Regime Shift: The End of Free Money

Global Multi-Asset Viewpoint

When the Fed raises the price of money from zero, it changes everything. For the past 10 years, money has essentially been free. In certain countries, they were actually giving it away (and still are). In the U.S., the Treasury borrowed short term at around 0.05% for most of the past decade. Highly-rated corporates and speculators funding levered investments borrowed at a LIBOR rate of 0.25%. Households were never able to borrow as cheaply, but some floating-rate mortgages fell as low as 2.5%, the lowest rate ever.1

What happens when money is free? Everyone (households, businesses, governments, speculators) lines up to borrow some. In this cycle, it has been mostly businesses, governments and speculators, as households were too recently burned by their housing borrowing binge of the early 2000’s to want to re-lever. When money is free, debt rises sharply because interest payments are so low, no one has trouble servicing it (Display 1). In addition, the price of assets rises: when funding is near zero, any asset yielding anything looks tremendously attractive.

Real estate, with rental yields at record lows of 4.0%, looked very attractive; utility stocks, with a dividend yield of 3.7%, also attractive; junk debt, at 6.4%, staggeringly attractive; start-ups with big payoffs in 10 years, never looked better on a present value basis; LBO deals at 11x EV/ EBITDA, what’s not to like? Money is so cheap they’re practically begging you to borrow.2

Unfortunately, this fairy tale environment has come to an end. The end of free money has arrived. We are entering a new regime for the economy and for markets. The consensus appears to believe that there are no excesses in the economy, and therefore that a recession will not happen for at least two years and, importantly, since we cannot have a bear market without a recession, stocks must be owned and the dips bought. We disagree. With the end of free money, we believe:

1) Rising rates will expose the cost of carrying excessive debt—earnings will disappoint and defaults will rise more than expected;
2) The higher cost of debt will slow the economy—even though it appears nothing can stop growth today because of the global synchronized economic boom, the U.S. tax cut and fiscal spending ramp; and
3) Risky assets will re-price lower— not because of a 2020 recession, which is somewhat too far out—but because the rising price of money means all assets are less attractive (all else equal).

Below we expand on the impact of higher debt servicing costs on the corporate sector (via EPS and defaults), the economy, and asset prices.

Rising Debt Servicing Costs: Impact on EPS and Defaults
Our analysis indicates that U.S. corporate debt has shot up 50% from its cycle low nearly 10 years ago and now stands at $9 trillion. This represents a leverage ratio of 5.6x (i.e. debt is 5.6x EBIT), at levels last seen in 2007 just before the Financial Crisis. On the other hand, with record low borrowing costs, servicing record debt has been manageable for U.S. corporates. Interest expense has remained relatively low at 19% of EBIT. This is not as low as at the prior cycle bests of 15-17% in 1995, 2005 and 2015, but is much better than stressed periods such as 2001 and 2009 when interest expense rose to 30-45% of EBIT.3 However, our work shows that every 100 bps of rate hikes will increase interest expense as a share of EBIT by 200 basis points (i.e. from 19% to 21%) such that by the end of 2019, interest expense will rise to 22% of EBIT – the same level reached before the 2008-09 recession.4 (Display 2) The increase in interest expense is driven by the fact that over 30% of corporate debt is linked to short term rates and about a fifth of fixed rate debt will roll over at higher rates each year.5 Ability to pay is one of the key drivers of default rates and interest expense rising to 22% of EBIT points to U.S. high yield default rates rising from the current 3.5% to 4.2%. A 4.2% default rate implies high yield spreads of 490 basis points (up from the current 360 basis points).6

This outcome could be worse given that investment grade debt is of the lowest quality since 1990, with almost half of investment grade borrowers rated BBB, two notches above junk. In addition, by 2020, EBIT is likely to fall while debt will likely still be rising and unless the Fed actually cuts rates quickly enough, interest expense could rise to 27% of EBIT, which could drive the default rate above 6% and spreads above 800 basis points.7

Simultaneously, these rate hikes and interest expense increases would hit margins and earnings, which does not appear to be in consensus estimates. Our work points to a 3% hit to S&P 500 EPS in 2018 and 2019, from higher interest expense. This represents a roughly 35 basis point annual hit to margins in 2018 and 2019.8 And yet, the consensus forecasts margins to increase by 25 basis points in 2019 compared to 2018.9 This alone could cause EPS to grow at only 5-7%, rather than the 10% currently expected by the consensus for 2019. Some disappointment is also possible for 2018 EPS but will likely be swamped by the enormous boost from the tax cuts, strong global growth and the weaker dollar.

