Interesting data out of Morgan Stanley recently. According to their “debt-equity” clock they say it’s time to prefer stocks over bonds. According to MS we are entering the recovery phase after having been in the repair phase of the cycle. During the repair phase balance sheets are tirelessly repaired by corporations, debt is paid down, costs are cut, cash is boosted and ultimately credit expands. MS believes the repair phase is just ending and we are moving into the recovery phase.
Although credit should continue to perform well in this operating environment they are moving to an overweight equities position for the following reasons:
1) Fundamentals – Earnings should rebound more sharply than expected. The steep yield curve should help drive bank earnings.
2) Valuations – Equities are cheap compared to high quality credit.
3) The Quality Disconnect – MS believes there is a quality disconnect. While debt markets have been led by the rally in high quality debt the equity markets have rallied on lower quality names. This has created a value gap which makes high quality equity more attractive to high quality debt.
4) Lower risk in high quality equities – MS believes low quality firms are likely to issue debt and take advantage of their strengthened position to issue debt and equity. This adds another layer of risk to owning lower quality names whose debt has rallied substantially.