Morgan Stanley IM: bond yield rise signals strong growth, not stress

Morgan Stanley Investment Management interprets the rise in bond yields more positively than those who see it as a sign of fiscal trouble or a growth downturn. If the market adopts this perspective, US equities can continue to handle higher yields provided earnings hold up. The firm's underweight stance on duration and its overweight on credit indicate it expects long-term Treasuries to remain under pressure rather than rebound. Its preference for Japan aligns with strong nominal growth there, while its underweight on Europe reflects relative weakness in European stocks. As for oil, the inflation component of high nominal growth is a factor to monitor because energy costs related to the Iran conflict feed directly into it. The primary risk to this outlook is a weak third-quarter earnings season, which would eliminate the buffer that Caron says supports equity prices.

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Earlier:

• Goldman Sachs attributes the global rise in bond yields to increased competition for capital from government borrowing and AI investment.

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Morgan Stanley's investment arm views the rise in Treasury yields as an indication that the US economy is operating at a high level, and it is betting that US earnings can stay ahead of rising borrowing costs.

Summary:

• With roughly $2 trillion in assets under management, Morgan Stanley Investment Management prefers US and Japanese stocks while maintaining an underweight position on Europe.
• Jim Caron, chief investment officer of its Portfolio Solutions Group, says the higher yields reflect resilient nominal growth rather than economic stress, with US real growth plus inflation running at about 6.5%.
• The US 10-year yield peaked at around 5.3% on 5 October this year before easing to around 5.1%.
• The firm is underweight duration and overweight credit, and has cut interest rate sensitivity across its portfolios.
• Car on said potential Democratic gains in November's midterms could narrow US opportunities toward large, established companies such as AI hyperscalers.
• He said private credit has moved past its correction phase, with more exits allowing capital to be deployed at today's higher rates.

According to Morgan Stanley Investment Management, the increase in government bond yields this year is a sign of robust economic expansion, not strain, and it does not yet serve as a caution for equities. The firm continues to favor US and Japanese stocks over European ones.

Jim Caron, CIO of the Portfolio Solutions Group at the firm – which had roughly $2 trillion in assets under management at the end of September – said during a recent webinar that the higher yields are increasingly indicative of solid nominal growth. Nominal growth is the sum of real economic expansion and inflation, and Caron estimated it at around 6.5% in the US. He cited steady growth, strong labor markets and productivity improvements as supporting economic activity while helping to reduce inflation.

The US 10-year Treasury yield rose to roughly 5.3% on 5 October, its peak for the year, then declined to about 5.1%. Caron stated that this movement was a normal response to the speed of nominal growth, and he stressed that bonds are not indicating a deceleration and that yield increases are justified. In his opinion, bonds have suffered but are not damaged.

Investors are asking when higher yields will start to hurt stocks significantly. Caron's response depends on earnings. He noted that strong nominal growth suggests robust cash generation by corporations and called third-quarter earnings expectations very strong. He argued that the US stock market is in a better position than any other to take advantage of that growth, and he added that Japan is also well placed following a spell of strong nominal growth.

This perspective provides an alternative interpretation of the same phenomenon noted by Goldman Sachs (linked above), which has linked the worldwide increase in yields to heightened rivalry for capital resulting from government debt and AI spending. Both acknowledge higher yields as the new environment; their divergence lies in whether the driver is chiefly funding demand or economic vitality.

Regarding bonds, Morgan Stanley IM is underweight duration and overweight credit, and it has lowered interest rate sensitivity throughout its portfolios. On the political front, Caron said that if Democrats gain ground in the November midterms and push back against the administration's deregulatory policies, that could limit US opportunities and benefit large, established companies like AI hyperscalers.

In private markets, Caron stated that private credit has finished its correction period following stress earlier this year in sectors like software. An increase in exits is freeing up capacity to invest capital at the current higher rates, he said, but he anticipates a slower pace in the next phase.

The upcoming third-quarter earnings season will serve as a crucial test of whether corporate profits can keep ahead of increasing borrowing costs.