Thoughts on the Market

Europe's equity rally has surprised many investors. Our Europe Head of Research Product Paul Walsh and Chief European Equity Strategist Marina Zavolock discuss potential outcomes of the broadening market.
Read more insights from Morgan Stanley.

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Paul Walsh: Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Research Products here in Europe.
Marina Zavolock: And I'm Marina Zavolock, Chief European Equity Strategist.
Paul Walsh: And today, we're looking at whether European equities have more room to broaden – as markets assess the implications of a potential U.S.-Iran deal and a reopening of the Strait of Hormuz.
It's Monday, June the 29th at 10am in London.
Marina, it's always great having you on. And for our listeners out there, I think they'd be interested to hear that if we look at Europe's performance year-to-date, it's now on a par to the S&P. So, both indices are up somewhere between 7 and 8 percent year-to-date. So, Europe is starting to stage something of a comeback from the conflict lows.
And so, what's driving this? And are we beginning to see inflows into Europe again?
Marina Zavolock: So, I'm going to give a two-part answer to this.
Firstly, Europe has a lot of the same exposure as the U.S., so that is part of the reason… I know that Europe has this kind of reputation for not having a lot of tech exposure; but we do have tech exposure…
Paul Walsh: We do.
Marina Zavolock: Not to the same degree as the U.S., but, let me just give you some numbers here.
So, we have a number of sectors heavily exposed to the AI CapEx boom. These are led primarily by the semis sector in Europe, tech hardware, cap goods, and metals and mining; specifically, copper has a link to AI as well. And those sectors, let's say roughly they make up at this point about 15 percent weight of our index. And if you look at that year-to-date performance that's on par with the U.S., almost 90 percent of it is made up from these sectors.
Paul Walsh: Yes.
Marina Zavolock: So, these sectors have moved just as aggressively as many of the AI pockets within the U.S. That's the answer that's kind of similar to the U.S. The answer that's a bit different is that we get from time to time, over the years actually, but we had a very big one earlier this year. We get these waves of interest in Europe because investors start to think about diversification. So…
Paul Walsh: That’s right. The broadening.
Marina Zavolock: Yes. So, they... And we've called for broadening recently on the back of this, Iran-U.S. MOU. But this broadening has other drivers as well. So when we felt this wave of interest in diversification, and we saw the flows coming into Europe earlier this year, the driver was initially because the Mag7 was kind of going choppy and sideways. So, that just drove diversification out of Mag7 and into equal-weighted S&P, but that also always benefits Europe. Or tends to benefit Europe.
But also, we had this wave of interest in real assets earlier this year; and Europe has a higher share of real assets than the U.S. Now, at this moment, I am sensing that we are getting that pickup in broadening interest once again from my feedback with investors.
You had this MOU, which was the initial trigger. You have oil prices, broadly, they're falling. That's helpful as well. But I think the biggest driver of what's driving this diversification interest at this moment is actually the volatility that we're seeing in the AI complex.
Paul Walsh: Mm.
Marina Zavolock: So, what a lot of the feedback I'm getting these days from investors that are coming back to Europe after focusing primarily on the U.S. is, ‘Look, I have a lot of AI in my portfolio. I like my AI exposure. I'm not looking to get rid of it or to sell it, but incrementally, I'm a little bit worried about this volatility. And I'm looking to broaden my exposure. What do you like in Europe to help me diversify away from this kind of volatility that we're seeing now?’
Paul Walsh: And I think that's a great segue, Marina, to my second question, because with Europe having really kept pace with the S&P year-to-date, the question that really is going to be asked is the sustainability of that relative performance. And when we think about a backdrop here in Europe of pretty low economic growth, the market continues to be worried about rate hikes given recent inflationary dynamics.
And as you've articulated there, tech has played a very significant role here in Europe as well in terms of driving markets higher. So, you've alluded to it in a few of your comments already, but how sustainable do we see this as being?
Marina Zavolock: It depends on AI, to be honest with you. So, if AI starts to really move up at an aggressive pace like it was earlier this year, then it's hard for Europe to outperform given our exposure. But if that starts to move up at a more moderate pace, Europe has a chance to do very well.
Paul Walsh: Mm.
Marina Zavolock: I think there's a lot of misperceptions when it comes to European equities. And outside of AI, actually there's quite a lot of strength. So, misperception one, you've mentioned it, which is basically: Oh, look at our PMIs, look at our GDP growth. Why bother with European equities? I think this is maybe what some U.S. investors may think.
