No Summer Slowdown for Markets – Yet

Markets may seem calm following recent policy headlines, but for Michael Zezas, our Global Head of Fixed Income Research and Public Policy Strategy, investors may need to wait on more data to assess whether the macroenvironment will remain stable.Read more insights from Morgan Stanley.----- Transcript -----Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy. Today: Why there's no summer slowdown yet for U.S. policy catalysts for the financial markets. It's Friday, July 18th at 8am in New York. The past week and a half has seen many major policy, events and headlines relevant to the outlook for financial markets. This includes more speculation by the U.S. administration over leadership at the Fed, more information about the deficit impact of the new fiscal bill, and – perhaps most tangibly – announcements of new tariffs that, if they take effect, will be a meaningful step up from already elevated levels. It would all suggest a weaker growth outlook and less overseas demand for U.S. assets. Yet major financial markets seem to have shrugged it all off. The S & P and the U.S. dollar are up about 1 percent over that time, and Treasury yields are modestly higher. So, what's going on? Two possibilities to consider, and it implies investors should pay more attention than they may be inclined to this summer. First, when it comes to the impact of tariffs on the economy, it's possible we're dealing with a delayed impact. The effective average U.S. tariff rate shot up from 3 to 4 percent earlier this year to 13 percent, and if recent announcements go through, that could exceed 20 percent. That's a major escalation in costs for U.S. companies and consumers and something our economists argue takes growth down to 1 percent and elevates the possibility of a recession. But our economists also point out that we may not be experiencing these cost increases quite yet. History suggests several months of lag between implementation and economic impact as companies leverage existing lower cost inventory before making tough decisions on pricing and managing their own costs. That means hard economic data likely does not yet tell us about the impact or lack thereof of tariffs, but that may change in the coming months. Second. It's also possible that the recent announcements of tariff increases don't tell us the whole story. As my colleagues in our equity strategy team point out, corporate America's cost base is most sensitive to the U.S.' largest trading partners – China, Mexico, Canada, and Europe. As we've discussed in prior episodes, we see tariff rate increases as likely on all these trading partners as tough negotiations continue. However, the details will matter greatly if rates are increased, but with a healthy dose of exceptions or quotas. Even if they diminish over time, then the real impact could be significantly blunted. In that case, markets would resume taking cues from other factors such as earnings revisions and forward-looking expectations around AI driven productivity. So bottom line, market movements suggest investors are assuming benign U.S. policy outcomes. But there's plenty of developments to track in the coming weeks and months to test if those assumptions will hold. Trade policy details and hard economic data are key among them. Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review, and tell your friends about the podcast. We want everyone to listen.

The dollar’s bearish run is likely to affect U.S. equity markets. Michelle Weaver, our U.S. Thematic & Equity Strategist, and David Adams, our Head of G10 FX Strategy, discuss what investors should consider.Read more insights from Morgan Stanley.----- Transcript -----Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver, U.S. Thematic and Equity strategist at Morgan Stanley. David Adams: And I'm Dave Adams, head of G10 FX Strategy here at Morgan Stanley. Michelle Weaver: Our colleagues were recently on the show to talk about the impact of the weak dollar on European equities. And today we wanted to continue that conversation by looking at what a weak U.S. dollar means for the U.S. equity market.It's Thursday, July 17th at 2pm in London. Morgan Stanley has a bearish view on the U.S. dollar. And this is something our chief global FX strategist James Lord spoke about recently on the show. But Dave, I want to go over the outlook again, since Morgan Stanley has a really differentiated view on this. Do you think the dollar will continue to depreciate during the remainder of the year? David Adams: We do, and we do. We have been dollar bears this whole year, and it has been very out of consensus. But we do think the weakness will continue and our forecasts remain one of the most bearish on the street for the dollar. The dollar has had its worst first half of the year since 1973, and the dollar index has fallen about 10 percent year to date, but we think we're at the intermission rather than the finale. The second act for the dollar weakening trend should come over the next 12 months as U.S. interest rates and U.S. growth rates converge to that of the rest of the world. And FX hedging of existing U.S. assets held by foreign investors adds further negative risk premium to the dollar. The result is that we're looking for yet another 10 percent drop in the dollar by the end of next year. Michelle Weaver: That's really interesting and a differentiated view for Morgan Stanley. When I think about one of the key themes that we've been following this year, it's the multipolar world or a shift away from globalization to more localized spheres of influence. This is an important element to the dollar story.How have tariffs impacted currency and your outlook? David Adams: Tariffs play a key role in this framework. Tariffs have a positive impact on inflation, but a negative impact on U.S. growth. But the inflation impact comes faster and the negative impact on growth and employment that comes a bit later. This puts the Fed in a really tough spot and it's why our economists are pretty out of consensus in calling for both no cuts this year, and a much faster and deeper pace of cuts in 2026. The results for me in FX land is that the market is underestimating just how low the Fed will go and just how low U.S. rates will go, in general. Tariffs play a big role in helping to generate this rate convergence, and rate differentials are a fundamental driver of currencies. The more that U.S. rates are going to fall, the more likely it is that the dollar keeps falling too. Michelle Weaver: Tariffs have certainly impacted heavily on our view for the U.S. equity market and it's something that no asset class is not impacted by really. Given the volatility and the magnitude of the move we've seen this year, are foreign investors hedging more? David Adams: We do think they've started hedging more, but the bulk of the move is really ahead of us. Foreign investors own a massive amount of U.S. assets. European investors alone own $8 trillion of U.S. bonds and stocks, and that's only about a quarter of total foreign ownership of U.S. assets. Now when foreign investors buy U.S. assets, they have to sell their currency and buy the dollar. But at some point, you're going to have to bring that money back, so you're going to have to sell the dollar and buy back your home currency again. If the dollar rises over this period, you've made a gain, congratulations. But if it falls, you've made a loss. Now a lot of foreign investors will hedge this currency risk, and they'll use instruments like forwards and options to do so. But in the case of the U.S., we found that a lot of foreign investors really choose not to hedge this exposure, particularly on the equity side. And this reflects both a view that the dollar would appreciate; so, they want to take that gain. But it also reflects the dollar's negative correlation to equities. So, what's changing now? Well, a lot of investors are starting to rethink this decision and add those FX hedges, which really means dollar selling. Now, there's a lot of factors motivating their decision to hedge. One, of course is price. If U.S. rates are going to converge meaningfully to the rest of the world – like we expect – that flattens out the forward curve and makes those forwards cheaper to buy to hedge. But the breakdown in correlations that we've seen more broadly, the uptick in policy volatility