to near 100,000) or persistently weak PMI data (manufacturing and services) and a significant rise in initial jobless claims are needed to change the Fed's stance.

Last week's initial jobless claims below consensus expectations and the previous month's claims data did not show a widespread continued slowdown in the labor market, once again reinforcing the soft landing argument. The hawkish rate hike by the Bank of Japan last week also led to sharp market volatility globally. While Morgan Stanley economists anticipated this, the rate hike was hardly a consensus.

The real surprise was the significant shift towards a hawkish stance by Kuroda at the press conference, implying the possibility of early consecutive rate hikes. Coupled with growth concerns from the July US employment data, which raised the possibility of further Fed rate cuts, the hawkish stance of the Bank of Japan means that the divergence in policies between the Fed and the Bank of Japan is more pronounced, leading to a chain reaction affecting the yen and the closely watched "unwinding of carry trades" Despite the hawkish comments made by Hidehiko Haru, the Bank of Japan adopted a "damage control communication" to calm the market's anxiety. However, our Japanese macro and equity strategist, Hirokazu Sugizaki and Sho Nakazawa, pointed out that only about 60% of yen carry trades have been unwound. As they emphasized, their estimate has a wide margin of error.

In the credit market, we believe the recent weakness in spread products is justified, especially considering the tight starting levels. In the U.S. corporate credit market, recession risks are already priced into at least single-B high yield bonds, which are overvalued and over-positioned. We recommend investors to hedge against hard landing risks rather than reduce cash holdings.

The put spreads on high yield TRS and high yield CDX are reasonable in our view. In terms of emerging market sovereign credit, investment grade may outperform high yield, leading us to close our preference for high yield over investment grade. We suggest using a combination of CDS on single names in emerging markets as an attractive hedge.

What happens next? Despite some reversal of losses in risk markets and some yield giveback in U.S. Treasuries, we expect the market to remain tense until data confirms or denies the scenario of a soft or hard landing for the U.S. economy.

Every piece of data that emerges, especially those related to the labor market, will be closely watched. We will also monitor the healthy functioning of the funding markets and the capital market access for companies to obtain credit.

So far, the financing market remains intact, with some investment grade bond trades that were withdrawn from the market earlier last week returning and being well received - investment grade bond supply (exceeding $30 billion) hit the best level so far this year