Andrew Sheets: Unexpected Behavior in Markets

Chief Cross-Asset Strategist Andrew Sheets explains why it’s increasingly more favorable to be a lender than an asset owner.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, July 28th at 2 p.m. in London.

Markets have been stronger than we expected. Some of the story is straight forward, some of it is not. Indeed across asset classes, the capital structure increasingly looks upside down. 

Our investment strategy has been based on the assumption that strong developed market growth was set to slow sharply as post-COVID stimulus waned and policy tightened at the fastest pace in 40 years. Sharp slowing, from an elevated base, has often rewarded more defensive investment positioning. 

But our assumption about this growth backdrop has simply been wrong. Growth has been good, with the U.S. printing yet another set of better than expected economic data this week. 20 years from now, an investor looking back on the first half of 2023 might find nothing particularly out of place. The economic data was good and surprisingly so, stocks, especially more cyclical ones, outperform bonds. 

Yet that straightforward story has happened alongside something more unusual. Across markets, we can observe a capital structure, that is how much investors are expected to earn as the owner of an asset, a company, an office building and so on, relative to being the lender to the asset. The lender should get a lower return since they're taking less risk, and over the last decade, very low borrowing rates have meant that that very much is the case.

But it's been shifting. To varying degrees, the capital structure now looks almost upside down, with high yields on debt relative to more junior exposure, or the yield on the underlying asset. And we see this in several areas. 

In U.S. corporates, higher equity valuations have meant that the forward earnings yield for the Russell 1000, at about 4.8%, is now below the yield on US investment grade corporate debt at about 5.5%, and the difference between these two is only been more extreme in about 2% of observations over the last 20 years. 

In real estate, yields on debt have risen much faster than capitalization rates, that is the yield on the underlying real estate asset, and that's happened across both commercial and residential segments. 

And across leveraged loans and collateralized loan obligations, or CLO's, the so-called CLO ARB, which is the difference between the yield on the CLO loan collateral and the weighted cost of its liabilities, are unusually low. And we've also seen this in the loan market.

For much of the last decade, the economics of borrowing to buy assets has been attractive. As the examples I've mentioned try to show, these economics are changing. Across scenarios where growth stays solid or especially if it slows, we think being the lender to an asset rather than its owner, is now often the better risk/reward. 

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