Thoughts on the Market

Diesel is at the center of an international supply squeeze, with prices rising to historic highs. Andrew Sheets and Martijn Rats unpack why this industrial fuel matters far beyond the pump.
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.
Martijn Rats: And I'm Martijn Rats, Head of Commodity Research at Morgan Stanley.
Andrew Sheets: Today, the secret life of diesel and why there's so much attention on it.
It's Thursday, September 24th at 2pm in London.
Diesel is a fuel that I think a lot of investors may be aware of but not familiar with, so to speak. It's often the other price that you see when you're driving down the road.
But Martijn, it's incredibly important for the industrial side of the economy and unusually disrupted by current geopolitical events. And so, I'd like to really start at the top, or technically the middle of the barrel, so to speak.
What is diesel and what makes it so special?
Martijn Rats: Yeah. When people talk about diesel at the moment, they really talk about sort of three things combined. They talk about outright diesel, as well as jet fuel and also heating oil.
These are effectively part of the same pool of molecules coming out of the refinery. And so, when you look at that sort of pool of molecules, you talk about the things that fuel trucks, trains, ships, tractors in agriculture, excavators, generators, home heating. It is a molecule that has a tremendously broad range of applications.
It's really the fuel of the industrial economy.
One of the characteristics of diesel is that it has very high energy density. In contrast to, say, gasoline, electrifying the uses of diesel is harder because it carries so much punch.
Andrew Sheets: And why has there been so much on diesel recently, given the current energy disruption in these geopolitical events?
Martijn Rats: Yeah. So, the global refining system normally processes about 85 million barrels a day of crude oil and from that, it makes a range of products. Diesel is at the heart of it. But it's only one of many.
At the moment, we are short in terms of refinery runs, i.e., the amount of crude that refineries process to the extent of about somewhere between 4 to 5 million barrels a day. So, 4 to 5 million barrels a day on a base of 85, you're talking about 5 to 6 percent. That may not sound like a lot, but in the world of commodities, where prices really depend on relatively small changes, that is actually a very large amount.
That sort of 4 or 5 million barrels a day of refineries that are currently not running, they are fifty-fifty, either in the Middle East or in Russia. In the Middle East, it is a story of the Strait of Hormuz and refineries locked behind the strait, and they can't export their products. Some of them are also damaged, although information on that is hard to find.
And then the other half that is out is in Russia, where they are effectively taken out by Ukrainian drone attacks.
In total, that's sort of 4 to 5 million barrels a day of refining capacity that is not running. 40 percent of their output would typically be diesel, so we are missing something like 1.5 million barrels a day of global diesel supply, all into the seaborne market.
Now, I mentioned the seaborne market because the seaborne market is the traded market where traders buy and sell cargoes to each other. And that is where, from a physical market perspective, price formation takes place.
The global seaborne diesel market is an 8 million barrel a day market. And so given that all of the supply we're missing is also into the seaborne market, the comparison to make is to say that we're missing about, sort of, close to 1.5 million barrels out of an 8 million barrel a day traded…
Andrew Sheets: A pretty large percentage, yeah.
Martijn Rats: Absolutely. That is very, very large, and that is hard to offset. Every other refinery around the world that can run is running flat out. The margins are all-time highs. So, there's a lot of incentive to run very hard.
But nevertheless, it's left the market very, very tight.
Andrew Sheets: So, that tightness in the market shows up via price. And just talk us through a little bit about what has happened to the price of diesel and its related fuels. You know, I think a lot of listeners are probably more familiar with the price of gasoline. They're more familiar with the barrel of oil that's often the quoted benchmark in the market.
But what has been happening to these diesel prices?
Martijn Rats: Yeah. So, the way to really tell that story is to look at what we call the crack spread. So, making a barrel of refined product, including diesel, of course, you start with crude oil. So, the price of crude oil impacts the price of the refined product. So, quite often we focus more on the uplift from the price of crude to get to the price of the refined product, and we call that the crack spread.
