The rise in unused office space has triggered suggestions about converting commercial real estate into residential buildings. But our US Real Estate Research analyst lists three major challenges.

----- Transcript -----

Welcome to Thoughts on the Market. I’m Adam Kramer, from the Morgan Stanley U.S. Real Estate Research team. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss a hot real estate topic. Whether the surplus of vacant office space offers a logical solution to the national housing shortage.

It’s Wednesday, August 14, at 10am in New York.

Sitting here in Morgan Stanley’s office at 1585 Broadway, Times Square is bustling and New York seems to have recovered from COVID and then some. But the reality inside buildings is a little bit different.

On the one hand, 14 percent of U.S. office space is sitting unused. Our analysis shows a permanent impairment in office demand of roughly 25 percent compared to pre-COVID. And on the other hand, we have a national housing shortage of up to 6 million units. So why not simply remove obsolete lower-quality office stock and replace it with much-needed housing? On the surface, the idea of office-to-residential conversion sounds compelling. It could revitalize struggling downtown areas, creating a virtuous cycle that can lead to increased local tax revenues, foot traffic, retail demand and tourism.

But is it feasible?

We think conversions face at least three significant challenges. First, are the economics of conversion. In order for conversions to make sense, we would need to see office rents decline or apartment rents rise materially – which is unlikely in the next 1-2 years given the supply dynamics — and office values and conversion costs would need to decline materially.

Investors can acquire or develop a multifamily property at roughly $600 per square foot. Alternatively, they can acquire and convert an existing office building for a total cost of nearly $700 per square foot, on average. The bottom line is that total conversion costs are higher than acquisition or ground-up development, with more complexity involved as well.

The second big challenge is the quality of the buildings themselves. Numerous elements of the physical building impact conversion feasibility. For example, location relative to transit and amenities. Buildings in suboptimal locations are unlikely to be considered. Whether the office asset is vacant or not is also a factor. Office leases are typically longer duration, and a building needs to be close to or fully vacant for a full conversion. And lastly, physical attributes such as architecture, floor-plate depth, windows placement, among others.

And finally, regulation presents a third major hurdle. Zoning and building code requirements differ from city to city and can add substantive time, cost, complexity, and limitations to any conversion project. That said, governments are in a unique position to encourage conversions — for example, via tax incentives – and literally remake cities short on affordable housing but with excess, underutilized office space.

We have looked at conversion opportunities in three key markets: New York, San Francisco, and Washington, D.C. In Manhattan, active office to residential conversions have been concentrated in the Financial District, and we think this trend will continue. We also see the East Side of Manhattan as a uniquely untapped opportunity for future conversions, given higher vacancy today. This would shift existing East Side office tenants to other locations, boosting demand in higher-quality office neighborhoods like Park Avenue and Grand Central.

In San Francisco, we are concerned about other types of real estate properties beyond just office. Retail, multifamily, and lodging in the downtown area are taking longer to recover post-COVID, and we think this will limit conversions in the market.

And finally, in Washington, D.C. we think conversion would work best for older, Class B/C office buildings on the edges of pre-existing residential areas.

In these three markets, and others, conversions could work in specific instances, with specific buildings in specific sub-markets. But on a national basis, the economic and logistic challenges of wide-scale conversions make this an unlikely solution.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our US Public Policy Strategist expects a robust M&A cycle, regardless of the outcome of the US election. But rising antitrust concerns could create additional scrutiny on possible future deals.

----- Transcript -----

Welcome to Thoughts on the Market. I’m Ariana Salvatore, from Morgan Stanley’s US Public Policy Research Team. Along with my colleagues bringing you a variety of perspectives, today I’ll talk about the impact of the US election on M&A.

It’s Tuesday, August 13th, at 10am in New York.

2023 saw the lowest level of global mergers and acquisitions – or M&A – in more than 30 years, relative to the overall size of the economy. But we believe that the cycle is currently reversing in a significant way and that politics won't halt the "Return of M&A."

Why? Because M&A cycles are primarily driven by broader factors. Those include macroeconomics, the business cycle, CEO confidence and financing conditions. More specifically, unusually depressed volumes, open new issue markets, incoming rate cuts and the bottom-up industry trends are powerful tailwinds to an M&A recovery and can offset the political headwinds.

So far this year we’ve seen an increase in deal activity. Announced M&A volume was up 20 per cent year-over-year in the first half of [20]24 versus [20]23, and we continue to expect M&A volumes to rise in 2024 as part of this broader, multi-year recovery.

