A Whiff of Stagflation

Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.

Vishwas Patkar: And I'm Vishwas Patkar, Head of U.S. Credit Strategy at Morgan Stanley.

Vishy Tirupattur: Today we want to talk about the opportunities and challenges in the credit markets, in the context of AI and data center financing.

It's Wednesday, August 6th at 3pm in New York.

Vishy Tirupattur: So, Vishwas spending on AI and data centers is really not new. It's been going on for a while. How has this CapEx been financed so far predominantly? What has changed now? And why do we need greater involvement of credit markets of different stripes?

Vishwas Patkar: You're right, Vishy. So, CapEx on AI is certainly not new. So last year the hyperscalers alone spent more than $200 billion on AI related CapEx. What changes from here on, to your question, is the numbers just ramp up sharply. So, if you look at Morgan Stanley's estimates leveraging work done by our colleague Stephen Byrd over the next four years, there's about [$]2.9 trillion of CapEx that needs to be spent across hardware and data center bills.

So what changes is, while CapEx so far has been largely self-funded by hyperscalers, we think that will not be the case going forward. So, when we leverage the work that has been done by our equity research colleagues around how much the hyperscalers can spend, we've identified a [$]1.5 trillion financing gap that has to be met by external capital. And we think credit would play a big role in that.

Vishy Tirupattur: A financing gap of [$]1.5 trillion. Wow. That's a big number, by any measure. You talked about multiple credit channels that would need to be involved. Can you talk about rough sizing of these channels?

Vishwas Patkar: Yep. So, we looked at four broad channels in the report that went out a few weeks ago. So, that [$]1.5 trillion gap breaks out into roughly [$]800 billion across private credit, which we think will be led by asset-based finance. Another [$]200 billion we think will come from Investment Grade rated bond issuance from the large tech names. Another [$]150 billion comes through securitized credit issuance via data center ABS and CMBS. And then finally there is a [$]350 billion plug that we've used. It's a catchall term for all other forms of financing that can cover sovereign spend, PE (private equity), VC among others,

Vishy Tirupattur: The technology sector is fairly small within the context of corporate grade markets. You are estimating something like [$]200 billion of financing to come from this channel. Why not more?

Vishwas Patkar: So, I think it comes down to really willingness versus ability. And, you know, you raise a good point. Tech names certainly have a lot of capacity to issue debt. And when I look at some of the work done by my colleague Lindsay Tyler in this report, the big four hyperscalers alone could issue over [$]600 billion of incremental debt without hurting their credit ratings.

That said, our assumption is that early in the CapEx cycle, companies will be a little hesitant to do significantly debt funded investments as that might be seen as a suboptimal outcome for shareholder returns. And that's why we have reduced the magnitude of how much debt issuance could be vis-a-vis the actual capacity some of these companies have.

So, Vishy, I talked about private credit meeting about half of the investment gap that we've identified and within that asset-based finance being a very important channel. So, what is ABF and why do you expect it to play such a big role in financing AI and data centers?

Vishy Tirupattur: So, ABF is a very broad term for financing arrangements within the context of private credit. These are financing arrangements that are secured by loans and contractual cash flows such as leases – either with hard assets or without hard assets. So, the underlying concept itself is pretty widely used in securitizations.

So, the difference between ABF structures and ABS structures is that the ABF structures are highly bespoke. They enable lots of customization to fit the specific needs of the investors and issuers in terms of risk tolerance, ratings, returns, duration, term, et cetera.

So, ABS structures, on the other hand, are pretty standardized structures, you know, driven mainly by rating agencies – often requiring fairly stabilized cash flows with very strict requirements of lessee characteristics and sometimes residual value guarantees, in cases where hard assets are actually part of the collateral package.

So, ABF opens up a wider range of possible structures and financing options to include assets that are on different stages of development. Remember, this is a very nascent industry. So, there are data centers that are fully stabilized cash flows, and there are data centers that are in very early stages of building with just land, or land and power access just being established.

So, ABF structures can really do it in the form of a single asset or single facility financing or could include a portfolio of multiple assets and facilities that are in different stages of development.

So, put all these things together, the nascent nature and the bespoke needs of data center financing call for a solution like ABF.

Vishwas Patkar: And then taking a step back. So, as you said, the [$]1.5 trillion financing gap; I mean, that's a big number. That's larger than the size of the high yield market and the leveraged loan market.

So, the question is, who are the investors in these structures, and where do you think the money ultimately comes from?

Vishy Tirupattur: So, there is really a favorable alignment here of significant and substantial dry powder across different credit markets. And they're looking for attractive yields with appeal to a sticky investor base. This end investor base consists of investors such as insurance companies, sovereign wealth funds, pension funds, endowments, and high net worth retail individuals.

