Corporate Credit at a Crossroads?

Thoughts on the Market

Our Head of Corporate Credit Research looks at the Fed’s approach to rate cuts, seasonal trends and the US election to explain why the next month represents a crucial window for credit’s future.

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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 why the next month is a critical window for credit.

It's Thursday, September 12th at 9am in New York.

We’ve liked corporate credit as an asset class this year and think the outlook over the next 6-12 months remains promising. At a high level, credit likes moderation, and that continues to be exactly what Morgan Stanley’s economists are forecasting; with moderate growth, moderate inflation, and moderating policy in the US and Europe. Meanwhile, at the ground level, corporate balance sheets are in good shape, and demand for fixed income remains strong, dynamics that we think are unlikely to shift quickly.

But this good credit story is now facing a critical window. As we’ve discussed recently on this program, the Fed has taken a risk with monetary policy, continuing to keep interest rates elevated despite increasing indications that they should be lower. U.S. inflation has been coming down rapidly, to the point where the market now thinks the rate of inflation over the next two years will be below what the Fed is targeting. The labor market is slowing, and government bond markets are now assuming that the Fed will have to make much more significant adjustments to policy.

And so, this becomes a race. If the economic data can hold up for the next few months, while the Fed does make those first gradual rate cuts, it will help reassure markets that monetary policy is reasonable and in-line with the underlying economy. But if the data weakens more now, the market is vulnerable. Monetary policy works with a lag, meaning rate cuts are not going to help anytime soon. And so, it becomes easier for the market to worry that growth is slowing too much, and that the cavalry of rate cuts will be too late to arrive.

The second immediate challenge is so-called seasonality. Over almost a century, September has seen significantly weaker performance relative to any other month. Seasonality always has an element of mysticism to it, but in terms of specific reasons why markets tend to struggle around this time of year, we’d point to two factors. First, after a summer lull, you tend to see a lot of issuance, including corporate bonds issuance. And for Equities, September often sees more negative earnings revisions, as companies aim to bring full-year estimates in line with reality. Lots of supply and weaker earnings revisions are often a tough combination.

A final element of this critical window is the approaching US election. This appears to be an extremely close race between candidates with very different policy priorities. If investors get more nervous that monetary policy is mis-calibrated, or seasonality is unhelpful, the approaching election provides yet another reason for investors to hold back.

All of this is why we think the next month is a critical window for credit, and why we’d exercise a little bit more caution than we have so far this year. But we also think any weakness is going to be temporary. By early November, the US election will be over, and we think growth will be holding up, inflation will keep coming down, and interest rate cuts will be well underway. And while September is historically a bad month for stocks and credit, late-October onward is a different and much better story. Any near-term softness could still give way to a stronger finish to the year.

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