How Stocks Could React to a Fed Pivot

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Today – what to make of credit spreads as they hit some of their lowest levels in over 20 years? And what could change that?

It's Friday, August 22nd at 2pm in London.

The credit spread is the difference between the higher yield an investor gets for lending to a company relative to the government. This difference in yield is a reflection of perceived differences in risk. And bond investors spend a lot of time thinking, debating, and trading what they think it should be.

It increases as the rating of a company falls and usually increases for bonds with longer maturities relative to shorter ones. The reason one invests in credit is to hopefully pick up some extra yield relative to buying a government bond and do so without taking too much additional risk.

The challenge today is that these spreads are very low – or tight, in market parlance. In the U.S. corporate bonds with Investment Grade ratings only pay about three-quarters of a percent more than U.S. government bonds of the same maturity. It's a similar difference between the yield on companies in Europe and the yield on German debt, the safest benchmark in Europe.

And so, in the U.S. these are the lowest spread levels since 1998, and in Europe, they're the lowest levels since 2007. The relevant question would seem to be, well, what changes this?

One way of thinking about valuations in investing – and spreads are certainly a measure of valuation – is whether levels are so extreme that there's not really any precedent for them being sustained for an extended period of time.   But for credit, this is a tricky argument. Spreads have been lower than their current levels. They were that way in the mid 1990s in the U.S., and they were that way in the mid 2000s in Europe, and they stayed that way for several years. And if we go back even further in time to the 1950s? Well, it looks like U.S. spreads were lower still.

Another way to think about risk premiums – and spreads are also certainly a measure of risk premium – is: does it compensate you for the extra risk? And again, even with spreads quite low, this is tricky.  Only making an extra three-quarters of a percent to invest in corporate bonds feels like a pretty miserly amount to both the casual observer and yours truly, a seasoned credit professional. But when we run the numbers, the extra losses that you've actually experienced for investing in Investment Grade bonds over time relative to governments, it's actually been about half of that. And that holds up over a relatively long period of time.

And so, while spreads are very low by historical standards, extreme valuations don't always correct quickly. They often need another force to impact them. With credit currently benefiting from strong investor demand, good overall yields, and a better borrowing trajectory than governments, we'd be watching two dynamics for this to change.

First weaker growth than we have at the moment would argue strongly that the risk premium and corporate debt needs to be higher. While the levels have varied, credit spreads have always been significantly wider than current levels in a U.S. recession; and that's looking out over a century of data. And so, if the odds of a recession were to go up, credit, we think, would have to take notice.

Second, the fiscal trajectory for governments is currently worse than corporates, which argues for a tighter than normal corporate spread. And the recent U.S. budget bill only further reinforced this by increasing long-term borrowing for the U.S. government, while extending corporate tax cuts to the private sector. But the risk would be that companies start to take these benefits and throw caution to the wind and start to borrow more again – to invest or buy other companies.

We haven't seen this type of animal spirit yet. But history would suggest that if growth holds up, it's usually just a matter of time.

Thank you as always for listening. If you find Thoughts on the Market useful, please let us know by leaving a review wherever you found us. And also tell a friend or colleague about us today.

Adam Jonas: Welcome to Thoughts on the Market. I'm Adam Jonas. I lead Morgan Stanley's Research Department's efforts on embodied AI and humanoid robots.

Tim Hsiao: And I'm c, Greater China Auto Analyst.

Adam Jonas: Today – how the global auto industry is evolving from horsepower to brainpower with the help of AI.

It's Thursday, August 21st at 9am in New York.

Tim Hsiao: And 9pm in Hong Kong.

Adam Jonas: From Detroit to Stuttgart to Shanghai, automakers are making big investments in AI. In fact, AI is the engine behind what we think will be a $200 billion self-driving vehicle market by 2030. Tim, you believe that nearly 30 percent of vehicles sold globally by 2030 will be equipped with Level 2+ smart driving features that can control steering, acceleration, braking, and even some hands-off driving. We expect China to account for 60 percent of these vehicles by 2030.

