In the first of a series of articles on the direction of credit markets, Jim Cielinski, Global Head of Fixed Income, looks at three key factors that could determine their direction.
How many times have you seen a chart that looks like this, suggesting that the end of the current credit cycle must be nigh?
Figure 1: Length of US expansionary period (months)
Source: NBER, Janus Henderson Investors at 28 June 2018. Final column reflects period up to latest available official GDP figure at end Q1 2018.
Time is never a good test of the end of a credit cycle. Indeed, the one thing that the chart above does serve to highlight is that the length of economic cycles, and with it broader credit cycles, has varied significantly through time. Cycles vary not only in length, but also with respect to their drivers, making them extraordinarily difficult to predict.
In our view, there are three main factors to consider when assessing if we are at a crossroads for credit. While each cycle is different, a true turn in credit has always required three elements: high debt loads; an obstructed path to capital; and an exogenous shock to cash flow/earnings. We can think of these three factors in terms of a traffic light, where red is negative, amber is neutral, and green is supportive of credit and corporate bond returns.
1. The global debt load (red)
However you slice it, the volume of debt has increased markedly over recent years. The charts below highlight the growth of the investment grade, high yield, loans, and emerging market sovereigns markets.
Figure 2: Credit market size (USD billion)
Source: BofA Merrill Lynch Global Research, ICE BofAML Bond indices, S&P LCD, as at 28 March 2018.
Most leverage measures, such as debt relative to earnings before interest and taxes, are at new highs. Corporations are dining on debt, and even low rates have not been enough to stop interest bills from rising relative to earnings, although this is more pronounced in the US.
Debt outside the corporate sector has also been building, according to figures from the Bank of International Settlements1. In countries such as China, Korea, France, Canada, and Sweden household debt as a proportion of GDP has risen significantly since the crisis. Only in a very few countries such as Germany, Netherlands, and Spain has there been a decline in household debt in recent years. With household consumption accounting for a large proportion of aggregate demand in an economy, the higher stock of household debt means economies are increasingly sensitive to higher interest rates.
The other major borrower is governments. National debts as a percentage of GDP are nearly all larger than they were in 20072, so faced with a downturn similar to the 2008/09 Global Financial Crisis (GFC), governments would be in a weaker starting position.
The first test for ending a credit cycle – excessive debt – has clearly been met.
1 Source: BIS Quarterly Review, December 2017
2 Source: OECD, general government debt levels, December 2017
2. Access to capital (amber)
Post-GFC quantitative easing and the very low interest rate environment combined with minimal global inflation pushed real interest rates into negative territory. For many high quality corporates, the cost of financing through the debt capital markets has been low, in fact between 0 and 1.5% for issuers in Europe. Sub-investment grade (high yield) borrowers have found it easy to access capital and roll over maturing debt (typically at lower rates), contributing to a low default environment.
Figure 3: Global speculative grade default rate (%)
Source: Moody’s global speculative grade default rate, 31 May 2000 to 31 May 2018.
In the last 18 months, however, there has been a gradual shift in monetary policy as central banks reverse hyper-accommodative policies. The US Federal Reserve (Fed) has already embarked on reversing quantitative easing while the Bank of England has stopped expanding its balance sheet and the European Central Bank (ECB) announced that it will end its asset purchase programme in December 2018.
Figure 4: Central bank balance sheets (USD billion)
Source: Thomson Reuters Datastream, Janus Henderson Investors at 31 March 2018. Forecast data beyond this point shown in paler shade.
Balance sheet reduction may be gradual, but markets respond to change, and this is an important change. Interest rate policy is also shifting. In June, the Fed raised rates for a seventh time in this cycle to a target range of 1.75 to 2%, with the market expecting another two rate rises this year and a further three in 2019. Mario Draghi, president of the ECB, however, continues to sound dovish on interest rates, indicating no rate hike until at least the summer of 2019.
Capital may not yet be difficult to access, but it is certainly getting harder. The liquidity cycle has turned.
3. Exogenous earnings shock (amber in Europe, green in US)
Exogenous shocks are, by definition, difficult to predict. ‘Events’ like Brexit, the Italian elections, and the twists and turns in US politics have been more benign than might have been the case. Has the world become more immune to unpredictability – a reflection of the ‘new normal’ – or is it lucky timing with a relatively robust global economy being able to absorb any fallout?
The US tax cut has taken this risk of a global earnings collapse off the table for now and pushed any possible shock, in our opinion, to 2019. We are, however, noticing that while aggregate earnings may be growing, there is significant dispersion in earnings. Technology companies continue to take market share from traditional sectors. We need to be confident that the company will still exist to pay the bond coupon several years from now. For many, profits are doing little more than treading water.
Cause for concern?
Should we be concerned? In terms of the stack of debt, it is worrying since it makes borrowers more vulnerable to a rise in financing costs. High debt levels impair recovery values when the next default cycle emerges. Rising interest rates will force interest expense higher for households and corporations. Investors are also likely to demand a higher yield premium as the relative attractiveness of cash grows. We are less concerned by rising government debt, which can play a useful stabilising role when the private sector retrenches.
For the moment, access to capital remains relatively easy. The world is still awash with excess savings seeking a home in higher-yielding assets, but the reduction in central bank balance sheets is removing a relatively price-insensitive and significant buyer of bonds from the market. The absence of a key demand component (central bank purchases) will, all other things being equal, lead to lower liquidity and higher corporate bond yields. So far in 2018, we have seen widening of credit spreads alongside a general rise in government bond yields.
The decades-long bull run in government bonds seemingly ended in 2016. It now looks likely that the credit cycle is also drawing to a close. Not every indicator is flashing red, but the trends are clear, and this means that the most important pillars of credit outperformance in recent years are vanishing. Bond investors will need to tread much more carefully in their search for yield.
The next article in this series focuses on the first of the traffic light signals – the debt load. It looks at what increases in bond supply and index weighting for a bond sector has indicated historically and why a cautious approach to certain sectors may be warranted.
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