Our analysts Andrew Sheets and Aron Becker explain why European
credit markets’ performance for the rest of 2025 could be tied to
U.S. growth.
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.
Aron Becker: And I'm Aron Becker, Head of
European Credit Strategy.
Andrew Sheets: And today on the program, we're
continuing a series of conversations covering the outlook for
credit around the world. Morgan Stanley has recently updated its
forecast for the next 12 months, and here we're going to bring
you the latest views on what matters for European credit.
It's Thursday, June 12th at 2pm in London.
So, Aron, it's great to have this conversation with you. Today
we're going to be talking about the European credit outlook. We
talked with our colleague Vishwas in the other week about the
U.S. credit outlook. But let's really dive into Europe and how
that looks from the perspective of a credit investor.
And maybe the place to start is, from your perspective, how do
you see the economic backdrop in Europe, and what do you think
that means for credit?
Aron Becker: Right. So, on the European side,
our growth expectations remain somewhat more challenging. Our
economists are expecting growth after a fairly strong start to
slow down in the back half of this year. The German fiscal
package that was announced earlier this year will take time to
lift growth further out in 2026. So, in the near term, we see a
softening backdrop for the domestic economy.
But I think what's important to emphasize here is that U.S.
growth, as Vishwas and you have talked about last time around, is
also set to decelerate on our economists forecast more
meaningfully. And that matters for Europe.
Two reasons why I think the U.S. growth outlook matters for
European credit. One, nearly a quarter of European companies’
revenues are generated in the U.S. And two, U.S. companies
themselves have been very actively tapping the European corporate
bond markets. And in fact, if you look at the outstanding notion
of bonds in the euro benchmarks, the largest country by far is
U.S. issuers. And so, I do think that we need to think about the
outlook on the macro side, more in a global perspective, when we
think about the outlook for European credit. And if we look at
history, what we can deduct from the simple correlation between
growth and credit spreads is current credit valuations imply
growth would be around 3 percent. And that's a stark contrast to
our economists’ forecast where both Europe and U.S. is
decelerating to below 1 percent over the next 12 months.
Andrew Sheets: But Aron, you know, you talked
about the slow growth, here in Europe. You talked about a slower
growth picture in the U.S. You talked about, you know, pretty
extensive exposure of European companies into the U.S. story. All
of which sound like pretty challenging things. And yet, if one
looks at your forecasts for credit spreads, we think they remain
relatively tight, especially in investment grade.
So, how does one square that? What's driving what might look
like, kind of, a more optimistic forecast picture despite those
macro challenges?
Aron Becker: Right. That's a very important
question. I think that it's not all about the growth, and there
are a number of factors that I think can alleviate the pressures
from the macro side. The first is that unlike in the U.S., in
Europe we are expecting inflation to decelerate more meaningfully
over the coming year. And we do think that the ECB and the Bank
of England will continue to ease policy. That's good for the
economy and the eventual rebound. And we also think that it's
good for demand for credit products. For yield buyers where the
cash alternative is getting less and less compelling, I think
they will see yields on corporate credit much more attractive.
And I do think that credit yields right now in Europe are
actually quite attractive.
Andrew Sheets: So, Aron, you know, another
question I had is, if you think about some of those dynamics. The
fact that interest rates are above where they've been over the
last 10 years. You think about a growth environment in Europe,
which is; it's not a recession, but growth is, kind of, 1 percent
or a little bit below.
I mean, some ways this is very similar to the dynamic we had last
year. So, what do you think is similar and what do you think is
different, in terms of how investors should think about, say, the
next 12 months – versus where we've been?
Aron Becker: Right. So, what's really similar
is, for example, the yield, like I just mentioned. I think the
yield is attractive. That hasn't really changed over the past 12
months. If you just think about credit as a carry product, you're
still getting around between 3-3.5 percent on an IG corporate
bond today.
