As credit market investors, the most frequent question we get asked at present is: “are we at the end of the credit cycle yet?” As the current business cycle is now officially the second longest on record, having begun in June 2009, it is easy to understand why this is top of mind for many.
In our view, the answer is “not yet” but “prepare for landing” as a few signals are beginning to point to the end. The last nine years have not marked an ordinary cycle but a recovery from a deep financial crisis, which explains its unusual length and lackluster pace.
The table below shows both the structural factors unique to this period in credit markets and the fundamental factors that typically drive credit cycles. We color-code each factor as supportive (teal), neutral (purple) or negative (orange) for current credit markets.
The availability of credit has historically driven the credit cycle. When the financial plumbing of the economy is at the epicenter of a downturn, as happened in 2008, there are numerous primary and secondary impacts on credit. For example, the structural changes to the financial system that resulted from the 2008 crisis have both weighed on the recovery and more recently contributed to extending it.
Initially, the need to repair banks’ balance sheets and the introduction of new regulation hindered capital creation and the ability and willingness of banks to extend loans. To counter this, central banks such as the Federal Reserve and the European Central Bank slashed interest rates as far as they could, before resorting to unconventional asset purchases to stimulate lending and economic recovery.
This had several impacts. First, it provided more liquidity to the markets, prompting investors to seek out risk assets. Second, it led to lower rates and risk premia. This lowered the cost of capital, encouraging firms to borrow and lowered the Internal Rate of Return of capital investments.
The lower yield on assets, and the diminished ability of banks to provide funding, encouraged investors to find other ways to lend to borrowers, e.g., via private credit markets and direct lending. As these new borrowing conduits were created, the availability of credit improved again, extending the cycle.
Many of these structural factors have begun to turn and could now become headwinds. However, as their importance diminishes, we expect “normal” cyclical factors to exert a greater influence on the availability of credit.
In the US, the availability of credit, engineered by the Fed over the last decade, has led to significant growth in the debt markets, despite the country being in a period of policy tightening for some time.
However, as some of the cyclical indicators in the table above are now flashing red, we view the credit cycle as being in its later stages. Credit metrics point to a strong uptick in topline revenue growth while profit margins are approaching cyclical peaks. Company surveys indicate continued business optimism, with a pickup in capex spending for the first time in several years. Yet corporations seem to have mortgaged their balance sheets to get their equity valuations this far. Once the sugar rush of the tax reforms has worn off, we could see them struggle to maintain those valuations at current levels.
Thanks to the global search for yield in a low-rate environment, US credit availability for issuers has been ample and served to weaken investor protections. While the lack of a meaningful leveraged buyout (LBO) cycle coupled with a commodities mini-cycle has tempered excesses in the high yield universe, leverage within investment grade companies has remained stubbornly high, driven by rapid debt growth over several years. This high level of debt has left companies more exposed to an overall slowdown in the economy or a pickup in inflation, which could trigger higher interest rates. As always at this stage of the cycle, some companies and sectors are more at risk than others, creating opportunities for selective credit investors.
To summarize, we believe fundamental cyclical drivers are displacing structural ones as the determining factors at this stage of the cycle. The structural factors have diminished over time and, in some cases, become a drag on growth, but the picture is complicated by the recent tax cuts and some deregulation of the banking system. We expect these latter elements will help extend the cycle for some time, but also introduce the risk that the next downturn may be more severe when it finally arrives.
So while there is no need to be unduly cautious near term, we think it is worth considering taking some risk off the table over the medium term and moving into higher quality names further up the credit spectrum.
The views expressed in this material are the views of Chuck Moon, Pete Hajjar, Chris Ingle and Arvind Narayanan through the period ended May 3, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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