Podcast Summary: "More Talk, Less Action Could Be Good for Credit Markets"
Title: More Talk, Less Action Could Be Good for Credit Markets
Host/Author: Morgan Stanley
Episode Release Date: December 20, 2024
Speaker: Andrew Sheats, Head of Corporate Credit Research at Morgan Stanley
Duration Covered: 00:00 – 03:46
Introduction to Credit Market Outlook
In the episode titled "More Talk, Less Action Could Be Good for Credit Markets," Andrew Sheats, Morgan Stanley’s Head of Corporate Credit Research, delves into the potential scenarios where the credit markets might outperform expectations despite inherent limitations. Released on December 20, 2024, this episode provides a nuanced analysis of the factors that could contribute to a more optimistic credit market landscape in the upcoming year.
Current State of Credit as an Asset Class
Andrew Sheats begins by contextualizing credit as an asset class, highlighting its constrained upside potential:
“Credit is an asset class that always faces more limited upside and the low starting point for spreads as we enter 2025 further limits potential gains.”
[00:30]
He emphasizes that while the potential for significant gains may be limited due to already tight spreads, there remain avenues through which the market could exceed expectations.
US Policy and Its Impact on Credit Markets
A significant portion of the discussion centers on US policy and its ramifications for credit markets:
“Morgan Stanley's Public Policy Strategy team thinks that the incoming US Administration will be a story of fast announcement, slow implementation...”
[00:50]
Sheats explains that anticipated policies, particularly regarding tariffs and immigration, are expected to have delayed effects, primarily manifesting in 2026 rather than immediately. This delay could preserve the current credit-friendly environment longer than markets anticipate.
He further outlines Morgan Stanley's growth forecasts:
“Our growth numbers for 2025 are good. Our numbers for 2026 are weaker.”
[01:10]
Despite weaker growth projections for 2026, the scenario where policy announcements do not translate into swift, sustained actions could maintain favorable conditions for credit markets. Specifically, if tariffs remain a negotiating tool rather than becoming entrenched policies, the Federal Reserve might lower interest rates even as economic growth remains robust—a rare but highly beneficial combination for credit markets.
“Rate cuts with good growth is a rare occurrence, but when you do get it, it can be extremely good.”
[01:35]
Comparing to the mid-1990s, Sheats suggests that similar conditions then led to even tighter credit spreads than currently observed.
Market Funding Conditions
Another factor Sheats explores is the state of market funding conditions:
“Some loosening of bank capital requirements or stronger demand for collateralized loan obligations could both flow through to tighter spreads for the assets that these fund, especially things like leveraged loans.”
[02:00]
He posits that improved funding conditions, such as reduced bank capital requirements or increased demand for collateralized loan obligations (CLOs), could result in tighter spreads, particularly benefiting leveraged loans. Historical parallels indicate that periods of easier funding have often coincided with tighter credit spreads.
Corporate Activity and Mergers & Acquisitions (M&A)
The episode also touches upon the role of corporate activities, notably mergers and acquisitions, in shaping credit market outcomes:
“M&A can also be a positive event, especially on a name by name basis.”
[02:20]
Sheats suggests that increased M&A activity, especially large companies acquiring smaller ones, can absorb weaker high-yield credits into stronger, investment-grade balance sheets. This consolidation can enhance the overall quality of high-yield bonds and loans, presenting a favorable outcome for investors in these assets.
Global Economic Growth: Europe and China
Sheats broadens the scope to global economic performance, particularly in Europe and China:
“If growth in Europe and China is better than expected, spreads especially in Europe, which are not as tight as those in the US could go tighter.”
[02:50]
He notes that expectations for economic growth in these regions are currently low. Exceeding these modest projections could lead to tighter credit spreads, especially in Europe where spreads are generally wider compared to the US. Improved growth in these regions would bolster investor confidence and potentially enhance credit market performance.
The Federal Reserve and Global Central Banks’ Rate Cuts
Arguably the most impactful aspect of Sheats' bullish scenario revolves around anticipated interest rate cuts by major central banks:
“Morgan Stanley expects the Federal Reserve, the Bank of England and the European Central bank to all lower interest rates much more than markets expect next year...”
[03:15]
He forecasts substantial rate hikes by these institutions, which are expected to be more aggressive than market anticipations. These rate cuts are projected to support sustained economic growth in 2025 despite the loosening monetary policy. Additionally, Sheats expects bond yields to decline more than currently projected:
“We also think that yields fall more than expected. If that's right, credit could quietly have an outstanding year for total return...”
[03:30]
This combination of lower yields and maintained growth could significantly enhance total returns for credit investors. Specifically, Morgan Stanley's forecasts indicate that US investment-grade credit could achieve a total return approximately 10% higher than the projected total return for the S&P 500, presenting a highly attractive opportunity for investors focused on total return.
Conclusion: A Bullish Outlook for Credit Investors
Wrapping up the discussion, Andrew Sheats underscores the potential for a positive year ahead for credit markets, especially for those prioritizing total returns. While acknowledging the inherent limitations and challenges, the outlined scenarios present a compelling case for optimism in the credit sector.
Key Takeaways:
- Policy Delays: Slow implementation of US policies could maintain a credit-friendly environment longer than expected.
- Rate Cuts with Growth: Potential for the Federal Reserve and other central banks to lower rates while sustaining economic growth, enhancing credit market conditions.
- Improved Funding Conditions: Loosening bank capital requirements and increased demand for CLOs could tighten credit spreads.
- Corporate Consolidation: Increased M&A activity may improve the quality of high-yield credits.
- Global Growth Exceeding Expectations: Better-than-anticipated growth in Europe and China could further tighten credit spreads.
- Significant Total Returns: Potential for US investment-grade credit to outperform the S&P 500 by approximately 10%.
This episode provides credit investors with a multi-faceted analysis of the factors that could drive better-than-expected performance in the credit markets. By exploring policy impacts, funding conditions, corporate activities, and global economic growth, Andrew Sheats offers a comprehensive outlook that balances current constraints with pathways to potential growth.