Podcast Contributor: Andrew Sheets

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Jenna Giannelli: And I'm Jenna Giannelli, Head of U.S. Consumer and Retail Credit Research.

Andrew Sheets: And today on the podcast, we're going to dig into one of the biggest conundrums in the market today. Where and when are tariffs going to show up in prices and margins?

It's Friday, July 11th at 10am in New York.

Jenna, it's great to catch up with you today because I think you can really bring some unique perspective into one of the biggest puzzles that we're facing in the market today. Even with all of these various pauses and delays, the U.S. has imposed historically large tariffs on imports. And we're seeing a rapid acceleration in the amount of money collected from those tariffs by U.S. customs. These are real hard dollars that importers – or somebody else – are paying. Yet we haven't seen these tariffs show up to a significant degree in official data on prices – with recent inflation data relatively modest. And overall stock and credit markets remain pretty strong and pretty resilient, suggesting less effect.

So, are these tariffs just less impactful than expected, or is there something else going on here with timing and severity? And given your coverage of the consumer and retail sectors, which is really at the center of this tariff debate – what do you think is going on?

Jenna Giannelli: So yes, this is a key question and one that is dominating a lot of our client conversations. At a high level, I'd point to a few things. First, there's a timing issue here. So, when tariffs were first announced, retailers were already sitting on three to four months worth of inventory, just due to natural industry lead times. And they were able to draw down on this product.

This is mostly what they sold in 1Q and likely into 2Q, which is why you haven't seen much margin or pricing impact thus far. Companies – we also saw them start to stock up heavily on inventory before the tariffs and at the lower pause rate tariffs, which is the product you referenced that we're seeing coming in now. This is really going to help mitigate margin pressure in the second quarter that you still have this lower cost inventory flowing through.

On top of this timing consideration, retailers – we've just seen utilizing a range of mitigation measures, right? So, whether it's canceled or pause shipments from China, a shifting production mix or sourcing exposure in the short run, particularly before the pause rate on China. And then really leaning into just whether it's product mix shifts, cost savings elsewhere in the PNL, and vendor negotiations, right? They're really leaning into everything in their toolbox that they can.

Pricing too has been talked about as something that is an option, but the option of last resort. We have heard it will be utilized, but very tactically and very surgically, as we think about the back half of the year. When you put this all together, how much impact is it having? On average from retailers that we heard from in the first quarter, they thought they would be able to mitigate about half of the expected tariff headwind, which is actually a bit better than we were expecting.

Finally, I'll just comment on your comment regarding market performance. While you're right in that the overall equity and credit markets have held up well, year-to-date, retail equities and credit have fared worse than their respective indices. What's interesting, actually, is that credit though has significantly outperformed retail equities, which is a relationship we think should converge or correct as we move throughout the balance of the year.

Andrew Sheets: So, Jenna, retailers saw this coming. They've been pulling various levers to mitigate the impact. You mentioned kind of the last lever that they want to pull is prices, raising prices, which is the macro thing that we care about. The thing that would actually show up in inflation.

How close are we though to kind of running out of other options for these guys? That is, the only thing left is they can start raising prices?

Jenna Giannelli: So closer is what I would say. We're likely not going to see a huge impact in 2Q, more likely as we head into 3Q and more heavily into the all-important fourth quarter holiday season. This is really when those higher cost goods are going to be flowing through the PNL and retailers need to offset this as they've utilized a lot of their other mitigation strategies. They've moved what they could move. They've negotiated where they could, they've cut where they could cut. And again, as this last step, it will be to try and raise price.

So, who's going to have the most and least success? In our universe, we think it's going to be more difficult to pass along price in some of the more historically deflationary categories like apparel and footwear. Outside of what is a really strong brand presence, which in our universe, historically hasn't been the case.

Also, in some of the higher ticket or more durable goods categories like home goods, sporting goods, furniture, we think it'll be challenging as well here to pass along higher costs. Where it's going to be less of an issue is in our Staples universe, where what we'd put is less discretionary categories like Beauty, Personal Care, which is part of the reason why we've been cautious on retail, and neutral and consumer products when we think about sector allocation.

Andrew Sheets: And when do you think this will show up? Is it a third quarter story? A fourth quarter story?

Jenna Giannelli: I think this is going to really start to show up in the third quarter, and more heavily into the fourth quarter, the all-important holiday season.

Andrew Sheets: Yeah, and I think that’s what’s really interesting about the impact of this backup to the macro. Again, returning to the big picture is I think one of the most important calls that Morgan Stanley economists have is that inflation, which has been coming down somewhat so far this year is going to pick back up in August and September and October. And because it's going to pick back up, the Federal Reserve is not going to cut interest rates anymore this year because of that inflation dynamic.

