Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today I’m going to talk about why we think near term improvement may be temporary, and thus an opportunity to improve credit quality.
It's Friday March 28th at 2pm in London.
In volatile markets, it is always hard to parse how much is emotion, and how much is real change. As you would have heard earlier this week from my colleague Mike Wilson, Morgan Stanley’s Chief U.S. Equity Strategist, we see a window for short-term relief in U.S. stock markets, as a number of indicators suggest that markets may have been oversold.
But for credit, we think this relief will be temporary. Fundamentals around the medium-term story are on the wrong track, with both growth and inflation moving in the wrong direction. Credit investors should use this respite to improve portfolio quality.
Taking a step back, our original thinking entering 2025 was that the future presented a much wider range of economic scenarios, not a great outcome for credit per se, and some real slowing of U.S. growth into 2026, again not a particularly attractive outcome.
Yet we also thought it would take time for these risks to arrive. For the economy, it entered 2025 with some pretty decent momentum. We thought it would take time for any changes in policy to both materialize and change the real economic trajectory.
Meanwhile, credit had several tailwinds, including attractive yields, strong demand and stable balance sheet metrics. And so we initially thought that credit would remain quite resilient, even if other asset classes showed more volatility.
But our conviction in that resilience from credit is weakening as the fundamental backdrop is getting worse. Changes to U.S. policy have been more aggressive, and happened more quickly than we previously expected. And partly as a result, Morgan Stanley's forecasts for growth, inflation and policy rates are all moving in the wrong direction – with forecasts showing now weaker growth, higher inflation and fewer rate cuts from the Federal Reserve than we thought at the start of this year. And it’s not just us. The Federal Reserve's latest Summary of Economic Projections, recently released, show a similar expectation for lower growth and higher inflation relative to the Fed’s prior forecast path.
In short, Morgan Stanley’s economic forecasts point to rising odds of a scenario we think is challenging: weaker growth, and yet a central bank that may be hesitant to cut rates to support the economy, given persistent inflation.
The rising risks of a scenario of weaker growth, higher inflation and less help from central bank policy temper our enthusiasm to buy the so-called dip – and add exposure given some modest recent weakness. Our U.S. credit strategy team, led by Vishwas Patkar, thinks that U.S. investment grade spreads are only 'fair', given these changing conditions, while spreads for U.S. high yield and U.S. loans should actually now be modestly wider through year-end – given the rising risks.
In short, credit investors should try to keep powder dry, resist the urge to buy the dip, and look to improve portfolio quality.
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