Breaking Down the Fed’s New Course

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today – could interest rate cuts by the Fed unleash more corporate aggressiveness?

It's Wednesday, August 27th at 2pm in London.

Last week, the Fed chair, Jerome Powell hinted strongly that the Central Bank was set to cut interest rates at next month's meeting. While this outcome was the market's expectation, it was by no means a given.

The Fed is tasked with keeping unemployment and inflation low. The US unemployment rate is low, but inflation is not only above the Fed's target, it's recently been trending in the wrong direction. And to bring inflation down the Fed would typically raise interest rates, not lower them.

But that is not what the Fed appears likely to do; based importantly on a belief that these inflationary pressures are more temporary, while the job market may soon weaken. It is a tricky, unusual position for the Fed to be in, made even more unusual by what is going on around them.

You see, the Fed tries to keep the economy in balance; neither too hot or too cold. And in this regard, its interest rate acts a bit like taps on a faucet. But there are other things besides this rate that also affect the temperature of the economic water. How easy is it to borrow money? Is the currency stronger or weaker? Are energy prices high or low? Is the equity market rising or falling? Collectively these measures are often referred to as financial conditions.

And so, while it is unusual for the Federal Reserve to be lowering interest rates while inflation is above its target and moving higher, it's probably even more unusual for them to do so while these other governors of economic activity, these financial conditions are so accommodative. Equity valuations are high. Credit spreads are tight. Energy prices are low. The US dollar is weak. Bond yields have been going down, and the US government is running a large deficit. These are all dynamics that tend to heat the economy up. They are more hot water in our proverbial sink.

Lowering interest rates could now raise that temperature further.

For credit, this is mildly concerning, for two rather specific reasons. Credit is currently sitting with an outstanding year. And part of this good year has been because companies have generally been quite conservative, with merger activity modest and companies borrowing less than the governments against which they are commonly measured. All this moderation is a great thing for credit.

But the backdrop I just described would appear to offer less moderation. If the Fed is going to add more accommodation into an already easy set of financial conditions, how long will companies really be able to resist the temptation to let the good times roll? Recently merger activity has started to pick up. And historically, this higher level of corporate aggressiveness can be good for shareholders. But it's often more challenging to lenders.

But it's also possible that the Fed's caution is correct. That the US job market really is set to weaken further despite all of these other supportive tailwinds. And if this is the case, well, that also looks like less moderation. When the Fed has been cutting interest rates as the labor market weakens, these have often been some of the most challenging periods for credit, given the risk to the overall economy.

So much now rests on the data what the Fed does and how even new Fed leadership next year could tip the balance. But after significant outperformance and with signs pointing to less moderation ahead, credit may now be set to lag its fixed income peers.

Thank you as always for listening. 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.

Adam Jonas: Welcome to Thoughts on the Market. I'm Adam Jonas, Morgan Stanley's Embodied AI and Humanoid Robotics Analyst.

Alex Straton: And I'm Alex Straton, Morgan Stanley's U.S. Softlines Retail and Brands Analyst.

Adam Jonas: Today we're unpacking our annual summer intern survey, a snapshot of how emerging professionals view fashion retail, brands, and mobility – amid all the AI advances.

It is Tuesday, August 26th at 9am in New York.

They may not manage billions of dollars yet, but Morgan Stanley's summer interns certainly shape sentiment on the street, including Wall Street. From sock heights to sneaker trends, Gen Z has thoughts. So, for the seventh year, we ran a survey of our summer interns in the U.S. and Europe. The survey involved more than 500 interns based in the U.S., and about 150 based in Europe.

So, Alex, let’s start with what these interns think about fashion and athletic footwear. What was your biggest takeaway  from the intern survey?

Alex Straton: So, across the three categories we track in the survey – that's apparel, athletic footwear, and handbags – there was one clear theme, and that's market fragmentation.

So, for each category specifically, we observed share of the top three to five brands falling over time.  And what that means is these once dominant brands, as consumer mind share is falling – and it likely makes them lower growth margin and multiple businesses over time. At the same time, you have smaller brands being able to captivate consumer attention more effectively, and they have staying power in a way that they haven't necessarily historically. I think one other piece I would just add;  the rise of e-commerce and social media against a low barrier to entry space like apparel and footwear means it's easier to build a brand than it has been in the past.