Under normal conditions, say a year ago, crude was $70, and then the price of diesel was another $20 on top of that. And so, you got to diesel being 70 plus 20 is $90 per barrel. At the moment, crude is higher. Crude is about $100 per barrel. Crude has rallied. But the increment on top of it has spiked.
So, a couple of days ago we got to all-time high nominal term diesel prices over $200 per barrel. So, we're now having a situation that is [$]100 for crude plus another [$]100 to get to the diesel price. So, the crack spread is something that normally lives in a range of, like when the diesel market is weak, maybe sort of $8, $9, $10. When the market is normal, close to $20. If it's very strong, $25 to $30.
Now, that incremental crack spread is $100 per barrel, and that is something that we've not seen before. It is stronger than it was in 2022, when we also had a moment of a severe diesel crisis. Didn't last very long in 2022, but the crack spread got to sort of $60, $70 per barrel. So, that highlights the extent to which the price of diesel has rallied.
Andrew Sheets: So, Martijn, you mentioned this crack spread. You know, I think if we all go back to our organic chemistry, this is the refineries literally cracking a barrel of oil down into constituent distillates and other pieces.
But given those very high prices for diesel, why don't the refiners just refine more? Why aren't the incentives increasing production? What's getting in the way of that?
Martijn Rats: Yeah. That's just a matter of like the physical reality of the system.
So, when you build a refinery, you often quite think about two things. What crudes are available to me. So, if you're in the United States, you have U.S. shale crudes, or you have crude from Mexico, Canada. And based on those, you then also think about, you know, what is my consumption, where I am likely to be.
And based on that, you build a certain configuration – that converts the crudes that you can buy into the products that your specific customer set might need.
You fix the configuration of the refinery at the time you build it. And once it's built, there is a little bit of flexibility to say, "Oh, well, maybe at the moment I make a little bit more diesel and a little bit less gasoline," and change the – what we call the yield of these products. Like a little bit within, you know, a few percentage points range.
But that flexibility is small, so the only thing you can do to make more diesel is to run the refinery at 100 percent utilization. That is currently where we are. That has already happened. And then you put in the crude that you buy, you get the products for which your refinery is then designed, and that's it.
There are no other…
Andrew Sheets: You can’t just turn a big dial that says more diesel.
Martijn Rats: No. You can't say, "Oh, well, I don't like my naphtha output this week, so let's not make any naphtha for the chemical industry. Let's only make diesel." It's not contained in the barrel of crude and the kits that you have – takes many years to rebuild and probably very expensive.
So you're kind of then stuck. I mean, it is what it is.
Andrew Sheets: So Martijn, where is this leaving the global story? You know, if we think about just the relative price of this. Again, you mentioned it's an incredibly important fuel for agriculture, for industry… What's it looking like kind of across the major regions?
Martijn Rats: Yeah. Look, it leaves a very tight market at the moment. I mean, it's relatively straightforward.
The price of diesel depends very heavily on how the geopolitics of the Middle East and Russia sort of play out. So, in terms of the traded price that you see on the screen every day, it swings around very heavily with how the market foresees the future with regards to these two conflicts.
So, one week things flare up, the price of diesel rallies. The following week the market feels a bit more optimistic maybe around a deal, so then things sort of sell off. So, we have to live with that sort of geopolitical sort of reality. But other than that, those who can afford it pay a high price to effectively erode demand amongst sets of consumers who cannot afford these higher prices.
You see a substitution, for example, what I thought was very interesting last week. Some of the train companies in the United States were talking about a truck-to-train substitution of very high levels of cargo loads on trains because simply the diesel on trucks is too expensive.
So, you see those behavioral changes come through.
Andrew Sheets: But that point about demand destruction is really important because, you know, a point that you've made over many years is this idea that the solution to higher prices is higher prices. That that reduces the demand for the fuel, that helps these markets recorrect.
