In 2019, the current US economic expansion will be the longest on record and as time passes, anticipating the turn in the credit cycle becomes of ever greater importance forall investors.
A turn in the credit cycle typically precedes the onset of recession as credit conditions tighten, spreads widen and defaults pick-up, while equity markets enjoy a late cycle ‘last hurrah’. Timing the turn in the cycle is notoriously difficult, arguably made even more so by the distortions created by the extraordinary and unconventional monetary policies of the post-financial crisis era.
The two conditions
Two conditions need to be present for a decisive downturn in the credit and default cycle: a pending recession and the misallocation of capital, as happened in the ‘dot.com’ and telecom booms in the late 1990s, and the mortgage-backed securities blow-up in the mid-2000s.
In our view, neither condition is currently met in the US and other major developed economies. Late-cycle excesses typically show up in the emergence of financial imbalances in the private sector – exuberant CEOs spending more than income in the late 1990s and excessive household borrowing prior to the 2007-09 financial crisis – and are currently not present in the US or other major developed economies.
US DEBT TO GDP BY SECTOR
Source: US Bureau of Economic Analysis (BEA), Federal Reserve Q2 2018
Note: Shaded columns denote NBER-dated US recessions
In contrast to the private sector, the US federal government is running a large deficit despite above-trend growth. The budget deficit is unlikely to be the catalyst for an economic downturn but will make it much harder for fiscal policy to respond in a counter-cyclical manner when the economy eventually slows.
There are, however, signs of ‘late cycle behaviour’ in US leveraged loan markets, with leveraged buy-outs and merger and acquisition activity on the rise and the erosion of protections for lenders.
In contrast to the high yield market that has shrunk in recent years, the leveraged loan market is growing fast and stands at more than USD1.3 trillion – as large as the high yield bond market.
Strong investor demand for floating rate and secured credit is being matched by supply from borrowers attracted by the additional flexibility afforded by the loan market. Another 100bps of Fed rate hikes may trigger some stress among ‘B’rated issuers (some USD300 billion) if accompanied by weaker earnings, but in our view does not pose a systemic threat to broader credit markets and the economy. In contrast to the financial crisis, investors are not leveraged and reliant on short-term funding, while banks’ loan exposure is much lower.
Corporate leverage more generally is relatively high in the US but has recently stabilised. In the QE-era, investment grade publicly listed corporations have used cheap debt to fund share buybacks rather than capex and acquisitions.
The rise in ‘BBB’-rated debt is a key vulnerability in the next downtown phase of the credit cycle. BBB non-financial debt stands at around USD2.5 trillion – more than half the US investment grade market – compared to USD1 trillion at the end of 2010. The quantum of ‘fallen angel’ debt in the next downturn could be as much as USD300 billion, creating severe indigestion in the high yield market. Sectors that have accumulated the most debt in recent years would be the most vulnerable to downgrade risk: energy, healthcare, technology and media.
Europe is lagging the US in the credit and business cycle. Despite the ECB buying corporate bonds and adopting negative interest rates in the last few years, European companies have not been tempted by record-low yields to increase borrowing, and leverage has actually declined.
The threat to European credit investors does not emanate from the deterioration in corporate credit fundamentals, but from a China-led downturn in the European economic and corporate earnings outlook, and, closer to home, Italy
sovereign credit risk1.
We expect some narrowing of Italian government bond (BTP)spreads as investors conclude that the stand-off between the European Commission and populist Italian government over its 2019 Budget plans is not a prelude to an ‘Italexit’ (Italy abandoning the euro and leaving the EU) and the public debtto-GDP ratio is on a stable path.
Growth may not be strong enough in 2019 to drive global equity markets meaningfully higher, but it is good enough to keep default rates low and for credit to generate positive,albeit modest, returns.
European credit in particular fully prices lower growth as well as Italian political risk, while the challenge for US credit is increasing FX-hedging costs for international investors to fund dollar assets allied with a flattening US yield curve.
Going into 2019, in our view European credit offers an attractive risk / reward profile but greater dispersion and M&A activity means US credit offers greater alpha generation opportunities.
The case for cocos
The recovery of the European banking sector is a structural investment opportunity that remains in place despite disappointing growth and Italian political risk.
European bank healing and disintermediation can be accessed in a number of ways that best reflect investors’ risk appetite and liquidity profile.
The latest European Banking Authority (EBA) stress tests demonstrated the extent of banks’ improved credit fundamentals and resilience to adverse shocks, including the major Italian banks.
European bank debt, especially convertible contingent bonds (cocos) offer mid-to-high single-digit yields and meaningful spread pick-up over similarly rated non-financial corporate debt. The healing of European banks goes hand in hand with a secular trend of disintermediation that provides an investment opportunity for investors able to forgo liquidity to directly provide flexible capital to small and medium-sized business.
“Anticipating the turn in the credit cycle becomes of ever greater importance for all investors.”
EUROPEAN BANKS - SHRINKING BALANCE SHEET AND RISING CAPITAL
Source: ECB (European Central Bank) Eurostat Q1 2018, Q2 2018
1Italian issuers account for around 5% of outstanding euro investment grade corporate debt and 15% of the high yield market.