Where are the market divergences? Morgan Stanley responds to clients' doubts about its "2026 Outlook"

Morgan Stanley's 2026 outlook report has sparked intense debate among clients, focusing on artificial intelligence (AI) investments, the Federal Reserve's policy path, and the outlook for the credit market. Morgan Stanley predicts that driven by capital expenditures and merger and acquisition activities, the annual total issuance of U.S. investment-grade bonds will surge to $2.25 trillion, but credit spreads will only widen moderately by about 15 basis points. Some clients are skeptical about this, while the firm maintains its view that major central banks will continue to ease, expecting further interest rate cuts from the Federal Reserve and the European Central Bank in 2026, which differs from some market expectations and the official statements from the European Central Bank. Shortly after releasing the outlook report, the firm's chief economist Seth Carpenter and chief fixed income strategist Vishwanath Tirupattur responded to concentrated client feedback in a recent report. AI Investment Boom: Divergence in Growth Expectations and Financing Paths The core pillar of Morgan Stanley's 2026 capital expenditure forecast is a strong belief that the demand for computing power in the coming years will far exceed supply, driving a boom in AI and data center-related investments. The firm reiterates that the credit market will become the key channel for funding the next wave of AI investments, and this portion of expenditure is "relatively insensitive" to macro conditions such as interest rates and economic growth. However, client feedback has shown a duality. According to the firm's report, some clients questioned: Why does it not predict that AI capital expenditures will lead to "higher growth"? In response, Morgan Stanley stated that this is a process that will unfold over several years, and its boosting effect on economic growth will gradually become apparent over time. This suggests a cognitive difference between the firm and some more optimistic investors regarding the pace and scale of AI's impact. Credit Market Debate: Will the $2.25 Trillion Bond Issuance Surge Impact Spreads? A prediction from Morgan Stanley's U.S. credit strategists has garnered significant market attention: the total issuance of investment-grade (IG) bonds will reach $2.25 trillion in 2026 (a 25% year-on-year increase), with net issuance reaching $1 trillion (a 60% year-on-year increase). The firm believes that as capital expenditures grow faster than revenue growth and put pressure on free cash flow, credit will become a crucial financing bridge. AI is not the only driving factor; the rebound in merger and acquisition (M&A) activity will also play an important role. Despite the expected surge in issuance, the firm anticipates that credit spreads will only widen moderately by about 15 basis points, remaining at historically low levels. This has become another focal point for client rebuttals, with some clients arguing that the extent of spread widening should be much greater. Morgan Stanley defends its viewpoint by stating that several factors will stabilize spreads: First, most AI-related issuances will come from high-quality (AA-AAA rated) issuers; Secondly, the continued policy easing (the Federal Reserve is expected to have three more rate cuts); The economy will experience a moderate re-acceleration; Finally, the sustained demand from yield-seeking investors will also help anchor the spreads. Central Bank Policy Divergence: The Rate Cut Paths of the Federal Reserve and the European Central Bank The policy path of the Federal Reserve remains the focal point of market debate. Morgan Stanley admits that there have been internal reversals regarding whether the Federal Reserve will cut rates in December; currently, it believes a rate cut will occur in December. The current tricky situation is that the U.S. economy remains resilient, but the labor market is slowing down. This trend of slowing down has a decisive impact on the market, especially the credit market. Outside the U.S., the bank's predictions for the European Central Bank (ECB) have also faced the greatest opposition. Morgan Stanley expects the ECB to cut rates twice more in 2026 and explicitly disagrees with President Lagarde's statement that "the anti-inflation process has ended." The bank believes that there is still an output gap in the Eurozone, which will ultimately lead to inflation being below the ECB's 2% target. Debate on the Yield Curve: Steepening "Bull" and "Bear" At the macro strategy level, Morgan Stanley defines 2026 as a "transition year" for global interest rates—transitioning from synchronized tightening to asynchronous normalization. Its view that government bond yields will remain in a range-bound fluctuation has gained widespread acceptance. However, the real point of debate lies in the shape of the yield curve. While clients and Morgan Stanley generally agree that the yield curve will further steepen, the nature of this steepening—whether it is driven by a "bull steepening" (where falling rates drive the steepening) or a "bear steepening" (where long-term rates rise faster)—remains a focal point of contention. This divergence arises from Morgan Stanley's belief that the market will preemptively digest the Federal Reserve's easing bias