And yet, you know, we're hitting prices in diesel that are near all-time highs, and we've yet to see that demand really pull back a lot. A lot of economic indicators are still pretty good. What does that tell you maybe about where the demand destruction price really is?
Martijn Rats: Making estimates of the demand destruction price sort of bottom up in a sort of modeling sense, going sort of end use by end use, has turned out on many occasions to be very, very challenging analysis.
But we can sort of look at the market and say under certain conditions, prices have spiked and what were these conditions? And we can sort of try to learn something from that. We had a very severe diesel crisis in 2022 when the Russia-Ukraine conflict started, and effectively Russian diesel had to be significantly rerouted around the world. We got to $200 per barrel.
Andrew Sheets: Right about where we are now…
Martijn Rats: Right about where we are. That didn't last very long. Big spike to [$]200, and it sold off. In March-April, we got to [$]200, and it sold off. And now, a couple of days ago, we reached that again. And so, in the trading behavior of the market, it does look like what happens at [$]200 – there either is demand destruction. Or there may not be demand destruction in the fullness of time, but buyers just take a pause.
And this makes it quite difficult to kind of really unearth this issue in the sense that in the end, a lot of customers also have inventories of their own. Like airlines have tanks with jet fuel. In Europe, you have a lot of households that use heating oil for home heating if they're not connected to the gas grid. And they have tanks in their gardens.
And so, there are a lot of tertiary inventories, as we call them, where people can effectively afford to stop buying for a little bit and see how things pan out, and then they buy later. And so, the actual data points that we have on demand destruction, even at this price, they're actually not that convincing.
There seems to be some... There clearly is in China. In China, we have seen signs of demand destruction at these very high prices. But in the rest of the world, either there are subsidies in place, or people draw on their own inventories for a bit. Or they just absorb it because it's an indisplaceable fuel in the short run.
Actually, it's not all that convincing that there is a lot of demand destruction even at these prices.
Andrew Sheets: So, Martijn, the last thing I want to ask you about is – this is a fuel that is central to a lot of key industrial processes, as we've discussed, agriculture, trucking. What is the risk that the countries that have more of this refining capacity stop exporting it to the rest of the world. Try to keep more of it to themselves in order to cushion the domestic price impact?
Martijn Rats: That risk is very real. We've already seen some of this earlier on in the Hormuz crisis in March and April. For example, China at some point announced an export ban on all refined products. In retrospect, that wasn't quite as forcefully implemented as it was announced. But nevertheless, the Chinese government did announce that, and we saw a initially large decline.
The government of South Korea at some point banned refined product exports. In the United States, there are voices that say that this might be something that the government should consider. I would say, though, about the U.S. diesel export ban, there is a good reason why this has not happened yet.
Because the United States is broadly balanced in gasoline, domestic production of gasoline by the refiners. It broadly equals to domestic consumption. And there is a tiny little bit of exports. But in the overall scheme of things, it's not much.
In diesel, it has a very large surplus, which is exported. But if there were to be an export ban and that diesel cannot leave the country – for a little bit, you can store it. But you'd fill up those tanks very, very quickly. When those tanks are full, you then need to slow down the refineries because otherwise you simply have diesel that you cannot get rid of.
If you slow down the refineries, and this is how we come back to the start of the discussion, the mix of products that you produce is broadly fixed. So, if you slow down the refineries, you make less gasoline. And so, in the United States, you can get the counterintuitive outcome that a diesel export ban could lead to higher gasoline prices.
So, a lot of these things have unintended consequences, and there are good reasons why they haven't happened yet.
Andrew Sheets: I think that's a fascinating and counterintuitive way to think about it. Thank you, Martijn, as always, for taking the time.
Martijn Rats: My pleasure.
Andrew Sheets: And thank you for listening. If you find Thoughts on the Market useful, let us know by leaving a review wherever you hear us. And also tell a friend or colleague about us today.

Tighter AI safety requirements could reshape the pace of AI investment. Ariana Salvatore and Michael Zezas dig into why the spending may shift toward more compute, not less.