That being said, one factor that can impact M&A is antitrust regulation. Investors are reasonably concerned about the ways in which the election outcome could impact antitrust enforcement – and whether or not it would even be a tailwind or a headwind. If you think about traditional Republican attitudes toward deregulation, you might think that antitrust enforcement could be weaker in a potential Trump win scenario; but when we look back at the first Trump administration, we did see various antitrust cases pursued across a number of sectors.

Further, we’ve seen this convergence between Republicans and Democrats on antitrust enforcement, specifically the vice presidential pick JD Vance has praised Lina Khan, the current FTC chair, for some of her efforts on antitrust in the Biden administration. In that vein, we do think there are certain circumstances that could cause a deal to come under scrutiny regardless of who wins the election.

First, on a sector basis, we think both parties share a similar approach toward antitrust for tech companies. Voters across the ideological spectrum seem to want their representatives to focus on objectives like 'breaking up big tech' and targeting companies that are perceived to have outsized control.

We also think geopolitics is really important here. National security concerns are increasingly being invoked as a consideration for M&A involving foreign actors, in particular if the deal involves a geopolitical adversary like China. We’ve seen lawmakers invoke these kind of concerns when justifying increased scrutiny for proposed deals.

Finally, key constituencies' positions on proposed deals could also matter. The way that a deal might impact key voter cohorts – think labor unions, for example – could also play a role in determining whether or not that deal comes under extra scrutiny.

We will of course keep you updated on any changes to our M&A outlook.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen to podcasts and share Thoughts on the Market with a friend or colleague today.

As markets adjust to global volatility, our Head of Corporate Credit Research considers when the Fed might choose to cut interest rates and how long the impacts may take to play out.

----- Transcript -----

Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll discuss the market’s expectation for much larger rate cuts from the Federal Reserve, and how much that actually matters.

It's Friday, August 9th at 2pm in London.

Markets have been volatile of late. One of the drivers has been rising concern that the Fed may have left interest rates too high for too long, and now needs to more dramatically course-correct. From July 1st through August 2nd, the market’s expectation for where the Fed’s target interest rate will be in one year’s time has fallen by more than 1 percent.

But…wait a second. We’re talking about interest rates here. Isn’t a shift towards expecting lower interest rates, you know, a good thing? And that seems especially relevant in the recent era, where strong markets often overlapped with fairly low interest rates.

Zoom out over a longer span of history, however, and that’s not always the case.

Interest rates, especially the rates from the Federal Reserve, are often a reflection of economic strength. And so high interest rates often overlap with strong growth, while a weak economy needs the support that lower rates provide. And so if interest rates are falling based on concern that the economy is weakening, which we think describes much of the last two weeks, it’s easier to argue why credit or equity markets wouldn’t like that outcome at all.

That’s especially true because of the so-called lag in monetary policy. If the Fed lowered interest rates tomorrow, the full impact of that cut may not be felt in the economy for 6 to 12 months. And so if people are worried that conditions are weakening right now, they’re going to worry that the help from lower rates won’t arrive in time.

The upshot is that for Credit, and I would say for other asset classes as well, rate cuts have only tended to be helpful if growth remained solid. Rate cuts and weaker growth were bad, and that was more true the larger those rate cuts were. In 2001, 2008 and February of 2020, large rate cuts as the economy weakened led to significant credit losses. Concern about what those lower rates signalled outweighed the direct benefit that a lower rate provided.

We think that dynamic remains in play today, with the market over the last two weeks suggesting that a combination of weaker growth and lower rates may be taken poorly, not taken well.

But there’s also some good news: Our economists think that the market's views on growth, and interest rates, may both be a little overstated. They think the US economy is still on track for a soft-landing, and that last week’s jobs report wasn’t quite as weak as it was made out to be.

Because of all that, they also don’t think that the Fed will reduce interest rates as quickly as the market now expects. And so, if that’s now right, we think a stronger economy and somewhat higher rates is going to be a trade-off that credit is happy to take.

Thanks for listening. If you enjoy the show, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our Head of Europe Sustainability Research discusses how rising longevity is revolutionizing our fundamental approach from reactive to proactive treatment.

----- Transcript -----

Welcome to Thoughts on the Market. I’m Mike Canfield, Morgan Stanley’s European Head of Sustainability Research. Along with my colleagues, we’re bringing you a variety of perspectives; and today we’re focusing on a topic that affects everyone – how much does poor health cost us? And how are ageing populations and longer life expectancy driving a fundamental shift in healthcare?