But just like in the U.S., the equities market, and maybe even more so, the equities market in Europe – it is not the economy.
Paul Walsh: Mm.
Marina Zavolock: So, we just published our global exposure guide over this past weekend, which Morgan Stanley has been running 29 iterations of this guide.
Europe's exposure to Europe is pretty much at historical lows over decades. Europe's exposure to Europe as a percent of revenues is now 45 percent of revenues …
Paul Walsh: Yeah.
Marina Zavolock: ... is European exposed. The rest is very global, including the U.S. Um, Europe, uh, Of that 45 percent domestic, a lot of that is banks, some defensive sectors. Only a very small sliver is actually consumer-oriented sectors that would see earnings downgrades on the back of ECB hiking, for example. So, I think people may also be surprised to know that consensus earnings growth for Europe this year is over 16 percent.
Paul Walsh: Mm.
Marina Zavolock: It's really healthy.
Paul Walsh: It’s pretty healthy.
Marina Zavolock: I know the U.S. is over 20, but Europe is over 16 percent. These kinds of ideas of, you know – we have a shortage of energy and therefore our earnings are going to be down – they're misperceptions. Because actually, as long as oil doesn't spike to, I don't know, [$]150. If it stays within a healthy range, call it [$]70 to 90, that's actually a very good environment for Europe because we have a lot of real assets.
We have the banks which benefit from higher inflation because they trade on the steepness of the curve. And we have some AI exposure. If you add up those three things, which all benefit from inflation, that's 60 percent of our earnings pie.
Paul Walsh: Right.
Marina Zavolock: Hence, Europe's actually doing really well. And I'll just mention one other thing. Earlier this year, we broke out of a structural downtrend discount; that range that we were trading in versus the U.S. So, for almost 10 years, Europe's discount was just going wider and wider and wider and wider. And as of January 1st, this year, on a like-for-like basis, so sector neutral excluding Mag7, we broke out of that structural downtrend, and we keep seeing a narrowing.
Paul Walsh: Yeah.
Marina Zavolock: So, if you're going to broaden, it actually makes a lot of sense to look at Europe, where we have these discounts, and we have value, and we have growth.
Paul Walsh: Yeah. So, the point there being the relative valuation discount of Europe to the U.S. has been actually closing a little bit more recently. Final question from my side.
You have obviously recently refreshed your sector model. We have talked about the broadening in our conversation today. What are you advocating to your clients out there in terms of relative sector preferences?
Marina Zavolock: Yeah. So, we run a data-driven model. Just briefly, we look at things like earnings revisions breadth – works really well as a leading indicator in Europe; a leading indicator for future earnings as well.
Consensus price target revisions breadth, balance sheet measures. We look at a number of different things, AI exposure. And basically, I'll just give you the top sectors in our model now. Semis number one, metals and mining number two, led by copper.
Paul Walsh: Mm-hmm.
Marina Zavolock: Banks number three. I think banks, for me, it's a key diversification play.
Paul Walsh: Yes.
Marina Zavolock: A big differentiator. And trading on 10 times PE with very high distributions, buybacks and dividends, low teens earnings growth upgrades. Front of the line on AI adoption and seeing that ROI coming through. Cap goods, number four, that's also led by AI exposure.
Paul Walsh: Yeah.
Marina Zavolock: And then I'll just mention lastly, utilities is an overweight as well. That's also a little bit AI linked, but very, very under-owned; lagging the trends we've seen in the U.S. And broader based in terms of the positives there because we also have this drive for renewables, which is coming back.
Paul Walsh: Marina, always, we value your insights highly. Thanks as always for taking the time to talk.
Marina Zavolock: Great speaking with you, Paul.
Paul Walsh: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen. And please do share the podcast with a friend or colleague today.

Although markets may recalibrate to a different policy playbook under the new Fed chair Kevin Warsh, housing could remain in a holding pattern. Our co-heads of Securitized Products Research Jay Bacow and James Egan explain why.
Read more insights from Morgan Stanley.

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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, co-head of Securitized Products Research at Morgan Stanley.
James Egan: And I'm Jim Egan, the other co-head of Securitized Products Research at Morgan Stanley.
Jay Bacow: Today, the glow has maybe worn off the championship of the Knicks, so we can talk about the impact of Warsh on the mortgage and housing market.