Read more insights from Morgan Stanley.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Head of U.S. Public Policy Research at Morgan Stanley.
Michael Zezas: And I'm Michael Zezas, Deputy Global Head of Research at Morgan Stanley.
Ariana Salvatore: Today, we'll be talking about AI safety and regulation.
It's Wednesday, September 23rd, at 10am in New York.
We put out a note last week on AI frontier capability gain and the associated safety risks.
Those have been in focus in recent weeks, and as a result, we've gotten a number of questions about the path forward for government regulation.
So today, Mike and I are going to get into some of the newest developments, where we think things are headed, and how the midterms could shape that path.
Michael Zezas: Yeah, and this is pretty important because the concern is that if AI safety scrutiny increases, it's going to slow everything down. You might have less CapEx, fewer model releases, and there's all sorts of downstream effects for the pace of U.S. growth and investment strategy in equities and throughout the AI investment theme.
But Ariana, you and the team landed in a bit of a different place and are arguing that a bigger focus on AI safety could end up being a tailwind to compute spend rather than a brake on it. Can you break that down for us?
Ariana Salvatore: Sure. So, the way we see this playing out, is there are five potential states of the world. Some include industry self-policing; some include the prospects for heavier government intervention. Across all of them, as you mentioned, we actually think this is a pretty big tailwind to compute spend and CapEx more broadly.
That's because as the labs integrate greater safety monitoring infrastructure, we think that spend is only going to accelerate, especially as LLM capabilities increases at a nonlinear rate. Similarly, on the regulation front, we think there are a few things that prevent something like a large comprehensive AI regulation bill from coming to fruition.
We think there's really three, kind of, key obstacles to something like that happening.
The first is the politics. So, the president himself has said he's against some sort of large-scale regulation. The second is the procedure. So mechanically speaking, there would need to be a legislative vehicle for this sort of thing to ride on. That's hard to see emerging in the very near term. And the third is precedent.
So, historical precedent here tells you that usually regulation is catalyzed by some sort of high salience event. That's why our framework for government reaction here hinges on two components: incident salience, as I just mentioned, and instrument availability. Instrument availability basically reflects the extent to which the government already has a tool that it can pull in this direction.
So, that's how we think about it going forward. That doesn't mean all policy action is off the table, but that supports our expectation for higher CapEx, higher compute spend over the coming years.
Michael Zezas: Right. So, the idea is that the spending continues and the things that would otherwise limit that spending, you don't see as real plausible policy options at the moment. And can you break this down a little bit more? Because I know there's a lot of different proposals floating around Washington, D.C. from policymakers right now.
What are you paying attention to?
Ariana Salvatore: We don't expect an overarching AI regulatory authority in the near term. Now, importantly, we also don't expect sweeping open weight model regulation. The reason for that is threefold. First of all, we think the U.S. is keen on maintaining this managed stability relationship with China.
We've written about the expectations around the U.S.-China summit. That's kind of a delicate balance that we think is likely to persist. So, overly restricting open weights models might throw a little bit of a wrench into that equilibrium that we see. So that's the first reason.
The second reason is diffusion. We think the U.S. administration wants to see the proliferation of open weights models. We know that companies are using some sort of hybrid of open and closed weight. So, to the extent that, you know, banning these models would slow adoption, we don't think that's in the interest of the administration.
And the third reason is purely mechanical. It's really hard to enforce these sorts of restrictions. Once a model weight is published online, it can be really hard to clamp down exactly who and where it's going to.
Obviously, companies can download them, customize them, et cetera. So, the enforcement picture here is also really challenging. That being said, we do think that the executive can continue to lean in and, sort of, make some incremental adjustments or changes on the regulatory front. But we think it's likely less severe than some of the proposals you're seeing in Congress right now. Things like the Kill Switch Act, for example, which basically mandate that companies can maintain an ability to shut down models at a moment's notice, right? If a certain threshold is crossed.
