Lisa Shalett, our Wealth Management CIO, and Andrew Sheets, our
Head of Corporate Credit Research, conclude their discussion of
American Exceptionalism, factoring in fixed income, in the second
of a two-part episode.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Lisa Shalett: And I'm Lisa Shalett, Chief
Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: Today – a today a concluding
look at the theme of American exceptionalism and how it factors
into fixed income.
It's Thursday, July 31st at 4pm in London.
Lisa Shalett: And it's 11am here in New
York.
So, Andrew, it's my turn to ask you some questions. And yesterday
we talked a lot about equity markets, globalization, some of the
broader macro shifts. But I wanted to zoom in on the credit
markets today and one of our themes in the American
Exceptionalism paper was the constraints of debts and deficits
and how they play in. With U.S. debts level soaring and interest
costs rising, how concerned should investors be?
Andrew Sheets: So, you alluded to this a
bit on our discussion yesterday that we are in a very interesting
divide where you have inequality between very well-off companies
and weaker companies that aren't doing as well. You have a lot of
division within households between those who are, doing
better and struggling more with the rate environment.
But you know, I think we also see that the large deficits that
the U.S. Federal government are running are in some ways largely
mirrored by very, very good private sector financial positions.
In aggregate U.S. households have record levels of assets
relative to debt at the end of 2024; in aggregate the financial
position of the U.S. equity market has never been better.
And so, this is a dynamic where lending to the private sector,
whether that is to parts of the residential mortgage market or to
the corporate credit market, does have some advantages; where not
just are you dealing with arguably a better trend of financial
position, but you're just getting less issuance.
I think there are a number of factors that could cause the market
to cause the difference of yield between the government debt and
that private sector debt – that so-called spread – to be narrower
than it otherwise would be.
Lisa Shalett: Well, that's a pretty
interesting and provocative idea because, one of the hypotheses
that we laid out in our paper is that perhaps one of the
consequences of this extraordinary period of monetary stimulus of
financial repression and ultra low rates, of massive regulation
of the systemically important banking system, has been the
explosion of shadow banks, and the private credit markets. Our
thesis is they're a misallocation of capital. Has there been
excess risk taking – in that area? And how should we think about
that asset class, number one? And, number two, are they
increasingly, a source of liquidity and issuance, or are they a
drain on the system?
Andrew Sheets: This is, kind of, where your
discussion of normalization is is so interesting because in
aggregate household balance sheets are in very good shape; in
aggregate corporate balance sheets are in very good shape. But I
do think there's a distinct tail of the market. Lets call it 5
percent of the high yield market, where you really are looking at
a corporate capital structure that was designed for for a much
lower level of rates. It was designed for maybe a immediately
post COVID environment where rates were on the floor and expected
to stay there for a long period of time.
And so, if we are moving to an environment where Fed funds is at
3 or 4. Or as you mentioned – hey, maybe you could justify a rate
even a little bit higher and not be wildly off. Well then, you
just have the wrong capital structure. You have the wrong level
of leverage; and it's actually hard to do much about that other
than to restructure that debt, or look to change it in a larger
way.
So, I think we'll see a dynamic similar to the equity market –
where there is less dispersion between the haves and have
nots.
Lisa Shalett: As we kind of think about
where there could be pockets of opportunity in credit and in
private credit, both public and private credit, and where there
could be risks. Can you just help me with that and explore that a
little bit more?
Andrew Sheets: I think where credit looks
most interesting is in some ways where it looks most boring. I
think where the case for credit is strongest is – the investment
grade market in the U.S. pays 5.25 percent. A 6 percent long
run return might be competitive with certain investors’ long-term
equity market forecasts, or at least not a million miles off. I
think though the other area where this is going to be interesting
is – do we see significantly more capital intensity out of the
tech sector? And a real divide between fixed income and equities
is that tech has so far really been an equity story.
Lisa Shalett: Correct.
Andrew Sheets: But this data center build out is
just enormous. I mean, through 2028, our analysts at Morgan
Stanley think it's close to $3 trillion with a 't'. And so
there's a lot of interest in how can credit markets, how can
private credit markets fund some of this build out; and there are
opportunities and risks around that. And you know, something that
I think credit's going to play an interesting part of.
Lisa Shalett: And in that vision do you see
the blurring of lines or a more competitive market between public
and private?
Andrew Sheets: I do think there's always a
little bit of a funny nature about credit where it's not always
clear why a particular corporate loan would need to be traded
every day, would need to be marked every day. I think it is a
little bit different from the equity market in that way. And I
think you're also seeing a level of sophistication from investors
who now have the ability to traffic across these markets and move
capital between these markets, depending on where they think
they're being better compensated or where there's better
opportunities. So, I think we're kind of absolutely seeing the
blur of these lines.
