Q1 2026 Credit Research Outlook War, energy shocks, and credit cycles

Prolonged geopolitical and energy shocks reinforce late cycle credit risks, but strong bank balance sheets, senior and limited private credit exposures, and structural protections point to heightened volatility and earnings pressure—not systemic stress—absent a sustained policy constraint.

A key question is whether credit markets can continue to absorb additional source of strain. In our 2026 Credit Research Outlook in January, we outlined a framework for monitoring late cycle risks, including the continued growth of private credit. Since that publication, a clear grey-swan event has emerged in the form of military operations involving Iran, adding new uncertainty around inflation dynamics, interest rate expectations, and the near term path of the credit cycle.

The impact of the Middle East conflict on the cash investment universe

As our readers know, the Global Cash investment universe is concentrated in debt issued by large global banks and financial institutions. While our investment universe has limited direct exposure to the Middle East, an energy driven stagflationary shock would have material global economic effects.

As net energy importers, Asia and Europe would likely experience a faster and broader pass through from higher energy prices to inflation, alongside a meaningful drag on economic growth. Major banks in Europe, Japan, and Singapore therefore remain key investment counterparties for our Global Cash business.

These banking systems faced a similar stagflationary shock in 2022 following the onset of the Russia–Ukraine war and emerged with limited deterioration in their fundamental credit profiles. Importantly, we believe European and Japanese banks are better positioned today to absorb a comparable shock. Since 2022, operating performance and monetary policy conditions have supported a higher pre provision earnings base, increasing capacity to absorb elevated credit provisioning. Structural profitability has improved, with earnings now better geared to deposit volumes and less dependent on loan growth. Capitalization levels have also increased relative to 2022, providing a stronger second line of defense against earnings pressure. In addition, relevant banking systems have been effectively stress tested for energy related shocks—both in practice during 2022 and through ongoing regulatory exercises—supporting improved risk management of interest rate sensitive (notably CRE) and energy exposed portfolios, as well as funding and liquidity risks associated with higher for longer interest rates.

While stagflationary risk may be more immediate for our European and Japanese bank counterparties, recent events affect all of our global investment counterparties to some degree. For example, amid expectations of prolonged energy disruptions, Capital Economics revised its euro area forecasts.

Under its new base case, the European Central Bank (ECB) hikes rates three times this year as headline inflation peaks at 4% and core inflation trends higher, while gross domestic price broadly stagnates mid year and recovers only gradually thereafter.¹ These conditions are near recessionary.

Across all cases, the current strength of fundamental credit profiles within our bank credit approval universe provides capacity for some deterioration without materially altering overall credit assessments. We will continue to monitor developments with a conservative lens, as we did in 2022, and, if warranted, adjust exposure by reducing permitted maturities for specific counterparties. Historically, this has been our primary risk control mechanism to ensure portfolios maintain minimal credit risk as macroeconomic conditions evolve.

Credit cycle implications

A secondary impact of a prolonged energy-price shock is that the inflationary effects of higher energy prices may outweigh the disinflationary effects of weaker economic growth, biasing major central banks toward a tighter monetary policy stance. We believe this risk is more pronounced for the ECB, Bank of England, and Bank of Japan within our investment universe. More broadly, there is a risk that policy easing is delayed across major central banks even as growth weakens.

Such an outcome would impair the ability of monetary policy to smooth the credit cycle, which we characterized as “late cycle” in our 2026 Credit Outlook. At that time, we highlighted how a prolonged period of elevated inflation and higher interest rates was placing pressure on vulnerable segments of the credit markets—namely high yield and leveraged loan corporates (including private credit), certain areas of commercial real estate (CRE), and subprime consumer lending.

The events unfolding in the Middle East may reinforce a central bank reaction function that intensifies these pressures.

Within leveraged credit, we continue to focus on private credit markets and their role in the current credit cycle. This sector has attracted increased attention in the financial press over the past quarter. In this context, private credit refers to loans originated by non bank lenders outside the public bond and syndicated loan markets, and is characterized by greater opacity and lighter regulation. As outlined in our 2026 Outlook, the sector has expanded meaningfully since the Global Financial Crisis, largely due to tighter bank regulation that reduced bank lending to riskier borrowers. Typical private credit borrowers are highly leveraged middle market companies that are too small to access public markets. Most private credit loans are floating rate, meaning borrowers that originated debt prior to 2022—when policy rates were near zero—have faced materially higher interest costs. Default rates are rising gradually and may accelerate as the cumulative burden of higher rates builds, particularly if the energy shock anchors interest rates at elevated levels.

Against this backdrop, we consider the potential implications for the broader credit cycle of acute stress within this segment. Capital Economics outlined a scenario worth highlighting. During the Global Financial Crisis, default rates on middle market and leveraged loans rose to approximately 12%.

Assuming loss severity of 40–50% and a total US private credit market size of $2 trillion, Capital Economics estimates total write offs of $96–120 billion—roughly 0.4% of US GDP. This compares with roughly $1 trillion, or 6–7% of GDP, in estimated losses across US originated credit assets in 2008–09.² While material, such losses would be manageable from a systemic and macroeconomic perspective, particularly if the Federal Reserve were able to act to contain spillovers to the banking system. However, as private credit has become a key financing source for mid market companies, a pullback in lending could materially tighten credit conditions for this segment.

If private credit losses were to trigger a broader confidence shock, monetary easing would play a critical role in cushioning demand, limiting spillovers to banks, and preventing a mutually reinforcing cycle of weaker activity and reduced lending. The objective would not be to prevent losses, but to limit the risk of a contained shock evolving into a systemic downturn. This underscores the importance, from a system level perspective, of central banks retaining the ability to ease—an ability that is complicated by an energy driven inflation shock.

Another important consideration is the level of leverage within the private credit segment. Historically, rising corporate debt to GDP ratios have often signaled increasing systemic risk. Despite the growth of private credit, the overall stock of sub investment grade lending relative to GDP has remained broadly stable over the past decade, and total corporate debt to GDP has declined in recent years.

The primary change has been in the structure of credit intermediation rather than in the aggregate level of credit outstanding. Following regulatory driven bank retrenchment after the Global Financial Crisis, non bank lenders filled the gap by financing similar borrowers. More recently, private credit growth has largely come at the expense of bank lending and public credit markets, both of which experienced volatile issuance and outflows during the inflation shock and rapid rate hikes of 2022–23, while growth in high yield bonds and leveraged loans remained subdued.

Finally, leverage within private credit vehicles themselves remains limited. A report by the Office of Financial Research found that most private credit funds employ minimal leverage, with a median gross to net asset ratio of approximately 1.0—effectively indicating no net leverage.³ This limited use of leverage should help constrain systemic spillovers to the broader credit markets and the economy during periods of credit cycle stress.

The impact of the private credit stress on the cash investment universe

While the growth of private credit highlights the increasing role of non bank credit intermediation, we outlined in our 2026 Outlook the ways in which banks and private credit managers remain interconnected. In recent months, large banks have been more explicit in disclosing their exposures to private credit and private credit managers. Below, we provide additional detail on bank lending to non depository financial institutions (NDFIs) for US , UK and European banks, as these jurisdictions represent the most material exposure within our investment universe.