by the loomis sayles macro strategies team
What is the Credit Cycle Telling Us?
Our Takeaways
(Looking Out Six Months)
- The potential for further accommodative central bank policy, stronger profits and healthier productivity have contributed to a favorable growth environment.
- We believe the credit cycle is in mid-expansion and economic indicators suggest it could continue into 2025.
- The economy has more runway and the risk trade has potential to perform well in this phase of the cycle.
Graphic Source: Loomis Sayles. Views as of 4 December 2024. The graphic presented 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. Any opinions or forecasts contained herein reflect the current subjective judgments and assumptions of the authors only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. This information is subject to change at any time without notice.
Mid-Expansion Dynamics
The US economy remains in the mid-expansion phase of the credit cycle. Credit spreads are tight. While potential changes to trade and immigration policy are likely to have some impact on labor, growth and inflation, right now the macroeconomic landscape looks strong, in our view.
The disinflation trend appears intact. Consumers are still spending and the corporate backdrop appears healthy, in our view. While the labor market is cooling, we don’t expect a significant pick-up in layoffs as long as earnings hold up. The Fed is already in an easing cycle, which should help limit downside economic risks.
A Closer Look
Credit cycle analysis involves measuring the changing factors that influence the cycle’s movement and tracking the complex interactions between credit and asset prices. We use our credit cycle framework to interpret data and shape our views on where a country, sector or issuer may be in the cycle. We keep in mind the variability of indicators since they can shift in large and small ways and undermine or bolster market sentiment and valuations.
Interpreting the Cycle
The key economic indicators in the following table tend to behave differently in each phase of the credit cycle. Currently, most of these indicators display expansion/late-cycle characteristics. However, we do not interpret indicators at face value and make a conclusion. Our determinations incorporate art and nuance.i We believe the cycle is in mid-expansion with expectations of softer for longer growth—we have extended the runway for this cycle based on easing Fed policy, continued profit strength and healthy productivity.
In terms of putting capital to work, as long as disinflation continues with monthly inflation prints trending 0.2% or less and the next move in fed funds is lower, we think risk appetites can stay strong and spreads could tighten to new lows.
Table Source: Loomis Sayles. Views as of 4 December 2024. Highlighted cells represent attributes we’re currently observing. Lighter blue represents attributes typical of expansion/late cycle and navy blue represents attributes typical of downturn. The table presented 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.
What if...?
Because macroeconomic factors don’t always behave as expected, we prepare alternative scenarios that include indicators to watch:
Late Cycle/Higher Landing
In this scenario, the economy continues to chug along at an above-trend pace of growth driven by strong demand-side dynamics.
- Excess demand causes disinflation to stall out as services inflation proves to be sticky. Threats to the supply side of the economy could come from tariffs and tighter border controls limiting labor supply. (Further increases in oil prices could also play a role.)
- Consumers hold in strong; they still have jobs and feel positive impacts from improved wealth.
- Profits rebound continues, and margins can expand as firms hold on to pricing power.
- Although monetary policy may seem restrictive at first glance, the ballooned deficit and impacts from an overly expansionary fiscal policy offset monetary tightness and allow the economy to continue to run hot.
In this scenario, the Fed’s hands are tied with a strong economy, strong labor market and stubborn inflation; no rate cuts on the horizon and fears of further hikes could start to creep into the market. This scenario acknowledges the potential for bond yields to push past 5.0%.
Late Cycle/Recession Scare
This is a softer-growth scenario that could be the precursor to an eventual downturn.
- We have witnessed a historic Fed tightening cycle and real rates are elevated by historical standards, suggesting there are some vulnerabilities in the economy and the market.
- Despite plenty of warning signs, we don’t see much in real economic data that points toward an actual recession in the near term.
- The potential catalysts we see would be consumers and businesses facing significantly higher rates as loans reset. Higher unemployment is the critical mark of a recession but that requires a negative profit shock.
A true downturn has become a lower-probability event within our six-month horizon, but this scenario accounts for the risk of the market “readying” for a downturn in reaction to softer economic prints or exogenous shocks with risk-off sentiment and a soft rally in rates.
US Consumer
Our view: Overall consumer spending in the US still remains healthy and should be additive to economic growth.
The details: Higher-income households continue to spend at favorable rates. Lower-income households, a much smaller segment of total spending, are showing weakness.
Global Growth
Our view: Economic growth has held up in the US. In contrast, growth in the rest of the major economies—euro area and China—has been disappointing. The euro area is being pressured on industrial production, has much less fiscal stimulus and we are seeing more layoff announcements limiting consumer spending. More stimulus in China is likely, but the size and efficacy are uncertain. It is very hard to escape the deflationary pull of a property bust.
The details: With a disinflationary trend underway in the US and euro area, central banks have undertaken easing policies. An extended property market downturn and subdued consumer spending continue to weigh on China’s overall economic health. We expect trade tensions between China and the US to escalate given the US presidential outcome.
US Monetary Policy
Our view: While the timing is uncertain, we expect further rate cuts.
The details: We expect that inflation will continue its disinflationary trend. A further rise in the unemployment rate could cause the Fed to cut rates more aggressively. The gradual drift higher in unemployment has been unusual as it usually spikes higher at this point in the cycle.
US Corporate Profits
Our view: Earnings reports have continued to be favorable relative to those of 2023.
The details: Earnings-per-share estimates for 2025 have been approximating +13.7% growth based on expectations for strong economic data and solid margins. We expect earnings growth to broaden out into lagging sectors (healthcare, materials and energy) in 2025.
US Credit Risk Premium/Risk Appetite
Our view: Strong gross domestic product (GDP) growth expectations for 2025 persist, which, in our view, have been a critical factor supporting riskier corporate credits. Plus, we see all-in yield as very attractive.
The details: Given the "risk-on" environment of the past 12 months, we view credit spreads as tight. Elements of a soft landing allowed spreads to compress even further to near-record lows, but they also reflect solid corporate health. Credit spreads can remain in a tight range as long as earnings expectations for 2025 remain in the 5% to 8% range, in our view.
Inflation
Our view: The US disinflation trend continues.
The details: We are seeing a cooling labor market, which could contribute to softening wage growth. It is not a direct line toward the Fed’s 2.0% inflation target, but overall, inflation continues to decelerate, allowing the Fed to lower interest rates.
The US Dollar
Our view: Despite lower US rates, the dollar continues to be strong. The US economy and technology innovations continue to attract foreign capital.
The details: No other country has been able to match the US lead in high tech. The sector’s return on equity has been impressive. Capital has flowed into US equities, while the relatively high yields offered in the Treasury and corporate bond markets also attracted investors. Post-presidential-election sentiment bolstered the US dollar to nearly a year-to-date high.
China
Our view: A protracted property market downturn and subdued consumer spending are weighing on the economy's recovery.
The details: Despite positive data surprises in exports and PMIs, insufficient domestic demand still remains a challenge for China's recovery. The prospect for higher US tariffs could pose an additional hurdle for China’s growth outlook.
Geopolitics
Our view: For the time being, we do not expect geopolitics to have a material effect on the credit cycle.
The details: Countries involved in war face idiosyncratic risks; however, we do not believe wars in the Middle East and Ukraine will have a substantial effect on global growth or inflation at this juncture. We are continually assessing this view as geopolitical situations can unfold in unexpected ways.
Endnotes
i Unlocking the Credit Cycle (loomissayles.com).
Disclosure
All insights and views are as of 4 December 2024, unless otherwise noted.
This marketing communication 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 Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
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