Welcome to Thoughts on the Market.
I'm Andrew Sheets, Global Head of Corporate Credit Research at Morgan Stanley.
And I'm Lisa Shallott, Chief Investment Officer of Morgan Stanley Wealth Management.
Yesterday we focused on the topic of a higher-for-longer inflation regime and I was asking the questions.
Today, Lisa will grill me on my views for the next year.
It's Friday, December 19th at 4 p.m. in London.
And it's 11 a.m. in New York.
All right, Andrew, I'm happy to turn the tables on you.
What do you think are the main drivers behind this more constructive inflation outlook, especially taking into account the market's prevailing concerns about persistent price pressures?
There are a couple of factors that we think are going to be near term helps for inflation, although I don't think they totally rule out what you're talking about over that longer term period.
So first, we at Morgan Stanley are very cautious, very negative on oil prices.
We think that there's going to be more supply of oil over the next year than demand for it.
And so lower oil prices should help bring inflation down.
There's also some measures of just how the inflation indices measure shelter and housing.
And so, while we think, kind of looking further ahead, there are some real shortages emerging in things like the rental markets, where you just haven't had a whole lot of new rental construction coming online yet as you look out a year or two ahead.
But in the near term, rental markets have been softer, home prices are coming down with a lag in the data, and so shelter inflation is relatively soft.
So we think that helps while at the same time fiscal policy is very supportive.
And corporates.
As we discussed in our last conversation.
They're really embracing animal spirits with more spending, more spending on AI, more capital investment generally, more MA.
And so those factors together, we think can, over the next 12 months, still mean pretty reasonable growth and inflation.
That's still above target, but at least trending a little bit lower.
You believe that central banks, including the Fed, will cut rates more slowly given better growth.
And this slower pace of easing could actually be positive for the credit markets.
So could you elaborate on your expertise in credit and why a gradual Fed approach may be preferable?
What risks and opportunities might this create?
Yeah.
So I think this is kind of one of these big debates going into this year is which would we rather have?
Would we rather have a Fed that was more active, cutting more aggressively or cutting more slowly?
And indeed, we're having this conversation on the heels of a Fed meeting.
There's a lot of uncertainty about that path.
But the way that we're thinking about it is that the biggest risk to credit would be that this outlook for growth that we have is just too optimistic, that actually growth is weaker than expected, that this rise in the unemployment rate is signaling something far more challenging for the economy ahead.
And in that scenario, the Fed would be justified in cutting a lot more.
But I think historically, in those periods where growth has deteriorated more significantly while the Fed has been cutting more, those have been periods where credit and indeed the equity market have actually done poorly, despite kind of more quote-unquote Fed assistance.
Periods where the Fed is cutting more gradually tend to be more consistent, with policy in the right place, the economy being in an OK place.
And so we think that that's the better outcome.
So, again, we have to kind of monitor the situation.
But a scenario where the Fed ends up doing a little bit less than the market, or even we expect, with rate cuts because the economy is holding up, that can still be, we think, an OK scenario for markets.
So things are okay and animal spirits are returning.
What does that mean for credit markets?
Yeah, so I think this is.
The bigger challenge is that, if our growth scenario holds up corporates, I think, have a lot of incentives to start taking more risk in a way that could be good for stock markets but a lot more challenging to the lenders to these companies for credit.
Corporates have been impressively restrained over the last several years.
They've really kind of held back despite lots of fiscal easing, despite very low rates.
Those reasons for waiting are falling away.
And so, in this backdrop that you Lisa, were describing the other day, around easier monetary policy, easier fiscal policy, easy regulatory policy And, just for good measure, maybe the biggest capital spending cycle since the railroads through AI.
These are some pretty powerful forces of animal spirits.
And that's a reason why we think ultimately we see a lot more issuance.
We see roughly a trillion dollars of net supply.
So total supply, less redemptions in U.S. investment grade.
That's a huge uptick from this year.
And we think that drives spreads wider, even if my colleague Mike Wilson is correct that equity markets rise.
So, wow.
So we have very strong US equities, but perhaps an investment grade credit market that underperforms those equities.
How else would you think about your asset allocation more broadly?
And how might those dynamics around credit issuance and equity success play out regionally?
Yeah, so I think this scenario where equities are up credit is underperforming the cycle is getting more aggressive.
It's a little unusual, but I think we do have some templates for it.
And specifically, I think investors could look to 2005. or 1997 and 1998.
Those were all years where equities were up double digits, where credit spreads were wider, where yields were somewhat range bound, where corporate aggression was increasing.
That is all very consistent with Morgan Stanley's 2026 story.
And yet you did have this divergence between equities and credit markets.
I think it is a market where we see better risk reward in stocks than in credit.
I think it's a market where we want to be in somewhat smaller credits or somewhat smaller equities.
We like small and mid cap stocks in the U.S. over large caps.
We like high yield over investment grade.
And we do think that European credit might outperform, as it's somewhat lagging, this animal spirits theme that we think will be led by the US.
So if that's the outlook, what are the risks?
Yeah.
So I think there are two risks.
And we alluded to one of them early on in this conversation would be just that growth is weaker than we expect.
Usually, when the unemployment rate is rising, that's a pretty bad time to be in credit.
The unemployment rate is rising.
Now, Morgan Stanley economists think that that rise will be temporary, that it will reverse as we go through 2026.
And so it will be less of a thing to worry about.
But a sign that maybe companies have been holding off on firing, waiting for more tariff clarity.
If that doesn't come, then that would be a risk to growth.
The other risk to growth is just around this AI-related spending.
It is very large.
And the companies that are doing it are some of the wealthiest companies in the world.
And they see this spending potentially as really core to their long-term strategic thinking.
And so If you were to ever have an issuer or a set of issuers who were just less price sensitive, who would keep issuing into the market even if it was starting to reprice that market and push spreads wider, this might be the group.
And so a scenario where that spending is even larger than we expect and those issuers are less price sensitive than we expect.
That could also drive spreads wider, even if the underlying economic backdrop is somewhat OK.
Super.
That's probably a great place for us to wrap up.
So I'll hand it back to you, Andrew.
Well, great.
Lisa, always a pleasure to have this conversation.
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