Our Head of Corporate Credit Research, Andrew Sheets, expects a
sticky but shallow cycle for defaults on loans, with solid
quality overall in high-grade credit.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, head of Corporate Credit Research at
Morgan Stanley. Along with my colleagues, bringing you a variety
of perspectives, today I'll discuss some longer-term thoughts on
the credit market and the economic cycle.
It's Friday, September 6th at 2pm in London.
Concerns around US growth have risen, an issue that will probably
persist even after today’s US Payrolls report came roughly inline
with expectations. At Morgan Stanley, we continue to expect
moderate slowing in growth, not a slump. By the middle of next
year, our economists see growth slowing to a still respectable 2%
growth rate, and a total of seven rate cuts.
While growth is set to slow, we think corporate balance sheet
metrics are unusually good in the face of this slowing. Indeed,
the credit quality of the US investment grade and BB credit
markets, which represent the vast majority of corporate credit
outstanding, have actually improved since the Fed started hiking
rates.
Now, looking ahead, there's understandable concern that these
currently good credit metrics won't be sustainable as companies
will have to refinance the very cheap borrowing that they
received immediately after COVID, with the more expensive costs
of today's currently higher yields. But we actually think balance
sheets will be reasonably robust in light of this reset, and so
their ultimate rate sensitivity could be relatively low.
One reason is that a wave of refinancing means companies have
already tackled a significant portion of their upcoming debt,
reducing the so-called rollover or refinancing risk.
Interest coverage for floating rate borrowers has stabilized and
should actually improve as the Fed starts to lower rates.
The debt service costs for higher rated companies will increase
as cheaper debt matures and has to be replaced with more
expensive borrowing; but we stressed this is a pretty slow
process given the long-term nature of a lot of this borrowing.
And so, overall, we think the headwinds from higher debt costs
are going to be manageable, with the problems largely confined to
a smaller cohort of the lowest quality issuers.
We think all of that will drive a so-called sticky but shallow
default cycle, with defaults driven by higher borrowing costs at
select issuers rather than a single problem sector or
particularly poor corporate earnings. And there are also some
important offsets. Morgan Stanley's forecast suggests that the
Fed will be cutting rates, which will reduce overall borrowing
costs over the medium term. And another notable theme over the
last two years is that more defaults have been
becoming so-called restructurings rather than
bankruptcies. These restructurings are more likely to leave
a company operating -- just under new ownership -- and create
less negative feedback into the real economy.
Now, against all this, we're mindful that credit spreads are
tight, i.e. lower than average. But importantly, we don't think
this reflects some sort of euphoria from either the lenders or
the borrowers.
All-in borrowing costs for corporates remain high, and that's
made corporates less likely to be aggressive or increase their
leverage. Indeed, since COVID, the overall high yield bond and
loan markets have actually shrunk. Leverage buyout activity has
been muted and corporate leverage has gone sideways.
These are not the types of things you see when corporates are
being particularly aggressive and credit unfriendly. Credit
markets love moderation and that's very much what Morgan
Stanley's economic forecasts over the medium term expect. Spreads
may be tight. But we think they're currently supported by strong
fundamentals, modest supply, and improving technicals.
Today's roughly inline payroll number won’t resolve the
uncertainty around growth, but longer term, we think the picture
remains encouraging.
Thanks for listening. If you enjoy the show, please leave us a
review wherever you listen, and share Thoughts on the Market with
a friend or colleague today.
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