Morgan Stanley says the conflict in the Middle East is triggering a bearish signal in the bond market, raising the risk of a deeper equity downturn.
In a new Bloomberg interview, Jim Caron, CIO of the Portfolio Solutions Group at Morgan Stanley Investment Management, says the market’s reaction to the oil price shock is very much expected.
But Caron warns that the price shock could evolve into a deeper economic concern.
“I think it’s important that we frame this in the right way right now because I think the way markets are thinking is they’re really thinking about it as a tipping point.
So right now, what we have is a price shock in oil prices. Equities are following oil prices. There’s no question about that. That’s a price shock. That is something that’s going to degrade prices because effectively, what you’re going to do is you’re going to discount your future cash flows at higher interest rates. As oil prices go up, interest rates go up. And you’re going to get a lower present value. That’s a very normal reaction.
But the debate, though, is does this turn into a growth scare or does this potentially increase recession risk? Then it becomes a valuation shock.”
According to the Morgan Stanley executive, investors may begin to price in weakening growth and higher recession risks, which could spark a sell-off even if earnings remain strong or stable. Caron highlights that the bond market is already indicating investors are worried about worse long-term conditions.
“And I will say that right now, my view is that we are in a price shock, meaning that we have to adjust to higher oil prices, look at interest rates, interest rates are rising, and that’s an issue. But today has shown me something very significant, and that today’s the first time really that the curve is steepened in the way that two-year yields have come down and 10-year rates have actually gone up. That is now the market starting to think that we could be tiptoeing into more of a valuation shock, which is something that would be a longer-lasting downturn in prices.”
A steepening yield curve suggests that the short-term outlook is weakening, while inflation and government borrowing risks are rising.
Caron notes that while the market is not yet in the midst of a valuation shock, the shift in signals is driving growing concern.
“We’re not there yet. That’s not my case. That’s not my view. But overall, that’s I think what the debate is, and that’s what the market’s worried about.”
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