and uncertainty, and the sell off in the dollar that we've already seen year to date, have all increased the relative benefit of FX hedging. Now, Michelle, I often get asked the question, that's a nice story, but is hedging actually picking up? And the answer is yes. The initial data suggests that hedging has picked up in the second quarter, but because of the size of U.S. asset holdings and given how much it was initially unhedged, we could be talking about a significant long-term flow. We have a lot more to go from here. Michelle Weaver: Yeah. David Adams: We estimated that just over half of Europe's $8 trillion holdings are unhedged. And if hedge ratios pick up even a little bit, we could be talking about hundreds of billions of dollars in flow. And that's just from Europe. But Michelle, I wanted to ask you. What do you think a weaker dollar means for U.S. companies? Michelle Weaver: The weaker dollar is a substantial underappreciated tailwind for U.S. multinational earnings, and this is because these companies sell products overseas and then get paid in foreign currency. So, when the dollar's down, converting that foreign revenue back into dollars, gives them a nice boost, something that domestic only companies aren't going to benefit from. And this is called the translation effect. Recently we've seen earnings revisions breadth, essentially a measure of whether analysts are getting more optimistic or pessimistic start to turn up after hitting typical cycle lows. And based on our house view for the dollar, there's likely more upside ahead based on that relationship for revisions over the next year. David Adams: Interesting. Interesting. And is this something you're hearing about from companies on things like earnings calls? Michelle Weaver: No, this dynamic isn't being highlighted much on earnings calls. Typically, companies talk about foreign exchange effects when the dollar's strengthening and provides a headwind for corporate earnings. But when we're in the reverse scenario like we are now with the dollar weakening and getting a boost to earnings, we tend to not hear as much discussion, which is why I called this an underappreciated tailwind. And according to your team's forecast, we still have a substantial amount of weakening to go and thus a substantial amount of benefit for U.S. companies to go. David Adams: Yeah, that makes sense. And who do you think benefits most from this dynamic? Are there any sectors or investment styles that look particularly good here? Michelle Weaver: Mm hmm. So generally, it's the large cap companies that stand to gain the most from this dynamic, and that's because they do more business overseas. If we look at foreign revenue exposure for different indices, around 40 percent of the S & P 500’s revenue comes from outside the U.S., while that's just 22 percent for the Russell 2000 Small Cap Index. But the impact of a weaker dollar isn't the same across the board. Foreign revenue exposure and earnings revision sensitivity to the dollar vary quite a bit, when we look at the sector and the industry group level. From a foreign revenue exposure perspective, Tech Materials and Industrials have the highest foreign revenue exposure and thus can benefit a lot from that dynamic we've been talking about. When we look from an earnings revisions perspective, Capital Goods, Materials, Software and Tech Hardware have the most earnings revisions, sensitivity to a weaker dollar, so they could also benefit there. David Adams: So, I guess this brings us to the million-dollar question that all of our listeners are asking. What do we do with this information? What does this mean for investors? Michelle Weaver: So as the dollar, continues to weaken, investors should keep a close eye on the industries and companies poised to benefit the most – because in this multipolar world, currency dynamics are not just a macro backdrop, but an important driver of earnings and equity performance.Dave, thank you for taking the time to talk. And to our listeners, thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen to the show and share the podcast with a friend or colleague today. 

U.S. tariffs have had limited impact so far on inflation and corporate earnings. Our Head of Corporate Credit Research Andrew Sheets explains why – and when – that might change.Read more insights from Morgan Stanley.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today I'm going to talk about why tariffs are showing up everywhere – but the data; and why we think this changes this quarter. It's Wednesday, July 16th at 2pm in London. Investors have faced tariff headlines since at least February. The fact that it's now mid-July and markets are still grinding higher is driving some understandable skepticism that they're going to have their promised impact. Indeed, we imagine that maybe more of one of you is groaning and saying, ‘What? Another tariff episode?’ But we do think this theme remains important for markets. And above all, it's a factor we think is going to hit very soon. We think it's kind of now – the third quarter – when the promised impact of tariffs on economic data and earnings really start to come through. My colleague Jenna Giannelli and I discussed some of the reasons why, on last week's episode focused on the retail sector. But what I want to do next is give a little bit of that a broader context. Where I want to start is that it's really about tariff impact picking up right about now. The inflation readings that we got earlier this week started to show US core inflation picking up again, driven by more tariff sensitive sectors. And while second quarter earnings that are being reported right about now, we think will generally be fine, and maybe even a bit better than expected; the third quarter earnings that are going to be generated over the next several months, we think those are more at risk from tariff related impact. And again, this could be especially pronounced in the consumer and retail sector. So why have tariffs not mattered so much so far, and why would that change very soon? The first factor is that tariff rates are increasing rapidly. They've moved up quickly to a historically high 9 percent as of today; even with all of the pauses and delays. And recently announced actions by the US administration over just the last couple of weeks could effectively double this rate again -- from 9 percent to somewhere between 15 to 20 percent.A second reason why this is picking up now is that tariff collections are picking up now. US Customs collected over $26 billion in tariffs in June, which annualizes out to about 1 percent of GDP, a very large number. These collections were not nearly as high just three months ago. Third, tariffs have seen pauses and delayed starts, which would delay the impact. And tariffs also exempted goods that were in transit, which can be significant from goods coming from Europe or Asia; again, a factor that would delay the impact. But these delays are starting to come to fruition as those higher tariff collections and higher tariff rates would suggest. And finally, companies did see tariffs coming and tried to mitigate them. They ordered a lot of inventory ahead of tariff rates coming into effect. But by the third quarter, we think they've sold a lot of that inventory, meaning they no longer get the benefit. Companies ordered a lot of socks before tariffs went into effect. But by the third quarter and those third quarter earnings, we think they will have sold them all. And the new socks they're ordering, well, they come with a higher cost of goods sold. In short, we think it's reasonable to expect that the bulk of the impact of tariffs and economic and earnings data still lies ahead, especially in this quarter – the third quarter of 2025. We continue to think that it's probably in August and September rather than June-July, where the market will care more about these challenges as core inflation data continues to pick up. For credit, this leaves us with an up in quality bias, especially as we move through that August to September period. And as Jenna and I discussed last week, we are especially cautious on the retail credit sector, which we think is more exposed to these various factors converging in the third quarter. Thank you as always for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen; and also tell a friend or colleague about us today.

