A crossroads for credit, should we be concerned?
Jim Cielinski, Global Head of Fixed Income at Janus Henderson Investors, looks at three key factors that could determine the direction of credit markets.
How many times have you seen a chart that looks like this, suggesting that the end of the current credit cycle must be nigh?
Source: NBER, Janus Henderson Investors at 28 June 2018. Date on horizontal axis is start of each expansion period. 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 positive.
However you slice it, the volume of debt has increased markedly over recent years. The charts below highlight the growth of the investment grade corporate bond, high yield corporate bond, loans, and emerging market sovereigns markets.
Figure 2: Credit market size (USD billion)
Source: BoA Merrill Lynch Global Research, ICE BofAML Bond indices, S&P LCD, as at 28 March 2018.
Most leverage measures, such as debt 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.
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 gross domestic product (GDP) has risen significantly since the crisis. While there was some retrenchment among households in the US and UK in the years initially after the financial crisis, this has tailed off and debt levels have been flat or rising recently. 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 – debt – has clearly been met.