It’s Thursday, August the 8th, at 4pm in London.

As populations age across the developed world, health systems need to help people live both longer and healthier. The current system is typically built around to focus on acute conditions and it’s more reactive; so it introduces clinical care or drugs to respond to a condition after it’s already arisen, rather than keeping people healthy in the first instance. So increasingly, with the burden of chronic disease becoming by far the greatest health and economic challenge we face, we need to change the structure of the healthcare system.

Essentially, the key question is how much is poor health amongst the ageing population really costing society? To get a true sense of that, we need to keep in mind that workers over 50 already earn one out of every three dollars across the G20 regions. By 2035, they're projected to generate nearly 40 per cent of all household income. So with that in mind, preventable conditions amongst those people aged 50-64 at the moment, are already costing G20 economies over $1 trillion annually in productivity loss. And there’s one more key number: 19 per cent. That's how much age-diverse workforces can raise GDP per capita over the next thirty years, according to estimates from the Organization for Economic Co-operation and Development, or OECD. So clearly, keeping workers healthier for longer underpins a more productive, more efficient, and a profitable global economy. So it’s clear that [if] the current healthcare system were to shift from sick from care to prevention, the global gains would be substantial.

The BioPharma sector is already contributing some targeted novel treatments in areas like smart chemotherapy and in CRISPR – which is a technology that allows for selective DNA modification. While we can credit BioPharma and MedTech for really powerful innovations in diagnostics, in AI deployment for areas like data science and material science, and in sophisticated telemedicine – all these breakthroughs together give a more personalized, targeted health system; which is a big step in the right direction, but honestly they alone can’t solve this much broader longevity challenge we face.

Focus on health and prevention, ultimately, could address those underlying causes of ill-health, so that problems don’t arise even in the first instance. Governments around the world are obviously realizing the value of preventive care over sick care. And as a strategy, disease prevention fundamentally aims to promote wellness across the board, whether that’s in things like mental state, nutrition or even in things like sleep and stress. While it might be easy to kind of conflate that with wellness trends – things like green smoothies or meditation – the underlying benefits of boosting health at the cellular level have much broader and deeper implications. Things like Type 2 diabetes and heart disease, supporting better health across populations can significantly reduce the incidence of a wide range of chronic conditions. It can lower the burden on health systems overall, and actually increase healthy lifespan at the end of the day.

BioPharma advances are significant, but addressing longevity will require a much broader alignment across a myriad of elements; everything really from the food system to sanitation to training healthcare professionals. And of course, all of that will require consistent policy support. Regulators and policymakers are paying very close attention to their ageing population – and so are we. We’ll continue to bring you updates on this topic, which is so important to all of us.

Thanks for listening. If you enjoy the show, please do leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Risk-averse investors have poured trillions into money-market funds since 2019. Our Chief Fixed Income Strategist explains why investors shouldn’t expect this money to pivot to equities and other risk assets as rates fall.

----- Transcript -----

Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about money market funds.

It's Tuesday, August 6th at 3pm in New York.

Well over $6.5 trillion sit in US money market funds. A popular view in the financial media is that the assets under management in money market funds represent money on sidelines, waiting to be allocated to risk assets, especially stocks. The underlying thesis is that the current level of interest rates and the consequent high money market yields have resulted in accumulation of assets in money market funds; and, when policy easing gets under way and money market yields decline, these funds will be allocated towards risk assets, especially stocks. To that I would say, curb your enthusiasm.

Recent history provides helpful context. Since the end of 2019, money market funds have seen net inflows of about $2.6 trillion, occurring broadly in three phases. The first phase followed the outbreak of COVID, as the global economy suddenly faced a wide array of uncertainties. The second leg mainly comprised retail inflows, starting when the Fed began raising rates in 2022.The third stage came during the regional bank crisis in March-April 2023, with both retail and institutional flows fleeing regional bank deposits into money market funds.

Where do we go from here?

We think money market funds are unlikely to return to their pre-COVID levels of about $4 trillion, even if policy easing begins in September as our economists expect. They see three 25 basis point rate cuts in 2024 and four in 2025 as the economy achieves a soft landing; and they anticipate a shallow rate-cutting cycle, with the Fed stopping around 3.75 per cent. This means money market yields will likely stabilize around that level, albeit with a lag – but still be attractive versus cash alternatives.

