A Credit Bear Market Has Started

Morgan Stanley: "A Credit Bear Market Has Started And Will Be Painful"

Authored by Vishwanath Tirupattur, Morgan Stanley's head of Fixed Income Research

As the Cycle Turns… 

It is that time of the year again – time to review how the year has been and for strategists like us to return to the occupational hazard of crystal ball-gazing about the prospects for next year. Corporate credit markets, particularly in the US, are heading to a notably negative return year. Notable because it is a dramatic reversal of fortunes from a year ago and coming in a year of strong growth in the US economy, with defaults and ratings downgrades at rather benign levels. It is worth noting that this reversal of fortunes is precisely what our US credit strategists had predicted for this year. They now expect this bearish turn to continue in 2019. 

The tricky handoff from quantitative easing (QE) to quantitative tightening (QT) that is under way is central to the cracks that have appeared across risk markets and credit markets in particular. Global QE provided the necessary conditions for corporations to lever up, which is exactly how they responded.

Outstanding US corporate credit market debt has more than doubled from US$3.2 trillion in 2008 to well over US$7 trillion today, with the biggest chunk of it coming in the BBB portion of the credit curve, the lowest rung of investment grade ratings. High debt growth has translated to high leverage – BBBs with 31% of BBB debt leveraged at or above 4.0x.

The consequence of this shape of evolution of the credit cycle is that the large systemic dimension of the last crisis would be much less pronounced and what we will realise is a more garden-variety credit cycle turn, something credit investors have more experience in dealing with. That said, no doubt a cycle turn is coming, and this bearish turn will be painful for credit investors, in our view. 

The silver lining is that investor complacency is lower and valuations have gotten cheaper in the last few months. Even if the consensus has embraced the idea that end-of-cycle risks are rising notably, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. That said, the credit bear market has started, and until valuations have truly priced in long-term fundamental risks, our advice is that investors should use rallies to move up-in-quality. Have a great Sunday.