Relief and Volatility Ahead for U.S. Stocks

With the rising cost of oil comes concerns around economic growth, but the distinction between the impact in Europe and the US is important, presenting both challenges and opportunities for investors.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 9th at 1:00 PM in New York. This week, the United States closed its markets to imports of Russian oil as another measure in its response to the invasion of Ukraine. In anticipation of this announcement, the price of oil increased to as high as $129 per barrel, leading the average gas price in the United States to reach $4.25. Understandably, this has created a new burden for consumers and also has investors concerned about the macroeconomic impacts of higher fuel prices. Here’s the latest thinking from our economists.We expect the downside to economic growth to be felt more in Europe than the United States. Unlike the US, Europe is a net importer of energy, which means when fuel prices go up they have to pay the price but don’t earn the extra income from selling fuel at a higher price. Accordingly, our European economics team has revised down their expectations for GDP growth by nearly 1% for 2022. The impact in the US should be more muted, with our colleagues dropping their growth forecast by 30 basis points to 4.3%. Again, this is because the US enjoys substantial domestic energy production. So while higher prices at the pump might interfere with some consumer purchases, the income from those fuel purchases will drive consumption elsewhere in the economy. But these views aside, we have to acknowledge these conditions of elevated fuel and commodities prices drive uncertainty around the future economic and monetary impacts that markets will consider. Increasingly, clients want to discuss and debate the idea of stagflation, which is the combination of slowing growth and rising inflation, in both the US and Europe. And that sentiment could persist for some time, as our commodities research team thinks swings in the price of oil between $100 and $150 are possible in the near term. We’ll have a lot more on that in future podcasts, but for now wanted to point out one tangible takeaway for investors: potential upside for equities in the energy exploration and production sector. Higher prices at the pump means potential for more revenue, yet the sector is valued at a discount to the S&P 500 when accounting for its prices relative to the cash flow of companies in that sector. Bottom line, the global economy is changing quickly, presenting both challenges and opportunities. We’ll be keeping you in the loop on both. Thanks for listening! If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

9 Mars 20222min

As European markets price in slowing growth, increased inflation and geopolitical tensions, pricing power is a potential focus for European investors looking to weather the storm.-----Transcript-----Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the impacts of recent geopolitical developments on European markets and why rising stagflation pressures point towards owning companies with good pricing power. It's Tuesday, March the 8th at 1:00 pm in London.Since our last podcast on European equities, the backdrop has changed considerably, with an escalation in geopolitical tensions putting upward pressure on inflation, downward pressure on growth and generally raising European risk premia as uncertainty spikes. Last week my colleague Jens Eisenschmidt, our Chief European Economist, cut his forecasts for European GDP growth for this year and next, while also raising his projections for inflation on the back of higher energy costs. While Jens is not predicting a European recession at this time, investors are becoming incrementally more worried about this possibility as geopolitical tensions extend and oil and gas prices continue to rise. Even if Europe does manage to avoid falling into an outright recession, the stagflationary conditions that are building in the region, namely slowing growth and rising inflation, have important implications for investors. Across the broader market it points to a more challenging backdrop for corporate profits as slowing top line momentum coincides with growing margin pressures from higher input costs. At the same time, heightened geopolitical uncertainty is putting downward pressure on equity valuations as investors rotate out of the region, thereby lowering the price to earnings ratio at the same time as profit expectations retrench. After a near 20% decline from their January highs, it's fair to say that European stocks are pricing in quite a lot of bad news here, with equity valuations now below long run averages and close to record lows vs. U.S. stocks. While we think this provides an attractive entry point for longer term investors, European markets will likely remain tricky in the short term as investor sentiment oscillates between hope and fear. Our experience suggests that markets rarely trough on valuation grounds alone, instead requiring a backdrop of broad capitulation, coupled with a more positive turn in the news flow - conditions that have not yet fallen into place. In many respects stagflation is the worst environment for asset allocators, as slow growth weighs on stocks at the same time as high inflation potentially undermines the case for bonds. Thankfully such an environment has been rare over the last 50 years, however we can still construct a ‘stagflation playbook’ for equity markets when it comes to picking stocks and sectors. Specifically, we identify prior periods when inflation was rising at the same time as growth indicators were falling. We then analyze performance trends over those periods. When we do this, we find that a stagflationary backdrop tends to favor commodity and defensive oriented stocks at the expense of cyclical and financial companies - a trend that has repeated itself over the last month here in Europe. An alternative strategy is to focus on companies that have strong pricing power, as they should have more ability to raise prices to offset higher input costs than other stocks. In a European context, sectors that are currently raising prices to expand their margins, even in the face of rising input costs, include airlines, brands, hotels, metals and mining companies, telecoms and tobacco. To be clear, not every stock in these sectors will enjoy superior pricing power, but we think these areas are a good place to start the search. Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