Our analysts Paul Walsh, James Lord and Marina Zavolock discuss the dollar’s decline, the strength of the euro, and the mixed impact on European equities.Read more insights from Morgan Stanley.----- Transcript -----Paul Walsh: Welcome to Thoughts on the Markets. I'm Paul Walsh, Morgan Stanley's Head of European Product. And today we're discussing the weakness we've seen year-to-date in the U.S. dollar and what this means for the European stock market.It's Tuesday, July the 15th at 3:00 PM in London.I'm delighted to be joined by my colleagues, Marina Zavolock, Morgan Stanley's Chief European Equity Strategist, and James Lord, Morgan Stanley's Chief Global FX Strategist.James, I'm going to start with you because I think we've got a really differentiated view here on the U.S. dollar. And I think when we started the year, the bearish view that we had as a house on the U.S. dollar, I don't think many would've agreed with, frankly. And yet here we are today, and we've seen the U.S. dollar weakness proliferating so far this year –  but actually it's more than that.When I listen to your view and the team's view, it sounds like we've got a much more structurally bearish outlook on the U.S. dollar from here, which has got some tenure. So, I don't want to steal your thunder, but why don't you tell us, kind of frame the debate, for us around the U.S. dollar and what you're thinking.James Lord: So, at the beginning of the year, you're right. The consensus was that, you know, the election of Donald Trump was going to deliver another period of what people have called U.S. exceptionalism.Paul Walsh: Yeah.James Lord: And with that it would've been outperformance of U.S. equities, outperformance of U.S. growth, continued capital inflows into the United States and outperformance of the U.S. dollar.At the time we had a slightly different view. I mean, with the help of the economics team, we took the other side of that debate largely on the assumption that actually U.S. growth was quite likely to slow through 2025, and probably into 2026 as well – on the back of restrictions on immigration, lack of fiscal stimulus. And, increasingly as trade tariffs were going to be implemented…Paul Walsh: Yeah. Tariffs, of course…James Lord: That was going to be something that weighed on growth.So that was how we set out the beginning of the year. And as the year has progressed, the story has evolved. Like some of the other things that have happened, around just the extent to which tariff uncertainty has escalated. The section 899 debate.Paul Walsh: Yeah.James Lord: Some of the softness in the data and just the huge amounts of uncertainty that surrounds U.S. policymaking in general has accelerated the decline in the U.S. dollar. So, we do think that this has got further to go. I mean, the targets that we set at the beginning of the year, we kind of already met them. But when we published our midyear outlook, we extended the target.So, we may even have to go towards the bull case target of euro-dollar of 130.Paul Walsh: Mm-hmm.James Lord: But as the U.S. data slows and the Fed debate really kicks off where at Morgan Stanley U.S. Economics research is expecting the Fed to ultimately cut to 2.5 percent...Paul Walsh: Yeah.Lord: That’s really going to really weigh on the dollar as well. And this comes on the back of a 15-year bull market for the dollar.Paul Walsh: That's right.James Lord:  From 2010 all the way through to the end of last year, the dollar has been on a tear.Paul Walsh: On a structural bull run.James Lord: Absolutely. And was at the upper end of that long-term historical range. And the U.S. has got 4 percent GDP current account deficit in a slowing growth environment. It's going to be tough for the dollar to keep going up. And so, we think we're sort of not in the early stages, maybe sort of halfway through this dollar decline. But it's a huge change compared to what we've been used to. So, it's going to have big implications for macro, for companies, for all sorts of people.Paul Walsh: Yeah. And I think that last point you make is absolutely critical in terms of the implications for corporates in particular, Marina, because that's what we spend every hour of every working day thinking about. And yes, currency's been on the radar, I get that. But I think this structural dynamic that James alludes to perhaps is not really conventional wisdom still, when I think about the sector analysts and how clients are thinking about the outlook for the U.S. dollar.But the good news is that you've obviously done detailed work in collaboration with the floor to understand the complexities of how this bearish dollar view is percolating across the different stocks and sectors. So, I wondered if you could walk us through what your observations are and what your conclusions are having done the work.Marina Zavolock: First of all, I just want to acknowledge that what you just said there. My background is emerging markets and coming into covering Europe about a year and a half ago, I've been surprised, especially amid the really big, you know, shift that we're seeing that James was highlighting – how FX has been kind of this secondary consideration. In the process of doing this work, I realized that analysts all look at FX in different way. Investors all look at FX in different way. And in …Paul Walsh: So do corporates.Marina Zavolock: Yeah, corporates all look at FX in different way. We've looked a lot at that. Having that EM background where we used to think about FX as much as we thought about equities, it was as fundamental to the story...Paul Walsh: And to be clear, that's because of the volatility…Marina Zavolock: Exactly, which we're now seeing now coming into, you know, global markets effectively with the dollar moves that we've had. What we've done is created or attempted to create a framework for assessing FX exposure by stock, the level of FX mismatches, the types of FX mismatches and the various types of hedging policies that you have for those – particularly you have hedging for transactional FX mismatches.Paul Walsh: Mm-hmm.Marina Zavolock: And we've looked at this from stock level, sector level, aggregating the stock level data and country level. And basically, overall, some of the key conclusions are that the list of stocks that benefit from Euro strength that we've identified, which is actually a small pocket of the European index. That group of stocks that actually benefits from euro strength has been strongly outperforming the European index, especially year-to-date.Paul Walsh: Mm-hmm.Marina Zavolock: And just every day it's kind of keeps breaking on a relative basis to new highs. Given the backdrop of James' view there, we expect that to continue. On the other hand, you have even more exposure within the European index of companies that are being hit basically with earnings, downgrades in local currency terms. That into this earning season in particular, we expect that to continue to be a risk for local currency earnings.Paul Walsh: Mm-hmm.Marina Zavolock: The stocks that are most negatively impacted, they tend to have a lot of dollar exposure or EM exposure where you have pockets of currency weakness as well. So overall what we found through our analysis is that more than half of the European index is negatively exposed to this euro and other local currency strength. The sectors that are positively exposed is a minority of the index. So about 30 percent is either materially or positively exposed to the euro and other local currency strength. And sectors within that in particular that stand out positively exposed utilities, real estate banks. And the companies in this bucket, which we spend a lot of time identifying, they are strongly outperforming the index.They're breaking to new highs almost on a daily basis relative to the index. And I think that's going to continue into earning season because that's going to be one of the standouts positively, amid probably a lot of downgrades for companies who have translational exposure to the U.S. or EM.Paul Walsh: And so, let's take that one step further, Marina, because obviously hedging is an important part of the process for companies. And as we've heard from James, of a 15-year bull run for dollar strength. And so most companies would've been hedging, you know, dollar strength to be fair where they've got mismatches. But what are your observations having looked at the hedging side of the equation?Marina Zavolock: Yeah, so let me start with FX mismatches. So, we find that about half of the European index is exposed to some level of FX mismatches.Paul Walsh: Mm-hmm.Marina Zavolock: So, you have intra-European currency mismatches. You have companies sourcing goods in Asia or China and shipping them to Europe. So, it's actually a favorable FX mismatch. And then as far as hedging, the type of hedging that tends to happen for companies is related to transactional mismatches. So, these are cost revenue, balance sheet mismatches; cashflow distribution type mismatches. So, they're more the types of mismatches that could create risk rather than translational mismatches, which are – they're just going to happen.Paul Walsh: Yeah.Marina Zavolock: And one of the most interesting aspects of our report is that we found that companies that have advanced hedging, FX hedging programs, they first of all, they tend to outperform, when you compare them to companies with limited or no hedging, despite having transactional mismatches. And secondly, they tend to have lower share price volatility as well, particularly versus the companies with no hedging, which have the most share price volatility.So, the analysis, generally, in Europe of this most, the most probably diversified region globally, is that FX hedging actually does generate alpha and contributes to relative performance.Paul Walsh: Let's connect the two a little bit here now, James, because obviously as companies start to recalibrate for a world where dollar weakness might proliferate for longer, those hedging strategies are going to have to change.So just any kind of insights you can give us from that perspective. And maybe implications across currency markets as a result of how those behavioral changes might play out, I think would be very interesting for our listeners.James Lord: Yeah, I think one thing that companies can do is change some of the tactics around how they implement the hedges. So, this can revolve around both the timing and also the full extent of the hedge ratios that they have. I mean, some companies who are – in our conversations with them when they're talking about their hedging policy, they may have a