Thoughts on the Market: What Could Go Wrong for Corporate Credit?

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: What Could Go Wrong for Corporate Credit?
• Release Date: December 11, 2024

Summary:

In the December 11, 2024 episode of Thoughts on the Market, Morgan Stanley’s Head of Corporate Credit Research, Andrew Sheetz, delves into the bear case scenarios that could adversely impact corporate credit markets. Sheetz systematically explores various risk factors ranging from US policy shifts to global economic uncertainties, providing a comprehensive analysis for investors and market enthusiasts alike.

1. Introduction to Corporate Credit Baseline

Andrew Sheetz opens the episode by outlining the current optimistic baseline for corporate credit. He emphasizes that “low credit spreads can remain low, especially in the first half of next year,” citing factors such as delayed policy changes, stable economic data, accommodative monetary policies from the Federal Reserve and the European Central Bank, and sustained investor interest in high-yield corporate bonds ([00:02]).

2. US Policy Risks

Sheetz transitions to potential risks stemming from US policy developments. He notes that “the incoming US Administration will see fast announcement but slow implementation on key issues like tariffs, fiscal policy, and immigration” ([00:30]). This slow implementation could delay economic changes, potentially leading to:

• Accelerated Policy Changes: Contrary to slow implementation, any rapid policy shifts—such as “tariffs hitting earlier or in larger size”—could trigger weaker economic growth and heightened inflation ([00:35]).

• Immigration Policy: While current forecasts anticipate “positive net immigration over the next several years,” a more stringent immigration policy could exacerbate labor shortages, compounding economic challenges ([00:40]).

3. Labor Market Concerns

A significant portion of the discussion centers on the robustness of the US labor market. Sheetz highlights the unprecedented recovery since COVID-19 but warns of potential stagnation:

• Job Market Saturation: He points out that “companies have now done all the hiring they need to do,” leading to a projected slowdown in job growth ([01:00]).

• Base Case vs. Bear Case: In the baseline scenario, job growth is expected to decelerate modestly to 28,000 jobs per month in 2026—a stark drop from the recent average of 190,000 jobs per month ([01:05]). The bear case posits an even more severe slowdown, increasing the risk of a recession and reducing demand for corporate bonds due to lower bond yields ([01:10]).

4. Corporate Aggression and Economic Overheating

Sheetz introduces another risk factor related to corporate behavior:

• Corporate Aggression Levels: While current corporate aggression is “still quite low,” a sudden increase in aggressive business tactics “could be a negative” for credit markets if it leads to overheating without corresponding economic growth ([01:20]).

5. Global Economic Outlook

Turning to the international landscape, Sheetz outlines potential global risks:

• Europe: Although the European economy is expected to maintain “growth near this year’s levels around 1%” due to rate cuts by the European Central Bank and modestly reduced savings rates, numerous challenges persist. Issues such as “political instability in France” and “structural questions around Germany's economy” could undermine growth prospects ([01:35]).

• China: As the world’s second-largest economy, China faces its own set of challenges. Sheetz observes that while “growth in China muddles through,” the risk of a “larger trade escalation” could pose significant downside risks to global credit markets ([01:40]).

6. Valuation Risks

A critical examination of market valuations reveals underlying vulnerabilities:

• Credit Spreads and Equity Multiples: Sheetz warns that “credit spreads in the US are near 20-year lows,” and the US equity market’s price-to-earnings multiple is hovering near 20-year highs ([02:00]). Such high valuations “leave a lot less margin for error,” signaling potential corrections if market conditions deteriorate ([02:05]).

• Long-Term vs. Short-Term Outlook: He emphasizes that valuation metrics are more indicative of “returns over the next six years rather than say, the next six months,” suggesting that while immediate risks are manageable, long-term uncertainties could have more pronounced effects ([02:10]).

7. Conclusion and Forward Look

In wrapping up, Sheetz reiterates the importance of recognizing these bear case scenarios to prepare for potential market downturns. He stresses that while the baseline scenario remains constructive, vigilance is essential given the multitude of risk factors that could derail corporate credit performance.

Notable Quotes:

• Andrew Sheetz ([00:02]): “Low credit spreads can remain low, especially in the first half of next year…”
• Andrew Sheetz ([00:30]): “The incoming US Administration will see fast announcement but slow implementation on key issues…”
• Andrew Sheetz ([01:00]): “Companies have now done all the hiring they need to do…”
• Andrew Sheetz ([02:00]): “Credit spreads in the US are near 20-year lows, while the US price to earnings multiple for the equity market is near 20-year highs.”

Conclusion:

Andrew Sheetz provides a thorough analysis of the potential risks facing corporate credit markets, emphasizing that while current conditions are favorable, a range of factors—from US policy shifts and labor market dynamics to global economic uncertainties and high market valuations—could precipitate adverse outcomes. Investors are advised to consider these bear case scenarios in their strategic planning to navigate the complex and uncertain economic landscape ahead.