Net-net, 2018 and 2019 rate hikes will increase interest expense and corporate defaults and cause corporate spreads to widen and margins and EPS to miss expectations.

Rising Debt Servicing Costs: Impact on Economy
Given the apparent on-going global synchronized growth boom and U.S. fiscal stimulus, it is no wonder that economists and market participants hold a very positive view on U.S. growth in 2018. We share that view. The consensus expects U.S. growth of 2.8% this year and our forecast is 2.9%. However, it is striking that the consensus expects growth to remain exceptionally strong in 2019 and 2020, at 2.4% and 2.1%, respectively. These forecasts mean the economy would grow 0.9% and 0.6% above its potential growth rate of 1.5% in the 10th and 11th year of an economic expansion. In our opinion, this is extremely unlikely, as it implies that the Fed’s hiking cycle of 200 basis points by 2018-end and 275 basis points by 2019-end will have had a near-zero impact on economic activity. Remember it took zero rates over the last 8 years to get the economy to grow at a 2.2% pace.

On the contrary, we expect growth to moderate significantly in 2019 and in 2020, as the Fed’s actions are already beginning to bite and will continue to do so over the next two years.

Conceptually, we believe one of the better ways of describing the degree of policy tightness is to compare the real fed funds rate to the Fed’s estimated neutral rate.10 For nearly 10 years, real policy rates were 100-200 basis points below the neutral rate. Today, because of 150 basis points of tightening from the Fed, policy is now neutral (which is clearly a function of the very low real neutral rate or r* – we use the Laubach-Williams estimate of r* which is currently 0%). Historically, going from very easy to neutral policy has been sufficient to cap growth and drive it back towards trend. And 100-130 basis points of “tightness” (i.e. rates above neutral by 100-130 basis points), which is where we will be by end-2019, has historically been sufficient to drive the economy into recession.

More practically, higher policy rates act to restrain growth through multiple channels and are visibly doing so already:

• Housing investment: The expectations of higher policy rates has caused a doubling in 10 year yields in the past two years, which has driven mortgage rates to the highest levels in nearly four years.11 As a result, housing activity has slowed, with home sales flat for the past year. We expect housing investment to go from contributing roughly 15 basis points to growth over the past two years to detracting just over 5 basis points over the next two years.12
• Consumer spending, though in large part a function of disposable income, is also affected by higher interest rates, which impact auto loans, credit card debt and home equity loans. So far those interest rates have only risen 80-135 basis points from their lows. We would expect another 150 basis points of rate increases over the next two years.13 Based on historical behavior, every 100 basis points of rate hikes likely detracts 30 basis points from consumer spending.
• Corporate activity is also impacted by higher policy rates through a variety of channels. Capital spending and investment tends to be negatively impacted initially, via the reduction in profits that comes from higher interest expense, and then, via the lower sales and profits that come from falling housing investment and consumer spending, described above. This has yet to occur, but higher interest expense will likely increasingly impact corporates in 2019. Importantly, higher policy rates also lead to reduced bank lending to corporates. Historically, corporate lending standards stop easing a couple of quarters after rates begin to normalize, and then begin to tighten 6-8 quarters after policy rates reach neutral. Again, we have not yet seen this but expect that the Senior Loan Officer Survey, when released for the first quarter of 2018, should indicate a reduction in easing of credit standards, which would portend a tightening of standards in 2019 (based on the historical 6-8 quarter lag). So capital spending by corporates, which is always partially funded by internal cash flows but also by debt, should stay strong this year but will begin to reflect less easy credit standards by 2019.

