Andrew Sheets: Credit Markets Take a Sunny View

How has corporate credit fared through slow growth and high inflation? Here’s our view on what comes next for this market.

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[00:00:02] Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, December 22nd at 4 p.m. in London.

[00:00:18] Sometimes it's hard to explain why a market is moving. This is not one of them. U.S. economic data has been unquestionably good over the last two months, delivering an unusual combination of better than expected growth with lower than expected inflation. In the U.K. and Euro area, inflation has been declining even faster. 

[00:00:35] Central banks, seeing this encouraging decline in inflationary pressure, have signaled an end to their recent rate hiking campaigns and hinted that next year will bring cuts. These shifts have been significant. The market's expectation of one year interest rates in the eurozone in one year's time have fallen almost 1% in the last month alone. In the U.S., they've fallen about 1.25% over the last two. 

[00:00:56] As you've heard us discuss on this program throughout the year, inflation is incredibly important to the current macroeconomic story. Much of the concerns this year, especially at the beginning, were based on a widespread view that in an economy near full employment, high inflation could only be brought down with much weaker growth, leaving investors with the unappetizing choice of either a recession or permanently higher inflation. 

[00:01:17] But the last two months have presented a notable glass half full, more optimistic challenge to that story. In the U.S., there are signs the economy is increasing capacity, which in economic terms allows for more output without higher prices. U.S. energy production has hit record levels, with the U.S. currently producing 40% more oil than Saudi Arabia. More workers are joining the labor force. New business formations are high and supply chain stresses are improving. All of that has helped reduce inflationary pressure and reinforce the idea that policy shifts in the Federal Reserve towards easier monetary policy can be credible over the next several years. 

[00:01:52] In Europe, growth has been weaker, but this has meant inflation is coming down even faster, bolstering the view that the European Central Bank has taken interest rates much higher than it needs to, and could also reverse these significantly over the next 12 months. 

[00:02:04] For a market that spent much of the last two years worried about being stuck between this rock and a hard place with growth and inflation, the data over the last two months is welcome news and we remain positive on corporate credit. While levels have rallied more than we expected, we think this is balanced, for now, with these better than expected economic developments. 

[00:02:22] Within the credit rally, however, we see dispersion. Long term U.S. investment grade bonds, a highly volatile sector, have done so well that spreads are now near the tightest levels in 20 years. We think this looks overdone. In contrast, performance in the lowest rated and also volatile cohort of triple C issuers has lagged significantly. While we've previously had a higher quality bias within credit, we think U.S. and European triple C's can now start to catch up, given some of the better macroeconomic developments we've been seeing in the recent months. 

[00:02:51] Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.