Vishy Tirupattur: These are looking for scalable high quality asset exposures that can provide diversification benefits. And what we are talking about in terms of AI and data center financing precisely fall into that kind of investment. And we think this alignment of the need for capital and need for investments, that bridges this gap for [$]1.5 trillion that we're talking about here.

So, my final question to you, Vishwas, is this. Where could we be wrong in our assessment of the financing through the various credit market channels?

Vishwas Patkar: With the caveat that there are a lot of assumptions and moving parts in the framework that we build, I would flag really two risks. One macro, one micro.

The macro one I would talk about in the context of credit market capacity. A lot of the favorable dynamics that you talked about come from where the level of rates are. So, if the economy slows and yields were to drop sharply, then I think the demand that credit markets are seeing could come into question, could see a slowdown over the coming years.

The more micro risks, I think really come from how quickly or how slowly AI gets monetized by the big tech names. So, while we are quite optimistic about revenue generation a few years out, if in reality revenues are stronger than expected, then you could see more reliance on the public markets.

So, for instance, the 200 billion of corporate bond issuance is likely going to be skewed higher in a more optimistic scenario. On the flip side, if there is mmuch ore uncertainty around the path to revenue generation, and if you see hyperscalers pulling back a bit on CapEx – then at the margin that could push more financing to the way of credit markets. In which case the overall [$]1.5 trillion number could also be biased higher.

So those are the two big risks in my view.

Vishy Tirupattur: So, Vishwas, any way you look at it, these numbers are big. And whether you are involved in AI or whether you're thinking about credit markets, these are numbers and developments that you cannot ignore.

So, Vishwas, thanks so much for joining.

Vishwas Patkar: Thank you for having me on Vishy.

Vishy Tirupattur: And thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist.

Matthew Hornbach: Today – a look back at last week’s meeting of the Federal Open Market Committee or FOMC, and the path for rates from here.

It's Tuesday, August 5th at 10am in New York.

Mike, last week the Fed met for the fifth time this year. The committee didn't provide a summary of their economic projections, but they did update their official policy statement. And of course, Chair Powell spoke at the press conference. How would you characterize the tone of both?

Michael Gapen: Yeah, at first the statement I thought took on a slightly dovish tone for two reasons. One, unexpected; the other expected. So, the committee did revise down their assessment of growth and economic activity. They had previously described the economy as growing at a quote, ‘solid pace,’ and now they said, you know, the incoming data suggests that growth and economic activity moderated.

So that's true. That's actually our view as well. We think the data points to that.

The second reason the statement looked a little dovish, and this was expected is the Fed received two dissents. So, Governors Bowman and Waller both dissented in favor of a 25 basis point rate cut at the July meeting.

But then the press conference started. And I would characterize that as Powell having at least some renewed concerns around persistence of inflation. So, he did recognize or acknowledge that the June inflation data showed a tariff impulse.

But I'd say the more hawkish overtones really came in his description of the labor market, which I know were going to get into.

And we've been kind of wondering and, you know, asking implicitly – is the Fed ever going to take a stand on what constitutes a healthy and/or weak labor market? And Powell, I think put down a lot of markers in the direction; that said, it's not so much about employment growth, it's about a low unemployment rate. 

And he kept describing the labor market as solid, and in healthy condition, and at full employment. So, the combination of that suggests it's a higher bar, in our mind, for the Fed to cut in September.

Matthew Hornbach: And on the labor market, if we could dig a little bit deeper on that point. It did seem to me certainly that Powell was channeling your views on the labor market.

Michael Gapen: Well, I wish I had that power but thank you.

Matthew Hornbach: Well. I'd like to now channel your views – and of course his views – to our listeners. Can you just go a little bit deeper into this dichotomy that you've been highlighting between the pace of job growth and the unemployment rate itself?

Michael Gapen: Yeah. Our thesis and what we've laid out coming into the year, and we think the data supports, is the idea that immigration controls have really slowed growth in the labor force. And what that means is the break-even rate of employment has come down.

So even as economic growth has slowed and demand for labor has slowed, and therefore employment growth has slowed – the unemployment rate has stayed low, and there's some paradox in that. Normally when employment growth weakens, we think the economy’s rolling over; the Fed should be easing.

But in an environment of a very slow growing labor force, the two can coincide. And there's tension in that, we recognize. But our view is – the more the administration pushes in the direction of restraining immigration, the more likely it is you'll see the combination of low employment growth, but a low unemployment rate. And our view is that still means the labor market is tight.

Matthew Hornbach: Indeed, indeed. Just one last question from me. How are you thinking about the Fed's policy path from here? In particular, how are you looking at the remaining data that could get the Fed to cut rates in September?