Rising Debt Servicing Costs: Impact on Asset Prices
It is well understood that the Fed did create conditions for a borrowing binge, hoping to stimulate economic activity. Indeed, one of the stated objectives of free money was to encourage increases in asset prices in order to generate a wealth effect, so that households would increase spending. In that sense, free money succeeded beyond expectations. As we have previously shown, all assets benefited from massive inflows as households, businesses and speculators flowed cash and reallocated to all other asset classes. As a result, most asset classes are sitting today at record or near- record valuations (see Display 3). At no other time in history have so many asset classes been simultaneously overvalued: a bubble in everything, as The Economist magazine cover recently proclaimed. When you are getting “robbed” at the bank getting 0% return on your savings, long term bonds yielding 1.5-2% look appealing, as do corporate bonds yielding 2-3%, junk bonds yielding 6%, stocks yielding 2-4%, and so on. As mentioned earlier, when you can borrow at near zero (and expect to for a long time), paying up for businesses, as private equity firms have been doing at a record pace, or seeding venture deals for companies that are years away from positive cash flows, makes sense.

However, the world has changed. Money and Residential Housing1 is no longer free: cash is now yielding nearly 2% (a 6-month Treasury bill yields 1.91% and a 12 month one 2.08%).14 That has already driven 10-year yields back up to nearly 3%, though investment grade bonds still only yield 3.8% and stocks still only yield 2%.15 But as inflation approaches 2%, a bit earlier than the Fed expects, cash rates are likely to keep climbing and will likely approach 3% in 12 months.16 Since a bond has both duration and credit risk, it will need to yield more when cash pays 3%, than when cash pays zero, given that cash has no duration or credit risk.

Similarly, large cap equities, which currently pay 2% dividends, clearly look a lot less attractive when cash is 3% than when it pays 0% – particularly as it is very unlikely that the dividend growth will suddenly accelerate to make up for the lack of a dividend yield premium over cash. (Display 4)

For this reason, we are of the view that a reset in asset price valuations is likely to occur as the Fed continues on its tightening path. And importantly, this valuation reset will not necessarily come in anticipation of a recession in economic activity and earnings, as a recession might still be 18-24 months into the future. It will occur because the opportunity cost of investing in longer duration assets has gone from zero to 3%.

In a way, the risk premium has gone from an infinite multiple of cash returns to barely 1-2x cash returns – in many cases that is not sufficient given the massive risk differential between long duration or illiquid assets and cash. This applies to speculators as well, who could earn carry while speculating, on a leveraged basis, on the capital appreciation of many long duration assets: getting paid to wait – does it get better than that?! Now the carry for many such levered speculations has been eliminated: it has become a pure bet on capital appreciation. There is likely to be less capital willing to take these types of bets until a valuation reset restores carry to a level sufficient to justify the risk. Individual investors have shown this willingness to borrow to invest, by taking more margin debt than any time in history. The negative carry will soon make it less attractive to hold long equity positions and give them less tolerance for short- term downside.

In our view then, the end of free money as the Fed raises rates to 2% and beyond is a regime shift that the markets do not appear to have discounted yet. The tailwinds of easy money are turning into headwinds as the cost of servicing record corporate debt hits corporate profits and forces weaker, highly levered companies into default. In addition, higher borrowing costs are already impacting economic activity in housing and will likely impact consumers and corporates, particularly after the boost from the tax cut and fiscal spending passes. Ultimately, economic growth is likely to slow more and earlier (2019 rather than 2020-21) than the consensus believes. Lastly, even though everyone seems to believe that “if the recession is not around the corner, you gotta own stocks,” the surprise may very well be that asset valuations reset well in advance of a 2020 recession as the price of money climbs back to more normal levels.

The scenario we lay out will likely unfold over the coming quarters. As a result, we believe the defensive stance we have favored year to date continues to be warranted in the U.S. (and China), with better value in eurozone and Japanese equities and local rates in emerging markets. Against this cautious backdrop, we do expect a stabilization both in U.S. growth expectations as the stimulus kicks in for the second quarter, and in trade war fears as the war of words turns to negotiations. This may temporarily stabilize sentiment in equity markets until the theme of The End of Free Money reasserts itself, as inflation and Fed rate expectations both continue to climb.


