Welcome to Thoughts on the Market. I’m Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.
Today on the podcast, I’ll be discussing how much comfort or concern equity and credit markets should be taking from each other’s recent moves.
It’s Friday, March 14th at 2pm in London.
Credit has weakened as markets have gyrated in the face of rising uncertainty around U.S. economic policy. But it has been a clear outperformer. The credit market has taken longer to react to recent headlines, and seen a far more modest response to them. While the U.S. stock market, measured as the S&P 500, is down about 10 per cent, the U.S. High Yield bond index, comprised of lower-rated corporate bonds, is down about just 1 per cent.
How much comfort should stock markets take from credit’s resilience? And what could cause Credit to now catch-down to that larger weakness in equities?
A good place to start with these questions is what we think are really three distinct stories behind the volatility and weakness that we’re seeing in markets.
First, the nature of U.S. policy towards tariffs, with plenty of on-again, off-again drama, has weakened business confidence and dealmaking; and that’s cut off a key source of corporate animal spirits and potential upside in the market.
Second and somewhat relatedly, that reduced upside has lowered enthusiasm for many of the stocks that had previously been doing the best. Many of these stocks were widely held, and that’s created vulnerability and forced selling as previously popular positions were cut.
And third, there have been growing concerns that this lower confidence from businesses and consumers will spill over into actual spending, and raise the odds of weaker growth and even a recession.
I think a lot of credit’s resilience over the last month and a half, can be chalked up to the fact that the asset class is rightfully more relaxed about the first two of these issues. Lower corporate confidence may be a problem for the stock market, but it can actually be an ok thing if you’re a lender because it keeps borrowers more conservative. And somewhat relatedly, the sell-off in popular, high-flying stocks is also less of an issue. A lot of these companies are, for the most part, quite different from the issuers that dominate the corporate credit market.
But the third issue, however, is a big deal. Credit is extremely sensitive to large changes in the economy. Morgan Stanley’s recent downgrade of U.S. growth expectations, the lower prices on key commodities, the lower yields on government bonds and the underperformance of smaller more cyclical stocks are all potential signs that risks to growth are rising. It's these factors that the credit market, perhaps a little bit belatedly, is now reacting to.
So what does this all mean?
First, we’re mindful of the temptation for equity investors to look over at the credit market and take comfort from its resilience. But remember, two of the biggest issues that have faced stocks – those lower odds of animal spirits, and the heavy concentration in a lot of the same names – were never really a credit story. And so to feel better about those risks, we think you’ll want to look at other different indicators.
Second, what about the risk from the other direction, that credit catches up – or maybe more accurately down – to the stock market? This is all about that third factor: growth. If the growth data holds up, we think credit investors will feel justified in their more modest reaction, as all-in yields remain good. But if data weakens, the risks to credit grow rapidly, especially as our U.S. economists think that the Fed could struggle to lower interest rates as fast as markets are currently hoping they will.
And so with growth so important, and Morgan Stanley’s tracking estimates for U.S. growth currently weak, we think it's too early to go bottom fishing in corporate bonds.
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