To conclude their two-part discussion, our Head of Corporate
Credit Research Andrew Sheets and Chief Investment Officer for
Morgan Stanley Wealth Management Lisa Shalett discuss the outlook
for inflation and monetary policy, with implications for
investment-grade credit.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Global Head of Corporate Credit
Research at Morgan Stanley.
Lisa Shalett: And I am Lisa Shalett, Chief
Investment Officer of Morgan Stanley Wealth Management.
Andrew Sheets: Yesterday we focused on the
topic of a higher for longer inflation regime, and I was asking
the questions. Today, Lisa will grill me on my views for the next
year.
It's Friday, December 19th at 4pm in London.
Lisa Shalett: And it's 11am in New
York.
All right, Andrew, I'm happy to turn tables on you now. I'm very
interested in your thoughts about the past year – 2025 – and
looking towards 2026. In 2026, Morgan Stanley Research seems to
expect a resilient global growth backdrop, with inflation
moderating and central banks easing policy gradually. What do you
think are the main drivers behind this more constructive
inflation outlook, especially taking into account the market's
prevailing concerns about persistent price pressures.
Andrew Sheets: There are a couple of
factors that we think are going to be near term helps for
inflation, although I don't think they totally rule out what
you're talking about over that longer term period.
So first, we, at Morgan Stanley, are very cautious, very negative
on oil prices. We think that there's going to be more supply of
oil over the next year than demand for it. And so lower oil
prices should help bring inflation down. There's also some
measures of just how the inflation indices measure shelter and
housing. And so, while we think, kind of, looking further ahead,
there are some real shortages emerging in things like the rental
markets – where you just haven't had a whole lot of new rental
construction coming online, as you look out a year or two
ahead.
But in the near term, rental markets have been softer. Home
prices are coming down with a lag in the data. And so, shelter
inflation is relatively soft. So, we think that helps. While at
the same time fiscal policy is very supportive and corporates, as
we discussed in our last conversation, they're really embracing
animal spirits – with more spending, more spending on AI, more
capital investment generally, more M&A. And so, those factors
together, we think, can over the next 12 months, still mean
pretty reasonable growth and Inflation that's still above target
– but at least trending a little bit lower.
Lisa Shalett: You believe that central
banks, including the Fed, will cut rates more slowly given better
growth. And this slower pace of easing could actually be positive
for the credit markets. So, could you elaborate on your expertise
on credit and why a gradual Fed approach may be preferable? What
risks and opportunities might this create?
Andrew Sheets: Yeah, so I think this is
kind of one of these big debates going into this year is – which
would we rather have? Would we rather have a Fed that was more
active, cutting more aggressively? Or cutting more slowly? And,
indeed, we're having this conversation on the heels of a Fed
meeting. There's a lot of uncertainty about that path.
But the way that we're thinking about it is that the biggest risk
to credit would be that this outlook for growth that we have is
just too optimistic. That actually growth is weaker than
expected. That this rise in the unemployment rate is signaling
something far more challenging for the economy ahead and in that
scenario the Fed would be justified in cutting a lot more.
But I think historically in those periods where growth has
deteriorated more significantly while the Fed has been cutting
more, those have been periods where credit – and indeed the
equity market – have actually done poorly despite more quote
unquote Fed assistance. So, periods where the Fed is cutting more
gradually tend to be more consistent with policy in the right
place. The economy being in an okay place. And so, we think, that
that's the better outcome.
So again, we have to kind of monitor the situation. But a
scenario where the Fed ends up doing a little bit less than the
market, or even we expect with rate cuts – because the economy's
holding up. That can still be, we think, an okay scenario for
markets.
Lisa Shalett: So, things are okay and
animal spirits are returning. What does that mean for credit
markets?
Andrew Sheets: Yeah, so I think this is the
bigger challenge: is that if our growth scenario holds up,
corporates I think have a lot of incentives to start taking more
risk – in a way that could be good for stock markets, but a lot
more challenging to the lenders, to these companies for credit.
Corporates have been impressively restrained over the last
several years. They've really, kind of, held back despite lots of
fiscal easing, despite very low rates. Those reasons for waiting
are falling away.
And so, in this backdrop that you, Lisa, were describing the
other day around – easier monetary policy, easier fiscal policy,
easy regulatory policy, and you know, just for good measure,
maybe the biggest capital spending cycle since the railroads
through AI. These are some pretty powerful forces of animal
spirits. And that's a reason why we think ultimately, we see a
lot more issuance. We see roughly a trillion dollars of net
supply. So, total supply, less redemptions in U.S. investment
grade. That's a huge uptick from this year, and we think that
drives spreads wider, even if my colleague Mike Wilson is correct
that equity markets rise.
Lisa Shalett: So, wow. So, we have very
strong U.S. equities. But perhaps an investment grade credit
market that underperforms those equities. How else would you
think about your asset allocation more broadly, and how might
those dynamics around credit issuance and equity success play out
regionally?
Andrew Sheets: Yeah, so, I think this
scenario where equities are up, credit is underperforming. The
cycle is getting more aggressive. It's a little unusual, but I
think we do have some templates for it and specifically I think
investors could look to 2005 or 1997 and 1998. Those were all
years where equities were up double digits, where credit spreads
were wider. Where yields were somewhat range bound, where
corporate aggression was increasing. That is all very consistent
with Morgan Stanley's 2026 story. And yet, you did have this
divergence between equities and credit market.
So, I think it is a market where we see better risk-reward in
stocks than in credit. I think it's a market where we want to be
in somewhat smaller credits or somewhat smaller equities. We like
small and mid cap stocks in the U.S. over large caps. We like
high yield over investment grade. And we do think that European
credit might outperform as it's somewhat lagging this animal
spirits theme that we think will be led by the U.S.
Lisa Shalett: So, if that's the outlook,
what are the risks?
Andrew Sheets: Yeah, so I think there are
two risks, and you know, we alluded to one of them early on in
this conversation – would be just that growth is weaker than we
expect. Usually when the unemployment rate is rising, that's a
pretty bad time to be in credit. The unemployment rate is rising.
Now, Morgan Stanley economists think that that rise will be
temporary, that it will reverse as we go through 2026. And so,
it'll be less of a thing to worry about. But you know, a sign
that maybe companies have been holding off on firing, waiting for
more tariff clarity, if that doesn't come, then that would be a
risk to growth.
The other risk to growth is just around this AI-related spending.
It is very large and the companies that are doing it are some of
the wealthiest companies in the world, and they see this spending
potentially as really core to their long-term strategic thinking.
And so, if you were to ever have an issuer or a set of issuers
who were just less price sensitive, who would keep issuing into
the market, even if it was starting to reprice that market and
push spreads wider, this might be the group. And so, a scenario
where that spending is even larger than we expect, and those
issuers are less price sensitive than we expect – that could also
drive spreads wider, even if the underlying economic backdrop is
somewhat okay.
Lisa Shalett: Super. That's probably a
great place for us to wrap up. So, I'll hand it back to you,
Andrew.
Andrew Sheets: Well, great, Lisa, always a
pleasure to have this conversation. And, as a reminder for all
you listening, if you enjoy Thoughts of the Market, please take a
moment to rate and review us wherever you listen, it helps more
people find the show.
*****
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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