By Morgan Stanley Investment Management
Cyril Moullé-Berteaux, Portfolio Manager, Head of Global Multi-Asset Team Managing Director
Sergei Parmenov, Portfolio Manager Global Multi-Asset Team Managing Director

DISCLOSURES
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. In general, equity securities’ values fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest- rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer- term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities (MBS and ABS) are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Portfolio, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the United States. It is possible that these issuers will not have the funds to meet their payment obligations in the future. The issuer or governmental authority that controls the repayment of sovereign debt may not be willing or able to repay the principal and/ or pay interest when due in accordance with the terms of such obligations. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Real estate investment trusts are subject to risks similar to those associated with the direct ownership of real estate and they are sensitive to such factors as management skills and changes in tax laws. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the Portfolio’s performance. Trading in, and investment exposure to, the commodities markets may involve substantial risks and subject the Portfolio to greater volatility. Nondiversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses. Subsidiary and Tax Risk The Portfolio may seek to gain exposure to the commodity markets through investments in the Subsidiary or commodity index-linked structured notes. The Subsidiary is not registered under the 1940 Act and is not subject to all the investor protections of the 1940 Act. Historically, the Internal Revenue Service (“IRS”) has issued private letter rulings in which the IRS specifically concluded that income and gains from investments in commodity index-linked structured notes or a wholly-owned foreign subsidiary that invests in commodity- linked instruments are “qualifying income” for purposes of compliance with Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). The Portfolio has not received such a private letter ruling, and is not able to rely on private letter rulings issued to other taxpayers. If the Portfolio failed to qualify as a regulated investment company, it would be subject to federal and state income tax on all of its taxable income at regular corporate tax rates with no deduction for any distributions paid to shareholders, which would significantly adversely affect the returns to, and could cause substantial losses for, Portfolio shareholders.
FOOTNOTES
1Source: Bloomberg; Bankrate.com
2Source: Bloomberg; Datastream; Haver Analytics.
3Source: U.S. National Income and Product Accounts (NIPA), Nonfinancial Corporate Business net Interest Coverage Ratio.
4Source: Global Multi-Asset Team Estimates; U.S. National Income and Product Accounts (NIPA).
5Source: Global Multi-Asset Team Estimates.
6Moody’s 12 month trailing default rate.
7Source: Moody’s.
8Source: Global Multi-Asset Team Estimates; Factset.
9ibid.
10Source: Laubach-Williams model described in “Measuring the Natural rate of Interest,” by Thomas Laubach and John C. Williams, published in the Review of Economics and Statistics, November 2003.
11Source: Global Multi-Asset Team Analysis; Bloomberg.
12Source: Global Multi-Asset Team Estimates; Historical data from U.S. Bureau of Economic Analysis.
13Source: Global Multi-Asset Team Estimates; based on 150 basis points of Fed rate hikes. 14Source: Global Multi-Asset Team Analysis; Bloomberg.
15ibid.
16Source: Global Multi-Asset Team Estimates.
DEFINITIONS
The S&P GSCI Total Return Index is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities.
IMPORTANT DISCLOSURES
The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers. Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product. Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness. This material is a general communication, which is not impartial and all information provided has been prepared solely for information purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results. This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto. There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.
DISTRIBUTION
This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations. United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA, authorised and regulated by the Financial Conduct Authority. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich Branch Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0) 44 588 1074. Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.
U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2. Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley. com/im or call 1-800-548-7786. Please read the prospectus carefully before investing. Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.
NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT
IMPORTANT INFORMATION
EMEA: This communication has been issued by Morgan Stanley Investment Management Limited (“MSIM”). Authorised and regulated by the Financial Conduct Authority. Registered in England No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA. The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the applicable European or Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research. MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.
This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.
Explore our site at www.morganstanley.com/im
© 2018 Morgan Stanley. All rights reserved. CRC 2087011
Exp. 4/15/2019 9216181_CH_0418 Lit-Link: GMAVIEWPOINT 03/18