It's Friday, June 26th at 10am in New York.
James Egan: If we have to stop talking about the Knicks, we can stop talking about the Knicks. But Jay, I think one of the things, if we take a little bit of a step back in mortgage markets, in housing markets, in fixed income markets more broadly – from the beginning of the year to now, we've gone from the market pricing in 2.5 cuts from the Fed by the end of 2026, to the market pricing in roughly 1.5 hikes. 100 basis point difference in market expectations over the course of the past five and a half months.
Now, that's happened at different times, with different levels of velocity and severity. But one of the key talking points we have now is – we have a new Fed chair. We had the first FOMC meeting and his press conference after that last Wednesday.
What do you think that means for mortgage markets, for volatility? How are you thinking about this?
Jay Bacow: look, Jim, it's a great question, and we've got asked that by a number of different investors. Chair Warsh has been pretty clear that he thinks people should do more of what they're good at and less of what they're not good at.
And so, he's felt like the Fed should keep their communication on future guidance relatively short. And so, with less forward guidance from the Fed, the market has more uncertainty, and more uncertainty translates into more volatility.
And more volatility is generally bad for the mortgage market, given that investors are short the option to the homeowner to refinance. Furthermore, shifting from expectations of the Fed cutting to expectations of the Fed hiking generally makes it a little bit less favorable environment for investors like banks and overseas investors to come to the mortgage market.
James Egan: Alright. Now, we've been on this podcast several times this year where we've talked about, you mentioned banks... We've talked about deregulation. We've talked about Fannie Mae and Freddie Mac, the GSEs – them buying mortgages, that being constructive for our mortgage view.
Is that still the case, or how are you layering that into your thought process?
Jay Bacow: now? That's definitely still the case. Those things haven't changed. The deregulation is still flowing through the markets. That longer term should be supportive of bank demand in aggregate, although obviously there are a number of different regulations going through. The GSEs are still forecasted to buy 200 billion mortgages on behalf of President Trump's initiative.
So, that's why we're just sort of tactically negative – those technicals are very strong in an environment where there really has not been much supply. Now, some of that supply is because mortgage rates are still in the context of 6.5 percent. Some of that is because with mortgage rates at 6.5 percent, there hasn't been that much housing activity.
So, Jim, turning it to you, what is the outlook for the housing market in a world where they are expecting the Fed to hike and rates to stay elevated?
James Egan: Right. So, the main thing that we focus on from a housing market perspective is less specifically Fed action and more the 5- and 10-year part of the curve.
So, when you start to say something like you're tactically negative mortgage-backed securities here – how can I interpret that from a mortgage rate perspective?
Jay Bacow: If we're tactically negative, it's more of a small move than some massive move. And as you said, and we've talked about on this call beforehand, realistically, the mortgage rate is a little bit less dependent on the Fed policy rate and more around the belly of the Treasury curve. And, you know, what's going to happen with the belly of the Treasury curve is going to be dependent on sort of market expectations along with what's happening in the geopolitical situation.
So realistically, if you've written down that the mortgage rate is 6.5 percent right now, our view probably doesn't change things too much.
James Egan: And if that's the case, then affordability in the housing market, as we've been talking about, is going to continue to be challenged. And what we think that means from a housing activity perspective is any upside that we really thought would have been there gets pretty significantly capped. But the same side of this token – or the other side of this token, if you will, we do think that the current level is well-supported here.
There's some level of housing activity that has to occur regardless of where affordability is, and we think we found that. We're at 40-year lows from a turnover perspective. From the fourth quarter of 2023 through now, we've been roughly at the same level. That's 11 consecutive quarters now.
We think this is the kind of base level for people that need to transact regardless of where mortgage rates are. So, the more that the rate environment remains challenged, the more that we kind of hang in this low to mid 6 percent mortgage rate environment. We just think that that continues to curtail upside.
So, it's a housing market and a housing activity space that continues to very much just remain stuck in neutral.
Jay Bacow: Alright. So, if we're in this new environment and the Fed might be hiking, it's not great locally for mortgage valuations. Housing market more broadly, probably kind of stuck in neutral here. Jim, always a pleasure speaking with you.
James Egan: And always great speaking to you too, Jay. And to all of our regular listeners, thank you for adding us to your playlist. Let us know what you think wherever you get this podcast and share Thoughts on the Market with a friend or colleague today.
