What's Next for the Credit Cycle?
The Loomis Sayles Macro Strategies Team
As of September 14, 2020
The COVID-19 pandemic 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?
We use the table below to track important indicators of the credit cycle. While the majority of signals continue to indicate credit repair, we are seeing more indicators consistent with the recovery phase of the credit cycle, especially when incorporating our forward-looking views. This suggests the cycle is in credit repair and heading toward recovery.
The credit repair phase of the cycle doesn’t imply that economic challenges are behind us. Instead, it highlights a behavioral shift toward saving and deleveraging on top of 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 bankruptcies and defaults, so we believe credit selection is critical.
Over the past few months, we’ve seen market moves consistent with credit repair—credit spreads have tightened and valuations have moved from undervalued toward normal levels. The run in equity markets may appear a little overdone, but investors seem to be looking through 2020 and discounting much better earnings in 2021.
We are often asked how long it will take to recover the previous peak in global GDP, reached in the fourth quarter of 2019. Our base case assumption is sometime in late 2021 or early 2022, though this is highly uncertain. We believe powerful monetary and fiscal policy should help strengthen the social safety net, though some painful social and business failures are inevitable.
WHAT ARE WE WATCHING?
The table above tracks the most significant indicators of the credit cycle. However, we’re also watching factors specific to our current circumstances that might influence our progress through the cycle. In our view, no individual variable is likely to single-handedly shift the cycle, but it may ignite a chain of developments that ultimately rotates the cycle. Here’s a snapshot of these special factors:
READ ON FOR A SNAPSHOT OF OUR VIEWS ON KEY TOPICS RELATED TO RECOVERY
OUR VIEW: We expect a second wave of the virus this fall, though we expect it to be less severe than the first wave.
THE DETAILS: We anticipate another spike in cases this fall, which could slow the recovery. However, we think testing, tracing, and containment measures will be much better this time, with less severe lockdowns and economic damage. We’ve seen this play out already in France and Spain, where new cases have reached March levels but the mortality rate is currently less than a third of what it was during the first wave. Vaccine trials have released encouraging data, but the process takes time. We expect to see at least a partially effective vaccine by spring 2021. Until then, or until testing capacity increases, we believe economic activity should remain below normal.
OUR VIEW: The worst of the global recession appears to be behind us. Global GDP will likely take a large hit in 2020, but we expect a strong recovery in 2021.
THE DETAILS: Our current view hinges on continued successful implementation of fiscal policy and COVID-19 vaccine distribution in spring 2021. Otherwise, we foresee a more severe, prolonged downturn. Vaccine or not, we believe economic scarring will keep GDP below pre-COVID trend levels until late 2021 or early 2022.
OUR VIEW: Effective fiscal delivery is critical for the recovery. Despite delays, we believe the US will ultimately deliver what’s needed.
THE DETAILS: Markets have cheered the announcements of impressive fiscal spending packages from many governments. But what people and businesses do with the fiscal stimulus (save or spend) will impact how successful it is.
OUR VIEW: Credit repair should bring a rebound in corporate profits, especially in the second half of 2020.
THE DETAILS: Corporate profits were better than expected in Q2 2020. We believe fiscal transfers to small businesses through the paycheck protection program helped prevent more severe outcomes, but more is needed.
OUR VIEW: Once profits and incomes start to rebound, we expect companies to pursue genuine deleveraging. In the meantime, defaults should 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. We believe defaults may rise as another form of deleveraging.
OUR VIEW: Credit risk premiums have declined substantially in recent months as fiscal and monetary policy have supported companies and eased liquidity constraints.
THE DETAILS: After blowing out to extremely wide levels in March, spreads have compressed and retraced about three quarters of the selloff. It has been an impressive rebound given the uncertainty surrounding COVID-19 and the economic recovery. Markets appear to be looking forward to a successful vaccine and an end to social distancing by mid-2021. Any significant delay in a vaccine would be a major headwind for the markets.
OUR VIEW: Deflation is a bigger risk than inflation.
THE DETAILS: We have gone through the steepest and deepest economic contraction since the Great Depression. Unemployment is high and bankruptcies are rising. It is hard to imagine that wages can accelerate—a condition we believe is critical for driving inflation. Central bank and fiscal policy appear to be doing just enough to fill the deep hole left from the COVID-19 crisis.
OUR VIEW: The US dollar appears more likely to depreciate as long as risk appetite stays well supported.
THE DETAILS: The dollar is considered a relative safe-haven currency and tends to rally in times of crisis. The dollar strengthened significantly as the COVID-19 crisis hit in the spring of 2020. We believe the trend is changing toward a weaker dollar as investors feel more comfortable taking risk and shifting their portfolios abroad.
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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