8 Mars 20223min

The year of the stock picker is in full swing as investors look towards a future of Fed tightening and geopolitical uncertainty, where some individual stocks will fare better than others.-----Transcript-----Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 7th at 11:00 a.m. in New York. So let's get after it. Since publishing our 2022 outlook in November, we've taken a more bearish view of stocks for reasons that are now more appreciated, if not fully. First was the Fed's pivot last fall, something most suggested would be a small nuisance that stocks would easily navigate. Part of this complacency was understandable due to the fact that the Fed had never really administered tough medicine in the past 20 years. Furthermore, when things got rough in the markets, they often pivoted back - the proverbial Fed “Put”, or the safety net for markets. We argued this time was different, just like we argued back in April 2020 that this quantitative easing program was different than the one that followed the Great Financial Crisis, or GFC. In short, printing money after the GFC didn't lead to the inflation many predicted, because it was simply filling the holes created on bank and consumer balance sheets that were left over from the housing collapse. However, this time the money printing was used to massively expand the balance sheets of consumers and businesses, who would then spend it. We called it helicopter money at the time. In short, the primary difference between the post GFC Fed money printing and the one that followed the COVID lockdown, is that the money actually made it into the real economy this time and drove demand well above supply. This imbalance is what triggered the Fed to pivot so aggressively on policy. In fact, Chair Powell has admitted that one of the Fed's miscalculations was thinking supply, including labor, would be able to adjust to the higher levels of demand making this inflation transitory. This has not been the case, and now the Fed must be resolute in its determination to reduce money supply growth. Nowhere was this resolve more clear than during Chair Powell's congressional testimony last week, when he was asked if he would be willing to take draconian steps, as Paul Volcker did in the early 1980s to fight inflation. Powell confidently answered, "Yes". To us this suggests the Fed "Put" on stocks is well below current levels, and investors should consider this when pricing risk assets. The other reason most investors and strategists have remained more bullish than us is due to the path of earnings. So far, this positive view has been correct. Earnings have come through, and it's the primary reason why the S&P 500 has held up better than the average stock. Therefore, the key question continues to be whether earnings growth can continue to offset the valuation compression that is now in full swing. We think it can for some individual stocks, which is why the title of our outlook was the year of the stock picker. As regular listeners know, we have been focused on factors like earnings, stability and operational efficiency when looking for stocks to own. Growth stocks might be able to do a little better as earnings take center stage from interest rates, but only if the valuations have come down far enough and they can really deliver on growth that meets the still high expectations. The bottom line is that the terribly unfortunate events in Ukraine make an already deteriorating situation worse. If we achieve some kind of cease fire or settlement that both Russia and the West can live with, equity markets are likely to rally sharply. We would use such rallies to lighten up on equity positions, however, especially those that are vulnerable to the earnings disappointment we were expecting before this conflict escalated. More specifically, that would be consumer discretionary stocks and the more cyclical parts of technology that are vulnerable to the payback in demand experienced over the past 18 months. Another area to be careful with now is energy, with crude oil now approaching levels of demand destruction. On the positive side, stick with more defensively oriented sectors like REITs, healthcare and consumer staples. Thanks for listening! If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

7 Mars 20223min

While the U.S. continues to see high valuations, rising inflation, and slow policy tightening, the story is quite different for many markets outside the U.S.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----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, March 4th at 3 p.m. in London. While Russia’s invasion of Ukraine has implications for financial markets, it has bigger implications for people. Hundreds of thousands have already been displaced, numbers which are likely to grow in the coming weeks. These refugees deserve our compassion, and support. To those impacted by this tragedy, you have our sympathies. And to those helping them, our admiration.Our expertise, however, is in financial markets, and so that’s where we’ll be focusing today. For those that are most negative on the market right now, the refrain is pretty simple and pretty straightforward. Assets are still expensive relative to historical valuations. Inflation is still high and it's still rising. And central banks are still behind the curve, so to speak, with lots of interest rate increases needed to bring monetary policy back in line with the broader economy. What I want to discuss today, however, was how different some of these concerns can look when you move beyond the United States. Let's start with the idea that assets are expensive. Now, this clearly applies to some markets, but less to others. Stocks in Germany, for example, trade at less than 12 times next year's earnings, Korean stocks trade at 10 times next year's earnings, Brazil, it's 8 times. And many currencies trade at historically low valuations relative to the U.S. dollar. Next up is inflation. While inflation is high in the U.S. and Europe, it's low in Asia, a region that does account for roughly 1/3 of the entire global economy. What do I mean by low? U.S. consumer prices have increased 7.5% Relative to a year ago. Consumer prices in China and Japan, in contrast, are up less than 1%. My colleague Chetan Ahya, Morgan Stanley's Chief Asia Economist, notes that these differences aren’t just some mathematical illusion, but rather reflect real differences in Asia's economy and policy response. Finally, there's the idea that central banks are behind the curve, so to speak. Now, the hindsight here is a little tricky, as the Federal Reserve and the ECB were dealing with enormous uncertainty around the scope of the pandemic for much of last year. But what's notable is that not all central banks took that path. Central banks in Chile, Brazil, Poland and Hungary, just to name a few, have been raising interest rates aggressively for the better part of the last 12 months. In times of crisis, markets often try to simplify the story. But the challenges facing global markets, from valuations, to inflation, to monetary policy, really are different. As events unfold, it will be important to keep these distinctions in mind.Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