So, that's something that we see as less likely to come to fruition. But again, setting safety standards, guardrails, all of that from the administration we think is possible in the near term.
Michael Zezas: What about some of the pushback that would at least appear to be rising at the state and local level around construction of data centers?
Is that something that you think might materially slow the industrial build-out and the CapEx levels around AI?
Ariana Salvatore: So far, what we've seen is that AI safety risks are not the top of the priority list when it comes to data center pushback, right? So, things like environmental concerns, affordability – those tend to be the main vectors of the opposition.
That being said, we've gotten the question, right, to your point, of does this, sort of, risk focus mean that the data center backlash is likely to grow? We think that it could, but at the same time, we think this is a highly idiosyncratic issue, meaning that this is something to pay attention to on a very granular level.
Certain states and localities will be the ones to really administer these restrictions, and we think in the aggregate, hyperscalers are going to be able to continue to mitigate. We've already seen these mitigation measures employed. We're still constructive on AI CapEx this year and next, because overall, we see the build-out really becoming more of a conditional build-out.
So, that means contingent upon some of these concessions, maybe it's more expensive in certain areas. But overall, we don't think that the concerns around safety are going to derail that story.
Michael Zezas: So, then when it comes to data centers, the conditions that might be being put on their construction at the state and local level, for the most part – those building out the data centers have been willing to make those concessions, so it hasn't slowed that much. Is that fair?
Ariana Salvatore: That's right, and it really depends on where the pushback is coming from, right? So, in some cases, you're seeing communities push back on things like water usage, right? And we're seeing the hyperscalers come out and respond and say explicitly, you know, how much water they're using in some of these operations. Google is proposing a regulatory framework, so that's something that they're mitigating through that lens.
In another example, you've got local communities pushing back on just, sort of, disruptions to quality of life, and you're seeing companies like Meta announce a fund to engage more locally there.
So, it really is different. There's no one-size-fits-all solution here. But yes, I agree with you that overall, we don't think this is going to meaningfully constrain the build-out.
Michael Zezas: Got it. So, it seems like the idea here is that the secular trend around AI development is going to continue in your view. Is there any way that you think the midterm elections or the outcome around that might change your thinking?
Ariana Salvatore: So, I think the midterms will be important for sentiment, but when it comes to the actual policy path, we don't think they're the main driver, and there's two key reasons for that.
The first is obviously the president is not changing until 2029. So, the fact that President Trump still has to be involved in any capacity – if we were to see a bill emerge from Congress to us gives a little bit of clarity on what that bill could actually look like. And so ultimately, whatever comes to fruition will have to be a product of collaboration between Democrats, Republicans in Congress, and the president. So, that's a pretty much a constant.
The second reason I would say is because, as I kind of alluded to earlier, you tend to see government response when there's a high salience event. And in that case, it doesn't really matter what the government configuration is if it's reactionary.
When you think back to things like the pandemic, we saw the CARES Act. In 2008-2009, you saw the ARRA. Those are all efforts that were produced in a divided government. And so, in that vein, we basically think that you need to see some sort of event catalyze a response.
The key driver is not going to be government configuration. It's going to be the salience of that event specifically.
Michael Zezas: Okay, got it. So, the guidance to investors on the back of all of this is what?
Ariana Salvatore: So, the thematic recommendations from our team are intact, right? So, what we were talking about is basically we see these all converging towards a tailwind to CapEx and a tailwind to compute supply.
So, in that vein, we still think that you should own inference compute bottlenecks because of that excess demand relative to supply. We think that's going to persist regardless of most of the policy scenarios.
We also think own leaders in cybersecurity, as we mentioned. This should drive increased spend, especially as open weight models become much more capable. And then in the third piece, we think you should own AI adopters. AI models are already pretty capable to drive significant productivity. We think that that's just going to continue to unlock.
The last thing I would mention, we didn't really get into it in this podcast, but in this conversation we typically also talk about AI sovereignty and the U.S.-China restrictions here.
