How Will Credit Markets Fare in 2026?

To conclude their two-part discussion, our Head of Corporate Credit Research Andrew Sheets and Chief Investment Officer for Morgan Stanley Wealth Management Lisa Shalett discuss the outlook for inflation and monetary policy, with implications for investment-grade credit.Read more insights from Morgan Stanley.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research at Morgan Stanley.Lisa Shalett: And I am Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management.Andrew Sheets: Yesterday we focused on the topic of a higher for longer inflation regime, and I was asking the questions. Today, Lisa will grill me on my views for the next year. It's Friday, December 19th at 4pm in London. Lisa Shalett: And it's 11am in New York. All right, Andrew, I'm happy to turn tables on you now. I'm very interested in your thoughts about the past year – 2025 – and looking towards 2026. In 2026, Morgan Stanley Research seems to expect a resilient global growth backdrop, with inflation moderating and central banks easing policy gradually. What do you think are the main drivers behind this more constructive inflation outlook, especially taking into account the market's prevailing concerns about persistent price pressures. Andrew Sheets: There are a couple of factors that we think are going to be near term helps for inflation, although I don't think they totally rule out what you're talking about over that longer term period.So first, we, at Morgan Stanley, are very cautious, very negative on oil prices. We think that there's going to be more supply of oil over the next year than demand for it. And so lower oil prices should help bring inflation down. There's also some measures of just how the inflation indices measure shelter and housing. And so, while we think, kind of, looking further ahead, there are some real shortages emerging in things like the rental markets – where you just haven't had a whole lot of new rental construction coming online, as you look out a year or two ahead. But in the near term, rental markets have been softer. Home prices are coming down with a lag in the data. And so, shelter inflation is relatively soft. So, we think that helps. While at the same time fiscal policy is very supportive and corporates, as we discussed in our last conversation, they're really embracing animal spirits – with more spending, more spending on AI, more capital investment generally, more M&A. And so, those factors together, we think, can over the next 12 months, still mean pretty reasonable growth and Inflation that's still above target – but at least trending a little bit lower. Lisa Shalett: You believe that central banks, including the Fed, will cut rates more slowly given better growth. And this slower pace of easing could actually be positive for the credit markets. So, could you elaborate on your expertise on credit and why a gradual Fed approach may be preferable? What risks and opportunities might this create? Andrew Sheets: Yeah, so I think this is kind of one of these big debates going into this year is – which would we rather have? Would we rather have a Fed that was more active, cutting more aggressively? Or cutting more slowly? And, indeed, we're having this conversation on the heels of a Fed meeting. There's a lot of uncertainty about that path. But the way that we're thinking about it is that the biggest risk to credit would be that this outlook for growth that we have is just too optimistic. That actually growth is weaker than expected. That this rise in the unemployment rate is signaling something far more challenging for the economy ahead and in that scenario the Fed would be justified in cutting a lot more. But I think historically in those periods where growth has deteriorated more significantly while the Fed has been cutting more, those have been periods where credit – and indeed the equity market – have actually done poorly despite more quote unquote Fed assistance. So, periods where the Fed is cutting more gradually tend to be more consistent with policy in the right place. The economy being in an okay place. And so, we think, that that's the better outcome. So again, we have to kind of monitor the situation. But a scenario where the Fed ends up doing a little bit less than the market, or even we expect with rate cuts – because the economy's holding up. That can still be, we think, an okay scenario for markets. Lisa Shalett: So, things are okay and animal spirits are returning. What does that mean for credit markets? Andrew Sheets: Yeah, so I think this is the bigger challenge: is that if our growth scenario holds up, corporates I think have a lot of incentives to start taking more risk – in a way that could be good for stock markets, but a lot more challenging to the lenders, to these companies for credit. Corporates have been impressively restrained over the last ...