4 Mars 20222min

As the Fed continues to signal coming rate hikes this year, the housing market will face implications across home sales, mortgage rates, and fundamentals.-----Transcript-----Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. Jay Bacow: And on this edition of the podcast, we'll be talking about changes in the Fed policy and what the possible implications are for mortgages and the housing market more broadly. It's Thursday, March 3rd at 11:00 a.m. in New York. Jim Egan: Okay, Jay, we've talked about affordability pressures as mortgage rates have moved higher a couple of other times in the past on this podcast, and we would encourage listeners to go back and listen to those prior podcasts for a deeper dive on affordability. But Jay Powell just testified this week that he'll support a 25 basis point hike in March. Furthermore, if inflation pressures are persistent, then he's gonna raise Fed funds by more than 25 basis points at later meetings. The markets priced in six hikes this year. What does that mean for mortgage rates going forward? When I think about affordability, am I gonna have to think of another 150 basis point increase in mortgage rates? Jay Bacow: No. So you saying the market has priced in six hikes is really important, because mortgage rates are based on generally sort of the belly of the Treasury curve. And the belly of the Treasury curve is effectively a function of what the market's expecting the Fed to do, along with how much risk premium there is. And if the market's expecting the Fed to hike six times this year, then if the Fed hikes six times this year and there's no change in risk premium, then mortgage rates aren't really going to move very much from where they are right now. Now, Powell said that he's worried about inflation and so if inflation comes in higher than expected or the market changes their demand for risk premium, then mortgage rates are gonna move. Jay Bacow: But Jim, mortgage rates have already moved a lot, they've gone up 100 basis points this year in just two months. What does this mean for affordability? Jim Egan: From the affordability perspective, it's a problem. But that also really depends on how we define what a problem is. The housing market's been doing very, very well. But when we think about this kind of move in mortgage rates, existing home sales, transaction volumes, they're going to have to fall. Jay Bacow: But haven't existing home sales gone up a lot already? Jim Egan: Yes, and that's where we think it's important to really look at historical experiences during times like this. If we look back to mortgage rates to 1990 we have five other instances of this kind of increase in mortgage rates. Now, one of those was during the housing crisis, so we're going to remove the experience there, but if I look at the other four instances existing home sales climbed very sharply during that first 6 month period, while mortgage rates were climbing by 100 basis points. That's where we are right now, we're seeing that climb. The 12 months after, the subsequent year, which we're going to start to enter March of this year going forward, that's where existing home sales tend to plateau and in a lot of instances come down. And they tend to come down further if mortgage rates continue to climb during that year, which is what we just discussed. So we think it's very likely, and if historical precedent holds, then we've already seen the peak of existing home sales for at least the next 12 months. Jay Bacow: What about home prices? Powell was asked if he thinks that home prices are going to fall and go back to pre-COVID levels, and he said he thought that raising mortgage rates would just slow down home prices, and he doesn't want to see home prices fall. What do we think? Jim Egan: Well, I'd like to believe he's reading our research because that's very much in line with how we think about things right now. We think that home price appreciation at a 19% rate right now is going to have to slow. And as we've said on this podcast before, affordability pressures are really one of, if not the key reason that the rate of HPA has to come down. Simply put, potential homebuyers cannot continue to afford to buy homes, at prices that would allow HPA to continue to climb at almost 20% year over year levels. However, if we think about the other factors that would come into play to bring home prices from a positive level to a negative level, we just do not see those characteristics in the market right now. Supply conditions are very constrained. We think they'll be alleviated somewhat this year, but that's not enough for there to be an overhang of supply that would weigh on home prices. We think that the credit availability in the market has been very conservative. We don't think we're at a risk of increased defaults and foreclosures. What we think happens is that transaction volumes fall, as we've stated, as home buyers aren't willing to pay the prices that home sellers want to sell at. But those sellers are not forced. And so you end up with a market that kind of doesn't trade, home price growth slows and we see it bottoming out kind of in a positive 5-6% percent range from here. So, long story short, we agree with that assessment from Jay Powell. Jim Egan: Now, the other side of the equation, mortgages. With rates backing up by that much, Jay, what do we think about the mortgage market here? Jay Bacow: So rates backing up means that there's going to be less people refinancing. And you said that there's going to be a slowdown in existing home sales as well. But, we're still worried about the supply to the agency mortgage market. And that's because the supply that we care about the most is the new supply coming from new home sales. And the thing about new home sales is that it's about an 8-month period from the time that the homebuilder gets the permit to start building the house, to when it actually gets sold. So we're going to have about 6 more months of supply from people that started to build their house when mortgage rates were a lot lower. And that's going to weigh on the market, particularly given that Powell said during his testimony that they're going to start balance sheet normalization in the coming months. So, we've got supply coming and we've got the biggest buyer stepping away from the market. Now, mortgage rates have gone up and mortgage spreads have widened, but we think there's a little bit more room for mortgages to underperform given the supply that's coming, and the lack of demand coming from the Fed. Jim Egan: Certainly interesting times. Jay, thanks for taking the time to talk today. Jay Bacow: Always great speaking with you, Jim. Jim Egan: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