So, in that context, we would avoid negative exposure to rising U.S.-China technology transfer restrictions. We think that's an increasing probability because we do see the governments taking more of an active role, which we think drives bifurcation of the global market.
Michael Zezas: Well, Ariana, thanks for breaking it down. Appreciate talking to you today.
Ariana Salvatore: Always great speaking with you, Mike. And thank you 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.

Central banks are turning more hawkish as inflation risks increase. Our Global Chief Economist and Head of Macro Research Seth Carpenter explains what that means for the Fed, ECB and Bank of Japan.
Read more insights from Morgan Stanley.

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Seth Carpenter: Welcome to Thoughts on the Market. I’m Seth Carpenter, Morgan Stanley’s Global Chief Economist and Head of Macro Research. Today, I’m going to talk about all the movement we’ve seen in central banks and how it’s changing our forecasts.
It’s Tuesday, September 22, at 10 a.m. in New York.
Over the past two weeks, our economists here at Morgan Stanley have revised their outlooks for the Fed, the ECB, and the Bank of Japan to include more rate hikes.
Each economy faces different challenges, but all three central banks have arrived at roughly the same conclusion: growth has remained remarkably resilient despite all of the shocks hitting the global economy. And renewed energy-price pressures have increased the risk that inflation proves more persistent than they had previously expected.
The clearest example—and our biggest revision here—is the Fed.
Now for much of this year, we had actually thought the Fed might avoid hiking interest rates altogether. But in addition to this increase that we just saw at the September FOMC meeting, we now expect two additional rate hikes—in December and in March that will bring the terminal rate up to 4.25 to 4.5 percent.
While Chair Warsh has highlighted the inflationary implications of higher energy and commodity prices, for me, the more important signal was the assessment that policy is not sufficiently restrictive.
So in our view, the Fed appears to be reassessing not just the inflation outlook, but the amount of restraint that is required to bring inflation sustainably back to target.
But even with all of that said, we’re still looking at this shift as more of a recalibration of policy for the Fed rather than a fundamental shift in policy. And so the market may have—just may have—overestimated how much hiking is left.
But the shift does have clear and important market implications.
Our rate strategists expect investors to pull forward additional tightening expectations in the near term, while increasingly questioning how long policy can remain at restrictive levels before growth starts to slow.
But more broadly, the Fed now appears a bit more sensitive to energy-driven inflation pressures, and that strengthens the case for a firmer dollar.
Over recent months, rising energy prices have supported the euro because investors have seen the ECB respond more aggressively than the Fed. That maybe former asymmetry could be changing.
Our foreign-exchange strategists therefore continue to favor dollar strength, particularly against the yen.
Now Europe does face a similar inflation challenge to the Fed, though through a different mechanism.
The renewed rise in natural-gas and other energy prices has led our economists to revise up their inflation forecast materially and, therefore, to add in another ECB rate hike in December.
But we have got to keep in mind that it is not energy prices all by themselves that have changed the outlook.
Economic activity in the euro area has also proven to be much more resilient than we had anticipated. And that reduces concerns that an additional modest tightening of policy would derail growth.
And so if you take it all together, the ECB is increasingly focused on preventing higher energy costs from feeding into broader inflationary dynamics.
Now Japan might seem different, but the underlying story is really surprisingly similar.
For decades, the BoJ’s challenge was generating inflation. But now policymakers are now increasingly concerned about the possibility that inflation will overshoot its target.
After the BoJ’s hike last week, we expect it to raise rates to 1.5 percent in December and then raise rates further, to about 1.75 percent, in March.
Like the Fed and the ECB, the BoJ faces an economy that has absorbed tighter financial conditions much better than had been expected.
And yet, unlike the Fed and the ECB, our strategists believe that markets have become too aggressive in pricing the eventual destination of rates. And that creates scope for expectations to be revised lower over time.
