Our Head of Corporate Credit Research lists realistic scenarios
for why credit could outperform expectations in 2025, despite
some risks posed by policy changes from the incoming
administration.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Andrew Sheets, head of
Corporate Credit Research at Morgan Stanley. Today I’ll be
discussing realistic scenarios where things could be better than
we expect.
It's Friday December 20th at 2pm in London.
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. Nevertheless, there are still a number of
ways where this market could do better than expected, with
spreads tighter than expected, into next year.
An obvious place to start is U.S. policy. Morgan Stanley’s public
policy strategy team thinks the incoming administration will be a
story of “fast announcement, slow implementation”, with the
growth and inflation impact of tariffs and immigration falling
more in 2026 (rather than say earlier). And so if one looks at
Morgan Stanley’s forecasts, our growth numbers for 2025 are good,
our 2026 numbers are weaker.
The bull case could be that we see more talk but less ultimate
action. Scenarios where tariffs are more of a negotiating tool
than a sustained policy would likely mean less change to the
current (credit friendly) status quo, and also increase the
likelihood that the Federal Reserve will be able to lower
interest rates even as growth holds up. Rate cuts with good
growth is a rare occurrence, but when you do get it, it can be
extremely good. If one thinks of the mid-1990s, another time
where we had this combination, credit spreads were even tighter
than current levels. Another path to the bull case is better
funding conditions in the market. 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.
If we think back to periods where credit spreads were tighter
than today, easier funding was often a part of the story.
Now, a more aggressive phase of corporate activity could be a
risk to credit, but M&A can also be a positive event,
especially on a name by name basis. If merger and acquisition
activity becomes a story of, say, larger companies buying smaller
ones, that could mean that weaker, high yield credits get
absorbed by larger, stronger, investment grade balance sheets.
And so for those high yield bonds or loans, this can be an
outstanding outcome. Another way things could be better than
expected for credit is that growth in Europe and China is better
than expected. In speaking with investors over the last few
weeks, I think it's safe to say that expectations for both
regions are pretty low. And so if things are better than these
low expectations, spreads, especially in Europe, which are not as
tight as those in the U.S., could go tighter.
But the most powerful form of the credit bull case might be the
simplest. 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, even as, for the
most part, growth in 2025 holds up. Due in a large part to those
expected rate cuts, we also think the yields fall more than
expected. If that's right, credit could quietly have an
outstanding year for total return, which is boosted as yields
fall. Indeed, on our forecast, U.S. investment grade credit, a
relatively sleepy asset class, would see a total return of
roughly 10%, higher than our expected total return for the mighty
S&P 500. Not all credit investors care about total return.
But for those that do, that outcome could feel very
bullish.
Thanks for listening. If you enjoy the show, leave us a review
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