- The corporate credit cycle is ending, but is not over in Europe.
- Faced with negative interest rates, a half-hearted economic recovery and the threat of deflation, we expect demand to remain for credit products.
- We remain more positive about returns from credit than returns from government bonds.
By Global Head of Fixed Income Jim Cielinski and Head of Investment Credit David Oliphant
As corporate credit markets have now finished what has been a challenging calendar year for performance, it is perhaps timely to revisit the “credit triggers” work we carried out over a year ago. In 2015, bond markets had to deal with an energy and commodity crisis, heightened geopolitical risk, an emerging market growth shock and a rising tide of equity-friendly corporate behavior. This came at a time of sometimes compromised market liquidity and asset class outflows.
The aim of our credit triggers work is to help identify the likelihood and the timing of the end of the credit cycle, which is typically associated with significant negative returns. In doing this analysis, we revisit the five signposts (numbered below) which we felt were likely to be useful harbingers of upcoming market stress.
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Exhibit 1: Total Returns
1. Policy conditions will remain supportive for credit markets
Contractionary monetary policy has preceded many credit market corrections. This makes sense intuitively. Higher interest rates lead to higher borrowing costs and make funding the debt burden more challenging for companies. As we have just witnessed the first rate hike in the United States since 2006, should we be concerned that policymakers are hell-bent on creating such conditions?
At this stage, policy conditions in developed economies remain very supportive for corporate credit markets and we believe will remain so over the coming quarters. Though there is debate about the timing and extent of future federal funds rate rises, this should be considered as a move from a very accommodative policy to merely accommodative and certainly not restrictive. Indeed, the market’s current expected trajectory of rate rises is very shallow by historical standards.
Moreover, there remains the possibility that the European Central Bank might extend its own policy stimulus should inflation fail to meet the mandated target of 2%. Presently, interest rates are deeply in negative territory, and the ECB is purchasing €60 billion of assets every month. The Bank of England seem keen on distancing itself from the U.S. rate cycle and looks unlikely to touch policy conditions until the second half of 2016.
2. The economic outlook is fairly benign
The economic background remains a concern and, in spite of the sheer scale of policy stimulus thrown at the developed world, growth has not rebounded at a pace that might have been expected. Moreover, the inflation rate in many developed market countries hovers around zero.
We expect the U.S. and U.K. economies to remain on a reasonably firm growth track into 2016, and the turnaround in the performance of Europe has added to a somewhat more optimistic feel. Global growth concerns are focused on emerging markets—for example, China and Brazil. The transition from an investment-led, commodity-fed economy to a more balanced state in China is prompting fears of a material slowdown in growth. The ongoing implied reduction in demand for commodities has had a profound effect on countries whose livelihood is more dependent on sales of basic materials and energy products.
Overall then, the economic backdrop is becoming less supportive, but the shape of that deterioration is quite specific in terms of industry. A “not too hot, not too cold” world is not a bad place for credit markets and will help rein in some of the animal spirits we would normally expect to see towards the end of a typical credit cycle.
3. Credit market spreads/valuations are reasonably attractive
Market valuations are certainly more attractive than was the case at the start of 2015. Viewed on a purely spread basis, U.S. investment-grade corporate bonds, for example, have cheapened to a great extent, taking them to nearly one standard deviation cheap when compared to long-term history (Exhibit 2). Yields are clearly very low not just in credit but everywhere, and not just in pure nominal terms, but also when compared to present and expected levels of inflation.
Exhibit 2: USD Investment Grade Corporate Bond Spreads (5-10year maturity) 1971-2015
4. Corporate credit health is deteriorating and becoming more of a concern
Corporate credit health is certainly not improving. After the global financial crisis, the corporate world rebalanced itself, and debt holders benefitted from tighter spreads and higher prices. More recently, it has been in the financial arena that balance sheet strength has been restored and profitability revisited.
It is fair to say these trends have ended or are ending. If the typical credit cycle is to reassert itself, we should expect to see more equity-friendly activity from both banks and corporations which may well be to the detriment of balance sheet strength and bondholders’ interests. Moreover, the cheap cost of funding and a return of corporate optimism have reignited the global merger and acquisition market in what could ultimately become another debt-fueled binge.
The chart below (produced by Deutsche Bank) shows that key credit trends are turning, with both leverage and interest cover deteriorating, albeit from a very healthy start. It is worth emphasizing that there is a marked divergence between the U.S. and Europe in terms of corporate health. In the U.S., corporate health is clearly deteriorating, and this is not merely an energy story as corporate profits are struggling in most of the economy’s indebted sectors.
Exhibit 3: Aggregate Leverage and Coverage Ratios for European Issuers
5. Volatility is spiking once again, and moral hazard remains in today’s illiquid markets
Volatility has been low, and the concern is often that market participants, looking with perfect hindsight, expect these conditions to prevail and take more and more risk to achieve returns. This is the moral hazard faced by policymakers when they leave interest rates low for too long. The fear remains that, faced with compressed nominal and inflation-linked yields, market participants will fail to change return assumptions and take commensurately more risk. This risk might be in terms of taking interest rate risk (duration), increased credit risk, liquidity premium and/or volatility risk.
Conclusion: The credit cycle is ending but is not over in Europe
This long-running corporate credit cycle is ending but is not over yet. Faced with negative interest rates, a half-hearted economic recovery and the threat of deflation, we expect demand to remain for credit products in general. Policy conditions are different in Europe and excess returns will be low, but they should be positive. We remain more positive about returns from credit than those from government bonds.
Link to “A fork in the road,” by Colin Moore: “A fork in the road”
Link to “Not so great expectations,” by Mark Burgess: “Not so great expectations”