Thoughts on the Market: How Waning American Dominance Could Move Yields

Podcast Information:

• Title: Thoughts on the Market
• Host/Authors: Morgan Stanley
  • Andrew Sheats: Head of Corporate Credit Research
  • Lisa Shallet: Chief Investment Officer for Morgan Stanley Wealth Management
• Episode: How Waning American Dominance Could Move Yields
• Release Date: July 31, 2025
• Description: Short, thoughtful, and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.

Introduction

In this episode of Thoughts on the Market, Andrew Sheats and Lisa Shallet delve into the theme of American exceptionalism and its implications for fixed income markets. Released on July 31, 2025, the discussion centers around the dynamics of US debt levels, interest rates, and the evolving landscape of credit markets amidst shifting macroeconomic conditions.

American Exceptionalism and Fixed Income

Andrew Sheats opens the conversation by highlighting the dichotomy within the US economy:

"[00:53] ...large deficits that the US Federal government are running are in some ways largely mirrored by very, very good private sector financial positions."

Sheats emphasizes that while government debt is soaring, private sector households and the equity market maintain record asset levels relative to debt. This creates a complex environment where lending to the private sector can be advantageous due to stronger financial positions and reduced issuance.

US Debt Levels and Investor Concerns

Lisa Shallet prompts a discussion on the implications of high US debt levels and rising interest costs:

"[00:19] ...constraints of debts and deficits and how they play in with US debt levels soaring and interest costs rising, how concerned should investors be?"

Sheats responds by acknowledging the unequal landscape between financially robust companies and those struggling under the current rate environment. He points out that:

"[02:12] ...the spread to be narrower than it otherwise would be."

This suggests that despite high government deficits, the private sector's strong financial health may mitigate some investor concerns regarding rising yields.

Shadow Banking and Private Credit Markets

The conversation shifts to the expansion of shadow banks and private credit markets, a consequence of prolonged monetary stimulus and financial repression:

"[02:12] ...the explosion of shadow banks and the private credit markets."

Shallet presents the hypothesis that there has been a misallocation of capital and excessive risk-taking within these private credit spheres. She questions whether these markets will become sources of liquidity and issuance or act as drains on the financial system.

Normalization and Corporate Debt Structures

Sheats discusses the challenges faced by a subset of the high-yield market, where corporate debt structures are ill-suited for the current interest rate environment:

"[03:09] ...you have the wrong capital structure, you have the wrong level of leverage and it's actually hard to do much about that other than to restructure that debt."

He draws parallels to the equity market, predicting increased dispersion between financially stable entities and those struggling, akin to a "haves and have nots" scenario.

Opportunities and Risks in Credit Markets

Exploring the credit market landscape, Sheats identifies investment-grade bonds as particularly attractive:

"[04:30] ...the investment grade market in the US pays five and a quarter percent. A six percent long run return might be competitive..."

He also highlights the burgeoning tech sector's capital needs, particularly in data center buildouts, as a potential area for credit market funding:

"[05:09] ...this data center buildout is just enormous... $3 trillion with a T."

This presents both opportunities and risks, as the credit markets may play a pivotal role in financing significant technological infrastructure.

Blurring Lines Between Public and Private Credit

The hosts examine the evolving distinctions between public and private credit markets:

"[05:34] ...credit where it's not always clear why a particular corporate loan would need to be traded every day."

Sheats notes increasing sophistication among investors who navigate between these markets based on where they perceive better compensation or opportunities:

"[06:28] ...private credit has until recently been somewhat synonymous with high yield lending, riskier lending, lower rated lending."

However, the nature of lending is shifting, with some private credit lending resembling investment-grade standards, indicating a convergence of credit market segments.

Cross-Asset Portfolio and Shifting Correlations

Shallet raises concerns about the breakdown of traditional cross-asset correlations, particularly between stocks and bonds:

"[06:51] ...cross asset correlations are starting to break down... stocks and bonds are more often than not positively correlated."

Sheats responds by identifying two main takeaways:

1. US Dollar Dynamics:

   "[07:30] ...the US dollar... has really broken down."

2. Rates and Equity Markets:

   "[07:30] ...rates going higher might be more of a problem for the S&P 500 than rates going lower."

He underscores that bonds still hold a crucial role in diversifying portfolios, especially in scenarios involving recessions where their protective qualities become invaluable.

Duration, Risk, and Portfolio Construction

Addressing portfolio management, Shallet discusses the relevance of the traditional 60/40 portfolio split in the current market:

"[09:02] ...the perfect world of negative correlations between stocks and bonds... probably is over."

She emphasizes the enduring importance of bonds, particularly the five to ten-year segment, due to their lower volatility and competitive returns:

"[09:02] ...a fixed income asset that's returning sixes and sevens has a definite role to play in portfolios."

Sheats adds that while the 60/40 split may be evolving, the bond component remains essential, especially given the stretched valuations on the equity side:

"[10:56] ...the equity side that has a more stretched valuation."

Valuation and Expected Returns

The discussion concludes with an analysis of valuation metrics and their implications for expected returns:

"[10:56] ...the equity side that has a more stretched valuation."

Shallet advocates for the inclusion of bonds in portfolios, noting that much of the growth has already been priced into equities, aligning expected returns closer to long-term averages. This strategy benefits long-term investors seeking stability over exploiting short-term volatility.

Conclusion

Andrew Sheats and Lisa Shallet provide a comprehensive analysis of the current market dynamics influenced by waning American dominance. They explore the interplay between government deficits, private sector strength, evolving credit markets, and shifting asset correlations. The episode underscores the continued relevance of bonds in diversified portfolios, even as traditional correlations between asset classes change. Investors are advised to remain attentive to the evolving credit landscape and maintain balanced portfolio strategies to navigate potential risks and opportunities.

Notable Quotes:

• Andrew Sheats [00:53]:
  "Large deficits that the US Federal government are running are in some ways largely mirrored by very, very good private sector financial positions."

• Andrew Sheats [02:12]:
  "...the spread to be narrower than it otherwise would be."

• Andrew Sheats [03:09]:
  "You have the wrong capital structure, you have the wrong level of leverage and it's actually hard to do much about that other than to restructure that debt."

• Andrew Sheats [04:30]:
  "The investment grade market in the US pays five and a quarter percent. A six percent long run return might be competitive..."

• Andrew Sheats [06:28]:
  "...private credit has until recently been somewhat synonymous with high yield lending, riskier lending, lower rated lending."

• Andrew Sheats [07:30]:
  "The US dollar... has really broken down."

• Andrew Sheats [10:56]:
  "The equity side that has a more stretched valuation."

Final Note:
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