Jay Bacow: And go smash that subscribe button.

Our U.S. Public Policy Strategist Ariana Salvatore joins our Deputy Global Head of Research Michael Zezas to consider the consumer outlook and how it may impact the November midterm elections.
Read more insights from Morgan Stanley.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's U.S. Public Policy Strategist.
Michael Zezas: And I'm Mike Zezas, Deputy Global Head of Research.
Ariana Salvatore: Today, we'll be discussing the consumer outlook, policy catalysts, and what it could mean for the 2026 midterm elections.
It's Thursday, June 25th at 9am in New York.
Mike, you're on the road, obviously not in New York City this week. Why don't you tell us a little bit about the conference that you're at, and then we can get into some of the topics that have come up in your conversations.
Michael Zezas: Yeah. I'm down in South Carolina at Morgan Stanley's Captains of the Consumer Industry Conference, where we put together investors and leadership of key consumer companies in the U.S. to learn about each other in a more informal way, brainstorm… And it's been really interesting.
We've had a lot of meetings with leadership from different prominent consumer companies throughout the U.S. And it's been really fascinating to hear how the consumer's been quite resilient. But in general, one pattern that sticks out is rising concern about lower-income consumers' behavior starting to lag in meaningful way higher-income consumers' behavior.
You're starting to see substitution and sort of more selectivity amongst lower-income households, a pattern that began a bit last year as a lot of these companies would report with higher tariffs. That seems to have continued with higher gas prices driven by the conflict in the Middle East.
So, there's a lot of discussion and concern about how durable it is. And in particular, if there are some policy choices here that might alleviate some of that pressure and bring some fundamental strength to what is a challenged segment of the consumer market right now.
Ariana Salvatore: Let's talk a little bit more about tariffs. It's our economists’ view that we've mostly gotten through the tariff pass-through. Is that the sentiment that you're hearing from corporates and the clients that you're talking to?
Michael Zezas: It is. Well, it's certainly the hope. And I guess the follow-up questions here are: once some of the temporary tariff authority that was put into place after the Supreme Court struck down the use of IEEPA, will there be a restoration of those tariff levels? And will the USMCA negotiations create higher tariffs?
So, Ariana, what's your thoughts there? Is there any concern for companies that they're going to start needing to deal with a re-escalation of tariff costs relative to what we experienced, say, last year?
Ariana Salvatore: Yeah, I think to answer that question, we need to dig into this under the surface a little bit and understand what types of tariffs that we're talking about.
So, to your question on the USMCA, we see that largely as a story of continuity, right? So, the USMCA exemption has been in place since the deal was signed, right? And since Trumpimposed those Section 301 tariffs, we think that's likely to stay the case. That means the vast majority of the goods trade between the U.S., Mexico, and Canada is right now not subject to the 301 tariffs.
Now, on the other hand, we have existing Section 232 tariffs in place on not just sectors like steel and aluminum, but a bunch of other goods, too, and we're supposed to get more of those investigations wrapped up in the next week or so.
So, on that front, I do think there could be some potential room for escalation, but more broadly speaking, we think the direction of travel is relatively stable, if not slightly lower, because, as you mentioned, the IEEPA tariffs that were replaced by the Section 122s have to get replaced again end of July, right?
So that Section 122 authority was a temporary authority. The president is going to have to replace that with a mix of Section 232 and 301. It's been our view that when that happens, there could be some alleviation for very specific pockets of goods that fall into really neither bucket, right? So,they're not necessarily critical for national security, and they're coming from countries that are difficult to maintain a Section 301 investigation on.
So, it's actually very nuanced under the surface. I would say in the aggregate level, what we think is that you're going to see the tariff rate stay somewhere around 8 to 9 percent on a headline basis; if not directionally, maybe a little bit lower throughout the course of this year.
Michael Zezas: Got it. And I think that message has been music to the ears of a lot of these companies. And I’ve been doing these meetings with our chief economist, Michael Gapen, who has said that that's contributing to what he forecasts as being a meaningfuldeceleration in inflation into the end of the year. Certainly an inflation level lower than what the aggregate Fed forecast isat the moment.
Another question that comes up is whether or not the recent decrease in oil prices, which should feed through into lower gasoline prices, is durable. If that's something that could be counted on, because obviously these companies are thinking about it being a potential tailwind to demand going into the second half of the year.
How do you think about that, Ariana?
