What’s Next for the Credit Cycle?
In economics the impact of rate hikes tends to happen slowly—then all at once.
Witness the financial distress triggered by Silicon Valley Bank (SVB). Poor balance sheet management amid a liquidity crunch contributed to its bankruptcy. The event may not be a recession catalyst in the US since it wasn’t about weak borrower profits resulting in loan defaults. But it did reveal a degree of financial distress—a hallmark ingredient of downturns.
Is a downturn finally here? We will have to wait to see. In our view, the missing spark is a profits collapse and higher unemployment. Based on our analysis, we think there is a high probability of more substantial declines in economic momentum in 2023.
Currently, a US Treasury bill yields almost 5%, which is a strong alternative to riskier investments. Housing markets are already showing recession-like characteristics because high mortgage rates have made it more expensive to purchase a home. We believe higher borrowing costs will eventually erode the purchasing power of companies to maintain current employment levels. If company profits decline more substantially, as we expect, then layoffs will likely increase as companies cut costs. Rising unemployment rates is another hallmark of recessions.
What Is the Cycle Telling Us?
In our view, the cycle remains in late cycle; whether it shifts to downturn in the next six months is uncertain. While we have been seeing more indicators consistent with a recession and disinflation, we are watching for a large drop in corporate profits—often a telltale sign of a recession. Profits typically drive the cycle because they tend to be the most volatile component of national income. Once profits decline, companies usually have to cut costs—labor being one of the most expensive line items for many companies.
There is a risk that labor demand remains stronger than we expect and inflation fails to drop below 3.0%. This could lead to a higher-for-longer Federal Reserve (Fed) path of tightening with the fed funds rate ending the year as high as 5.75% to 6.0%. That would likely shock the markets and could lead to risk-off sentiment and higher odds of a downturn in 2024.
Table Source: Loomis Sayles views as of 10 April 2023. Highlighted cells represent attributes we’re currently observing. Navy blue represents attributes typical of expansion/late cycle and bright 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 Other Factors Are We Watching?
The table above tracks what we consider to be the most significant indicators of the credit cycle. However, we’re also watching factors specific to current circumstances that might influence progress through the cycle.
The market’s risk appetite has been volatile and we saw a rush for liquidity after the banking distress in March. Earnings and employment are key variables that could determine what happens next. 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.
Graphic Source: Views as of 10 April 2023. 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.
What Could Prolong the Late-Cycle Phase?
- Low unemployment, excess savings
- Resilient corporate earnings
- Global growth – a V-shaped recovery in China
- Cooling wage pressures
- Fed patience
- Containment of financial distress in the banking sector
What Could Shift the Cycle Into a Downturn?
- Strident Federal Reserve
- Deteriorating corporate profits; rising defaults
- Spike in unemployment
- Rise in consumer delinquencies
- Global weakness
Stress in Banking Sector
Our view: We see SVB’s bankruptcy as evidence of an ongoing liquidity crunch. While its failure is expected to be “contained” (it’s not the 2007/08 subprime crisis), it will likely tighten lending conditions, which could exacerbate liquidity conditions and lead to higher default rates.
The details: We view the SVB bankruptcy as a liquidity crisis, not a solvency crisis. We do not expect the deposit runs and liquidity problems at the failed banks to spread to other regional banks. The Fed has implemented the Bank Term Funding Program to address liquidity and the duration mismatch.
Looking at likely Fed actions, for now, we think the Fed is carefully tracking the markets. There is significant tension between inflation control and financial stability. Inflation data has put the Fed under pressure to keep rates high.
From a broader perspective, global bank fundamentals are materially different from those that led to the US bank failures in 2007 and 2008, which gives us some confidence. Banking is a confidence-based business, so increasing uncertainty is a negative, particularly for banks already facing idiosyncratic challenges.
Global Bank Fundamentals
Our view: Overall, global bank fundamentals appear solid.
The details: European banks’ loan books are generally well diversified across retail and corporate clients, and corporate clients tend to be active across a range of economic sectors. Deposit bases are usually diversified across account types. Deposits tend to be stickier, primarily due to fewer alternatives (i.e., money market funds), less-competitive markets dominated by large national champion banks, lower loan growth and lower absolute rates. Regulations implemented in Europe since the global financial crisis have strengthened liquidity profiles.
Our view: Growth outlook improving more quickly than expected.
The details: The worst of China’s growth slump may be over given the country’s improved purchasing manager data released in January, strong Lunar New Year holiday travel numbers and an earlier-than-expected peak in the COVID “exit wave.” We would not be too surprised to see a V-shaped recovery in China for 2023. But it could be led mostly by the service sector, which could have narrower implications for global growth. Mobility and travel spending in China have increased. However, looking forward, the scope of heavy infrastructure and property development projects are likely to be limited. The recent property bust left many developers severely reluctant investors.
Our view: OPEC+’s continued price protection is likely to put a floor under prices in the $70 per barrel range.
