Our analysts Andrew Sheets and Vishwas Patkar take stock of the
U.S. credit market, noting which segments are on firm footing
going into a period of slower 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.
Vishwas Patkar: And I'm Vishwas Patkar,
Head of U.S. Credit Strategy at Morgan Stanley.
Andrew Sheets: Today on the program, we're
going to have the first in a series of conversations covering our
outlook for credit around the world.
It's Wednesday, June 4th at 2pm in London.
Vishwas Patkar: And 9am in New York.
Andrew Sheets: Vishwas, along with many of
our colleagues at Morgan Stanley, we recently updated our
12-month outlook for credit markets around the world. Focusing on
your specialty, the U.S., how do you read the economic backdrop
and what do you think it means for credit at a high level?
Vishwas Patkar: So, our central scenario of
slowing growth, somewhat firm inflation and no rate cuts from the
Fed until the first quarter of 2026 – when I put all of that
together, I view that as somewhat mixed for credit. It's good for
certain segments of the market, not as good for others.
I think the positive on the one side is that with the recent
de-escalation in trade tensions, recession risks have gone lower.
And that's reflected in our economists' view as well. I think for
an asset class like credit, avoiding that drill downside
tail I think is important. The other positive in the market
today is that the level of all in yields you can get across the
credit spectrum is very compelling on many different measures.
The negative is that we are still looking at a fair bit of
slowing in economic activity, and that's a big downshift from
what we've been used to in the past few years. So, I would say
we're certainly not in the Goldilocks environment that we saw for
credit through the second half of last year. And it's important
here for investors to be selective around what they invest in
within the credit market.
Andrew Sheets: So, Vishwas, you kind of
alluded to this, but you know, 2025 has been a year that so far
has been dominated by a lot of these large kind of macro
questions around, you know, what's going to happen with tariffs.
Big moves in interest rates, big moves in the U.S. dollar. But
credit is an asset class that's, you know, ultimately about
lending to companies. And so how do you see the credit worthiness
of U.S. corporates? And how much of a risk is there that with
interest rates staying higher for longer than we expected at the
start of the year – that becomes a bigger problem?
Vishwas Patkar: Yeah, sure. I think it's a
very important question Andrew because I think taking a call on
markets based on the gyrations in headlines is very hard. But in
some ways, I think this question of the credit worthiness of U.S.
companies is more important and I think it really helps us filter
the signal from the noise that we've seen in markets so far this
year.
I would say broadly, the health of corporate balance sheets is
pretty good and, in some ways, I think it's maybe a more
distinguishing feature of this cycle where corporate credit
overall is on a firmer footing going into a period of slower
growth – than what we may have seen in prior instances. And you
can sort of look at this balance sheet health along a few
different lines.
In aggregate, we haven't really seen credit markets grow a lot in
the last few years. M&A activity, which is usually a
harbinger of corporate aggression, has also been fairly muted in
absolute terms. Corporate balance sheet leverage has not grown.
And I think we've been in this high-interest rate environment,
which has kept some of these animal spirits at bay. Now what this
means is, that the level of sensitivity of credit markets to a
slow down in the economy is somewhat lower.
It does not mean that credit markets can remain immune no matter
what happens to the economy. I think it's clear if we get a
recession, spread should be a fair bit wider. But I think in our
central scenario, it makes us more confident than otherwise that
credit overall can hold up okay.
Now your question around the risk of rates staying higher. This I
think goes back to my point about where in the credit market
you're looking. I think up the quality spectrum, I think there
are actually – there's a lot of demand tailwinds for credit given
the pickup in sponsorship we've seen from insurance companies and
pension funds in this cycle.
At the other end of the quality spectrum, if you're looking at
highly levered capital structures, that's where I think the risk
of interest rates being high can lead to defaults being sort of
around average levels and higher than they would otherwise be.
Andrew Sheets: So, Vishwas, kind of
sticking with that central scenario, kind of briefly, what would
be a segment of U.S. credit that you think offers some of the
best risk adjusted return at the moment? And what do you think
offers some of the worst?
Vishwas Patkar: Yep. So, we framed our
credit outlook as being good for quality, bad
for beta. So, as that suggests, I think this is a fairly good
environment for investment grade credit. In our base case, we are
calling for double digit total returns. In IG we also expect
investment grade credit to modestly outperform government bonds.
And I would sort of extend that to the upper tiers within the
high yield market as well, specifically BBs. And where I would
say risk reward looks the weakest is the lowest tier. So, for
CCCs and for many segments within Bs where leverage is fairly
elevated, debt costs are still high. We think this is still a
challenging environment where growth is set to slow and rate cuts
are still a fair bit out the outer forecast rise.
Andrew Sheets: So far we focused on that
central scenario, but let's close out with how things could be
different. In our view, what do you think are the realistically
better and worse scenarios for U.S. credit this year, and how
does that shape your overall view on the market?
Vishwas Patkar: So, I think the better
scenario for credit versus our base case potentially revolve
around tariffs being rolled back even further. And it's
essentially a repeat of the second half of 2024, where you had a
combination of good growth and declining inflation and rate cuts
moving up versus our expectations.
I think in that scenario, it's likely that you see investment
grade credit spreads go back to the tights that we saw in
December. On the flip side, I think the worst scenario really is
you know – what if we are being too optimistic about growth? And
what if the economy is set to slow much further? And then what if
we get a recession?
So, I think in that environment, we see spreads retesting the
wides that we saw through the volatility in April. Although even
here, I would draw an important nuance that because of some of
the fundamental and technical tailwinds I discussed earlier, we
think spreads even in this downside scenario may not test the
types of levels that we've seen through prior bear markets.
Andrew Sheets: Vishwas, thanks for taking
the time to talk.
Vishwas Patkar: Thanks, Andrew.
Andrew Sheets: And thanks for sharing a few
minutes of your day with us. If you enjoy Thoughts of the Market,
let us know by leaving a review wherever you listen, and tell a
friend or colleague about us today.
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