by Thomas Aubrey.
Credit cycles play a key role in the pricing of financial assets. Throughout history, periodic jumps in default rates – from the railroad crash in the late 1870s, the bank panic of the 1890s and the Great Depression, to the dot-com crash and global financial crisis – have placed downward pressure on asset prices.
The reason for this clustering of defaults is related to the nature of the credit cycle. When the return on capital increases faster than the cost of capital, the net result is increased credit creation in pursuit of higher profits. This process leads some firms to overextend themselves, resulting in their inability to pay back their debts due to a shift in the macroeconomic environment. This is why the default correlation jumps during stressed periods.
Equity valuations fall during periods of higher default correlation, hence avoiding equities during these periods remains central to successful asset allocation decisions. However, once the default correlation returns to normal conditions, the firms that have survived the shock have the opportunity to ride the next cycle potentially reaching higher valuation levels. Hence determining the starting and end points of credit cycles is critical for investors.
One approach in determining whether a new credit cycle has begun is to look at the correlation of equity returns which tend to jump in times of stress. As is shown in exhibit 1, when the asset correlation jumps above 0.3, equity returns tend to fall. While there are specific market reasons for equity correlations to jump, the end of a credit cycle is also marked by a jump in defaults which occurred during the dot com crash and following the default of Lehman. The global COVID-19 pandemic has also resulted in a jump in defaults.
Exhibit 1: Asset correlation and equity performance – U.S.
For equity valuations to rise in a new credit cycle, the outlook for profit growth needs to be positive combined with an increase in consumer and corporate leverage. Although the ex-post Wicksellian Differential fell in 2020 from 5.52% to 4.05% – derived from the weighted average return on capital minus the BBB cost of funding – markets were up overall. This can be largely explained by the ex ante data demonstrating the rising profitability of the technology sector, which is heavily weighted in equity indices.
The near term outlook for profits in the U.S. market is unsurprisingly positive, with all sectors rising, providing further confirmation a new credit cycle has started. Trended near term profit expectations are strongest for industrials, with the other services including technology indicating the weakest but still positive outlook for profit growth. Critically though, consumer and corporate leverage have started to rise again which will help drive a new wave of credit creation and increased growth prospects.
Further evidence indicating a new credit cycle has started can be observed in Credit Benchmark’s credit transition matrices. The credit transition matrix for North American corporates, which is based on nearly 40,000 observations, indicates that for both b and bb obligors there are now more upgrades than downgrades. It is also important to note that the overall universe of investment grade names has shifted down the credit quality curve, suggesting that this credit cycle may well be a much shorter one.
Exhibit 2: Credit Transition Matrix – North America Corporates
Source: Credit Benchmark, Credit Capital Advisory
Given that credit risk has fallen since the jump in default rates in 2020, there is less chance that investment grade and high yield bond yields are about to rise due to increased risk. While government bond yields have widened considerably since January, the increase in yields across other credit categories has been much lower, resulting in a compression of spreads against the government benchmark.
Exhibit 3: U.S. Bond Market Indicators
This leaves inflation as a possible negative factor for equity investors as it would most likely cause yields to increase significantly. To date, the bond market appears to be ignoring the inflation spike, based on the assumption that the spike will prove transitory. While supply side constraints driven by the COVID downturn and the subsequent surge in demand have resulted in commodities increasing 40% over the last year, since early May commodity prices have fallen. And while the price of global container shipping increased by 250%, the rate of increase has fallen. The Chinese PPI still remains on a steeper upward trend, but as noted in last quarter’s note; this is partly due to a delay in increasing capacity. Hence this is likely to flatten out in the next few months.
Exhibit 4: Inflation indicators
Concerns with regards to a wage price spiral are also overblown. While nominal wage growth is showing few signs of a tight labor market, the recent spike in inflation is unlikely to spur aggressive wage bargaining, given the ongoing market consensus that this inflation is transitory. Crucially, the employment participation rate remains relatively low at under 62% – well down from the 66% prior to the global financial crisis.
Exhibit 5: Labor market indicators
Another indicator that signals a tendency for wage inflation is a fall in the level of trade openness. Despite President Biden continuing the protectionist rhetoric of the Trump administration, the reality is rather different with a slight decline of 3% in trade openness since 2016. The only economy that appears to have embraced protectionism is the United Kingdom, due to its decision to leave the single market of the European Union and thereby dramatically increasing barriers to trade.
Exhibit 6: Trade openness
Fluctuations in the credit cycle offer investors an opportunity to allocate assets to equities during periods of near term profit growth while reducing exposure as profit growth decelerates. Since 2006, this strategy outperformed the S&P 500 by 58%, and since 2014 when these notes started to be published, it has resulted in outperformance of the S&P 500 by 17%. Furthermore, this outperformance was delivered with a downside or semi-variance over 4 times lower than the S&P 500. For investors with long dated liabilities, investing across the credit cycle can play a central role in maintaining a high level of returns with low downside volatility.
Thomas Aubrey is the founder of Credit Capital Advisory.