Ariana Salvatore: The MOU that the U.S. and Iran signed, I would say was a welcome development for markets. But that being said, there are a number of paths to re-escalation, in our view. Really four things to keep an eye on, kind of outstanding questions or uncertainties.
The first is on execution risk of the MOU itself. It's very light on details. We need to see more about how exactly the Strait of Hormuz is going to reopen, if there's going to be a servicing fee, a tolling regime, et cetera. That was a red line of the United States. But again, implementation there is a big question.
The second is on the calibration or divergence between the U.S. and Israel in terms of their objectives. We identified that early in the conflict as a potential indicator of how long this could possibly last, and I think it's equally as important in assessing how long the ceasefire or the MOU could stay in place.
The third thing I would say we need to learn more about is the role of Congress in all of this. So, some Republican lawmakers actually pushed back against the MOU, saying it didn't go far enough to advance U.S. interests. Now Congress has a more limited role when it comes to the actual MOU implementation itself. Remember, the JCPOA, the Iran nuclear deal in 2015, didn't go through Congress either.
But Congress can exert some more power come the fall when we start talking about defense appropriations, right? The Pentagon is asking for $1.5 trillion. [$]300 billion of that is supplemental war funding. And so, I think if you see Republicans push back, that's going to be an easy forum for them to do so.
And the last point is on the negotiations themselves. So, the MOU is a 60-day ceasefire throughout which both parties are supposed to be discussing the nuclear question. Now, looking back at historical context here, the JCPOA took about 20 months to negotiate start to finish. This is a very compressed timeframe, and again, obviously potential risk for escalationas we see these negotiations go on the next few months.
So, Mike, I would say, like I said before, markets are definitely seeing this as a welcome development, but that doesn't mean it's without execution risk. Across the board, our outlook actually expected a normalization of flows by the end of June, so we're kind of pulling things up by about two weeks.
That means that the outlook basically remains intact, but with marginal upside as this is a slightly more constructive outlook.
Michael Zezas: Got it. So net net, there's still plenty of execution risk going on, but the trend is at least towards easing of some of these policy pressures that have been impacting the consumer. And it's also been interesting that a lot of the conversations have led to questions about artificial intelligence.
Now, at this conference last year, a lot of the discussion about artificial intelligence was around how these companies were implementing it to create new marketing opportunities, create efficiencies inside of their operations.
This year, a lot of the discussion is actually about the macro trend around artificial intelligence, the acknowledgment of the industrial build-out around this new technology and how that is buoying investment and employment – and therefore consumption. And so, the policy concern or consideration from some of these companies is whether or not there are upcoming electoral issues, either in the midterms or in the next election cycle, that might change the dynamic around the AI industrial build-out.
Are there signs that would show that a tougher regulatory regime? Data center construction bans that these things might take on a bipartisan flavor? And so right now, I think that's a very difficult question to answer.
There is obviously some level of concern about if policy might change this dynamic around the AI industrial build-out that really has kind of helped the economy deal with some other external shocks from policy, namely what's going on in the Middle East and trade policy changes before that
Ariana Salvatore: Yeah, to that point, this question around AI pushback, especially on data center build-out, has been a big theme in the elections. Thus far, it's really been dealt with on more of a state and local level. But our view is that it's been kind of bubbling up to the national level. Efforts there are nascent, but I don't think they're going away anytime soon.
So obviously something that we're going to watch heading into November because it matters a lot for corporates and for investors alike. Mike, maybe we'll leave it there. Thanks so much for taking the time to talk.
Michael Zezas: And thanks for taking the time to talk to me.
Ariana Salvatore: And 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.

In his first meeting as Fed Chair, Kevin Warsh signaled restraint in providing guidance. Our Global Head of Fixed Income Research Andrew Sheets looks at possible impacts of the new approach.
Read more insights from Morgan Stanley.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.
Today, why the Fed could do less than expected and why that could still lead to more volatility.
It's Wednesday, June 24th at 2pm in London.
Last week saw the first meeting of the Federal Reserve under its new chair, Kevin Warsh. It didn't disappoint.
The Fed’s Summary of Economic Projections saw significantly higher inflation than the last iteration in March, and in turn, a much stronger case to raise interest rates, perhaps multiple times. The Fed's statement, which laid out its views around the economy and its reasons for action, was changed dramatically – and also significantly shortened.
