Will High Yields Crack the Market’s Resilience?

Andrew Sheets (0:00)

Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley. Today, exploring further the question that seems to be on everyone's mind. At what point do higher rates become a problem for markets? It's Friday, October 9th at 2 p.m. in London.

We recently hosted Morgan Stanley's ninth annual European Credit Conference here in London. Fifty companies, over a thousand investors, and to some extent, one dominating question. The market has been impressively resilient this year. But as yields rise, at what point does this change? I think a good place to start with this question is whether the current level of interest rates are obviously wrong. And I don't think it's clear that they are. Growth in the US, Europe and Asia remains surprisingly robust and has for a lot of this year. Meanwhile, inflation across regions is still generally above central bank targets, too high, and a sign that conditions are more likely too hot than too cold. That's the opposite of what the wrong level of rates would imply, as rates that were too high would be curtailing activity and pushing inflation down below target. Thanks in part to the scale of AI spending and how insensitive the spending has been to the level of interest rates, we're just not seeing this.

I think the yield curve is also confirming this message that the level of rates for now is okay. In an environment where the market thinks that central banks have raised rates too much, it will often so-called invert the yield curve, pushing short-term interest rates above longer-term ones on the belief that rates that are too high today will need to be lowered when conditions weaken in the future. We're not seeing that, and that is, I think, a pretty important indicator. At the risk of being pedantic, I think there's also the premise of the question around resilience. At one level, without a doubt, markets have been impressively solid, given the large rise in yields this year. US and European stocks have been posting double-digit gains. Credit spreads, a measure of risk premium, sit near multi-decade lows.

But under the surface, that resilience isn't so apparent. Spreads on the lowest-rated credits, so-called triple Cs, have increased significantly this year across both the US and Europe. Publicly traded BDCs, which contain portfolios of lower-rated private credit, have traded at widening discounts to their book value. And even in the mighty US stock market, my colleague Mike Wilson and our US equity strategy team note that over half of the 3,000 largest stocks have seen a drawdown of at least 20% since June, which happens to be the month that yields started to rise.

2026 may be showing that global growth overall is just less sensitive to higher rates than was initially expected. Large government deficits in the US, Europe and Asia and large spending on AI may be two reasons why. With growth strong and inflation still too high, rates may be simply seeking out a level that they think will keep things in balance.

But the interest rate that helps balance this technology and spending boom are not the same rates that keep a smaller, weaker or more indebted company happy. If higher rates are needed to balance things overall, the weaker tales of the market can still suffer. We've seen this in the past, particularly 2005 When simultaneous booms in capex in China and the US housing market pushed up rates back then, the overall economy held up for several more years, while weaker pockets of credit suffered more quickly. Back then, a large US government deficit, booming China capex and significant US housing wealth all helped push up rates. The overall economy held up for several more years, but weaker parts of the credit market were challenged by those rates more quickly. We think the same may be true today, and therefore favor an upper quality bias. We favor high yield bonds over loans, and decompression across credit indices.

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

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