And the intern survey shows us this likely continues as this generation is increasingly inclined to shop online. Their social media usage is heavy, and they heavily rely on AI to inform, you know, their purchases.

So, the big takeaway for me here isn't that the big are getting bigger in my space. It's actually that the big are probably getting smaller as new players have easier avenues to exist.

Adam Jonas:  Net apparel spending intentions rose versus the last survey, despite some concern around deteriorating demand for this category into the back half. What do you make of that result?

Alex Straton: I think there were a bit conflicting takes from the survey when I look at all the answers together. So yes, apparel spending intentions are higher year-over-year, but at the same time, clothing and footwear also ranked as the second most category that interns would pull back on should prices go up.

So let me break this down. On the higher spending intentions, I think timing played a huge role and a huge factor in the results. So, we ran this in July when spending in our space clearly accelerated. That to me was a function of better weather, pent up demand from earlier in the quarter, a potential tariff pull forward as headlines were intensifying, and then also typical back to school spending.

So, in short, I think intention data is always very heavily tethered to the moment that it's collected and think that these factors mean, you know, it would've been better no matter what we've seen it in our space.

I think on the second piece, which is interns pulling back spend should prices go up. That to me speaks to the high elasticity in this category, some of the highest in all of consumer discretionary. And that's one of the few drivers informing our cautious demand view on this space as we head into the back half.

So, in summary on that piece, we think prices going higher will become more apparent this month onwards, which in tandem with high inventory and a competitive setup means sales could falter in the group. So, we still maintain this cautious demand view as we head into the back half, though our interns were pretty rosy in the survey.

Adam Jonas: Interesting. So, interns continue to invest in tech ecosystems with more than 90 percent owning multiple devices. What does this interconnectedness mean for companies in your space?

Alex Straton:  This somewhat connects to the fragmentation theme I mentioned where I think digital shopping has somewhat functioned as a great equalizer in the space and big picture. I interpret device reliance as a leading indicator that this market diversification likely continues as brands fight to capture mobile mind share.

The second read I'd have on this development is that it means brands must evolve to have an omnichannel presence. So that's both in store and online, and preferably one that's experiential focus such that this generation can create content around it. That's really the holy grail.

And then maybe lastly, the third takeaway on this is that it's going to come at a cost. You, you can't keep eyeballs without spend. And historical brick and mortar retailers spend maybe 5 to 10 percent of sales on marketing, with digital requiring more than physical.

So now I think what's interesting is that brands in my space with momentum seem to have to spend more than 10 percent of sales on marketing just to maintain popularity. So that's a cost pressure. We're not sure where these businesses will necessarily recoup if all of them end up getting the joke and continuing to invest just to drive mind share. 

Adam, turning to a topic that's been very hot this year in your area of expertise. That's humanoid robots. Interns were optimistic here with more than 60 percent believing they'll have many viable use cases and about the same number thinking they'll replace many human jobs. Yet fewer expect wide scale adoption within five years.

What do you think explains this cautious enthusiasm?

Adam Jonas: Well actually Alex, I think it's pretty smart. There is room to be optimistic. But there's definitely room to be cautious in terms of the scale of adoption, particularly over five years. And we're talking about humanoid robots. We're talking about a new species that's being created, right? This is bigger than just – will it replace our job?

I mean, I don't think it's an exaggeration to ask what does this do to the concept of being human? You know, how does this affect our children and future generations? This is major generational planetary technology  that I think is very much comparable to electricity, the internet. Some people say the wheel, fire, I don't know.

We're going to see it happen and start to propagate over the next few years, where even if we don't have widespread adoption in terms of dealing with it onaverage hour of a day or an average day throughout the planet, you're going to see the technology go from zero to one as these machines learn by watching human behavior. Going from teleoperated instruction to then fully autonomous instruction, as the simulation stack and the compute gets more and more advanced.

We're now seeing some industry leaders say that robots are able to learn by watching  videos.  And so, this is all happening right now, and it's happening at the pace of geopolitical rivalry, Sino-U.S. rivalry and terra cap, you know, big, big corporate competitive rivalry as well, for capital in the human brain.