We don't think the Fed will ultimately follow through on the interest rate rises that were flagged in this meeting and will choose instead to remain on hold this year. But we think this scenario of them staying on hold can still lead to more volatility.
I'll try to address each side of this apparent contradiction.
First, the Fed is clearly worried about inflation, which has been elevated for a considerable period of time. But working through the numbers, Morgan Stanley economists forecast lower inflation over the rest of this year than the Fed now expects. And so, while we think it would be entirely reasonable for the Fed to expect to raise interest rates based on the high inflation that they have penciled in, we think they could reach a different conclusion if our lower estimates are ultimately correct.
Supporting our case, at least in our view, is that energy prices have fallen significantly in recent weeks since some of these Fed forecasts were set, as markets have moved to believe not only would existing oil production resume in the Persian Gulf, but Iran could increase exports materially under its new agreement with the United States.
That would greatly reduce a source of underlying inflationary pressure in the U.S., Europe, and Asia. With inflation set to come in lower than feared, we think the Fed's most natural option will be to remain on hold this year rather than raise rates.
But if the Fed's not doing anything, how exactly is that going to drive volatility?
Our answer to that question lies in another thing that it's not going to be doing – providing as much information about where it thinks monetary policy is going next. Indeed, since the financial crisis, the Fed often went out of its way to give so-called forward guidance and significant detail about when and how they may change policy in the future.
Proponents saw this as a way to avoid surprises and smooth the transmission of this policy, but critics saw it as limiting and potentially giving markets a false sense of certainty. The new Fed chair, Kevin Warsh, is one of these critics and has promised to give a lot less forward guidance. That lack of handholding by the Fed about what they might do next is a big change.
Coupled with the potential for a smaller Fed balance sheet and big questions around the path of inflation and the impact of AI and productivity, every data point now has more potential to shift the market's thinking. My strategy colleagues think that this will lead to higher volatility in two-year interest rates, as well as more volatility in currencies.
I'd also note that here in the UK, this paradox is not nearly as puzzling. Here, the Bank of England's target rate has been the same level since mid-December.
But that hasn't stopped the UK two-year bond yield from trading in an over 100 basis point range.
Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.

First-time homebuyers may get short windows of relief, but our co-head of Securitized Products Research James Egan and Senior Economist and Strategist in Morgan Stanley's Private Wealth Management Sarah Wolfe say the bigger story is a housing market resetting around a higher bar to entry.
Read more insights from Morgan Stanley.

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James Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Morgan Stanley's U.S. Housing Strategist and Co-Head of Securitized Products Strategy.
Sarah Wolfe: And I'm Sarah Wolfe, Senior Economist and Strategist within Morgan Stanley Wealth Management.
James Egan: And today, why first-time homebuyers are facing a tougher path to ownership.
It's Tuesday, June 23rd at 10am in New York.
Buying a first-time home has always been a big step, but for a growing number of first-time buyers today, the goal can really seem insurmountable.
Mortgage rates might be down from where they were in the second half of 2023, but they're significantly higher than they were for the several years before that. Monthly payments have roughly doubled for a median-priced home. And my colleague Jay Bacow and I have talked several times on this podcast about how many homeowners feel like they're locked into those lower rates.
And they're staying put because they just don't want to give up a two or three-handle mortgage rate for something that has a six in front of it. But Sarah, as we know, this is bigger than just first-time buyers. Now, they often start the housing transaction chain, and when they can't buy, current owners may not be able to sell and trade up.
That slows turnover across the market, and it also reduces activity tied to housing – from mortgages and renovations to moving and furniture. And it can keep would-be buyers renting for longer, which adds pressure to rental demand.
So, how do you see this situation? Is this just another affordability squeeze, or has the housing market reset to a higher barrier to entry?
Sarah Wolfe: I do think that we're on the upper bound of affordability pressures. This is about as bad as it's going to get. But as we discussed in our recent publication of The Economy Explained, unfortunately, we do think that the housing market is resetting at a structurally higher barrier to entry. There's a lot of reasons for that.
The first is higher interest rates. Yes, mortgage rates are sitting around 6.5 percent, and they should come down from here, but maybe not better than 5.5 percent, right, in an optimistic scenario. The second is demographic pressures. Remember, we have this tremendous aging population of baby boomers. All of their children are now entering their prime home-buying years, so there's a lot of demand for ownership.
