What's Next for the Credit Cycle?
The Loomis Sayles Macro Strategies Team
As of 4 June 2021
Many of the signals we anticipate on a forward-looking basis appear consistent with the expansion phase of the credit cycle. We expect economic growth to remain solid, though the pace of economic growth will likely peak in the months ahead. We believe the US Federal Reserve and other central banks will gradually wind down emergency measures as inflationary pressures start to build and risk appetite in some segments of the market becomes frothy.
|Weak - Deteriorating||Weak - Stabilizing||Strong - Improving||Very Strong - Peaking|
|CENTRAL BANK POLICY||Easing||Easy||Starting to Tighten||Tightening - Policy Errors|
|High - Breaking Lower||Low - Stabilizing||Moderate - Rising||High - Rising|
|VOLATILITY||Above Average - Rising||Above Average - Falling||Below Average - Stable||Below Average - Rising|
|RISK APPETITE||Low||Low - Improving||High||High - Irrational|
|LIQUIDITY||Low||Improving - High||High||Declining|
|YIELD CURVE||Steepening||Steep||Flattening||Flat - Inverted|
|FUNDAMENTALS||Profit Contraction||Debt Contraction||Profit Growth > Debt Growth||Debt Growth > Profit Growth|
|ASSET VALUATIONS||Falling to Below Average||Below Average - Rising||Near Average - Rising||Above Average - Rising|
|CREDIT VS EQUITY||Credit & Equity Both Down||Credit Preferred||Credit & Equity Both Up||Equity Preferred|
Source: Loomis Sayles, as of 4 June 2021. Highlighted cells represent attributes we anticipate on a forward-looking basis. Black represents attributes typical of downturn, navy blue represents attributes typical of credit repair, bright blue represents attributes typical of recovery, and light blue represents attributes typical of expansion.
This is an unusual cycle in terms of speed. Employment in many countries remains far below pre-pandemic levels, which would normally suggest recovery. However, massive job and economic gains have facilitated a quick transition into expansion. We expect further progress as more countries open up in the months ahead.
Themes to watch as the cycle progresses through expansion:
We believe the US is further along in the credit cycle than the rest of the world, largely because of its swift COVID-19 vaccination progress and large injections of fiscal stimulus. Lagging vaccine distribution in other countries has left many economies playing catch-up.
Our base case: Assumes that growth in the rest of the world gradually catches up with the US by the end of 2021, leading to a strong global expansion.
Our bull case: Assumes the rest of the world catches up quickly, keeping pace with or even outperforming US growth. Meanwhile, the Fed and other central banks maintain super-low interest rates as they wait for inflation to remain sustainably above target (most countries have an inflation target of at least 2.0%).
Our bear case: Assumes US growth accelerates so quickly that the Fed pulls forward rate hike expectations, shocking the markets and denting global risk appetite.
Here’s a quick comparison of the three expansion scenarios:
|GLOBAL GROWTH||Synchronized||US leads, rest of the world catches up||Uneven|
|US INFLATION||Meets Fed's 2% target||Gradually reaches Fed's 2% target||Overshoots Fed's 2% target|
|YIELDS||Rise at healthy pace||Rise gradually||Surge higher|
|RISK APPETITE||Remains healthy||Remains healthy||Dented|
|FED RATE HIKE EXPECTATIONS||Early 2024||Early 2023||Pulled forward to 2022|
|US DOLLAR VIEW||Weaker||Trend weaker||Stronger|
We place the highest odds on our base case scenario, an expansion with the US leading and the rest of the world slowly catching up by the end of 2021. Combined with a slower pace of rising yields, we believe growth dynamics should continue to support credit spreads and riskier assets.
OUR VIEW: We expect COVID-19-related hospitalizations and deaths to trend lower as vaccinations pick up pace around the globe.
THE DETAILS: We believe markets will shrug off the spread of more transmissible COVID-19 variants as long as vaccines remain effective and vaccination rates continue to pick up. We are watching the number of COVID-19-related hospitalizations and deaths rather than the number of cases. We view Israel as a good indicator of what to expect—it has the largest percentage of vaccinated residents and hospitalizations, and deaths are currently declining.
OUR VIEW: Expectations for vaccine distribution and herd immunity support a strong outlook for global growth in 2021.
THE DETAILS: Our growth expectations are based on successful COVID-19 vaccine distribution. Uneven vaccination rates in different economies have led to diverging growth rates around the world. We expect lagging economies to ramp up their vaccine efforts in the coming months, leading to more synchronized global growth.
OUR VIEW: More US fiscal spending is likely to come. Other countries have more limited fiscal capacity.
THE DETAILS: The Biden administration has proposed an ambitious plan to expand jobs and improve infrastructure. The big question is how the US government will pay for infrastructure and other spending—will it run persistent deficits or match spending goals with revenue raised from taxes?
Europe is still digesting its landmark jointly funded €750 billion fiscal plan. In other major countries, fiscal policy has been more constrained, especially in emerging markets. We are concerned that a fiscal risk premium is keeping emerging market exchange rates cheap compared to the rise in commodity prices.
OUR VIEW: Consensus estimates for corporate profits have been rising, but we think upside surprises are likely. We see potential for year-over-year profit growth to reach around 35% this year.
THE DETAILS: Consumers have not been holding back on spending. We expect an all-inclusive rebound in corporate earnings, from growth to value sectors. Above-average earnings-per-share growth is likely to continue in 2022, though at a less robust rate around 10%. We think President Biden’s tax plans will get watered down to some extent and should not cause a major disruption in the markets.
OUR VIEW: We expect companies to pursue genuine deleveraging, where profit growth exceeds debt growth and the debt-to-profits ratio declines.
THE DETAILS: The profit surge has begun, and so far, it has beaten consensus forecasts. Having profits exceed debt growth is an easy way to deleverage. We expect this trend to continue, leading to more upgrades in credit ratings. There is a risk that corporate managers shift to late-cycle behavior and take on more risk to maximize equity returns, leading to higher earnings volatility. We believe this would increase the risk of downgrades and defaults.
OUR VIEW: We think risk appetite can remain strong despite credit spreads grinding lower and equities hitting new highs.
THE DETAILS: Our position in the credit cycle (early expansion) typically offers favorable conditions for taking risk. Credit spreads appear well supported as profits bounce back and fiscal policy remains easy. Spreads have not flinched in the face of higher yields. We would view near-term weakness as a buying opportunity.
OUR VIEW: We expect global inflation to drift higher given the cyclical upturn.
THE DETAILS: Central banks have vowed to look through significant jumps in year-over-year inflation due to base effects in the second quarter. We expect global inflation to return to trend levels in the second half of 2021 and gradually move higher as economies normalize. We expect major central banks to tolerate a modest rise in inflation without tightening.
OUR VIEW: We think the primary trend of the dollar is lower.
THE DETAILS: Growth and interest rate differentials are likely to remain in favor of the dollar near term, but we believe the dollar is likely to drift lower as the global economy catches up to the US. A weak dollar helps to export US reflation efforts around the world, supporting global growth. That is why we consider the dollar a pro-cyclical currency.
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