As a result, while Japanese rates may continue to rise gradually, our foreign-exchange strategists still expect a broader trend of yen weakness to emerge once temporary positioning effects fade.
So the common thread across all three of these central banks that I’ve discussed is that, while the energy shock has changed the inflation conversation, the resilience in growth has further changed the policy conversation.
And so for investors, next year is probably going to be characterized by higher policy rates and a stronger dollar than markets expected at the beginning of the year.
Well, thanks for listening. And If you enjoy the show, please leave us a review and share Thoughts on the Market with a friend or colleague today.

Our CIO and Chief U.S. Equity Strategist Mike Wilson discusses why quality stocks, strong earnings and price momentum support his view that the bull market remains intact.
Read more insights from Morgan Stanley.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist.
Today on the podcast I’ll be discussing the ongoing mid-cycle transition.
It's Monday, September 21st at 11:30 am in New York.
So, let’s get after it.
The S&P 500 is near record highs. That’s despite rising energy prices, two wars running in parallel and AI safety concerns back in the headlines. Meanwhile central banks are tightening. On paper, that's a lot of reasons to be nervous. So are investors just being complacent? I don't think so.
More than 40 percent of the Russell 3000 has fallen at least 20 percent since June, while the S&P 500’s forward price earnings multiple has fallen back to 19 times, which is almost 20 percent lower than a year ago. At the same time, median stock earnings growth is running around 15 percent, and revisions breadth is back near cycle highs. Falling valuations alongside strong earnings growth is not complacency. It is the definition of a classic mid-cycle transition.
That distinction matters because mid-cycle markets tend to frustrate almost everyone. The index can remain resilient while much of the market corrects. Earnings can stay strong while multiples fall. And leadership can change without the bull market ending.
Last week’s Fed meeting fits squarely into that framework. The 25-basis-point hike was largely priced, so the real information was Chair Warsh’s willingness to follow through on his commitment to fight inflation. Recent core inflation data were firmer than expected, but the details were not uniformly hot.
Some of the upside was concentrated in a handful of categories, shelter remained soft, and tariff pass-through appears to be fading. That gave the Fed room to act without forcing investors to assume we are heading into another 2022-style tightening campaign.
In my view, the hike can enhance credibility. If investors believe the Fed is acting early enough to contain inflation, a higher policy rate can reduce uncertainty and term premium rather than automatically driving long-term financing costs higher.
But the rate hike is not my concern. A few additional hikes over the next year are unlikely to end this bull market if earnings remain strong. The bigger unknown is how a Warsh-led Fed approaches the balance sheet, money supply, and credit growth. His philosophy has historically leaned more monetarist than prior Fed chairs. However, we still don’t know how aggressively he will apply it – or how much influence he will have over the rest of the committee. That matters because the private economy is using more capital, and an overly restrictive approach to liquidity could become more consequential than the policy rate itself.
This is one reason I continue to favor large-cap quality. High free-cash-flow yield, low accruals, and operating-efficiency factors are leading, while the high-sales-per-employee factor has been one of the strongest recent performers. That also aligns closely with our preference for AI adopters rather than the enablers.
Price momentum is not disappearing. But its composition is changing toward quality, services-oriented, asset-light, and fee-based businesses. That is exactly what should happen during a mid-cycle transition.
The near-term swing factor remains energy prices. Another meaningful rise in crude or refined products would put upward pressure on the expected policy path, long-end yields, and bond volatility in an unhealthy way. It would also arrive during a period when midterm-election seasonality often produces a 5 to 10 percent index correction.
In a worst-case near-term scenario, the S&P 500 could trade near 7100, but I would view that as a tactical correction within the bull market – not a change in our fundamental views. Either way, I remain convicted in our 8,000 year-end price target.
The bottom line is that this market is behaving exactly like a mid-cycle market should: valuations are compressing, earnings are carrying the load, and leadership is moving toward quality. The index may look calm, but plenty of concern has already been priced at the stock level.