What's driving this rapid adoption in China and how does it compare to the rest of the world?

Tim Hsiao: China has the largest EV market globally, and the country’s EV sales are not only making up over 50 percent of the new car sales locally in China but also accounting for over 50 percent of our global EV sales. As a result, the market is experiencing intense competition. And the car makers are keen to differentiate with the technological innovation, to which smart driving serve as the most effective means. This together with the AI breakthrough, enables China to aggressively roll out Level 2+ urban navigation on autopilot. In the meantime, Chinese government support and cost competitive supply chains also help.

So, we are looking for China's the adoption of Level 2+ smart driving on passenger vehicle to reach 25 percent by end of this year, and the 60 percent by 2030 versus 6 percent and the 17 percent for the rest of the world during the same period.

Adam Jonas: How is China balancing an aggressive rollout with safety and compliance, especially as it moves towards even greater vehicle automation going forward?

Tim Hsiao: Right.  That's a great and a relevant question because over the years, China has made significant strides in developing a comprehensive regulatory framework for autonomous vehicles. For example, China was already implementing its strategies for innovation and the development of autonomous vehicles in 2022 and had proved several auto OEM to roll out Level 3 pilot programs in 2023.

Although China has been implementing stricter requirements since early this year, for example, banning the terms like autonomous driving in advertisement and requiring stricter testing, we still believe more detailed industry standard and regulatory measures will facilitate development and adoption of Level 2+ Smart driving. And this is important to prevent, you know, the bad money from driving out goods.

Adam Jonas: , One way people might encounter this technology is through robotaxis. Robo taxis are gaining traction in China's major cities, as you've been reporting. What's the outlook for Level 4 adoption and how would this reshape urban mobility?

Tim Hsiao: The size of Level 4+ robotaxi fleet stays small at the moment in China, with less than 1 percent penetration rate. But we've started seeing accelerating roll out of robotaxi operation in major cities since early this year. So, by 2030, we are looking for  Level 4+ robotaxis to account for 8 percent of China's total taxi and ride sharing fleet size by 2030. So, this adoption is facilitated by robust regulatory frameworks, including designated test zones and the clear safety guidance. We believe the proliferation of a Level 4 robotaxi will eventually reshape the urban mobility by meaningfully reducing transportation costs, alleviating traffic congestion through optimized routing and potentially reducing accidents.

So, Adam, that's the outlook for China. But looking at the global trends beyond China, what are the biggest global revenue opportunities in your view? Is that going to be hardware, software, or something else?

Adam Jonas:  We are entering a new scientific era where the AI world, the software world is coming into far greater mental contact, and physical contact, with the hardware world and the physical world of manufacturing. And it's being driven by corporate rivalry amongst not just the terra cap, you know, super large cap companies, but also between public and private companies and competition. And then it's being also fueled by geopolitical rivalry and social issues as well, on a global scale. So, we're actually creating an entirely new species. This robotic species that yes, is expressed in many ways on our roads in China and globally, but it's just the beginning.

In terms of whether it's hardware, software, or something else – it’s all the above. What we've done with a across 40 sectors at Morgan Stanley is to divide the robot, whether it flies, drives, walks, crawls, whatever – we divide it into the brain and the body. And the brain can be divided into sensors and memory and compute and foundational models and simulation. The body can be broken up into actuators, the kind of motor neuron capability, the connective tissue, the batteries. And then there's integrators, that kind of do it all – the hardware, the software, the integration, the training, the data, the compute, the energy, the infrastructure. And so, what's so exciting about this opportunity for our clients is there's no one way to do it. There's no one region to do it.

. So, stick with us folks. There's a lot of – not just revenue opportunities – but alpha generating opportunities as well.

Tim Hsiao: We are seeing OEMs pivot from cars to humanoids and the electric vertical takeoff in the landing vehicles or EVOTL. Our listeners may have seen videos of these vehicles, which are like helicopters and are designed for urban air mobility. How realistic is this transition and what's the timeline for commercialization in your view?

