While the list of specific issues that have challenged the duration of the cycle continued to evolve over the past decade, it has nevertheless persevered. Yet we’re still left pondering how close we are to the end of the current credit and business cycles.
While we certainly don’t want to sound like a broken record, we unfortunately, or fortunately since it means that the credit cycle has not come to an end, find ourselves in the same situation that we’ve been in at the end of the past two calendar years. As economic historians will tell you, recessions are typically caused by either tightening of monetary policy, tightening of fiscal policy, bursting of a credit or debt bubble, bursting of a housing or asset price bubble, and/or a banking crisis. We believe the risk of each of these is low in the near term. However, we believe that the risk of a cyclical downturn driven by an exogenous shock (for example, global trade uncertainty) is moderate. It is unclear if reactive monetary and/or fiscal policy would be able to provide enough of a buffer to prevent a recession and a pronounced downturn in the credit cycle.
As we approach the end of 2019, financial markets (both debt and equity) are striking a relatively optimistic tone, despite evidence that suggests that the credit and business cycles are in the latter stages. In some ways, we can understand this optimism. After all, in our opinion, there has been evidence that we are in the later stages of the cycle for more than two years, so perhaps this sustainability and perseverance is, by itself, a cause for optimism. Further, there has been some tangible positive news on the trade front, with the potential for the postponement or even abandonment of the potential tariff increases for China in December and the potential action on European autos. With regards to economic data releases, there has been some relief that the weakness in the global manufacturing sectors have not yet led to recessionary data in non-manufacturing and consumer sectors in most developed economies. Perhaps the biggest driver of positive financial market performance has been the pronounced U-turn taken by global central banks to a definitive easing monetary policy stance during the year. Indeed, trade tensions and monetary policy are easing simultaneously for the first time in more than two years.
Will these factors be enough to assure the sustainability of the current cycle? Our credit research team has our doubts that central bank policy easing will be enough to sustain the cycle on its own. From a fundamental economic perspective, further monetary policy easing will only improve economic growth trajectories if private credit creation accelerates because of it. While the global flow of private sector credit creation has been stable in 2019 (perhaps because of more accommodative central banks), there is little to suggest that lower rates have boosted demand to borrow in developed markets1. An increase in the private sector credit creation may ultimately occur, if monetary policy remains exceptionally accommodative. This will also require further improvement in the global economic data, in our opinion. The US and China may sign a Phase 1 trade deal and tariffs may be rolled back somewhat. We don’t think, however, this will not be enough to reverse a recession in manufacturing and capital expenditure business spending. Morgan Stanley has estimated that trade tensions and their impact on corporate confidence and capital expenditure have cost the global economy 90 to 100 basis points (bps) of growth momentum thus far2. At the same time, relatively strong employment and wage conditions, high household savings rates and historically low aggregate consumer debt-to-income ratios have supported the service and consumer-oriented sectors of many developed market economies, creating divergent paths for various components of these economies (Figure 1).
Source: Bloomberg data (11/19/19)
In our view, this divergence cannot continue for much longer without materially increasing the probability of a US and/or global recession and in turn, ending the business and credit cycles. At minimum, a pause in trade tension escalation seems required to end this divergence.
As our team’s investment universe is more concentrated in debt issued by large banks and financial institutions, we always consider the condition of the credit cycle in that context. Heading into 2020, we need to consider the risk that trade tensions via weakened global growth trajectories and aggressive central bank easing will negatively impact banks’ earning capacity. While earnings are a more important consideration for equity analysts and investors, the ability of banks’ to organically accrete capital through earnings is an important factor in fundamental credit assessments.
In general, slower economic growth and lower interest rates are negative for bank earnings, especially if or when lower rates do not spur demand for private credit. Given the persistence of low and negative rates in Europe and Japan, earnings capacity in those sectors are particularly challenged, which weakens the first line of defense against bank balance sheet devaluation in the event of weaker global growth, as strong operating income levels help absorb higher credit losses, preventing banks from generating earnings losses and the erosion of its balance sheet’s book value.
In last year’s Credit Research Outlook, we identified the European banking sector as the most vulnerable in our focus universe to the end of the credit cycle. The same factors we identified last year as rationale for vulnerability persist for 2020. The inefficient and inadequate structure of the European financial and political systems, as well as the prolonged period of ultra-low to negative interest rates for the continent’s banking system. The risk associated with these factors could be mitigated if progress is made in improving the structure of the European Union. For example, near-term prospects of progress towards completing the development of a full banking union with Pan-European deposit insurance are only modestly better than they were a year ago.
Yet another theme from last year’s Global Cash Outlook is despite the risk factors outlined, we reiterate that we broadly view the global banking sector as a source of strength in mitigating macro-economic impacts when the cycle ends due to the significant evolution of banking regulations since the Global Financial Crisis. These regulations, especially as they pertain to systemically important banks, assure that bank capital buffers are materially higher, and funding and liquidity conditions are more stable. Even European banks have materially improved their credit profiles in these capacities. Indeed, when the cycle does end, and the most leveraged areas of the corporate credit markets suffer material degradation, we believe that the strength and soundness of the reformed banking system will prevent systemic impacts and broad contagion. As such, we also believe that credit events are more apt to be idiosyncratic or industry-specific than systemic.
For the last two years, our Credit Research team motto has been: “Don’t worry about the end of the credit cycle: be ready for it.” To us this means continuing to select cash investment counterparties that are best-equipped to maintain their fundamental credit profiles when a downturn inevitably occurs.
1 Citi Research: Global Credit View; “Has the Monetary Tsunami Restarted?”; by Matt King; 11/15/19
2 Morgan Stanley Research What’s Next in Global Macro; by Chetan Ahya (Chief Economist and Global Head of Economics); 10/20/19
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent. This document may contain certain statements deemed to be forward-looking statements. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.
Investing involves risk including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
Disclosure related to each of the State Street Institutional Liquid Reserves Fund and the State Street ESG Liquid Reserves Fund: You could lose money by investing in the Fund. Because the share price of the Fund is expected to fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund's liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.
Distributor: State Street Global Advisors Funds Distributors, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Global Advisors, Inc.. The Fund pays State Street Bank and Trust Company for its services as custodian, transfer agent and shareholder servicing agent and pays SSGA Funds Management, Inc., an affiliate of State Street Bank and Trust Company, for investment advisory services.
Before investing, carefully consider a fund's investment objectives, risks, charges and expenses. Click the link to obtain a prospectus or summary prospectus which contains this and other information, or by calling 1.877.521.4083. Please read it carefully before investing.