3 Mars 20226min

The recent crisis in Ukraine has caused a great deal of uncertainty in the economy and markets. To cut through the noise, we take a look at the three key questions we are hearing from investors.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bring you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 2nd at 3pm in New York. As an analyst focusing on the interaction between geopolitical events and financial markets, I'm accustomed to dealing with uncertainties evolving at a rapid pace. But even by those standards, nothing in my career compares to the events of the past two weeks: the Russian invasion of Ukraine and the sanctions response by the US, the UK and Europe. To help cut through the noise, here's answers to the three most frequently asked questions by our investor clients. First, do sanctions mean higher energy costs? In the short term, the answer is likely yes. While sanctions on Russian banks currently permit payments for various energy commodities, there's still restrictions on, and disruptions to, their transportation. With Russia being a key producer of several commodities, including 10% of the world's oil, it's not surprising that global oil inventories have declined and the price of a barrel of oil is sitting above $100. This dovetails with the second question. Should we expect the Fed will shy away from hiking rates? In short, we don't think so, at least at the Fed's March meeting, but it certainly creates substantial uncertainty in the outlook. This conflict seems to be affecting both parts of the Fed's dual mandate in opposite directions. It risks dampening economic growth, but for the reasons we just described, it can also boost inflation. Accounting for both, our economists still expect the Fed to hike 0.25% in March but the conflict adds another layer to an already unprecedented level of complexity for the Fed. This is actually the key point for fixed income markets, in our view, where investors should prepare for ongoing volatility in Treasury and credit markets as the Fed may have to regularly tinker with their own assessment of growth and inflation. Finally, what are the long-term implications for investors? To answer this question, we refer you back to our framework for 'Slowbalization,' or the idea that companies will have to, in certain industries, spend more to adjust supply chains and exit certain businesses as governments create policies that prioritize economic and national security over short term profits. You can see how this trend may already be accelerating after the onset of the Ukraine crisis, with several multinational companies announcing they'll sell stakes in, exit joint projects with or pause sales to Russian companies. But some equity sectors may see upside. Defense and software, for example, could see bigger spending as governments reorient their budgets towards these efforts, most notably Germany announcing it will boost its defense spending to 2% of GDP. Of course, the situation remains fluid, and we'll continue to track it and keep you in the loop on what it means for the economy and markets. Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

