Ever since I read Hayek’s “Monetary Theory and the Trade Cycle” as an LSE undergraduate, I have been obsessed about the idea of measuring the credit cycle. This obsession was put on steroids after stumbling across a Barclays equity-gilt study which noted how correctly predicting whether equities or government debt would outperform each year generated astonishing excess returns compared to buy and hold.
The brilliant late Meghnad Desai in 1999 suggested I read Knut Wicksell whose book, “Interest and Prices,” provided a theoretical interest rate framework for understanding a credit economy. This resulted in a quest to apply Wicksell’s theory to measure the credit cycle, thereby facilitating an asset allocation model to switch between equity and debt.
Central to Wicksell’s theory are his two rates of interest. The money rate of interest and the natural rate of interest, which should be interpreted as the cost of capital and the return on capital. Wicksell’s great insight was that these two rates could diverge creating a disequilibrium.
Empirical analysis of these two rates demonstrates they are hardly ever in equilibrium, providing signals to firms to increase demand for credit in the good times while contracting demand in the bad times. When the blue bars are above the orange bars as shown in Exhibit 1, there will be a credit expansion and rising capital values. In the few instances when the orange bars are above the blue bars, capital will be destroyed leading to declining equity values. The height of the blue bars relative to the orange bars following the financial crisis explains why equities have performed so well, given that the returns on capital have grown faster than the cost of capital.
Exhibit 1: Comparison of the two rates for the US (1980-2023)
The difference between the two bars I subsequently termed the Wicksellian Differential. Exhibit 2 demonstrates the relationship through time between an increasing Wicksellian Differential and rising asset values and a decreasing Wicksellian Differential and falling asset values.
Exhibit 2: Relationship between US Wicksellian Differential and US stock market
My book, “Profiting from Monetary Policy,” published in 2012, argued inflation targeting was flawed because in a world of variable productivity, stabilizing the price level does not result in a monetary equilibrium. But it is the existence of this monetary disequilibrium that enables investors to profit.
Over the last 20 years, I have had the good fortune to discuss monetary theory, my investment framework and its results with numerous academics and practitioners and have learned a great deal in the process. These are some of the main lessons:
- The standard interest rate theory as espoused by Fisher and Keynes does not apply to the real world as the demand for credit does not continue until the return on capital equals the cost of capital. This flaw has major implications for the way we think about both monetary policy and investment strategy.
- Never trust your intuition or be swayed by market narratives. Running the model at the beginning of 2007 indicated a falling Wicksellian Differential and a switch to government bonds which continued until the end of 2009. Many investors at the time I spoke to said I was nuts to be missing out on the equity bull run. All intuition ever does is to reinforce your own biases – which is just a bad way of investing.
- Having skin in the game ensures you continue to improve the model. Over time, I have expanded the model to generate quarterly signals, increase the number of markets covered, as well provide sectoral signals.
- Don’t equate luck with skill. Although I have been using the model since 2006, I focus on the returns data from 2014 when my articles were published given that the excess returns from 2006 were largely explained by the extent of the financial crisis both in terms of rising bond prices and falling equity prices. From 2014, the credit cycle signal has outperformed buy and hold equities by a considerable margin returning 775% since 2014 to Jun 2025 compared to 314% for the S&P 500.
Exhibit 3: Returns from different investment strategies
- There are some investor opinions you won’t be able to change. I rarely found any issues debating the returns and the signals, but discussions on risk or volatility measures were rather different. Typically, investors use the standard deviation to provide a measure of volatility which is then used as a proxy for risk. This measure is embedded in the Sharpe Ratio which is widely used to measure a fund’s risk adjusted return. On that measure, the credit cycle signal is just as risky as holding equities. However, the flaw with the standard deviation is that it does not take into account the difference between upside and downside volatility, highlighting a major issue with the Sharpe Ratio. If there were two funds with the same standard deviation, but the volatility of the returns for one fund were positive and the other negative, most – if not all – investors would go for the one with positive volatility. This is why I believe a better measure of volatility is the coefficient of variation, or the volatility relative to the returns. On that measure the credit cycle signal is by far the least riskier approach. While many investors accepted the logic of the argument, many were required to use the Sharpe Ratio in their own reporting.