range. Maybe they don't hedge a 100 percent of the risk that they're trying to hedge. They might have to do something between 80 and a hundred percent. So, you can, you can adjust your hedge ratios…Paul Walsh: Adjust the balances a bit.James Lord: Yeah. And you can delay the timing of them as well.The other side of it is just deciding like exactly what kind of instrument to use to hedge as well. I mean, you can hedge just using pure spot markets. You can use forward markets and currencies. You can implement different types of options, strategies.And I think this was some of the information that we were trying to glean from the survey was this question that Marina was asking about. Do you have a limited or advanced hedging program? Typically, we would find that corporates that have advanced programs might be using more options-based strategies, for example. And you know, one of the pieces of analysis in the report that my colleague Dave Adams did was really looking at the effectiveness of different strategies depending on the market environment that we're in.So, are we in a sort of risk-averse market environment, high vol environment? Different types of strategies work for different types of market environments. So, I would encourage all corporates that are thinking about implementing some kind of hedging strategy to have a look at that document because it provides a lot of information about the different ways you can implement your hedges. And some are much more cost effective than others.Paul Walsh: Marina, last thought from you?Marina Zavolock: I just want to say overall for Europe there is this kind of story about Europe has no growth, which we've heard for many years, and it's sort of true. It is true in local currency terms. So European earnings growth now on consensus estimates for this year is approaching one percent; it’s close to 1 percent. On the back of the moves we've already seen in FX, we're probably going to go negative by the time this earning season is over in local currency terms. But based on our analysis, that is primarily impacted by translation.So, it is just because Europe has a lot of exposure to the U.S., it has some EM exposure. So, I would just really emphasize here that for investors; so, investors, many of which don't hedge FX, when you're comparing Europe growth to the U.S., it's probably better to look in dollar terms or at least in constant currency terms. And in dollar terms, European earnings growth at this point are 7.6 percent in dollar terms. That's giving Europe the benefit for the euro exposure that it has in other local currencies.So, I think these things, as FX starts to be front of mind for investors more and more, these things will become more common focus points. But right now, a lot of investors just compare local currency earnings growth.Paul Walsh: So, this is not a straightforward topic, and we obviously think this is a very important theme moving through the balance of this year. But clearly, you're going to see some immediate impact moving through the next quarter of earnings.Marina and James, thanks as always for helping us make some sense of it all.James Lord: Thanks, Paul.Marina Zavolock: Thank you.Paul Walsh: And to our listeners out there, thank you as always for tuning in.If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

Our analysts Paul Walsh, James Lord and Marina Zavolock discuss the dollar’s decline, the strength of the euro, and the mixed impact on European equities.Read more insights from Morgan Stanley.----- Transcript -----Paul Walsh: Welcome to Thoughts on the Markets. I'm Paul Walsh, Morgan Stanley's Head of European Product. And today we're discussing the weakness we've seen year-to-date in the U.S. dollar and what this means for the European stock market.It's Tuesday, July the 15th at 3:00 PM in London.I'm delighted to be joined by my colleagues, Marina Zavolock, Morgan Stanley's Chief European Equity Strategist, and James Lord, Morgan Stanley's Chief Global FX Strategist.James, I'm going to start with you because I think we've got a really differentiated view here on the U.S. dollar. And I think when we started the year, the bearish view that we had as a house on the U.S. dollar, I don't think many would've agreed with, frankly. And yet here we are today, and we've seen the U.S. dollar weakness proliferating so far this year –  but actually it's more than that.When I listen to your view and the team's view, it sounds like we've got a much more structurally bearish outlook on the U.S. dollar from here, which has got some tenure. So, I don't want to steal your thunder, but why don't you tell us, kind of frame the debate, for us around the U.S. dollar and what you're thinking.James Lord: So, at the beginning of the year, you're right. The consensus was that, you know, the election of Donald Trump was going to deliver another period of what people have called U.S. exceptionalism.Paul Walsh: Yeah.James Lord: And with that it would've been outperformance of U.S. equities, outperformance of U.S. growth, continued capital inflows into the United States and outperformance of the U.S. dollar.At the time we had a slightly different view. I mean, with the help of the economics team, we took the other side of that debate largely on the assumption that actually U.S. growth was quite likely to slow through 2025, and probably into 2026 as well – on the back of restrictions on immigration, lack of fiscal stimulus. And, increasingly as trade tariffs were going to be implemented…Paul Walsh: Yeah. Tariffs, of course…James Lord: That was going to be something that weighed on growth.So that was how we set out the beginning of the year. And as the year has progressed, the story has evolved. Like some of the other things that have happened, around just the extent to which tariff uncertainty has escalated. The section 899 debate.Paul Walsh: Yeah.James Lord: Some of the softness in the data and just the huge amounts of uncertainty that surrounds U.S. policymaking in general has accelerated the decline in the U.S. dollar. So, we do think that this has got further to go. I mean, the targets that we set at the beginning of the year, we kind of already met them. But when we published our midyear outlook, we extended the target.So, we may even have to go towards the bull case target of euro-dollar of 130.Paul Walsh: Mm-hmm.James Lord: But as the U.S. data slows and the Fed debate really kicks off where at Morgan Stanley U.S. Economics research is expecting the Fed to ultimately cut to 2.5 percent...Paul Walsh: Yeah.Lord: That’s really going to really weigh on the dollar as well. And this comes on the back of a 15-year bull market for the dollar.Paul Walsh: That's right.James Lord:  From 2010 all the way through to the end of last year, the dollar has been on a tear.Paul Walsh: On a structural bull run.James Lord: Absolutely. And was at the upper end of that long-term historical range. And the U.S. has got 4 percent GDP current account deficit in a slowing growth environment. It's going to be tough for the dollar to keep going up. And so, we think we're sort of not in the early stages, maybe sort of halfway through this dollar decline. But it's a huge change compared to what we've been used to. So, it's going to have big implications for macro, for companies, for all sorts of people.Paul Walsh: Yeah. And I think that last point you make is absolutely critical in terms of the implications for corporates in particular, Marina, because that's what we spend every hour of every working day thinking about. And yes, currency's been on the radar, I get that. But I think this structural dynamic that James alludes to perhaps is not really conventional wisdom still, when I think about the sector analysts and how clients are thinking about the outlook for the U.S. dollar.But the good news is that you've obviously done detailed work in collaboration with the floor to understand the complexities of how this bearish dollar view is percolating across the different stocks and sectors. So, I wondered if you could walk us through what your observations are and what your conclusions are having done the work.Marina Zavolock: First of all, I just want to acknowledge that what you just said there. My background is emerging markets and coming into covering Europe about a year and a half ago, I've been surprised, especially amid the really big, you know, shift that we're seeing that James was highlighting – how FX has been kind of this secondary consideration. In the process of doing this work, I realized that analysts all look at FX in different way. Investors all look at FX in different way. And in …Paul Walsh: So do corporates.Marina Zavolock: Yeah, corporates all look at FX in different way. We've looked a lot at that. Having that EM background where we used to think about FX as much as we thought about equities, it was as fundamental to the story...Paul Walsh: And to be clear, that's because of the volatility…Marina Zavolock: Exactly, which we're now seeing now coming into, you know, global markets effectively with the dollar moves that we've had. What we've done is created or attempted to create a framework for assessing FX exposure by stock, the level of FX mismatches, the types of FX mismatches and the various types of hedging policies that you have for those – particularly you have hedging for transactional FX mismatches.Paul Walsh: Mm-hmm.Marina Zavolock: And we've looked at this from stock level, sector level, aggregating the stock level data and country level. And basically, overall, some of the key conclusions are that the list of stocks that benefit from Euro strength that we've identified, which is actually a small pocket of the European index. That group of stocks that actually benefits from euro strength has been strongly outperforming the European index, especially year-to-date.Paul Walsh: Mm-hmm.Marina Zavolock: And just every day it's kind of keeps breaking on a relative basis to new highs. Given the backdrop of James' view there, we expect that to continue. On the other hand, you have even more exposure within the European index of companies that are being hit basically with earnings, downgrades in local currency terms. That into this earning season in particular, we expect that to continue to be a risk for local currency earnings.Paul Walsh: Mm-hmm.Marina Zavolock: The stocks that are most negatively impacted, they tend to have a lot of dollar exposure or EM exposure where you have pockets of currency weakness as well. So overall what we found through our analysis is that more than half of the European index is negatively exposed to this