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- [00:01]
A
Welcome to Thoughts on the Market. I'm Andrew Sheats, Head of Corporate Credit Research at Morgan Stanley.
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And I'm Lisa Shallet, Chief Investment Officer for Morgan Stanley Wealth Management.
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Today, a concluding look at the theme of American exceptionalism and how it factors into fixed income. It's Thursday, July 31st at 4pm in.
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B
London and it's 11am here in New York. So Andrew, it's my turn to ask you some questions. And yesterday we talked a lot about equity markets, globalization, some of the broader macro shifts. But I wanted to zoom in on the credit markets today. And one of our themes in the American Exceptionalism paper was the constraints of debts and deficits and how they play in with US debt levels soaring and interest costs rising, how concerned should investors be?
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A
So you alluded to this a bit on our discussion yesterday, that we are in a very interesting divide where you have inequality between very well off companies and weaker companies that aren't doing as well. You have a lot of division within households between those who are doing better and struggling more with the rate environment. But I think we also see that the large deficits that the US Federal government are running are in some ways largely mirrored by very, very good private sector financial positions. In aggregate, US households have record levels of assets relative to debt at the end of 2024. In aggregate, the financial position of the US equity market has never been better. And so this is a dynamic where lending to the private sector, whether that is to parts of the residential mortgage market or to the corporate credit market, does have some advantages, where not just are you dealing with arguably a better trend of financial position, but you're just getting less issuance. I think there are a number of factors that could cause the market to cause the difference of yield between the government debt and that private sector debt that so called spread to be narrower than it otherwise would be.
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B
Well, that's a pretty interesting and provocative idea because one of the hypotheses that we laid out in our paper is, is that perhaps one of the consequences of this extraordinary period of monetary stimulus of financial repression and ultra low rates of massive regulation of the systemically important banking system has been the explosion of shadow banks and the private credit markets. And our thesis is there a misallocation of capital? Has there been excess risk taking in that area and how should we think about that asset class, number one and number two, are they increasingly a source of liquidity and issuance or are they a drain on the system?
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A
This is kind of where your discussion of normalization is so interesting because in aggregate Household balance sheets are in very good shape. In aggregate, corporate balance sheets are in very good shape. But I do think there's a distinct tail of the market. It's call it 5% of the high yield market where you really are looking at a corporate capital structure that was designed for a much lower level of rates. It was designed for maybe an immediately post Covid environment where rates were on the floor and expected to stay there for a long period of time. And so if we are moving to an environment where fed funds is at 3 or 4 or as you mentioned, hey, maybe you could justify a rate even a little bit higher and not be wildly off. Well then you've just 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 or look to change it in a larger way. So I think we'll see a dynamic similar to the equity market where there is this dispersion between the haves and have nots.
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B
As we kind of think about where there could be pockets of opportunity in credit and in private credit, both public and private credit, and where there could be risks. Can you just help me with that and explore that a little bit more?
- [04:31]
A
I think where credit looks most interesting is in some ways where it looks most boring. I think where the case for credit is strongest is the investment grade market in the US pays five and a quarter percent. A six percent long run return might be competitive with certain investors long term equity market forecasts or at least not a million miles off. I think though the other area where this is going to be interesting is do we see significantly more capital intensity out of the tech sector and a real divide between fixed income and equities is that tech has so far really been an equity story.
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Correct.
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A
But this data center buildout is just enormous. I mean through 2028 our analysts at Morgan Stanley think it's close to $3 trillion with a T. And so there's a lot of interest in how can credit markets, how can private credit markets fund some of this build out? And there are opportunities and risks around that. And you know something that I think credit's going to play an interesting part of.
- [05:34]
B
And in that vision do you see the blurring of lines or a more competitive market between public, private and private?
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A
I do think there's always a little bit of a funny nature about credit where it's not always clear why a particular corporate loan would need to be traded every day, would need to be marked every day. I think it is a little bit different from the equity market in that way. And I think you're also seeing a level of sophistication from investors who now have the ability to traffic across these markets and move capital between these markets, depending on where they think they're being better compensated or where there's better opportunity. So I think we're kind of absolutely seeing the blur of these lines. And again, I think private credit has until recently been somewhat synonymous with high yield lending, riskier lending, lower rated lending.