The third and fourth ones are land regulation and permitting, which is at the state and local level, really hard to change. And the last one is climate risk. It's just raising insurance pricing and making it much more difficult to buy a home.
So overall, we see a world where, yes, mortgage rates come down a bit, improve affordability marginally, but we think neutral and other interest rates at the longer end of the curve are going to be higher than the post-financial crisis period. And what we're going to see is that those forces are going to widen the divide between who can own a home and who cannot. And who gains from that wealth accumulation and who does not.
James Egan: Right. So now, you mentioned where mortgage rates are today, above that 6 percent rate. Rates did briefly – in February, we got below 6 percent before they bounced back up here. Why did that short-lived relief matter so much?
Sarah Wolfe: I think that short-lived relief showed us that moves in the mortgage rate make a difference, but things are so unaffordable that it didn't make that much of a difference.
So, the dip below 6 percent was very exciting. It happened this past February. It was the first time that mortgage rates fell below 6 percent since 2022, and we saw a few things happen. First, it lowered the monthly payment for first-time homebuyers from about two point two thousand dollars a month to one point nine thousand.
So makes a bit of a difference. And it lowered the share of income that goes towards monthly mortgage payments from about 26 percent of income to 22 percent, from peak to trough. So, that is a notable improvement. But what we saw in the new home sales data and the existing home sales data, that it did not drive people back into the housing market.
I want to turn it back to you though, Jim, because you've actually done a lot of interesting work on this. And how this change in mortgage rates has changed the monthly cost that people have to pay for a median-priced home. Can you tell us a little bit more?
James Egan: Sure. So, we talk about the lock-in effect a lot, and it's kind of easy to point to: Well, there are a lot of people with mortgage rates that are around 3 percent or 3.5 percent, and the prevailing rate's at 6 percent, and that's a lot higher, so they're locked in.
But when we look at the actual numbers in terms of what we're asking a homeowner to do – to list their home for sale and move to another home today, pay off that existing mortgage, take out a new one. When you take into account how much higher home prices are today…
You bought a home in 2016, for instance, right? Let's assume you refinanced in 2020 or 2021 if you still live there, right? Most homeowners did. So, you've actually taken your monthly payment, and it is lower today than it was when you bought your home in 2016. If we assume that your income has risen alongside just median household income over that time period, your monthly payment as a share of your income today is probably sub 8 percent.
If you bought over the past three years, your monthly payment is a share of your income. You mentioned some numbers earlier. It's low to mid 20 percent. From a dollar amount perspective, if you were to pay off that 2016 mortgage, as an example, and take out one today, your payment is probably [$]13[00] or $1400 higher. It's like a 200 percent increase. That's very difficult economically for a lot of households, and that's the kind of physical manifestation of that lock-in effect.
Now, Sarah, given this significant change in housing math, what does that mean for who is actually able to buy in this market?
Sarah Wolfe: It's making who's able to buy into the market a lot more selective. So, what we're seeing is that first-time home buyers today are actually not meaningfully older. They're still about 36 years old, but they are a much more selective group financially. The Federal Reserve Bank of New York put out a great analysis on this recently, and they basically found that the first-time home buyer profile today is taking out a mortgage that's nearly $350,000, compared to $240,000 in 2019 and $200,000, a decade ago. So, significant increase in mortgage balances.
At the same time, credit standards have tightened significantly, so that average credit score to get a mortgage has risen quite a bit over the last 5 to 10 years. And what this is doing is it's shifting who can buy and also where they can buy. So, we're seeing higher-quality home buyers moving to lower-income zip codes. So, buying cheaper homes in lower-income metro areas, and so it's wealthier buyers in lower-income areas.
And that's the really big shift that we're seeing. It's a demand resorting story. And what we're also seeing, and we hear this a lot when we talk to our financial advisors and their clients, is that family is increasingly helping their other family members put that down payment down; in particular, parents helping their children buy that first home.
So, we're seeing that first-time buyers may be feeling this pressure, right, when it comes to rates. How much of this affordability issue, though, is being driven by the locked-in effect specifically?
James Egan: So, look, it's clearly playing a role. We just talked about some of the math behind that. But then when you look at what that means on a nationwide basis when it comes to inventory, when it comes to so many other aspects of this, that homeowner who's unwilling to give up that lower mortgage rate, that lower payment, right, their homes are off the market.