So, we are entering an unprecedented – maybe precedented in the last century – perhaps unprecedented era of technological and scientific discovery that I think you got to go back to the European and American Enlightenment or the Italian Renaissance to have any real comparisons to what we're about to see.

Alex Straton:  So, keeping with this same theme, interns showed strong interest in household robots with 61 percent expressing some interest and 24 percent saying they're very or extremely interested. I'm going to take you back to your prior coverage here, Adam. Could this translate into demand for AI driven mobility or smart infrastructure?

Adam Jonas: Well, Alex, you were part of my prior coverage once upon a time. We were blessed with having you on our team for a year, and then you left me…

Alex Straton: My golden era.

Adam Jonas: But you came back, you came back. And you've done pretty well.

So, so look, imagine it's 1903, the Wright Brothers just achieved first flight over the sands at Kitty Hawk. And then I were to tell you, ‘Oh yeah, in a few years we're going to have these planes used in World War I. And then in 1914, we'd have the first airline going between Tampa and St. Petersburg.’ You'd say, ‘You're crazy,’ right?

The beauty of the intern survey is it gives the Morgan Stanley research department and our clients an opportunity to engage  that surface area with that arising – not just the business leader – but that arising tech adopter. These are the people, these are the men and women that are going to kind of really adopt this much, much faster. And then, you know, our generation will get dragged into it eventually. So, I think it says; I think 61 percent expressing even some interest. And then 24 [percent], I guess, you know…

The vast majority, three quarters saying, ‘Yeah, this is happening.’ That's a sign I think, to our clients and capital market providers and regulators to say, ‘This won't be stopped. And if we don't do it, someone else will.’

Alex Straton: . So, another topic, Generative AI. It should come as no surprise really, that 95 percent of interns use that tool monthly, far ahead of the general population. How do you see this shaping future expectations for mobility and automation?

Adam Jonas: So, this is what's interesting is people have asked kinda, ‘What's that Gen AI moment,’ if you will, for mobility? Well, it really is Gen AI. Large Language Models and the technologies that develop the Large Language Models and that recursive learning, don't just affect the knowledge economy, right. Or writing or research report generation or intelligence search.

It actually also turns video clips and physical information into tokens that can then create and take what would be a normal suburban city street and beautiful weather with smiling faces or whatever, and turn it into a chaotic scene of, you know, traffic and weather and all sorts of infrastructure issues and potholes.

And that can be done in this digital twin, in an omniverse. A CEO recently told me when you drive a car with advanced, you know, Level 2+ autonomy, like full self-driving, you're not just driving in three-dimensional space. You're also playing a video game training a robot in a digital avatar.

So again, I think that there is quite a lot of overlap between Gen AI and the fact that our interns are so much further down that curve of adoption than the broader public – is probably a hint to us is we got to keep listening to them, when we move into the physical realm of AI too.

Alex Straton: So, no more driving tests for the 16-year-olds of the future.

Adam Jonas: If you want to. Like, I tell my kids, if you want to drive, that's cool. Manual transmission, Italian sports cars, that's great. People still ride horses too. But it's just for the privileged few that can kind of keep these things in stables.

Alex Straton: So, let me turn this into implications for companies here. Gen Z is tech fluent, open to disruption? How should autos and shared mobility providers rethink their engagement strategies with this generation?

Adam Jonas: Well, that's a huge question. And think of the irony here.  As we bring in this world of fake humans and humanoid robots, the scarcest resource is the human brain, right? So, this battle for the human mind is – it’s incredible. And we haven't seen this really since like the Sputnik era or real height of the Cold War. We're seeing it now play out and our clients can read about some of these signing bonuses for these top AI and robotics talent being paid by many companies. It kind of makes, you know, your eyes water, even if you're used to the world of sports and soccer, .  I think we're going to keep seeing more of that for the next few years because we need more brains, we need more stem. I think it's going to do; it has the potential to do a lot for our education system in the United States and in the West broadly.

Alex Straton: So, we've covered a lot around what the next generation is interested in and, and their opinion.  I know we do this every year, so it'll be exciting to see how this evolves over time. And how they adapt. It's been great speaking with you today, Adam.

Adam Jonas: Absolutely. Alex, thanks for your insights.  And to our listeners, stay curious, stay disruptive, and we'll catch you next time. 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.