What's really different is that over the same period, the ECB has
already lowered front-end rates by 200 basis points. And at the
same time, if you think about the fiscal developments in Germany
or broader rates dynamics, we've seen a sharp steepening of yield
curves; and curves are actually at the steepest levels in two
years now. And what this leaves us with is not only high carry
from the yield on corporate bonds, but also investors are now
rolling down on a much steeper curve if they buy bonds today,
especially further out the curve.
So, by our estimate, if you aggregate the two figures in terms of
your expected total return, credit offers actually total returns
much higher than over the past 12 months, and closer to where we
were in the LDI crisis in 2022.
Andrew Sheets: So, Aron, another development I
wanted to ask you about is, if you look at our forecast for the
year ahead, our global forecast. One theme is that on the
government side there's projected to be a lot more borrowing.
There's more borrowing in Germany, and then there's more
borrowing in the U.S., especially under certain versions of the
current budget proposals being debated. So, you know, it does
seem like you have this contrast between more borrowing and kind
of a worsening fiscal picture in governments, a better fiscal
picture among corporates. We talk about the spread. The spread is
the difference between that corporate and government borrowing.
So, I guess looking forward first, do you think European
companies are going to be borrowing more money? And certainly
more money on a relative, incremental basis at these yield
levels, which are higher than what they're used to in the past.
And, secondly, how do you think about the relative valuation of
European credit versus some of the sovereign issuers in Europe,
which is often a debate that we'll have with investors?
Aron Becker: Big picture? We have seen companies
be very active in tapping the corporate bond markets this year.
We had a record issuance in May in terms of supply. Now I would
push back on the view that that's negative for investors, and
expectations for spreads to widen as a result for a number of
reasons. One is a lot of gross issuance tends to be good for
investors who want to pick up some new issue premiums – as these
new bonds do come a little bit cheap to what's out there in terms
of available secondary bonds.
And second, it creates a lot of liquidity for investors to
actually deploy capital, when they do want to enter the bond
market to invest. And what we really need to remember here is all
this strong issuance activity is coming against very high
maturing, volumes of bonds. Redemptions this year are rising by
close to 20 percent versus last year. And so, even though we are
projecting this year to be a record year for growth issuance from
investment grade companies, we think net supply will be lower
year-on-year as a result of those elevated, maturities.
So overall, I think that's going to be a fairly positive
technical backdrop. And as you alluded to it, that's a stark
contrast to what the sovereign market is facing at the moment.
Andrew Sheets: So, on that net basis, on the
amount that they're issuing relative to what they're paying back,
that actually is probably looking lower than last year, on your
numbers.
Aron Becker: Exactly.
Andrew Sheets: And finally, Aron, you know, so
we've talked a bit about the market dynamics, we've talked about
the economic backdrop, we've talked about the issuance backdrop.
Where does this leave your thoughts for investors? What do you
think looks, kind of, most attractive for those who are looking
at the European credit space?
Aron Becker: Opportunities are abound, but I
think you need to be quite selective of where to actually
increase your risk exposure, in my view. One part which we are
quite out of consensus on here at Morgan Stanley is our
recommendation in European credit to extend duration further out
the curve.
This goes back to the point I made earlier, that curves are very
steep and a lot of that carry and roll down that I think look
particularly attractive; you do need to extend duration for that.
But there are a number of reasons why I think that that type of
trade can work in this backdrop.
For one, like I said, valuations are attractive. Two, I also
think that from an issuer perspective, it is expensive to tap
very long dated bonds now because of that yield dynamic, and I
don't necessarily see a lot of supply coming through further out
the curve. Three, our rates team do expect curves to bull steepen
on the rate side and historically that has tended to favor excess
returns further out the curve.
And fourth is, a word we love to throw around – convexity. Cash
prices further out the curve are very low in investment grade
credit. That tends to be actually quite attractive because then
even if you get the name wrong, for example, and there are some
credit challenges down the line for some of these issuers, your
loss given default may be more muted if you entered the bond at a
lower cash price.
Andrew Sheets: Aron, thanks for taking the time
to talk.
Aron Becker: Thanks, Andrew. Andrew Sheets: And
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