Existing inventories for sale, they've picked up from historic lows in 2023, but they're still very, very low on a long-run basis. The fewer homes there are for sale, the more upward pressure or the absence of downward pressure that's going to put on home prices, right?
We saw affordability plummet in 2022 and 2023 when rates backed up. We saw existing home sales really, really come down as a result. But home prices remained at record highs. They continued to set new record highs. For home prices to actually come down, right, you need people who are willing to sell at lower home prices.
Sarah, you just mentioned that lending standards themselves remain tight.
Sarah Wolfe: Mm-hmm.
James Egan: Those forced sales, those tend to be distressed transactions. We don't see that distress in the market providing the inventory and the motivated inventory to lead to softer home prices. So, it's really that lack of inventory which we think is in large part driven by the lock-in effect that's kept home prices. And as a result, that piece of the affordability equation kind of stuck at these higher levels.
Sarah Wolfe: I mean, it's really this vicious cycle, the locked-in effect making it difficult for entry-level buyers to get into the market – and then fewer existing homeowners sell or trade up or relocate. So, on and on it goes.
Are there broader implications of this freeze?
James Egan: Right. So, we just talked about what that means from an inventory perspective. And then if you think about affordability remaining challenged, lending standards themselves remaining tight, inventory remaining as low as it is, you could argue that we're at one of the more difficult times that we've seen for renters to exit rentership and step into homeownership.
Now, there's a lot of different things that drive rent growth, and the fact that you have a stuck renter is just one of them. The other side of that equation can be the supply of rental units, right? So that's just a piece of the equation.
But those are some of the externalities that we think about when it comes to how the tightness of the housing market – what the lock-in effect and what affordability is doing there. But outside of the housing market, Sarah, the wider economy, like how do these housing costs play a role there?
Sarah Wolfe: Massive effect. Some of the work that we've done shows that housing affordability is the number one driver pushing down fertility rates in America. The number one driver. Above childcare costs, above finding a partner, finding a good job. It's housing affordability. So, you could see how that could pretty significantly ripple through the broader economy.
But there's other components, right? So, as we discussed earlier, it's driving migration from unaffordable areas to more affordable regions. That has significant implications. And then putting my consumer economist hat on, as we discussed earlier in the podcast, when people buy a home, they tie themselves to that home. They spend money on couches, on beds, on TVs, right? Durable goods. And if we're going to have more people as renters for longer, that's going to expand the services economy at the expense of the goods economy.
All right. Let's take a step back and think about where this is all going. It hasn't been a very optimistic conversation. Jim, what is the outlook for affordability in your view? Do we get anywhere back to the post-financial crisis period or even the pre-financial crisis period?
James Egan: When it comes to the outlook for mortgage rates, the outlook for affordability, the outlook for the U.S. housing market – look, we just, throughout Morgan Stanley Research and Strategy, published our 2026 major outlook. From now through the end of 2027, we don't have conventional mortgage rates getting below 6 percent.
We do have affordability improving on the margins. We have income growth exceeding home price appreciation that makes it a little bit better, but that doesn't get us back to the post-GFC affordability era, which was very, very affordable. Looking back over the past several decades, it gets us closer to where we were pre-GFC, not all the way back there.
But when we think about how that ripples through the housing market and how we think about that evolving from here, look, we do think that the state of mortgage credit availability means there will be a lack of distress. We think that while affordability itself may be challenged and inventories may be low, there is some level of housing activity that has to occur regardless of where mortgage rates are or affordability is.
We think we found that level. We think there's support for home sales at these current levels, and that combination of support for home sales, lack of inventory, means that home prices, very little room for them to grow from here. But we think they're going to be pretty supported.
So, from a housing market perspective, at a ten-thousand-foot view, we're calling it 1-2 percent growth in sales, in home prices, well-supported. But the affordability outlook that we've outlined throughout this podcast – challenged to see a lot of acceleration.
Now, when we pull it back to the first-time home buyer, based on our conversation, it seems that the key question is becoming less about when to buy, more about who can still afford to enter the market.
But Sarah, it's really been great talking with you about the housing market today.
Sarah Wolfe: It was great speaking with you, Jim.
James Egan: And thanks for listening. 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.
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Sarah Wolfe is a member of Morgan Stanley's Wealth Management Division and is not a member of Morgan Stanley’s Research Department. Unless otherwise indicated, her views are her own and may differ from the views of the Morgan Stanley Research Department and from the views of others within Morgan Stanley.