What's Next for the Credit Cycle?
The Loomis Sayles Macro Strategies Team
As of June 2020
The COVID-19 pandemic upended financial markets and delivered an enormous shock to the global economy. It forced a rapid transition from late cycle into the downturn phase of the global credit cycle. Here, we share our analysis of the credit cycle and key factors we’re watching.
WHAT IS THE CYCLE TELLING US?
The signals we’re observing suggest the cycle is transitioning toward the credit repair phase. The table below displays typical attributes of the credit cycle and highlights the attributes we’re seeing now. While we’re seeing signals across three different phases, the majority are indicating credit repair.
Credit repair doesn’t imply that economic challenges are behind us. Instead, it highlights a behavioral shift toward saving and deleveraging, combined with easy central bank policy and above-average but declining volatility. It’s typically the sweet spot for credit as companies start to clean up their balance sheets. But deleveraging can also happen through rising defaults, so we believe credit selection is critical.
The depth of the downturn has been incredibly severe. It will take time to recover, but markets are forward-looking. Importantly, we believe risk appetite generally improves in credit repair as investors begin to anticipate a recovery, which can drive credit spreads tighter and reduce global risk premiums. We are often asked how long it will take to recover the previous peak in global GDP, reached in the fourth quarter of 2019. While it remains highly uncertain, our base case assumption is that it will happen sometime in late 2021 or early 2022. Thankfully, powerful monetary and fiscal policy should help strengthen the social safety net, although they won’t prevent some painful social and business failures.
WHAT ARE WE WATCHING?
As we consider the transition toward credit repair, we’re focused on the signals in the table above. But we’re also considering some variables specific to our current circumstances that could influence our progress through the cycle. We believe no one variable is likely to single-handedly shift the cycle, but it could ignite a chain of developments that ultimately rotates the cycle. Here’s a snapshot of these special factors:
The chart presented above is shown for illustrative purposes only. Some or all of the information on this chart may be dated, and, therefore, should not be the basis to purchase or sell any securities. The information is not intended to represent any actual portfolio.
READ ON FOR A SNAPSHOT OF OUR VIEWS ON KEY TOPICS RELATED TO RECOVERY
OUR VIEW: The reopening process will be slow and gradual. We could be in for a bumpy fall.
THE DETAILS: Vaccine trials have released encouraging data, but the process still takes time. We expect to see at least a partially effective vaccine in the next 12 months. Until then, or until testing capacity increases, we expect economic activity to remain below normal. If we get a second wave of the virus, we would expect much better testing, tracing, and more targeted containment measures compared to the first wave.
OUR VIEW: Global GDP will likely take a large hit in 2Q 2020; signs of normalization could emerge by the end of 3Q. We may not reach the previous Q4 2019 GDP peak until the first half of 2022.
THE DETAILS: Our current view hinges on successful implementation of fiscal policy globally, effective containment of COVID-19, and the smooth reopening of global economies. Otherwise, we foresee a more severe, prolonged downturn.
OUR VIEW: Effective fiscal delivery is critical to fill the cash flow gap from collapsing incomes and profits. Without it, restoring the economy and preventing a deep recession or depression is not possible.
THE DETAILS: Markets have cheered the announcements of impressive fiscal spending packages from many governments. We believe most will successfully follow through announced policies, which we view as critical for the recovery. Fiscal policy has been controversial for so long, the fact that policy makers are willing to “do whatever it takes” is big. But what people do with the fiscal stimulus will impact how successful it is.
OUR VIEW: Steep corporate profit declines in 2Q and 3Q 2020.
THE DETAILS: We expect S&P 500 and NIPA profits to fall around 30% or more as revenue and profits are likely to take a tremendous hit from shutdowns across the US. Fiscal packages are intended to slow or prevent the profits declines from taking companies into default by filling the cash flow gap.
OUR VIEW: Once profits and incomes start to rebound, we would expect companies to pursue genuine deleveraging. In the meantime, we expect defaults to rise.
THE DETAILS: We are not yet seeing companies deleverage as profits and incomes are still collapsing. It is critical that fiscal delivery effectively covers the cash flow gap. Once profits and incomes rebound, we expect to see more deleveraging efforts. Companies will shift their focus from financial engineering to fixing their balance sheets. Defaults will likely rise as another form of deleveraging.
OUR VIEW: In our assessment, the credit risk premium remains above average but should continue a gradual descent as companies and individuals shift to saving and deleveraging.
THE DETAILS: There is still much uncertainty around the virus, the effectiveness of fiscal support and the level of structural change catalyzed by the COVID-19 pandemic. As a result, investors are charging an elevated premium to bear credit risk. However, risk premium has changed dramatically from peak uncertainty around the end of March. So while risk premium remains squarely above average in our view, they have come a long way from the extreme levels at the end of March.
This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein, reflect the subjective judgments and assumptions of the authors only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual, or expected future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis cannot guarantee its accuracy. This information is subject to change at any time without notice.
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