euro and other local currency strength. The sectors that are positively exposed is a minority of the index. So about 30 percent is either materially or positively exposed to the euro and other local currency strength. And sectors within that in particular that stand out positively exposed utilities, real estate banks. And the companies in this bucket, which we spend a lot of time identifying, they are strongly outperforming the index.They're breaking to new highs almost on a daily basis relative to the index. And I think that's going to continue into earning season because that's going to be one of the standouts positively, amid probably a lot of downgrades for companies who have translational exposure to the U.S. or EM.Paul Walsh: And so, let's take that one step further, Marina, because obviously hedging is an important part of the process for companies. And as we've heard from James, of a 15-year bull run for dollar strength. And so most companies would've been hedging, you know, dollar strength to be fair where they've got mismatches. But what are your observations having looked at the hedging side of the equation?Marina Zavolock: Yeah, so let me start with FX mismatches. So, we find that about half of the European index is exposed to some level of FX mismatches.Paul Walsh: Mm-hmm.Marina Zavolock: So, you have intra-European currency mismatches. You have companies sourcing goods in Asia or China and shipping them to Europe. So, it's actually a favorable FX mismatch. And then as far as hedging, the type of hedging that tends to happen for companies is related to transactional mismatches. So, these are cost revenue, balance sheet mismatches; cashflow distribution type mismatches. So, they're more the types of mismatches that could create risk rather than translational mismatches, which are – they're just going to happen.Paul Walsh: Yeah.Marina Zavolock: And one of the most interesting aspects of our report is that we found that companies that have advanced hedging, FX hedging programs, they first of all, they tend to outperform, when you compare them to companies with limited or no hedging, despite having transactional mismatches. And secondly, they tend to have lower share price volatility as well, particularly versus the companies with no hedging, which have the most share price volatility.So, the analysis, generally, in Europe of this most, the most probably diversified region globally, is that FX hedging actually does generate alpha and contributes to relative performance.Paul Walsh: Let's connect the two a little bit here now, James, because obviously as companies start to recalibrate for a world where dollar weakness might proliferate for longer, those hedging strategies are going to have to change.So just any kind of insights you can give us from that perspective. And maybe implications across currency markets as a result of how those behavioral changes might play out, I think would be very interesting for our listeners.James Lord: Yeah, I think one thing that companies can do is change some of the tactics around how they implement the hedges. So, this can revolve around both the timing and also the full extent of the hedge ratios that they have. I mean, some companies who are – in our conversations with them when they're talking about their hedging policy, they may have a range. Maybe they don't hedge a 100 percent of the risk that they're trying to hedge. They might have to do something between 80 and a hundred percent. So, you can, you can adjust your hedge ratios…Paul Walsh: Adjust the balances a bit.James Lord: Yeah. And you can delay the timing of them as well.The other side of it is just deciding like exactly what kind of instrument to use to hedge as well. I mean, you can hedge just using pure spot markets. You can use forward markets and currencies. You can implement different types of options, strategies.And I think this was some of the information that we were trying to glean from the survey was this question that Marina was asking about. Do you have a limited or advanced hedging program? Typically, we would find that corporates that have advanced programs might be using more options-based strategies, for example. And you know, one of the pieces of analysis in the report that my colleague Dave Adams did was really looking at the effectiveness of different strategies depending on the market environment that we're in.So, are we in a sort of risk-averse market environment, high vol environment? Different types of strategies work for different types of market environments. So, I would encourage all corporates that are thinking about implementing some kind of hedging strategy to have a look at that document because it provides a lot of information about the different ways you can implement your hedges. And some are much more cost effective than others.Paul Walsh: Marina, last thought from you?Marina Zavolock: I just want to say overall for Europe there is this kind of story about Europe has no growth, which we've heard for many years, and it's sort of true. It is true in local currency terms. So European earnings growth now on consensus estimates for this year is approaching one percent; it’s close to 1 percent. On the back of the moves we've already seen in FX, we're probably going to go negative by the time this earning season is over in local currency terms. But based on our analysis, that is primarily impacted by translation.So, it is just because Europe has a lot of exposure to the U.S., it has some EM exposure. So, I would just really emphasize here that for investors; so, investors, many of which don't hedge FX, when you're comparing Europe growth to the U.S., it's probably better to look in dollar terms or at least in constant currency terms. And in dollar terms, European earnings growth at this point are 7.6 percent in dollar terms. That's giving Europe the benefit for the euro exposure that it has in other local currencies.So, I think these things, as FX starts to be front of mind for investors more and more, these things will become more common focus points. But right now, a lot of investors just compare local currency earnings growth.Paul Walsh: So, this is not a straightforward topic, and we obviously think this is a very important theme moving through the balance of this year. But clearly, you're going to see some immediate impact moving through the next quarter of earnings.Marina and James, thanks as always for helping us make some sense of it all.James Lord: Thanks, Paul.Marina Zavolock: Thank you.Paul Walsh: And to our listeners out there, thank you as always for tuning in.If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

Stocks hold steady as tariff uncertainty continues. Our CIO and Chief U.S. Equity Strategist Mike Wilson explains how policy deferrals, earnings resilience and forward guidance are driving the market.Read more insights from Morgan Stanley.----- Transcript -----Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist. Today on the podcast I’ll be discussing why stocks remain so resilient. It's Monday, July 14th at 11:30am in New York. So, let’s get after it. Why has the equity market been resilient in the face of new tariff announcements? Well first, the import cost exposure for S&P 500 industries is more limited given the deferrals and exemptions still in place like the USMCA compliant imports from Mexico. Second, the higher tariff rates recently announced on several trading partners are generally not perceived to be the final rates as negotiations progress. I continue to believe these tariffs will ultimately end up looking like a 10 percent consumption tax on imports that generate significant revenue for the Treasury. And finally, many companies pre-stocked inventory before the tariffs were levied and so the higher priced goods have not yet flowed through the cost of goods sold. Furthermore, with the market’s tariffs concerns having peaked in early April, the market is looking forward and focused on the data it can measure. On that score, the dramatic v-shaped rebound in earnings revisions breadth for the S&P 500 has been a fundamental tailwind that justifies the equity rally since April in the face of continued trade and macro uncertainty. This gauge is one of our favorites for predicting equity prices and it troughed at -25 percent in mid-April. It’s now at +3 percent. The sectors with the most positive earnings revisions breadth relative to the S&P 500 are Financials, Industrials and Software — three sectors we continue to recommend due to this dynamic. The other more recent development helping to support equities is the passage of the One Big Beautiful Bill. While this Bill does not provide incremental fiscal spending to support the economy or lower the statutory tax rate, it does lower the cash earnings tax rates for companies that spend heavily on both R&D and Capital Goods.Our Global Tax Team believes we could see cash tax rates fall from 20 percent today back toward the 13 percent level that existed before some of these benefits from the Tax Cuts and Jobs Act that expired in 2022. This benefit is also likely to jump start what has been an anemic capital spending cycle for corporate America, which could drive both higher GDP and revenue growth for the companies that provide the type of equipment that falls under this category of spending. Meanwhile, the Foreign-Derived Intangible Income is a tax incentive that benefits U.S. companies earning income from foreign markets. It was designed to encourage companies to keep their intellectual property in the U.S. rather than moving it to countries with lower tax rates. This deduction was scheduled to decrease in 2026, which would have raised the effective tax rate by approximately 3 percent. That risk has been eliminated in the Big Beautiful Bill. Finally, the Digital Service Tax imposed on online companies that operate overseas may be reduced. Late last month, Canada announced that it would rescind its Digital Service Tax on the U.S. in anticipation of a mutually beneficial comprehensive trade arrangement with the U.S. This would be a major windfall for online companies and some see the potential for more countries, particularly in Europe, to follow Canada’s lead as trade negotiations with the U.S. continue. Bottom line, while uncertainty around tariffs remains high, there are many other positive drivers for earnings growth over the next year that could more than offset any headwinds from these policies. This suggests the recent rally in stocks is justified and that investors may not be as complacent as some are fearing. Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!

