Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Today I’ll be discussing realistic scenarios where things could be better than we expect.
It's Friday December 20th at 2pm in London.
Credit is an asset class that always faces more limited upside, and the low starting point for spreads as we enter 2025 further limits potential gains. Nevertheless, there are still a number of ways where this market could do better than expected, with spreads tighter than expected, into next year.
An obvious place to start is U.S. policy. Morgan Stanley’s public policy strategy team thinks the incoming administration will be a story of “fast announcement, slow implementation”, with the growth and inflation impact of tariffs and immigration falling more in 2026 (rather than say earlier). And so if one looks at Morgan Stanley’s forecasts, our growth numbers for 2025 are good, our 2026 numbers are weaker.
The bull case could be that we see more talk but less ultimate action. Scenarios where tariffs are more of a negotiating tool than a sustained policy would likely mean less change to the current (credit friendly) status quo, and also increase the likelihood that the Federal Reserve will be able to lower interest rates even as growth holds up. Rate cuts with good growth is a rare occurrence, but when you do get it, it can be extremely good. If one thinks of the mid-1990s, another time where we had this combination, credit spreads were even tighter than current levels. Another path to the bull case is better funding conditions in the market. Some loosening of bank capital requirements or stronger demand for collateralized loan obligations could both flow through to tighter spreads for the assets that these fund, especially things like leveraged loans. If we think back to periods where credit spreads were tighter than today, easier funding was often a part of the story.
Now, a more aggressive phase of corporate activity could be a risk to credit, but M&A can also be a positive event, especially on a name by name basis. If merger and acquisition activity becomes a story of, say, larger companies buying smaller ones, that could mean that weaker, high yield credits get absorbed by larger, stronger, investment grade balance sheets. And so for those high yield bonds or loans, this can be an outstanding outcome. Another way things could be better than expected for credit is that growth in Europe and China is better than expected. In speaking with investors over the last few weeks, I think it's safe to say that expectations for both regions are pretty low. And so if things are better than these low expectations, spreads, especially in Europe, which are not as tight as those in the U.S., could go tighter.
But the most powerful form of the credit bull case might be the simplest. Morgan Stanley expects the Federal Reserve, the Bank of England, and the European Central Bank to all lower interest rates much more than markets expect next year, even as, for the most part, growth in 2025 holds up. Due in a large part to those expected rate cuts, we also think the yields fall more than expected. If that's right, credit could quietly have an outstanding year for total return, which is boosted as yields fall. Indeed, on our forecast, U.S. investment grade credit, a relatively sleepy asset class, would see a total return of roughly 10%, higher than our expected total return for the mighty S&P 500. Not all credit investors care about total return. But for those that do, that outcome could feel very bullish.
Thanks for listening. If you enjoy the show, leave us a review wherever you listen, and share Thoughts on the Market with a friend or colleague today.
