Morgan Stanley: Equities and credit under pressure in October, with widening divergence among lower-rated bonds

Which assets weakened in October, and which found support?

The Nasdaq index fell 5.3% in October, while the MSCI Emerging Markets Index fell 8.1%; over the same period, the US 10-year Treasury yield fell 36 basis points, and the bond's total return was 3.30%.
Credit markets also came under pressure, with euro high-yield spreads widening by 65 basis points. Commodities diverged: Brent crude rose 13.6%, while gold fell 6.2%; the US dollar index rose 0.4%.

US CCC-rated credit spreads rose above 1000 basis points, reaching their widest level in four years. Wider spreads mean that investors demand more yield compensation for holding these lower-rated bonds relative to Treasuries.
Issuance data also showed a divergence by credit quality: as of October, year-to-date developed-market investment-grade credit issuance was up 21% year on year and continued to outpace the issuance pace of the previous five years; issuance of developed-market high-yield bonds and emerging-market hard-currency bonds both fell 7% year on year.
Morgan Stanley believes higher interest rates are putting pressure on lower-quality borrowers, so its credit strategy team favors investment-grade over high-yield bonds; the bank also believes more planned investment-grade issuance helps the market absorb higher supply.

Morgan Stanley's market sentiment indicator continued to signal risk appetite at month-end; the US equity put-to-call trading ratio was 0.9, and the VIX volatility index stood at 19.4. Overall, the bank's sentiment indicators showed that the market remained relatively calm.
Investment Company Institute data show that in the latest 13 weeks covered by the report's data, equity funds recorded net outflows of 479 billion dollars, comprising outflows of 520 billion dollars from US equity funds and inflows of 41 billion dollars into non-US equity funds; over the same period, bond funds recorded net inflows of 151 billion dollars.

The bank's expanded US market cycle framework is in the “mature expansion” phase; historically, equities have outperformed fixed income in this phase, especially high-yield and government bonds.
Morgan Stanley notes that a transition from mature expansion to the defensive phase often coincides with interest rate hikes, but believes risk assets may withstand the transition. It therefore maintains its overweight in global equities through the US market.
As of the end of October, interest rate swap pricing reflected cumulative increases of about 60 and 67 basis points in Federal Reserve and European Central Bank policy rates, respectively, over the next 12 months, providing an interest rate backdrop for monitoring the cycle transition.