As U.S. retailers manage the impacts of increased tariffs, they have taken a number of approaches to avoid raising prices for customers. Our Head of Corporate Strategy Andrew Sheets and our Head of U.S. Consumer Retail and Credit Research Jenna Giannelli discuss whether they can continue to do so.Read more insights from Morgan Stanley.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.Jenna Giannelli: And I'm Jenna Giannelli, Head of U.S. Consumer and Retail Credit Research.Andrew Sheets: And today on the podcast, we're going to dig into one of the biggest conundrums in the market today. Where and when are tariffs going to show up in prices and margins? It's Friday, July 11th at 10am in New York. Jenna, it's great to catch up with you today because I think you can really bring some unique perspective into one of the biggest puzzles that we're facing in the market today. Even with all of these various pauses and delays, the U.S. has imposed historically large tariffs on imports. And we're seeing a rapid acceleration in the amount of money collected from those tariffs by U.S. customs. These are real hard dollars that importers – or somebody else – are paying. Yet we haven't seen these tariffs show up to a significant degree in official data on prices – with recent inflation data relatively modest. And overall stock and credit markets remain pretty strong and pretty resilient, suggesting less effect.So, are these tariffs just less impactful than expected, or is there something else going on here with timing and severity? And given your coverage of the consumer and retail sectors, which is really at the center of this tariff debate – what do you think is going on?Jenna Giannelli: So yes, this is a key question and one that is dominating a lot of our client conversations. At a high level, I'd point to a few things. First, there's a timing issue here. So, when tariffs were first announced, retailers were already sitting on three to four months worth of inventory, just due to natural industry lead times. And they were able to draw down on this product.This is mostly what they sold in 1Q and likely into 2Q, which is why you haven't seen much margin or pricing impact thus far. Companies – we also saw them start to stock up heavily on inventory before the tariffs and at the lower pause rate tariffs, which is the product you referenced that we're seeing coming in now. This is really going to help mitigate margin pressure in the second quarter that you still have this lower cost inventory flowing through. On top of this timing consideration, retailers – we've just seen utilizing a range of mitigation measures, right? So, whether it's canceled or pause shipments from China, a shifting production mix or sourcing exposure in the short run, particularly before the pause rate on China. And then really leaning into just whether it's product mix shifts, cost savings elsewhere in the PNL, and vendor negotiations, right? They're really leaning into everything in their toolbox that they can. Pricing too has been talked about as something that is an option, but the option of last resort. We have heard it will be utilized, but very tactically and very surgically, as we think about the back half of the year. When you put this all together, how much impact is it having? On average from retailers that we heard from in the first quarter, they thought they would be able to mitigate about half of the expected tariff headwind, which is actually a bit better than we were expecting. Finally, I'll just comment on your comment regarding market performance. While you're right in that the overall equity and credit markets have held up well, year-to-date, retail equities and credit have fared worse than their respective indices. What's interesting, actually, is that credit though has significantly outperformed retail equities, which is a relationship we think should converge or correct as we move throughout the balance of the year.Andrew Sheets: So, Jenna, retailers saw this coming. They've been pulling various levers to mitigate the impact. You mentioned kind of the last lever that they want to pull is prices, raising prices, which is the macro thing that we care about. The thing that would actually show up in inflation. How close are we though to kind of running out of other options for these guys? That is, the only thing left is they can start raising prices?Jenna Giannelli: So closer is what I would say. We're likely not going to see a huge impact in 2Q, more likely as we head into 3Q and more heavily into the all-important fourth quarter holiday season. This is really when those higher cost goods are going to be flowing through the PNL and retailers need to offset this as they've utilized a lot of their other mitigation strategies. They've moved what they could move. They've negotiated where they could, they've cut where they could cut. And again, as this last step, it will be to try and raise price.So, who's going to have the most and least success? In our universe, we think it's going to be more difficult to pass along price in some of the more historically deflationary categories like apparel and footwear. Outside of what is a really strong brand presence, which in our universe, historically hasn't been the case.Also, in some of the higher ticket or more durable goods categories like home goods, sporting goods, furniture, we think it'll be challenging as well here to pass along higher costs. Where it's going to be less of an issue is in our Staples universe, where what we'd put is less discretionary categories like Beauty, Personal Care, which is part of the reason why we've been cautious on retail, and neutral and consumer products when we think about sector allocation.Andrew Sheets: And when do you think this will show up? Is it a third quarter story? A fourth quarter story?Jenna Giannelli: I think this is going to really start to show up in the third quarter, and more heavily into the fourth quarter, the all-important holiday season.Andrew Sheets: Yeah, and I think that’s what’s really interesting about the impact of this backup to the macro. Again, returning to the big picture is I think one of the most important calls that Morgan Stanley economists have is that inflation, which has been coming down somewhat so far this year is going to pick back up in August and September and October. And because it's going to pick back up, the Federal Reserve is not going to cut interest rates anymore this year because of that inflation dynamic. So, this is a big debate in the market. Many investors disagree. But I think what you're talking about in terms of there are some very understandable reasons, maybe why prices haven't changed so far. But that those price hikes could be coming have real macroeconomic implications.So, you know, maybe though, something to just close on – is to bring this to the latest headlines. You know, we're now back it seems, in a market where every day we log onto our screens, and we see a new headline of some new tariff being announced or suggested towards countries. Where do you think those announcements, so far are relative to what retailers are expecting – kind of what you think is in guidance?Jenna Giannelli: Sure. So, look what we've seen of late; the recent tariff headlines are certainly higher or worse, I think, than what investors in management teams were expecting. For Vietnam, less so; I'd say it was more in line. But for most elsewhere, in Asia, particularly Southeast Asia, the rates that are set to go in effect on August 1st, as we now understand them, are higher or worse than management teams were expecting. Recall that while guidance did show up in many flavors in the first quarter, so whether withdrawn guidance or lowered guidance. For those that did factor in tariffs to their guide, most were factoring in either pause rate tariffs or tariff rates that were at least lower than what was proposed on Liberation Day, right? So, what's the punchline here? I think despite some of the revisions we've already seen, there are more to come. To put some numbers around this, if we look at our group of retail consumer cohort, credits, consensus expectations for calling for EBITDA in our universe to be down around 5 percent year-over-year. If we apply tariff rates as we know them today for a half-year headwind starting August 1st, this number should be down around 15 percent year-over-year on a gross basis…Andrew Sheets: So, three times as much.Jenna Giannelli: Pretty significant. Exactly. And so, while there might be mitigation efforts, there might be some pricing passed along, this is still a pretty significant delta between where consensus is right now and what we know tariff rates to be today – could imply for earnings in the second half.Andrew Sheets: Jenna, thanks for taking the time to talk.Jenna Giannelli: My pleasure. Thank you.Andrew Sheets: And thank you as always for your time. If you find Thoughts to the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.