In a hard landing scenario, the Fed will likely deliver significantly more cuts over a shorter period of time, but we think investors would be more inclined to seek liquidity and safety, allocating more assets to money market funds than to alternative assets.

Further, money market funds can delay the decline in their yields by simply extending the weighted average maturities of their portfolios and locking in current yields in the run-up to the cutting cycle. This makes money market funds more attractive than both short-term CDs and Treasury bills, whose yields reprice lower in sync with rate cuts. This relative appeal explains much of the lag between rate cuts and the peak in assets under management in money market funds. These have lagged historically, but average lag is around 12 months.

Finally, it is important to distinguish between institutional and retail flows into and out of money market funds, as their motivations are likely to be very different. Institutional funds account for 61 per cent of money market funds, while funds from retail sources amount to about 37 per cent. When they reallocate from money market funds, we think institutional investors are more likely to allocate to high-quality, short-duration fixed income assets rather than riskier assets such as stocks, motivated by safety rather than level of yield. Retail investors, the smaller segment, may have greater inclination to reallocate towards risk assets such as stocks.

The bottom line: While money market fund assets under management have grown meaningfully in the last few years, it is likely to stay high even as policy easing takes hold. Allocation toward risk assets looks to be both lagged and limited. Thus, this 'money on the sidelines' may not be as positive and as imminent a technical for risk assets as some people expect.

Thanks for listening. If you enjoy the podcast, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Although Monday’s correction springs from multiple causes, the real questions may be what’s next and when will the correction become a buying opportunity?

----- Transcript -----

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the recent equity market correction and whether it’s time to step in.

It's Monday, Aug 5th at 11:30am in New York.

So let’s get after it.

Over the past several weeks, global equity markets have taken on a completely different tone with most major averages definitively breaking strong uptrends from last fall. Many are blaming the Fed’s decision last week to hold interest rates steady in the face of weaker jobs data while others have highlighted the technical unwind of the Japanese yen carry trade.

However, if we take a step back, this topping process began in April with the first meaningful sell off since last October’s lows. Even as many stocks and indices rallied back to new highs this summer, the leadership took on a more defensive posture with sectors like Utilities, Staples and even Real Estate doing better than they have in years. As I have been discussing on this podcast this shift in leadership has coincided with softer economic data during the second quarter. This softness has continued into the summer with the all-important labor market data joining in as already noted.

This rotation was an early warning sign that stocks were likely vulnerable to a correction as we highlighted in early July. After all, the third quarter is when such corrections tend to happen seasonally for several reasons. This year has turned out to be no different. The real question now is what’s next and when will this correction become a buying opportunity?

Lost in the blame game is the simple fact that valuations reached very rich levels this year, something we have consistently discussed in our research. In fact, this is the main reason we have no upside to our US major averages over the next year even assuming our economists’ soft landing base case outcome for the economy. In other words, stocks were priced for perfection.

Now, with the deterioration in the growth data, and a Fed that is in no rush to cut rates proactively, markets have started to get nervous. Furthermore, the Fed tends to follow 2-year yields and over the last month 2-year treasury yields have fallen by 100 basis points and is almost 170 basis points below the Fed Funds rate. What this means is that the market is telling the Fed they are way too tight and they need to cut much more aggressively than what they have guided.

The dilemma for the Fed is that the next meeting is six weeks away and that’s a lifetime when markets are trading like they are today. Markets tend to be impatient and so I expect they will continue to trade with high volatility until the Fed appeases the market’s wishes. The flip side, of course, is that the Fed does an intra meeting rate cut; but that may make the markets even more nervous about growth in my view.

Bottom line, markets are likely to remain vulnerable in the near term until we get better growth data or more comfort from Fed on policy support, neither of which we think is forthcoming soon.

Finally, support can also come from cheap valuations, but we don’t have that yet at current prices. As of this recording the S&P 500 is still trading 20x forward 12-month earnings estimates. Our fair value multiple assuming a soft-landing outcome on the economy is closer to 19x, which means things aren’t actually cheap until we reach 17-18x, which is more than 10 per cent away from where we are trading.

In the meantime, we continue to recommend more defensive stocks in sectors like Utilities, Healthcare, Consumer Staples and some Real Estate. Conversely, we continue to dislike smaller cap cyclical stocks that are most vulnerable to the current growth slowdown and tight rate policy.

Thanks for listening. If you enjoy the podcast, please leave us a review wherever you listen, and share Thoughts on the Market with a friend or colleague today.