Adam Jonas:  Anything that can be electrified will be electrified. Anything that can be automated will be automated. And the advancement of the state of the art in robotaxis and Level 2, Level 3, Level 4+ autonomy is directly transferrable to aviation.   There's obviously different regulatory and safety aspects of aviation, the air traffic control and the FAA and the equivalent regulatory bodies in Europe and in and in China that we will have to navigate, pun intended. But we will get there. We will get there ultimately because taking these technologies of automation and electronic and software defined technology into the low altitude economy will be a superior experience and a vastly cheaper experience. Point to point, on a per person, per passenger, per ton, per mile basis.

So  the Wright brothers can finally get excited that their invention

from 1903, quite a long time ago  could finally, really change how humans live and move around the surface of the earth, even beyond,  few tens of thousands of commercial and private aircraft that exist today.

Tim Hsiao:  The other key questions or key focus for investors is about the business model. So, until now, the auto industry has centered on the car ownership model. But with this new technology, we've been hearing a new model, as you just mentioned, the sheer mobility and the autonomous driving fleet. Experts say it could be major disruptor in this sector. So, what's your take on how this will evolve in developed and emerging markets?

Adam Jonas: Well, we think when you take autonomous and shared and electric mobility all the way – that transportation starts to resemble a utility like electricity or water or telecom; where the incremental mile traveled is maybe not quite free, but very, very, very low cost. Maybe only the marginal cost of the mile traveled may only just be the energy required to deliver that mile, whether it's a renewable or non-renewable energy source.

And the relationship with a car will change a lot. Individual vehicle ownership may go the way of horse ownership. There will be some, but it'll be seen as a nostalgic privilege, if you will, to own our own car. Others would say, I don't want to own my own car. This is crazy. Why would anyone want to do that?

So, it's going to really transform the business model. It will, I think, change the structure of the industry in terms of the number of participants and what they do. Not everybody will win. Some of the existing players can win. But they might have to make some uncomfortable trade-offs for survival.  And for others, the car – let’s say terrestrial vehicle modality may just be a small part of a broader robotics and then physical embodiment of AI that they're propagating; where auto will just be a really, really just one tendril of many, many dozens of different tendrils. So again, it's beginning now. This process will take decades to play out. But investors with even, you know, two-to-three or three-to-five-year view can take steps today to adjust their portfolios and position themselves.

Tim Hsiao:  The other key focus of the investor over the market would definitely be the geopolitical dynamics. So, Morgan Stanley expects to see a lot of what you call coopetition between global OEMs and the Chinese suppliers. What do you mean by coopetition and how do you see this dynamic playing out, especially in terms of the tech deflation?

Adam Jonas: In order to reduce the United States dependency on China, we need to work with China. So, there's the irony here. Look, in my former life of being an auto analyst, every auto CEO I speak to does not believe that tariffs will limit Chinese involvement in the global auto industry, including onshore in the United States.

Many are actively seeking to work with the Chinese through various structures  give them an on-ramp to move onshore to produce their, in many cases, superior products, but in U.S. factories on U.S. shores with American workers. That might lead to some, again, trade-offs.

But our view within Morgan Stanley and working with you is we do think that there are on-ramps for Chinese hardware, Chinese knowhow, and Chinese electrical vehicle architecture, but while still being sensitive to the dual-purpose AI sensitivities around  software and the AI networks that for national security reasons, nations want to have more control over.

So  that's a long-winded way of saying we want the Chinese body, but we may need to find a way to have the U.S. brain in that body. And I actually am hopeful and seeing some signs already that that's going to happen and play out over the next six to 12 months.

Tim Hsiao: I would say it's clear that the road ahead isn't just smarter, it’s faster, more connected, and increasingly autonomous.

Adam Jonas: That's correct, Tim. I could not agree more.  Thanks for joining me on the show today.

Tim Hsiao: Thanks, Adam. Always a pleasure.

Adam Jonas: And to our listeners, thanks for listening. Until next time, stay human and keep driving forward. 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.