The ultimate market outcomes of President Trump’s tactical tariff escalation may be months away. Our Global Head of Fixed Income Research and Public Policy Strategy Michael Zezas takes a look at implications for investors now.Read more insights from Morgan Stanley.----- Transcript -----Welcome to Thoughts on the Market. I’m Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy. Today: The latest on U.S. tariffs and their market impact. It’s Thursday, July 10th at 12:30pm in New York. It's been a newsy week for U.S. trade policy, with tariff increases announced across many nations. Here’s what we think investors need to know. First, we think the U.S. is in a period of tactical escalation for tariff policy; where tariffs rise as the U.S. explores its negotiating space, but levels remain in a range below what many investors feared earlier this year. We started this week expecting a slight increase in U.S. tariffs—nothing too dramatic, maybe from 13 percent to around 15 percent driven by hikes in places like Vietnam and Japan. But what we got was a bit more substantial. The U.S. announced several tariff hikes, set to take effect later, allowing time for negotiations. If these new measures go through, tariffs could reach 15 to 20 percent, significantly higher than at the beginning of the year, though far below the 25 to 30 percent levels that appeared possible back in April. It’s a good reminder that U.S. trade policy remains a moving target because the U.S. administration is still focused on reducing goods trade deficits and may not yet perceive there to be substantial political and economic risk of tariff escalation. Per our economists’ recent work on the lagged effects of tariffs, this reckoning could be months away. Second, the implications of this tactical escalation are consistent with our current cross-asset views. The higher tariffs announced on a variety of geographies, and products like copper, put further pressure on the U.S. growth story, even if they don’t tip the U.S. into recession, per the work done by our economists. That growth pressure is consistent with our views that both government and corporate bond yields will move lower, driving solid returns. It's also insufficient pressure to get in the way of an equity market rally, in the view of our U.S. equity strategy team. The fiscal package that just passed Congress might not be a major boon to the economy overall, but it does help margins for large cap companies, who by the way are more exposed to tariffs through China, Canada, Mexico, and the EU – rather than the countries on whom tariff increases were announced this week. Finally, How could we be wrong? Well, pay attention to negotiations with those geographies we just mentioned: Mexico, Canada, Europe, and China. These are much bigger trading partners not just for U.S. companies, but the U.S. overall.  So meaningful escalation here can drive both top line and bottom line effects that could challenge equities and credit.  In our view, tariffs with these partners are likely to land near current levels, but the path to get there could be volatile.  For the U.S., Mexico and Canada, background reporting suggests there’s mutual interest in maintaining a low tariff bloc, including exceptions for the product-specific tariffs that the U.S. is imposing. But there are sticking points around harmonizing trade policy. The dynamic is similar with China. Tariffs are already steep—among the highest anywhere. While a recent narrow deal—around semiconductors for rare earths—led to a temporary reduction from triple-digit levels, the two sides remain far apart on fundamental issues.  So when it comes to negotiations with the U.S.’ biggest trading partners, there’s sticking points. And where there’s sticking points there’s potential for escalation that we’ll need to be vigilant in monitoring. Thanks for listening. If you enjoy Thoughts on the Market please leave us a review. And tell your friends about the podcast. We want everyone to listen.

Our Chief Cross-Asset Strategist Serena Tang discusses whether demand for U.S. stocks has fallen and where fund flows are surging. Read more insights from Morgan Stanley.----- Transcript -----Serena Tang: Welcome to Thoughts on the Market. I’m Serena Tang, Morgan Stanley’s Chief Cross-Asset Strategist.Today – is the demand for U.S. assets declining? Let's look at the recent trends in global investment flows.It’s Wednesday, July 9th at 1pm in New York.The U.S. equity market has reached an all-time high, but at the same time lingering uncertainty about U.S. trade and tariff policies is forcing global investors to consider the riskiness of U.S. assets. And so the big question we need to ask is: are investors – particularly foreign investors – fleeing U.S. assets?This question comes from recent data around fund flows to global equities. And we have to acknowledge that demand for U.S. stocks overall has declined, going by high-frequency data. But at the same time, we think this idea is exaggerated. So why is that? As many listeners know, fund flows – which represent the net movement of money into and out of various investment vehicles like mutual funds and ETFs – are an important gauge of investor sentiment and market trends. So what are fund flows really telling us about investors’ sentiment towards U.S. equities? It would be nice to get an unequivocal answer, but of course, the devil is always in the details. And the problem is that different data sources and frequencies across different market segments don’t always lead to the same conclusions. Weekly data across global equity ETF and mutual funds from Lipper show that international investors were net buyers through most of April and May. But the pace of buying has slowed year-to-date versus 2024. Still, it remains much higher than during the same period in 2021 through 2023. Treasury TIC data point to something similar – a slowdown in foreign demand, but not significant net selling. So where are the flows going, if not to the U.S.? They are going to the rest of the world, but more particularly, Europe. Europe stocks, in fact, have been the biggest beneficiary of decreasing flows to the U.S. Nearly $37 billion U.S. has gone into Europe-focused equity funds year-to-date. This is significantly higher than the run-rates over the prior five years. What’s more notable here is that year-to-date, flows to European-focused ETFs and mutual funds dominated those targeting Japan and Emerging Markets. This suggests that Europe is now the premier destination for equity fund flows, with very little demand spillovers to other regions' equity markets.These shifts have yet to show up in the allocation data, which tracks how global asset managers invest in stocks regionally. Global equity funds' portfolio weights to Rest-of-the-World has gone up by roughly the same amount as allocation to the U.S. has come down. But allocation to the U.S. has actually gone down by roughly the same amount, as its share in global equity indices; which means that If allocation to the U.S. has changed, it's simply because the U.S. is now a smaller part of equity indices. Meanwhile, an estimated U.S.$9 billion from Rest-of-the World went into international equity funds, which excludes U.S. stocks altogether. Granted, it’s not a lot; but scaled for fund assets, it's the highest net flows international equities have seen. In other words, some investors are choosing to invest in equities excluding U.S. altogether. These trends are unlikely to reverse as long as lingering policy uncertainty dampens demand for U.S.-based assets. But as we've argued in our mid-year outlook, there are very few alternative markets to the U.S. dollar markets right now. U.S. stocks might start to see less marginal flows from foreign investors – to the benefit of Rest-of-the-World equities, especially Europe. But demand is unlikely to dry up completely over the next 12 months. Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Arushi Agarwal from the European Sustainability Strategy team and Aerospace & Defense Analyst Ross Law unpack what a reshaped defense industry means for sustainability, ethics and long-term investment strategy.Read more insights from Morgan Stanley.