And again, I think private credit has until recently been
somewhat synonymous with high-yield lending, riskier lending,
lower rated lending.
Lisa Shalett: Correct. Yeah.
Andrew Sheets: And, yet, the lending
that we're seeing to some of this tech infrastructure is, you
could argue, maybe more similar to Investment Grade lending –
both in terms of risk, but also it pays a lot less. And so
again, this is kind of an interesting transition where you're
seeing a broader scope and absolutely, I think, more blurring of
the line between these markets.
Lisa Shalett: So, let's just switch gears a
little bit and pull out from credit to the broader diversified
cross-asset portfolio. And some of those cross-asset correlations
are starting to break down; and we go through these periods where
stocks and bonds are more often than not positively correlated in
moving together.
How are you beginning to think about duration risk in this
environment? And have you made any adjustments to how you think
about portfolio construction in light of these potentially
shifting changes in correlations across assets?
Andrew Sheets: I think there are kind of
maybe two large takeaways I would take from this. First is I do
think the big asset where we've seen the biggest change is in the
U.S. dollar. The U.S. dollar, I think, for a lot of the period
we've been discussing on these two episodes, was kind of the best
of both worlds. And recently that's just really broken down. And
so, I think, when we think about the reallocation to the rest of
the world, the focus on diversification, I think this is
absolutely something that is top of mind among non-U.S. investors
that we're talking to, which is almost the U.S. equity piece is
kind of a separate conversation.
The other piece though, is some of this debate around yields and
equities – and do equities fear higher rates or lower rates?
Which one of those is the biggest problem? And there's a question
of magnitude that's a little interesting here. Rates going higher
might be a little bit more of a problem for the S&P 500 than
rates going lower. That rates going higher might be more
consistent with the scenario of temporary higher inflation. Maybe
rates go lower [be]cause the market gets more excited about
Federal Reserve cuts.
But I think in terms of scenarios where – like where is the
equity market really going to have a problem? Well, it's really
going to have a problem if there's a recession. So, even though I
think bonds have been less effective diversifiers, I really do
think they're still going to serve a very healthy, helpful
purpose around some of those potentially kind of bigger
dynamics.
Lisa Shalett: Yeah that very much jives
with the way we've been thinking about it, particularly within
the context of managing private wealth, where very often we're
confronted with the, the question: What about 60-40? Is 60-40
dead? Is 60-40 back? Like, you talk about not wanting to hedge, I
don't want to hedge either. But the answer to the question we
agree is somewhat nuanced. Right?
We do agree that this perfect world of negative correlations
between stocks and bonds that we enjoyed for a good portion of
the last 15 years probably is over. But that doesn't mean that
bonds, and most specifically that 5 - 10 year part of the curve,
doesn't have a really important role to play in portfolios. And
the reason I say that is that one of the other elements of this
conversation that we haven't really touched on is valuation and
expected returns.
I know that when I speak of the valuation-oriented topics and the
CAPE ratio when expected 10-year returns, everyone's eyes glaze
over and roll to the back of their head and they say, ‘Oh, here
she goes again.’ But look, I am in the camp that says an awful
lot of growth has already been discounted and already been
priced. And that it is much more likely that U.S. equities will
return something closer to long run averages. So that's not
awful.
The lower volatility of a fixed income asset that's returning 6s
and 7s has a definite role to play in portfolios for wealth
clients who are by and large long term oriented investors who are
not necessarily attempting to exploit 90-day volatility every
quarter.
Andrew Sheets: Without putting too
fine of a point on it, I think when that question of is 60-40
over is phrased, I kind of think the subtext is often that it's
the bond side, the 40 side that has a problem. And not to be the
Fixed Income Defender on this podcast, but you could probably
more easily argue that if we're talking about, well, which
valuation is more stretched, the equity side or the bond side? I
think it's the equity side that has a more stretched valuation.
Lisa Shalett: Without a doubt, without a
doubt.
Andrew Sheets: Well, Lisa, thanks again
for taking the time to talk.
Lisa Shalett: Absolutely great to speak
with you, Andrew, as always.
Andrew Sheets: And thanks again for
listening to this two-part conversation on American
exceptionalism, the changes coming to that and how investors
should position. And to our listeners, a reminder to take a
moment to please review us wherever you listen. It helps more
people find the show. And if you found this conversation
insightful, tell a friend or colleague about Thoughts on the
Market today.
*****
Lisa Shalett is a member of Morgan Stanley’s Wealth Management
Division and is not a member of Morgan Stanley’s Research
Department. Unless otherwise indicated, her views are her own and
may differ from the views of the Morgan Stanley Research
Department and from the views of others within Morgan
Stanley.
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