- Over time it has become increasingly clear that the most important rate of interest driving investment performance is the one that practitioners tend to ignore, which is the return on capital. When markets believe the central bank is going cut the base rate as was the case last week, equities typically rally. But it’s important to remember that a firm’s cost of capital is largely determined by the 5 year BBB rate, which is affected by other factors. Furthermore, marginal changes in the cost of capital do not have much impact on investment decisions. If they did, we would see evidence of the Fisher / Keynes theory of interest in practice, but we don’t. Finally, firms tend to increase investment when they expect future profits to be higher, which generally takes place in an increasing interest rate environment.
- Most investors have their own investment framework so few will take any third-party signal and use it outright. Many just want to be challenged, which is increasingly important today due to the ongoing uncertainty created by the unraveling of the Liberal International Order.
The current outlook for the US remains reasonably robust. Only Construction and Industry & Energy have a declining or negative profit outlook. Firms are still investing and credit spreads remain narrow.
Exhibit 4: U.S. Summary ex ante signal
However, there are some indicators that suggest S&P 500 bets are increasingly risky. First, the continued deleveraging of consumers will at some stage filter through to lower consumption. Second, the rate of profit growth of Big-Tech is declining (Microsoft, Apple, Nvidia, Alphabet, Meta, Amazon). Given their lofty valuations, Big-Tech asset prices may have a way to fall from their current highs.
Exhibit 5: Big-Tech profit expectations
However, the rest of the technology sector continues to demonstrate rising near term trended profits, emphasizing the point that investors should move away from country indices to more targeted sectoral approaches, particularly due to the effect of tariffs which will continue to negatively impact the Industrials sector around the world.
In Europe where most sectors are finally experiencing a rise in short term profit expectations, Industrials has a negative outlook due to tariffs. However, the European defense sector continues to demonstrate robust short term profit growth, and despite recent falls in equity values, it is fanciful to assume an era of peace is around the corner given the rapid unraveling of the global order that took decades to put in place.
Across the UK, profit growth signs are positive for all sectors – at least for this quarter – which will most likely provide further support to drive equity values higher.
Exhibit 6: U.K. Summary ex ante signal
And finally to long term interest rates. For the last couple of years the data has been clear that some economies are becoming more closed, which is inherently inflationary. In addition, it is feasible that the slow trickle of tariffs may nudge up inflation expectations. Hence long term rates can be expected to maintain their current or even higher levels. Furthermore, interest rate cuts may increase long term yields if central banks are perceived as yielding to political interference. Chairman Powell’s speech at Jackson Hole last week indicated “the shifting balance of risks may warrant adjusting our policy stance.” But it’s not obvious from the data that a cut in September is truly warranted.
This project started out as an attempt to measure the credit cycle enabling investors to consistently outperform the market demonstrating that inflation targeting is not a neutral monetary stance. The brilliant monetary economist Charles Goodhart once told me that monetary frameworks are unlikely to be challenged unless there is robust data. To what extent this outperformance is robust I leave for others to judge, however, it seems likely that inflation targeting will remain in place for the foreseeable future. Hence investors can continue to generate excess returns should they chose to junk general equilibrium models that still form the backbone of many asset allocation models.
As this will be my last credit cycle note, I would like to thank everyone for all the feedback and conversations these articles have generated. The future of investment looks increasingly uncertain as core principles of liberalism such as the rule of law are being eroded by democratic systems. To what extent the bond market is going to be willing to fund governments who are disdainful of the rule of law remains to be seen. However, investors should be in no doubt that the unravelling of the rule of law will have a dramatic negative impact on asset values.
Thomas Aubrey is the founder of Credit Capital Advisory.
