Historical playbooks: 2005 versus 1997–1998

Our Head of Corporate Credit Research Andrew Sheets explains why 2026 might bring a credit cycle that burns hotter before it burns out.

Read more insights from Morgan Stanley.

----- Transcript -----

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

Today I'm going to talk about our outlook for global credit markets in 2026 and why we think the credit cycle burns hotter before it burns out.

It's Friday, December 12th at 2pm in London.

Surely it can't go on like this. That phrase is probably coming up a lot as global credit investors sit down and plan for 2026. Credit spreads are sitting at 25 year plus tights in the U.S. and Asia. Issuance in corporate activity are increasingly aggressive. Corporate CapEx is surging. Signs of pressure are clear in the lowest rated parts of the market. And credit investors are trained to worry. Aren't all of these and more signs that a credit cycle is starting to crack under its own weight?

Not quite yet, according to our views here at Morgan Stanley. Instead, we think that 2026 brings a credit cycle that burns hotter before it burns out. The reason is partly due to an unusually stimulative backdrop. Central banks are cutting interest rates. Governments are spending more money, and regulatory policy is easing. All of that, alongside maybe the largest investment cycle in a generation around artificial intelligence, should spur more risk taking from a corporate sector that has the capacity to do so.

In turn, we think the playbook for credit is going to look a lot like 2005 or 1997-1998. Both periods saw levels of capital expenditure, merger activity, interest rates, and an unemployment rate that are pretty similar to what Morgan Stanley expects next year. And so, looking ahead to 2026, these two periods offer two competing ways to view the year ahead.

2025 might be more similar to a period where the low-end consumer really is starting to struggle, but that another force – back then it was China, now it might be AI spending – keeps the broader market humming. 1997 or 1998, on the other hand, would be more similar to a narrative that investors are growing more confident that a new technology is really transformative. Back then, it was the internet and now it's AI.

Corporate bond issuance we think will be central to how this resolves itself. This is a strong regional theme and a key driver of our views across U.S., European and Asia Credit. We forecast net issuance to rise significantly in U.S. investment grade up over 60 percent versus 2025 to a total of around $1 trillion.

That rise is powered by a continued increase in technology spending to fund AI as well as a broader increase in capital expenditure and merger activity. All of those bonds being sold to the market should mean that U.S. spreads need to move wider to adjust. And that's true, even if underlying demand for credit remains pretty healthy, thanks to high yields, and the economy ultimately holds up.

We think this story is a bit better in other areas and regions that have less relative issuance, including European and Asian investment grade and global high yield. They all outperform U.S. investment grade on our forecast. In total returns, we think that all of these markets produce a return of around 4 to 6 percent, and if that's true, it would underperform, say U.S. equities, but outperform cash.

More granularly similar to 2025 or 2005, we think that single name and sector dispersion remain major themes. And where you position in maturity should also matter. Credit curves are steep and our U.S. interest rate strategist are expecting the U.S. Treasury curve to steepen significantly Further. That should mean that so-called carry and roll down and where you position on the maturity curve are a pretty big driver of your ultimate result. In our view, corporate bonds between five- and 10-year maturity in both the U.S. and Europe will offer the best risk reward.

The most significant risk for global credit remains recession, which we think would argue for wider spreads on both economic rounds, but also through weaker demand as yields would fall. It would mean that our spread forecasts are too optimistic and that our expectation that high yield outperforms investment grade would be wrong. And then there's a milder version of this bear case – that aggression and corporate supply are even stronger than we think, and that creates conditions closer to late 1998 or 1999.

Back then, U.S. investment grade spreads were roughly 30 basis points wider than current levels, even though the economy was strong and even though the equity market kept going up.

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