----- Transcript -----Ross Law: Welcome to Thoughts on the Market. I'm Ross Law from Morgan Stanley's European Aerospace and Defense team.Arushi Agarwal: And I'm Arushi Agarwal from the European Sustainability Research Team.Ross Law: Today, a topic that's rapidly defining the boundaries of sustainable investing and technological leadership – the use of AI in defense.It's Tuesday, July 8th at 3pm in London. At the recent NATO summit, member countries decided to boost their core defense spending target from 2 percent to 3.5 percent of GDP. This big jump is sure to spark a wave of innovation in defense, particularly in AI and military technology. It's clear that Europe is focusing on rearmament with AI playing a major role. In fact, AI is revolutionizing everything from unmanned systems and cyber defense to simulation training and precision targeting. It’s changing the game for how nations prepare for – and engage in – conflict. And with all these changes come serious challenges. Investors, policy makers and technologists are facing some tough questions that sit at the intersection of two of Morgan Stanley's four key themes: The Multipolar World and Tech Diffusion.So, Arushi, to set the stage, how is the concept of sustainability evolving to include national security and defense, particularly in Europe?Arushi Agarwal: You know, Ross, it's fascinating to see how much this space has evolved over the past year. Geopolitical tensions have really pushed national security much higher on the sustainability agenda. We're seeing a structural shift in sentiment towards defense investments. While historically defense companies were largely excluded by sustainability funds, we're now seeing asset managers revisiting these exclusions, especially around conventional and nuclear weapons. Some are even launching thematic funds, specifically focused on security and resilience.However, in the absence of standard methodologies to assess weapon related exposures, evaluate sector-specific ESG risks and determine transparency, there is no clear consensus on what sustainability focused managers can hold. Greater policy focus has created the need to identify a long-term approach to investing in this sector, one that is cognizant of ethical issues. Investors are now increasingly asking whether rapid technological integration might allow for a more forward-looking, risk aware approach to investing in national security.Ross Law: So, it's no news that Europe has historically underspent on defense. Now, the spending goal is moving to 3.5 percent of GDP to try and catch up. Our estimates suggest this could mean an additional $200 billion per year in additional spend – with a focus on equipment over personnel, at least for the time being. With this new focus, how is AI shaping the European rearmament strategy?Arushi Agarwal: Well, AI appears to be at the core of EU’s 800 billion euro rearmament plan. The commission has been quite clear that escalating tensions have not only led to a new arms race but also provoked a global technological race. Now to think about it, AI, quantum, biotech, robotics, and hypersonic are key inputs not only for long-term economic growth, but also for military pre-eminence.In our base case, we estimate that total NATO military spend into AI applications will potentially more than double to $112 billion by 2030. This is at a 4 percent AI investment allocation rate. If this allocation rate increases to 10 percent as anticipated by European deep tech firms, then NATOs AI military spend could grow sixfold to $306 billion by 2030 in our bull case.So, Ross, you were at the Paris Air Show recently where companies demonstrated their latest product capabilities. Which AI applications are leading the way in defense right now? Ross Law: Yeah, it was really quite eye-opening. We've identified nine key AI applications, reshaping defense, and our Application Readiness Radar shows that Cybersecurity followed by Unmanned Systems exhibit the highest level of preparedness from a public and private investment perspective.Cybersecurity is a major priority due to increased proliferation of cyber attacks and disinformation campaigns, and this technology can be used for both defensive and offensive measures. Unmanned systems are also really taking off, no pun intended, mainly driven by the rise in drone warfare that's reshaping the battlefield in Ukraine.At the Paris Airshow, we saw demonstrations of “Wingman” crewed and uncrewed aircraft. There have also been several public and private partnerships in this area within our coverage. Another area gaining traction is simulation and war gaming. As defense spending increases and potentially leads to more military personnel, we see this theme in high demand in the coming years.Arushi Agarwal: And how are European Aerospace and Defense companies positioning themselves in terms of AI readiness?Ross Law: Well, they're really making significant advancements. We've assessed AI technology readiness for our A&D companies across six different verticals: the number of applications; dual-use capabilities; AI pricing power; responsible AI policy; and partnerships on both external and internal product categories.What's really interesting is that European A&D companies have higher pricing power relative to the U.S. counterparts, and a higher percentage are both enablers and adopters of AI. To accelerate AI integration, these companies are increasingly partnering with government research arms, leading software firms, as well as peers and private players.Arushi Agarwal: And some of these same technologies can also be used for civilian purposes. Could you share some examples with us?Ross Law: The dual use potential is really significant. Various companies in our coverage are using their AI capabilities for civilian applications across multiple domains. For example, geospatial capabilities can also be used for wildfire management and tracking deforestation. Machine learning can be used for maritime shipping and port surveillance. But switching gears slightly, if we talk about the regulatory developments that are emerging in Europe to address defense modernization, what does this mean, Arushi, for society, the industry and investors?Arushi Agarwal: There's quite a lot happening on the regulatory front. The European Commission is working on a defense omnibus simplification proposal aimed at speeding up defense investments in the EU. It's planning to publish a guidance notice on how defense investment will fit within the sustainable finance framework. It’s also making changes to its sustainability reporting directive. If warranted, the commission will make additional adjustments to reflect the needs of the defense industry in its sustainability reporting obligations. The Sustainable Fund Reform is another important development. While the sustainability fund regulation doesn't prohibit investment into the defense sector, the commission is seeking to provide clarification on how defense investment goals sit within a sustainability framework.Additionally at the European Security Summit in June, the European Defense Commissioner indicated that a roadmap focusing on the modernization of European defense will be published in autumn. This will have a special focus on AI and quantum technologies. For investors, whilst exclusions easing has started to take place, pickup in individual positioning has been slow. As investors ramp up on the sector, we believe these regulatory developments can serve as catalysts, providing clear demand and trend signals for the sector.Ross Law: So finally, in this context, how can companies and investors navigate these ethical considerations responsibly?Arushi Agarwal: So, in the note we highlight that AI risk management requires the ability to tackle two types of challenges. First, technical challenges, which can be mitigated by embedding boundaries and success criteria directly into the design of the AI model. For example, training AI systems to refuse harmful requests. Second challenges are more open-ended and ambiguous set of challenges that relate to coordinating non-proliferation among countries and preventing misuse by bad actors. This set of challenges requires continuous interstate dialogue and cooperation rather than purely technical fixes.From an investor perspective, closer corporate engagement will be key to navigating these debates. Ensuring firms have clear documentation of their algorithms and decision-making processes, human in the loop systems, transparency around data sets used to train the AI models are some of the engagement points we mention in our note.Ultimately, I think the key is balance. On the one hand, we have to recognize the legitimate security needs that defense technologies address. And on the other hand, there's the need to ensure appropriate safeguards and oversight.Ross Law: Arushi, thanks for taking the time to talk.Arushi Agarwal: It was great speaking with you, Ross,Ross Law: And thank you all for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.