The mistake would be confusing resiliency with complacency—and missing the rotation taking place in plain sight.
Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!

As President Xi heads to Washington, trade, rare earths and AI are set to dominate the agenda. Our Head of U.S. Public Policy Research Ariana Salvatore unpacks what the meeting could mean for supply chains, tech stocks and the broader market.
Read more insights from Morgan Stanley.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Head of U.S. Public Policy Research at Morgan Stanley.
Today, I'll be talking about next week's U.S.-China summit, specifically the bilateral trade relationship, what we can expect on critical minerals and rare earths, AI dialogues, and what it all means for markets.
It's Friday, September 18th at 10am in New York.
President Xi is scheduled to visit the White House on September 24th for his second meeting with President Trump this year, and his first White House visit in roughly a decade.
The meeting follows President Trump's visit to Beijing in May, where the two sides established a framework for what they call a more constructive relationship of strategic stability. That meeting also produced new trade and investment dialogues, commitments around agricultural purchases and aircraft, and an agreement to begin a dialogue on artificial intelligence.
But next week's summit comes at an important moment because several of the temporary arrangements that helped stabilize the economic relationship are due to expire later this fall.
We think there are three areas to focus on.
The first is trade. The current U.S.-China tariff truce is scheduled to expire in November. Now, public reporting suggests that the two governments are discussing an extension alongside potential announcements on agriculture, non-tariff barriers, and a relatively narrow set of goods that could see lower tariffs.
The question for markets, therefore, is less whether next week produces a comprehensive new trade agreement and more so on whether the two sides can extend the current period of stability and prevent another significant increase in tariffs.
The second area is critical minerals. This is probably one of the clearest examples of the leverage that each side has over the other.
Washington, we think, wants more predictable Chinese exports of rare earths and other critical materials used across semiconductors, autos, aerospace, and defense. Beijing, meanwhile, has been pushing back against U.S. restrictions on Chinese companies' access to advanced technology.
Public reporting suggests that both of these issues are part of the negotiations heading into the summit, and the timing here is really important. November 10th is an upcoming cliff affecting China's rare earth restrictions and U.S. technology controls, followed later that month by another deadline covering certain minerals. So what happens next week could determine whether those restrictions remain suspended or begin to snap back.
The third area is technology, and increasingly artificial intelligence. The two leaders agreed in May to establish an AI dialogue, and President Trump has specifically said AI will be discussed next week.
Reporting also shows that shared AI risks could be one area for discussion, although the broader competitive relationship makes a comprehensive agreement difficult, we think. From a policy perspective, the most important point is that technology restrictions are moving beyond advanced chips. The debate includes cloud and compute access, model distribution, procurement, and potentially the use of certain foreign AI models themselves.
In other words, we think that while the summit could produce something like an agreement to keep talking on AI, the underlying shift matters more. AI sovereignty pushes both the U.S. and China toward more restrictions or heavier government involvement even over a longer period of time.
We expect that a middle path is the more plausible U.S. approach. So think targeted restrictions on specific Chinese developers rather than a blanket prohibition on Chinese open weight models. But even that would reinforce what we've called the two worlds thesis, increasingly distinct U.S. and Chinese tech ecosystems with separate infrastructure, supply chains, standards, and distribution channels.
There could also be a host of other issues on the agenda, specifically the U.S.-Iran conflict, which we see as a tail risk into the talks.
So what does all this mean for investors?
Even a constructive summit is unlikely to reverse the structural push toward technology and supply chain diversification. In fact, we argue that greater U.S.-China bifurcation will actually reinforce investment in parallel ecosystems, semiconductor capacity, data centers, cloud infrastructure, power, and critical mineral supply chains.
In that sense, actually less geopolitical friction next week could reduce near-term market volatility, but without necessarily changing the underlying investment cycle.
So, the key question coming out of the summit is not simply whether the relations are improving or deteriorating. It's whether the two sides can preserve enough stability to manage their competition while the longer-term process of de-risking continues underneath.
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