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Economic outlook: stock market realizes it has some 'hard work to do'

Yahoo Finance’s Myles Udland, Brian Sozzi, and Julie Hyman break down the stock market action and outlook with Jim Caron, Morgan Stanley Investment Management Fixed Income Portfolio Manager.

Video transcript

JULIE HYMAN: We are taking a look at futures this morning that are heading a bit lower ahead of the opening bell in just a few minutes here. And of course, we always talk about it's sort of an article of faith here that markets are a discounting mechanism. So the question is, what are we discounting right now? Jim Karen is joining us now. He is Morgan Stanley Investment Management fixed income portfolio manager.

So Jim, you know, at this point, we know or expect, right, that we are going to see strong earnings, strong economic data, a Fed that's on hold. So if we know all that, how are we going to see markets continue on their current trajectory? Or what's going to be a catalyst if we already know everything that's going to happen?

JIM CARON: Well, I think that's exactly the point, Julie, is that essentially, what we have is the absence of a catalyst. Everything that we've done over the past 12 months has been to build up to this point to get this recovery, to get a very, very strong second quarter GDP, which we think could be upwards of 10%.

But after that, things start to slow down. It doesn't mean that the data gets bad. It just means on a relative basis, that the third quarter will be weaker than the second quarter, and the fourth quarter maybe weaker than the third quarter. So it seems like a relative or the second derivative. The rate of change of growth is starting to slow down. But it's still at a good pace. We expect 7 and 1/2% growth this year annualized. And next year, we expect annualized growth to be 4.4%. These are really, really good numbers.

But the point here is that it's always the delta that matters. And when we start to think about this then also in terms of fiscal because policy is also a very, very big part of the driver here. So we have an infrastructure spending plan that's also coming out. We're going to have more information about that this quarter, too. We're going to at least know what the numbers are and how the debate is going to be framed. Right now, it's being discussed very, very heavily.

And but once we have that, we've already spent $5.8 trillion. We're going to spend some more. We're going to have a very, very large deficit. So then what comes next? OK, so the next 12 months of fiscal spending is probably going to be less than-- most likely going to be less than-- the last 12 months. So, again, that seems like a net tightening. And then we have Fed tapering to throw into the whole thing as well.

So the market's realizing that it's got some hard work to do. What we need to understand is, do we have enough momentum that there can be a handoff from the public sector support to the private sector driving growth in earnings and jobs and wages and all of these other various things? And that's what the market is trying to figure out right now-- do we have enough momentum?

BRIAN SOZZI: Jim, how much further do you think the market has to fall to price in this growth slowdown you were talking about?

JIM CARON: That's a really good question because I think the tails on both ends are flat. And some-- there are some camps that'll say that the 10-year Treasury is going up to 2% and above. And other camps are out there saying, no, it's going to go back down sub 1.25%. And I think the reality is, is that the tails on both sides are pretty flat. It really depends at this point on what the infrastructure spending is actually going to look like. Because we already-- we're getting the good economic data right now. That's already baked into the cake. That's from actions that have been taken over the past 12 months plus.

So when we start to think about the stimulus program, will this really create a lot of jobs? Will it create an acceleration of growth, not just in one year, but just over the next several years? Or is this going to be done through reconciliation where we're going to be talking more about tax hikes and drags on potential growth, as opposed to real stimulus with a positive fiscal multiplier?

So I think that we can think about this in several ways, where if we don't have enough of a boost, then the market's going to look through this. And they're going to say, well, the structural disinflationary forces that have been in place prior to the pandemic are just going to reassert themselves. They just didn't magically go away because we have a pandemic. It's really just taking a break.

So I can see both sides of this right now. But I can tell you what we're doing is that we are reducing some of our underweights in duration, and we're getting a little bit more neutral duration and even thinking about getting a little bit long. Not-- it's more tactical more so than anything else. But I think that we're going to be in a range from, say, 1.4% in the 10-year Treasury up to 1.8%. Nothing too out of the ordinary, but I think we can stay there for a while.

MYLES UDLAND: All right, there we saw UiPath ringing the opening bell on the floor of the New York Stock Exchange. We're talking to their CEO coming up in the 3:00 PM hour here on Yahoo Finance Live. You know, Jim, you just alluded to it there.

But I did want to ask about what levels on the 10 and the 30 are you guys starting to get more interest from your clients and actually taking the yield, getting fired up about 1 and 3/4 as generating some kind of income and how that dynamic could play into some of the-- I think some folks are now talking about a moderation at the long end of the curve and how those dynamics may have factored in, in recent conversations.

JIM CARON: Yeah, so it really depends where you are, right? So I think in the US, what we've seen in the first quarter was a surge higher in yields. And we think that surge higher in yields is over with until we get another catalyst. And that catalyst could be better growth than what we thought, higher inflation or inflation that's stickier than what we think, as opposed to transitory. So that could be part of it.

But what we're really starting to see is outside of the US that many people are looking at US Treasuries even after they do their FX exchange as having very, very attractive high yields. So there's a significant large yield pickup if you're a European investor to convert euros to dollars and with those dollars, buy US treasuries. Same thing if you're a Japanese investor. I mean, you could pick up 50, 75 basis points, depending on what your base currency is.

So, in the first quarter, we saw a lot of foreign demand leave the US because rates were going up, so people stayed away from that in terms of US treasuries. Today, what we're seeing is a little bit of the opposite. So as Europe starts to recover, get the vaccine rolled out, the virus under control, what we're seeing is that European yields are starting to rise marginally. But the point here is that they can maybe move some of that money into the US, where-- you know, where there's a bigger yield pick-up even once you account for the foreign currency exchange.

JULIE HYMAN: So a lot to pay attention to, obviously, as the year goes on. Jim Caron of Morgan Stanley, thank you so much for being here. Good to talk to you as always.

JIM CARON: Thank you. Good morning.