Michael Gapen: Yeah, I think that there's no magic sauce here, if you will; or secret sauce. Powell, you know, essentially is laying out a case where it's more likely than not inflation will be deviating from the 2 percent target as tariffs get passed through to consumer prices. And the flag that he planted on the labor market suggests maybe they're leaning in the direction of thinking the unemployment rates is likely to stay low.

So, we just need more revelations on this front. And the gap between the July and the September FOMC meetings is the longest on the Fed's calendar. So, they will see two inflation reports and two labor market reports.

And again, it just to provide context and color, right? What I think Powell was doing was positioning his view against the two dissents that he received. So where, for example, Governor Waller laid out a case where weaker employment growth could justify cuts, Powell was reflecting the view of the rest of the committee that said, ‘Well, it's not really employment growth, it's about that unemployment rate.’

So, when these data arrive, we'll be kind of weighing both of those components. What does employment growth look like going forward? How weak is it? And what's happening to that unemployment rate?

So, if the Fed's doing its job, this shouldn't be magic.

If the labor market's obviously rolling over, you'll get cuts later this year. If not, we think our view will play out and the Fed will be on the sideline through, you know, early 2026 before it moves to rate cuts then.

So Matt, what I'd like to do is kind of turn from the economics over to the rates views. How did the rates market respond to the meeting, to the statement, to the press conference? How are you thinking about the market pricing of the policy path into your end?

Matthew Hornbach: So initially when the statement was released, as you noted, it had a dovish flavor to it. And so, we had a small repricing in the interest rate market, putting a little bit of a higher probability, on the idea that the Fed would lower rates in September. But then as Chair Powell began the press conference and started to articulate his views around both inflation and the labor market we saw the market take out some probability that the Fed would lower rates in September.

And where it ended up at the end of that particular day was putting about a 50 percent probability on a rate cut and as a result of 50 percent probability of no rate cut; leaving the data to really dictate where the pricing of that meeting would go from there.

That to me speaks to this data dependence of the Fed, as you've discussed. And I think that in the coming weeks we get more of this data that you talked about, both on the inflation side of the mandate and on the labor market side of the mandate. And ultimately, if they end up, going in September, I would've expected the market to have priced most of that in, ahead of the meeting. And if they end up not cutting rates in September, then naturally the market will have moved in that direction ahead of time.

And again, I think what ends up happening in September will be critical for how the market ends up pricing the evolution of policy in November and December. But to me, what I think is more interesting is your view on 2026. And in that regard, the market is still some distance away from your view, that the Fed goes about 175 basis points in 2026.

Michael Gapen: Yeah, I mean, we're still thinking the lagged effects of tariffs and immigration will slow the economy enough to get more Fed cuts than the market's thinking. But, you know, we'll see if that happens. And maybe that's a topic we can turn back to in upcoming Thoughts on the Market.

But what I'd like to do is ask you this. I've been reading some of your recent work on term premiums. And in my view, had this really interesting analysis about how the market prices Fed policy and how U.S. Treasury yields then adjust and move.

You highlighted that Treasury yields built in a term premium after April 2nd. What's happening with that term premium today?

Matthew Hornbach: Yeah. The April 2nd Liberation Day event catalyzed an expansion of term premia in the Treasury market. And ultimately what that means is that Treasury yields went up relative to what people were thinking about the path of Fed policy, and of course, the risks that they were thinking about in the month of April were risks related to trade policy. Those risks have diminished somewhat, I would argue in the subsequent months as the administration has been announcing deals with some of our trading partners. And then the market's focus turned to supply and what was going to happen with U.S. Treasury supply. And then, of course, the reaction of investors to that coming supply.

And I would say, given what the Treasury announced last week, which was – it had no intention of raising supply, in the next several quarters. In our view is that the U.S. Treasury will not have to raise supply until the early part of 2027. So way off in the distance.

So, investors are becoming more comfortable taking on duration risk in their portfolios because some of that uncertainty that opened up after April 2^nd has been put away.

Michael Gapen: Yeah, I can see how the substantial tariff revenue we're bringing in could affect that story. So, for example, I think if you annualize the run rates on tariffs, you'll get something over $300 billion in a 12-month period. And that certainly will have an impact on Treasury supply.

Matthew Hornbach: Indeed. And so, as we make our way through the month of August, we'll get an update to those tariff revenues. And also, towards the end of August, we will have the economic symposium in Jackson Hole, where Chair Powell will give us his updated thoughts on what is the outlook for the economy and for monetary policy. And Mike, I look forward to catching up with you after that.

Thanks for taking the time to talk today.

Michael Gapen: Great speaking with you Matt.

Matthew Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.