3 Mars 20223min

As the conflict between Russia and Ukraine continues to unfold, implications for the oil and gas sector in Europe are beginning to take shape.Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Any references in this report to entities, debt or equity instruments, projects or persons that may be covered by such sanctions are strictly informational, and should not be read as recommending or advising as to any investment activities in relation to such entities, instruments or projects. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.-----Transcript-----Welcome to Thoughts on the Market. I'm Martijn Rats, Global Commodity Strategist and Head of the European Energy Research Team for Morgan Stanley. Along with my colleagues bringing you a global perspective, I'll be talking about developments in the oil and gas sector amidst geopolitical tensions. It's Tuesday, March 1st at 2:00 p.m. in London. As the situation between Russia and the Ukraine continues to develop, implications for commodity markets are beginning to take shape. Russia is a major commodity producer, playing in an especially important role in providing energy for Europe through oil and natural gas imports. With a new round of sanctions announced over the weekend, the precise impact on prices remains to be seen, but we can begin to forecast the direction. First, there is no sign at this stage that, at least at the aggregate level, the flow of commodities has been impacted yet. All of the pipeline and tanker tracking data that we've seen suggests that they continue to be shipped. That shouldn't be too surprising, it's still early days and the sanctions that have been announced so far have been carefully crafted to reduce the impacts on energy flows from Russia. Second, trade patterns will nevertheless likely shift. We can already see this in the oil markets. European refiners are traditionally big buyers of Russian crudes, and even though technically they have continued to be able to buy these grades, they are increasingly reluctant to do so. There have been indications that ship owners are reluctant to send vessels to Russian ports, and that European buyers are uncertain about where sanctions will ultimately go. This is requiring increasingly large discounts. As many buyers already move away from Russian crudes, this also creates more demand for others, including North Sea crudes, which therefore drives up the price of Brent. Third, all of this is happening against the backdrop of tightness in both global oil markets and the European gas markets. We are seeing low and falling inventories, low and falling spare capacity and low levels of investment across both. At the same time, there is a healthy demand recovery ongoing as the world emerges from COVID. Given this tightness, even a modest disruption can have large price impacts. Now, with that in mind, risks to oil and gas prices are still firmly skewed higher, at least in the short term. Finally, I want to point at the growing tension in Europe between diversification and decarbonization. Several key politicians have said over the last several days that Europe should reduce its dependance on Russian oil and gas, and diversify its sources of supply. At the same time, Europe has set ambitious targets to decarbonize. Diversification requires investment in new supply, while decarbonization then requires that those supplies, in the end, will not be used. How that tension will be resolved is hard to know, but this is an issue that at some point will need to be addressed. Bottom line, there is still a lot of uncertainty for commodity markets in the coming weeks and months. We will keep you posted, of course, as new developments take shape. Thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

2 Mars 20223min

Like many markets, Corporate Credit has faced a rocky start to 2022. For investors, understanding the difference between default and duration risk will be key to positioning for the rest of the year.-----Transcript-----Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about corporate credit markets against the background of policy tightening and heightened geopolitical tensions. It's Monday, February 28th at 10 a.m. in New York. It's been a rough start for the year for the markets. Central banks' hawkish shift towards removing policy accommodation, the significant flattening of yield curves that followed, rising geopolitical tensions, fading prospects for fiscal support, and growing concerns about stretched valuations have all combined to spawn jitters in financial markets. Corporate credit has been no exception. After two years of abundant inflows, the narrative has turned outflows from credit funds in conjunction with negative total returns. These outflows conjure up painful memories of 2018, the last time the credit markets had to deal with substantial policy tightening. Let us focus on the source - sharply higher interest rates and duration versus credit quality and default concerns. Consider leverage loans, floating rate instruments that have credit ratings comparable to high yield bonds which are fixed rate instruments. Since the beginning of the year, high yield bond spreads have widened almost three and half times more than leverage loan spreads. If you limit the comparison just to fixed rate bonds, the longer duration investment grade bonds have significantly underperformed the lower quality high yield bonds. Clearly, it is duration and not a fear of a spike in defaults that is at the heart of credit investor angst. My credit strategy colleagues, Srikanth Sankaran and Taylor Twamley, have analyzed the impact of rate hikes on interest coverage ratios for leveraged loan borrowers. This ratio is a measure of a company's ability to make interest payments on its debt, calculated by dividing company earnings by interest on debt expenses during a given year. The key takeaway from their work is this - What matters more for interest coverage is the point at which higher rates become a headwind for earnings growth. Loan interest coverage ratios have historically improved early in the hiking cycle as interest expenses are offset by growth in earnings. I draw comfort from the evidence that as long as earnings growth holds up and does not turn negative, corporate credit fundamentals measured in interest coverage ratios are positioned well enough to withstand our economists base case of six 25 basis point rate hikes in this year. While credit fundamentals look fine, valuations are not. Since the beginning of the year, we have seen spread widening, the pace of which has picked up in the last couple of weeks. So, we still prefer taking default risk over duration and spread risk. The risk to this view has increased in the last few weeks. Specifically, if central bank reaction to the heightened geopolitical risk is to control inflation at the expense of growth, lower quality credit may be more exposed. Thanks for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

28 Feb 20223min