Multi-Asset Insights: The evolution and stage of the current credit cycle
Economic and asset allocation views covering Q4 2015: Why we continue to favor developed market equities and the implications of the increased risk of a China hard landing.
When looking at the credit cycle it is worth remembering a quote from Howard Marks: “Rule number one: Most things will prove to be cyclical. Rule number two: Some of the greatest opportunities for gain and loss come when other people forget rule number one.” The pain of 2008 means very few have forgotten rule number 1, particularly given stresses in the energy sector due to commodity weakness, a series of big names coming under pressure within the US and Europe and increasing sovereign risk across the emerging markets (Russia, Brazil, China).
Beginning of the end or a pause?
Credit investors globally are trying to work out if this is the beginning of the end of this cycle, or if it is a pause half way through, providing opportunity for those who can find conviction one way or another. This question is all the more complicated by the role of divergent central bank policy and an ever-evolving trading liquidity landscape, making comparisons with previous cycles all the more difficult. It really could be different this time.
Whilst there are many ways to define the credit cycle, we can say the end of the credit cycle requires at least three factors: poor fundamental credit conditions, increased risk aversion and a trigger. The trigger is always hard to predict and we are certainly in a period of increased risk aversion, reflected by recent increases in global volatility and pro-cyclical valuations. Therefore, in our analysis we attempted to review the metrics that define our understanding of poor fundamental conditions.
Our latest research showed, perhaps unsurprisingly, that the interpretation of a variety of capital market indicators could, at the moment, support rather alternative conclusions. This justifies a degree of caution when trying to assess the precise stage we have reached during the current business cycle. We simply note that credit cycles remain well integrated, with global risk aversion generally leading to spread widening in all sectors during episodes of flight to quality.
Europe lagging the US
With this shorter-term consideration in mind, it appears relatively clear that Europe is at an earlier phase of the credit cycle than the US and, equally, that this process is likely to continue for some time (possibly as a direct consequence of the deeper balance sheet cleansing post the regional crisis). Whilst cross-border issuance further integrates a system of market pricing between the US and Europe that is already well-integrated, those European issuers that have looser ties to overseas economies should face an extended cycle compared to their North American peers. This potentially means European issuers prove more resilient to an increase in US-driven flight to quality.
The credit cycle
EM dollar debt credit pricing remains well-integrated with that of the US and is largely driven by global risk aversion rather than country-specific factors. Several corporate metrics still appear solid, largely owing to the quasi-sovereign nature of many issuers in those markets. However, clearly some worrisome risks of repatriation flows remain, triggered by further tightening in global monetary conditions. At this juncture, we acknowledge that some headline EM risks may be large enough to contaminate other developing markets; some examples of which are the Syrian war, the Brazilian downgrade and the renminbi devaluation. However, we remain of the opinion that the transmission mechanisms within EM are more likely to be expressed from a top-down rather than bottom up perspective, meaning that our investigation assigns a relatively low likelihood of future spillover effects emanating from the deteriorating EM corporate balance sheets.
Where does this leave us?
There is growing evidence derived from fundamental metrics and fragile economic momentum that the expansionary phase of this economic cycle is approaching its terminal stage. However, excluding some energy names, corporate fundamentals still seem well within their late cycle peaks, providing the opportunity for continued expansion out beyond a 12-month horizon. As risk aversion has increased, pricing of defaults appears to have stretched beyond what is reasonable given the fundamentals we observe. With central bank action likely to remain cautious, we believe the current picture resembles more a 2011 than 2007 scenario, i.e. more like a global growth-related risk aversion than the beginning of the end of the credit cycle.
This month's edition of Multi-Asset Views and Insights is available below.