Resilient Credit Markets Amid Slowing Growth

Our Head of Corporate Credit Research, Andrew Sheets, expects a sticky but shallow cycle for defaults on loans, with solid quality overall in high-grade credit.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss some longer-term thoughts on the credit market and the economic cycle.

It's Friday, September 6th at 2pm in London.

Concerns around US growth have risen, an issue that will probably persist even after today’s US Payrolls report came roughly inline with expectations. At Morgan Stanley, we continue to expect moderate slowing in growth, not a slump. By the middle of next year, our economists see growth slowing to a still respectable 2% growth rate, and a total of seven rate cuts.

While growth is set to slow, we think corporate balance sheet metrics are unusually good in the face of this slowing. Indeed, the credit quality of the US investment grade and BB credit markets, which represent the vast majority of corporate credit outstanding, have actually improved since the Fed started hiking rates.

Now, looking ahead, there's understandable concern that these currently good credit metrics won't be sustainable as companies will have to refinance the very cheap borrowing that they received immediately after COVID, with the more expensive costs of today's currently higher yields. But we actually think balance sheets will be reasonably robust in light of this reset, and so their ultimate rate sensitivity could be relatively low.

One reason is that a wave of refinancing means companies have already tackled a significant portion of their upcoming debt, reducing the so-called rollover or refinancing risk. Interest coverage for floating rate borrowers has stabilized and should actually improve as the Fed starts to lower rates.

The debt service costs for higher rated companies will increase as cheaper debt matures and has to be replaced with more expensive borrowing; but we stressed this is a pretty slow process given the long-term nature of a lot of this borrowing. And so, overall, we think the headwinds from higher debt costs are going to be manageable, with the problems largely confined to a smaller cohort of the lowest quality issuers.

We think all of that will drive a so-called sticky but shallow default cycle, with defaults driven by higher borrowing costs at select issuers rather than a single problem sector or particularly poor corporate earnings. And there are also some important offsets. Morgan Stanley's forecast suggests that the Fed will be cutting rates, which will reduce overall borrowing costs over the medium term. And another notable theme over the last two years is that more defaults have been becoming so-called restructurings rather than bankruptcies. These restructurings are more likely to leave a company operating -- just under new ownership -- and create less negative feedback into the real economy.

Now, against all this, we're mindful that credit spreads are tight, i.e. lower than average. But importantly, we don't think this reflects some sort of euphoria from either the lenders or the borrowers.

All-in borrowing costs for corporates remain high, and that's made corporates less likely to be aggressive or increase their leverage. Indeed, since COVID, the overall high yield bond and loan markets have actually shrunk. Leverage buyout activity has been muted and corporate leverage has gone sideways.

These are not the types of things you see when corporates are being particularly aggressive and credit unfriendly. Credit markets love moderation and that's very much what Morgan Stanley's economic forecasts over the medium term expect. Spreads may be tight. But we think they're currently supported by strong fundamentals, modest supply, and improving technicals.

Today's roughly inline payroll number won’t resolve the uncertainty around growth, but longer term, we think the picture remains encouraging.

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