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Correct. Yeah.
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And yet the lending that we're seeing to some of this tech infrastructure is, you could argue, maybe more similar to investment grade lending, both in terms of risk, but also it pays a lot less. And so again, this is kind of an interesting transition where you're seeing a broader scope and absolutely, I think, more blurring of the line between these markets.
- [06:51]
B
So let's just switch gears a little bit and pull out from credit to the broader diversified cross asset portfolio. And some of those cross asset correlations are starting to break down. And we go through these periods where stocks and bonds are more often than not positively correlated and moving together. How are you beginning to think about duration, risk in this environment? And have you made any adjustments to how you think about portfolio construction in light of these potentially shifting changes and correlations across assets?
- [07:31]
A
I think there are maybe two large takeaways I would take from this. First is, I do think the big asset where we've seen the biggest change is in the US dollar. The US dollar, I think for a lot of the period we've been discussing on these two episodes was kind of the best of both worlds. And recently that's just really broken down. And so I think when we think about the reallocation to the rest of the world, the focus on diversification, I think this is absolutely something that is top of mind among non US Investors that we're talking to, which is almost the US equity piece is kind of a separate conversation. The other piece, though, is some of this debate around yields and equities. And do equities fear higher rates or lower rates? Which one of those is the biggest problem? And there's a question of magnitude that's a little interesting here. Rates going higher might be a little bit more of a problem for the s and P500 than rates going lower. That rates going higher might be more consistent with the scenario of temporary higher inflation. Maybe rates go lower because the market gets more excited about Federal Reserve cuts. But I think in terms of scenarios where, like where is the equity market really going to have a problem. Well, it's really going to have a problem if there's a recession. So even though I think bonds have been less effective diversifiers, I really do think they're still going to serve a very healthy, helpful purpose around some of those potentially kind of bigger dynamics.
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B
Yeah, that very much jives with the way we've been thinking about it, particularly within the context of managing private wealth, where very often we're confronted with the question, what about 60 40? Is 6040 dead? Is 6040 back? Like you talk about not wanting to hedge, I don't want to hedge either. But the answer to the question we agree is somewhat nuanced. Right. We do agree that this perfect world of negative correlations between stocks and bonds that we enjoyed for a good portion of the last 15 years probably is over. But that doesn't mean that bonds, and most specifically that five to ten year part of the curve, doesn't have a really important role to play in portfolios. And the reason I say that is that one of the other elements of this conversation that we haven't really touched on is valuation and expected returns. I know that when I speak of the valuation oriented topics and the Cape ratio and expected 10 year returns, everyone's eyes glaze over and roll to the back of their head and they say, oh, here she goes again. But look, I'm in the camp that says an awful lot of growth has already been discounted and already been priced and that it is much more likely that US equities will return something closer to long run averages. So that's not awful. Lower volatility of a fixed income asset that's returning sixes and sevens has a definite role to play in portfolios for wealth clients who are by and large long term oriented investors who are not necessarily attempting to exploit 90 day volatility.
- [10:57]
A
Every quarter without putting too fine of a point on it. I think when that question of is 6040 over is phrased, I kind of think the subtext is often that it's the bond side, the 40 side that has a problem. And not to be the fixed income defender on this podcast, but you could probably more easily argue that if we're talking about, well, which valuation is more stretched, the equity side or the bond side. And I think it's the equity side that has a more stretched valuation.
- [11:25]
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Without a doubt, without a doubt.
- [11:28]
A
Well Lisa, thanks again for taking the time to talk.
- [11:31]
B
Absolutely great to speak with you, Andrew, as always.
- [11:35]
A
And thanks again for listening to this two part conversation on American exceptionalism. The changes coming to that and how investors should position and to our listeners, a reminder to take a moment to please review us wherever you listen. It helps more people find the show and if you found this conversation insightful, tell a friend or colleague about thoughts on the market today.
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