By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley
A Borrower Not a Lender Be
Obvious things can still matter. Across a number of metrics, this is an unusually good moment to borrow money. While we’re mindful that ‘yields are low’ has been a steady cry throughout the last decade, today we’re seeing borrowing costs, ability and need align in a unique way. It supports equities over credit, and caution on government bonds.
Let’s start with what it costs to borrow. Corporate bond yields in Europe are at all-time lows, while US corporates haven’t been able to borrow this cheaply since 1955. Mortgage rates, from the US to the Netherlands, are at historical lows. It’s a similar story for yields on government bonds.
Even more important, however, is the real cost. When debt funds an asset (capex, infrastructure, a house), it’s likely that the asset’s value, at a minimum, rises with inflation. This is why deflation is so bad, and self-reinforcing: if the value of things falls every year, you should never borrow to buy them, which constricts credit and creates even more deflationary pressure.
That may have been a fear for much of the last decade, when austerity and secular stagnation ruled the roost. And it may have been the fear just 15 months ago, with the arrival of COVID-19. But it’s not today. US 10-year inflation expectations (2.4%) are nearly 40bp above the 20-year average (2.0%). Expected German inflation over the next decade is the highest since 2014. This is new, and improves the economics of borrowing materially.
That better inflation picture also lines up with a better growth outlook. Morgan Stanley’s economists think that global growth is now on a higher trend than before COVID-19. Coupled with the inflation picture, the outlook for nominal growth – the key metric for nominal borrowing – is simply much better.
What about ability? After all, low rates don’t matter if borrowers can’t access or afford them. Again, we see encouraging signs and important changes.
On access, capital markets are wide open, especially for lower-rated issuers where access is more of an issue. Year-to-date issuance for DM high yield credit is almost double the average for the last five years. For EM sovereigns, it is 24% higher.
For banks, surveys from both the Fed and ECB suggest that lending standards are easing. The sector is now well capitalised and comfortably passing regulatory stress tests. Both mark a difference from the prior decade. We are overweight financials, believing that this is still a good part of the economic cycle in which to own them.
But can borrowers afford to take on additional debt? After all, debt/GDP for many governments is historically high and rising. Debt/EBITDA for corporate borrowers is elevated.
We think they can. Low yields make high levels of debt affordable, so much so that the US is spending less on debt interest today, with debt/GDP at ~128%, than in 1981, when it was ~31%. More detailed work by my colleagues Chetan Ahya and Julian Richers suggests an optimistic outlook for debt sustainability. For corporates, good interest coverage means that debt is still easy to service, for the time being.
Costs are low versus even recent history, and the ability to borrow has improved. But is there any need? This was the dominant fear of the last decade, and a self-fulfilling one: weak growth deterred investment. Weak investment hampered growth.
Again, we see encouraging signs and key differences from the last decade.
Our economists forecast a ‘red-hot’ capex cycle, as better growth and prior underinvestment drive capital deepening across the public and private sector. Higher wages should encourage the usual pattern of more investment to increase productivity of existing workers.
And then there’s the planet. If the weather this summer hasn’t convinced us of shifts in the climate, the latest report from the IPCC, the UN’s authority on climate change, should. Since 1970, global surface temperatures have risen faster than in any 50-year period over the last two millennia.
Combating climate change will require enormous investment – US$10 trillion by 2030, according to the IEA’s 2 degrees scenario. But there’s good news. The economics of investment have improved dramatically, with the cost of wind and solar power declining by 70% and 89%, respectively, in the last decade. The case to borrow to finance this has never been more economical.
What’s good for the borrower, of course, is bad for the lender. Given valuations and the incentives to issue, investors should favor equities over credit and be underweight government bonds.