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- [00:01]
A
2025 started with an expectation of slower economic growth and stubborn inflation. While growth did cool, the real surprise was the disconnect between the economy and financial markets. Unemployment ran higher than projected, yet markets showed resilience powered largely by an AI driven capital spending boom. Looking ahead to 2026, the backdrop is brighter. Global growth should accelerate modestly, inflation should ease in the second half of the year, and real incomes look poised to improve. We expect the US to lead the charge and remain most constructive on the US market. Thank you for listening throughout 2025 as we've navigated these issues and events that shape financial markets and society. We hope that you'll join us next year as we continue to bring you the most up to date information on the financial world this week. Please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January from all of us at Thoughts in the Market, Happy holidays and a very happy new Year.
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B
Welcome to Thoughts in the Market. I'm Michael Zesas, Global Head of Fixed Income Research and Public Policy Strategy.
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C
And I'm Serena Tang, Morgan Stanley's Chief Global Cross Asset Strategist.
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B
Today we'll be talking about key investor debates coming out of our Year Ahead outlook. It's Wednesday, December 3rd at 10:30am in New York. So Serena, it was a couple weeks ago that you led the publication of our Cross Asset Outlook for 2026. You've been engaging with clients over the past few weeks about our views where they differ, and it seems there's some common themes, really common questions that come up that represent some important debates within the market. Is that fair?
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C
Yeah, that's very fair. And by the way, I think those important debates are are from investors globally. So you have investors in Europe, Asia, Australia, North America all kind of wanting to understand our views on AI, on equity valuations on the dollar.
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B
So let's start with talking about equity markets a bit. And one of the common questions, and I get it too, even though I don't cover equity markets, is really about how AI is affecting valuations. And one of the concerns is that the stock market might be too high, might be overvalued because people have overinvested in anything related to AI. What does the evidence say? How are you addressing that question?
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C
It's interesting you say that because I think when investors talk about equities being too high of valuations, AI related valuations being very stretched, it's very much about sort of parallels to that 1990s valuation bubble. But the way I Approach, it is like there are some very important differences from that time period from valuations back then. First of all, the companies in major equity indices are higher quality than the past. They operate more efficiently, they deliver strong profitability, and in general, pretty solid free cash flow. I think we also need to consider how technology now represents a larger share of the index, which has helped push overall net margins to about sort of 14% compared to 8% during that 1990s valuation bubble. And you know, when margins are higher, I think like paying premium for stocks is more justified. In other words, I think multiples in the US right now look more reasonable after adjusting for profit margins and changes in index composition. But we also have to consider, and this is something that we stress in our outlook, the policy backdrop is unusually favorable.
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A
Right.
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C
Like you have economists expecting the Fed to continue easing rates into next year. We have the one big beautiful bill act that could lower corporate taxes and deregulation is continue to be a priority in the US And I think this combination, you know, monetary easing, fiscal stimulus, deregulation, and that combination rarely occurs outside of a recession. And I think this creates an environment that supports valuation, which is, by the way, like why we recommend an overweight position in US equities, even if absolute and relative valuation look elevated.
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B
Got it. So if I'm hearing you right, what I think you're saying is that comparisons to some bubbles of the past don't necessarily stack up because profitability is better. There aren't excesses in the system, monetary policy might be on the path that's more accommodative. And so when compared against all of that, the valuations actually don't look that bad.
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C
Exactly.
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B
Got it. And sticking with the equity markets, then another common question is it's related to AI, but it's around this idea that a small set of companies have really been driving most of the growth in the market recently. And it would be better or healthier if the equity market were to perform across a wider set of companies and names, particularly in mid and small cap companies. Is that something that we see on the horizon?
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C
Yes, we are expecting US Stock earnings to broaden out here. And it's one of the reasons why U.S. equity strategy team has upgraded small caps and now prefer it over large caps. And I think all of this comes from the fact that we are in a new bull market. I think we have a very early cycle earnings recovery here. I mean, as discussed before, the macro environment is supportive. And like Fed rate cuts over the next 12 months, growth positive tax and regulatory Policies that don't just support valuations, they also act as a tailwind to earnings. And I think on top of that, leaner cost structures, improving earnings revisions, AI driven efficiency gains, they all support a broad based earnings upturn. And our US equity strategy team do see above consensus 2026 earnings growth at sort of 17%. The only other region where we have earnings growth above consensus in 2026 is Japan. For both Europe and EM, we are below which drive out equal weight and slight underweight position in those two indices respectively.
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B
Got it. And so since we can't seem to get away from talking about AI and how it's influencing markets, the other common question we get here is around debt issuance related to AI. So our colleagues put together a report from earlier this year talking about the potential for nearly $3 trillion of AI related CapEx spending over the next few years. And we think about half of that is going to have to be debt financed. That seems to be a lot of debt, a lot of potential bonds that might be issued into the market. Are credit investors supposed to be concerned about that?
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C
We really can't get away from AI as a topic and I think this will continue because AI related capex is a long term trend with much of the capex still really ahead. And I think this goes to your question because this really means that we expect nearly another 3 trillion of data center related CapEx from here to 2028. You know, while half of the spend will come from operating cash flows of hyperscalers, it still leaves a financing gap of around one and a half trillion which needs to be sourced through various credit channels. Now part of it will be via private credit, part of it would be via asset backed securities, part of but some of it would also be via the US investment grade corporate credit bond space through add in financing for a faster M and a cycle. We forecast around 1 trillion in net investment grade bond issuance, you know, up 60% from this year. And I think given this technical backdrop, even though credit fundamentals should stay fine, we have double downgraded US investment grade corporate credit to underweight within our cross asset allocation.
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B
Got it. So the fundamentals are fine, but it's just a lot of debt to consume over the next year. And so somewhat strangely you might expect high yield corporate bonds to actually do better.
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C
Yes, because I think high yield doesn't really see the same headwind from the technical side of things. And on the fundamentals front our credit team actually has default rates coming down over the next 12 months which again I think supports high yield much better than investment grade.
- [09:00]
B
So before we wrap up moving away from the equity markets, let's talk about foreign exchange. The US dollar spent much of last year weakening, and that's a call that our team was early to eventually became a consensus call. It was premised on the idea that the US was going to experience growth weakness, that there would also be these questions among investors about the role of the dollar in the world as the US was raising trade barriers. It seemed to work out pretty well going into 2026 though I think there's some more questions amongst our investors about whether or not that trend could continue. Where do we land?
- [09:40]
C
I think in the first half of next year that downward pressure on the dollar should still persist. And as you said, we've had a very differentiated view for most of this year. Expecting the dollar to weaken in the first half versus G10 currencies and several things drive this. There is a pot higher dollar negative risk premium driven by I think like near term worries about the US labor markets in the short term and as investors I think debate the likely composition of the FOMC next year. Also, you know, compression in US versus rest of the world rate differentials should reduce FX hedging costs, which also adds incentive for hedging activity and dollar selling. All of this means that we see downward pressure on the dollar persisting in the first half of euro dollar at 123 and dollar JPY at 140 by the end of first half 2026.
- [10:41]
B
All right, well that's a pretty good survey about what clients care about and what our view is. So Serena, thanks for taking the time to talk with me today and thank.
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C
You for inviting me to the show.
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B
Today and to our audience. Thanks for listening. If you enjoy thoughts on the market, please leave us a review and share the podcast. We want everyone to listen.
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C
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