So, this is a big debate in the market. Many investors disagree. But I think what you're talking about in terms of there are some very understandable reasons, maybe why prices haven't changed so far. But that those price hikes could be coming have real macroeconomic implications.

So, you know, maybe though, something to just close on – is to bring this to the latest headlines. You know, we're now back it seems, in a market where every day we log onto our screens, and we see a new headline of some new tariff being announced or suggested towards countries. Where do you think those announcements, so far are relative to what retailers are expecting – kind of what you think is in guidance?

Jenna Giannelli: Sure. So, look what we've seen of late; the recent tariff headlines are certainly higher or worse, I think, than what investors in management teams were expecting. For Vietnam, less so; I'd say it was more in line. But for most elsewhere, in Asia, particularly Southeast Asia, the rates that are set to go in effect on August 1st, as we now understand them, are higher or worse than management teams were expecting.

Recall that while guidance did show up in many flavors in the first quarter, so whether withdrawn guidance or lowered guidance. For those that did factor in tariffs to their guide, most were factoring in either pause rate tariffs or tariff rates that were at least lower than what was proposed on Liberation Day, right?

So, what's the punchline here? I think despite some of the revisions we've already seen, there are more to come. To put some numbers around this, if we look at our group of retail consumer cohort, credits, consensus expectations for calling for EBITDA in our universe to be down around 5 percent year-over-year. If we apply tariff rates as we know them today for a half-year headwind starting August 1st, this number should be down around 15 percent year-over-year on a gross basis…

Andrew Sheets: So, three times as much.

Jenna Giannelli: Pretty significant. Exactly. And so, while there might be mitigation efforts, there might be some pricing passed along, this is still a pretty significant delta between where consensus is right now and what we know tariff rates to be today – could imply for earnings in the second half.

Andrew Sheets: Jenna, thanks for taking the time to talk.

Jenna Giannelli: My pleasure. Thank you.

Andrew Sheets: And thank you as always for your time. If you find Thoughts to the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Today on a special Independence Day episode of the podcast, we're going to talk a bit about the history of U.S. debt and the contrast between corporate and federal debt trajectories.

It's Thursday, July 3rd at 9am in Seattle.

The 4th of July, which represents the U.S. declaring independence from Great Britain, remains one of my favorite holidays. A time to gather with friends and family and celebrate what America is – and what it can still be.

It is also, of course, a good excuse to talk about debt.

Declaring independence is one thing, but fighting and beating the largest empire in the world at the time would take more than poetic words. The borrowing that made victory possible for the colonies also almost brought them down in the 1780s under a pile of unsustainable debt. It was a young treasury secretary Alexander Hamilton, who successfully lobbied to bring these debts under a federal umbrella – binding the nation together and securing a lower borrowing cost. As we'd say, it's a real fixed income win-win.

Almost 250 years later, the benefits of that foresight are still going strong, with the United States of America enjoying the world's largest economy, and the largest and most liquid equity and bond markets. Yet lately there's been more focus on whether those bond markets are, well, too large.

The U.S. currently runs a budget deficit of about 7 percent of GDP, and the current budget proposals in the house and the Senate could drive an additional 4 trillion of borrowing over the next decade above that already hefty baseline. Forecast even further out, well, they look even more challenging.

We are not worried about the U.S. government's ability to pay its bills. And to be clear, in the near term, we are forecasting at Morgan Stanley, U.S. government yields to go down as growth slows and the Federal Reserve cuts rates more than expected in 2026. But all of this borrowing and all the uncertainty around it – it should increase risk premiums for longer term bonds and drive a steeper yield curve.

So, it's notable then – as we celebrate America's birthday and discuss its borrowing – that it's really companies that are currently unwrapping the presents. Corporate balance sheets, in contrast, are in very good shape, as corporate borrowing trends have diverged from those of the government.

Many factors are behind this. Corporate profitability is strong. Companies use the post-COVID period to refinance debt at attractive rates. And the ongoing uncertainty – well, it's kept management more conservative than they would otherwise be. Out of deference to the 4th of July, I've focused so far on the United States. But we see the same trend in Europe, where more conservative balance sheet trends and less relative issuance to governments is showing up on a year-over-year basis. With companies borrowing relatively less and governments borrowing relatively more, the difference between what companies and the government pay, that so-called spread that we talk so much about – well, we think it can stay lower and more compressed than it otherwise would.

We don't think this necessarily applies to the low ratings such as single B or lower borrowers, where these better balance sheet trends simply aren't as clear. But overall, a divergent trend between corporate and government balance sheets is giving corporate bond investors something additional to celebrate over the weekend.

Thank you as always for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen, and also tell a friend or colleague about us today.

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 to our listeners, thank you for sharing a few minutes of your day with us. If you enjoy the show, leave us a review wherever you listen to this podcast and share Thoughts on the Market with a friend or colleague today.