Our Head of Corporate Credit Research Andrew Sheets explains why
corporate credit may struggle in 2025, including the risks of
aggressive policy shifts in the U.S. along with political and
structural challenges in Europe and Asia.
----- 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 are worse than we
expect. Next week, I’ll cover what could be better.
It's Wednesday, December 11th at 2pm in London.
Morgan Stanley strategists and economists recently completed our
forecasting process for the year ahead, and regular listeners
will have now heard our expectations across a wide range of
economies and markets. But I’d stress that these forecasts are a
central case. The world is uncertain, with a probability
distribution around all forecasts. So in the case of credit, what
could go wrong?
As a quick reminder, our baseline for credit is reasonably
constructive. We think that low credit spreads can remain low,
especially in the first half of next year – as policy change is
slow to come through, economic data holds up, the Fed and
European Central Bank ease rates more than expected, and
still-high yields on corporate bonds attract buyers.
So how does all of that go wrong? Well, there are a few specific,
realistic factors that could lead us to something worse, i.e.,
our bear case.
Let me start with US policy. Morgan Stanley’s Public Policy
team’s view is that the incoming US administration will see fast
announcement, but slow implementation on key issues like tariffs,
fiscal policy, and immigration; and that that slower
implementation of any of these policies will mean that change
comes less quickly to the economy. But that change could happen
faster, which would mean weaker growth and higher prices – if,
for example, tariffs were to hit earlier and or in larger size.
In the case of immigration, we are actually still forecasting
positive net immigration over the next several years. But a
larger change in policy would raise the odds of a more severe
labor shortage.
Even outside any specific change from the new US administration,
there’s also a risk that the US economy simply runs out of gas.
The recovery since COVID has been extraordinary – one of the
fastest on record, especially in the labor market. The risk is
that companies have now done all the hiring they need to do,
meaning a slower job market going forward. Even in their
base-case, Morgan Stanley’s economists see job market growth
slowing, adding just 28,000 jobs/month in 2026. And to give you a
sense of how low that number is, the average over the last 12
months was 190,000. And so, the bear case is that the labor
market slows even more, more quickly, raising the risk of
recession and dramatically lowering bond yields, both of which
would reduce investor demand for corporate bonds.
At the other extreme, credit could be challenged if conditions
are too hot. Because current levels of corporate aggression are
still quite low, we think they could rise in 2025 without
creating a major problem. But if those corporate animal spirits
arrive more rapidly, it could be a negative.
Outside the US, we think the growth in Europe holds up as the
European Central Bank cuts rates and Europeans end up saving at a
slightly less elevated rate, and that that can keep growth near
this year’s levels, around 1 per cent. But you don’t need me to
tell you that Europe is riddled with challenges: from the
political in France, to major structural questions around
Germany’s economy. Meanwhile, China, the world’s second largest
economy, continues to struggle with too little inflation. We
think that growth in China muddles through, but a larger trade
escalation could drive downside risk; one reason we prefer
ex-China credit within Asia.
Of course, maybe the most obvious risk to Credit is simply
valuation. Credit spreads in the US are near 20-year lows, while
the US Equity Price-to-Earnings Multiples for the equity market
is near 20-year highs. In our view, valuation is a much better
guide to returns over the next six years, rather than say the
next six months. And that’s one reason we are currently looking
through this. But those valuations do leave a lot less margin for
error.
Thanks for listening. If you enjoy the show, leave us a review
wherever you listen and share Thoughts on the Market with a
friend or colleague today.
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