Morgan Stanley: Time To Prefer Equities Over High-Quality Credit In Europe

I assume that legendary Teun Draaisma, the European equity strategist, accompanied by his credit colleagues at Morgan Stanley, published the note before they noticed the revisions of US unemployment figures.

However, the message is as simple as ever:

Debt-equity clock says it’s time to prefer equities over higher-quality credit … 2009 has been the ‘year of credit’ so far, with credit delivering ‘equity-like returns with credit-like risks’. Corporates’ rediscovered focus on cash generation and balance sheet repairs, as well as record-low starting valuations, have been the key drivers. We think this ‘repair’ phase is probably over now, as a new growth cycle is about to start. In the next phase, we believe both high-quality credit and equities will deliver positive returns, but equities will outperform.

… as earnings recovery is more favourable for equities … We expect earnings to grow by 20% in 2010, which should lead to more buybacks, capex, dividends and M&A. These ‘shareholder-friendly’ corporate activities, together with either higher rates and/or macro instability, could raise bankruptcy risks and trigger the underperformance of credit. …

and equities have become cheap versus credit. The pure equity risk premium is at a 10-year high of 4.3%. The spread between corporate bond yield and dividend yield in Europe has narrowed to 100bps, well below the LT average of 242bps. Also, higher-quality credit has led the credit rally, while the equity rally has been predominantly led by lower-quality companies. This disconnect presents opportunities, we believe.

Buy ‘equity carry’ stories with dividend yield > credit yield. Credit yields should be higher than dividend yields if there is growth, as coupons are fixed while dividends grow, and a negative yield differential implies that the market expects dividends to shrink over time. Investors should therefore buy into these ‘equity carry’ opportunities if they believe dividend streams are sustainable and growing. Oil and Telecom are two of the biggest OWs in our portfolio that fit this theme today.

Click on chart to enlarge, courtesy of Morgan Stanley.
The astute economists at Hoisington have challenging days?