The details: A warmer-than-expected winter in Europe helped the region avoid a spike in natural gas and heating oil prices and dampened what investors expected to be a bullish impetus.
Looking forward, Chinese mobility and desire to travel could have a significant impact on energy demand. We witnessed weaker oil demand when China was in lockdown, but that should reverse in 2023. Meanwhile energy companies have been very disciplined and not investing in much new energy supplies. In our view, OPEC’s surprise production cut on 2 April reflects a more activist approach intended keep control over prices and prevent a shale boom.
 Organization of the Petroleum Exporting Countries.
Our view: The global growth outlook has improved recently.
The details: While recession risks remain elevated in the US and Europe—signaled by many Leading Indicators—we have seen resiliency so far in both economies. Meanwhile, China’s re-opening has been more rapid than many originally thought it would be, which has prompted upgrades to 2023 global GDP forecasts.
Global manufacturing remains in contraction territory. However, improvements in global PMI data could signal that the global economy is at least decelerating at a slower pace for the time being.
Our view: We are seeing fiscal policy tighten and it could get more restrictive.
The details: The extraordinary stimulus for the pandemic in the US and Europe is past as budget deficits have meaningfully improved. There appears to be a strong appetite to rein in fiscal spending and we are likely to see a tense standoff in the US over expanding the debt ceiling. Concessions will likely have to be made, which could reinforce expectations for tighter fiscal spending in the future.
Our view: The Fed has long focused on a terminal rate at 5.25%.
The details: The Fed’s “dot plot” has been consistent in highlighting a majority of FOMC members believe 5.25% will be the peak fed funds upper bound. We are currently at 5.00%, so another 25 basis point hike could be forthcoming in May or June.
There is significant tension between inflation control and financial stability. But the Fed doesn’t have the same flexibility to cut rates as it did in the “lowflation” environment of the past two decades.
US Corporate Profits
Our view: Companies are losing pricing power and margins will likely decline as a result. We expect earnings to contract in 2023.
The details: Fourth-quarter 2022 earnings were down 2.5% and continued a deteriorating trend. Revenues in the third quarter of 2022 were 11.5% compared to 5.4% in the fourth quarter. Lower headline pricing power (a Fed priority) could continue to drive profits lower and unemployment higher.
US Corporate Leverage
Our view: We anticipate deteriorating profits from a high level and increased defaults from a low base.
The details: High yield defaults remain at low levels. We would expect defaults to rise into the 4% to 5% range by late 2023 or early 2024. Those default levels would be historically low in a downturn scenario. The corporate sector’s high interest coverage ratios have been providing significant support.
Global Credit Risk Premium/Risk Appetite
Our view: Credit spreads as a percent of yields are still relatively low. We would like to see credit spreads widen to compensate for the increased credit risks that we anticipate in 2023.
The details: We think spreads are at risk of creeping wider. The failure of SVB and speculation about financial distress in the banking sector caused spreads to shoot higher and we believe the risk is for that trend to continue.
Signals of disinflation had contributed to stronger-than-expected risk appetites. If the credit cycle moves toward a downturn phase, risk premiums could increase further.
Our view: We seem to be past peak inflation in major economies like the US and Europe, but questions remain regarding the speed of deceleration from here. US data has been stubbornly elevated.
The details: The 2023 Bloomberg consensus for global inflation is at 5.3% (from 5.2% in February). We are seeing flat-to-lower revisions in most major countries. The gas situation in Europe was better than many had anticipated given the mild winter, though supply remains limited and risks remain. China’s inflation remains considerably low, though re-opening and stimulus efforts will likely lead to more inflation moving forward. We could see oil prices move upward given increased demand from China’s reopening, continued supply constraints and a more active OPEC.
 As of 6 February 2023.
The US Dollar
Our view: The dollar had been weakening since risk assets took off in October 2022. We are wary of another leg lower. We would be inclined to see the dollar rally if we hit a period of global risk aversion.
The details: The dollar is a pro-cyclical currency, meaning when risk appetite is strong and global growth improving, the dollar tends to weaken. When risk appetite fades and global growth is weakening, the dollar tends to rally.
All insights and views are as of 10 April 2023, unless otherwise noted.
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We believe the US economy is late in the credit cycle as US Treasury bond yields move to highs not seen since 2007.
Mortgage rates have been forced higher and lending standards tighter, while oil prices have moved above $90 per barrel and the US dollar has hit new highs for the year. These factors will continue to tighten financial conditions and help move inflation back toward the Federal Reserve’s (Fed's) goal of 2.0%.
Will these late-cycle dynamics lead to a soft landing, no landing or a hard landing? So far, US markets do not seem close to pricing in a hard landing given resilient GDP growth in 2023, elevated equity prices and tight credit spreads. However, European GDP growth has stagnated close to zero for three quarters while China’s economy remains mired in deflation as
its property bust continues. Can the US remain an island of stability in an increasingly unstable global economy?
We will explore these credit cycle dynamics to provide insights as we start to look toward 2024.
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Loomis Sayles analysts are career professionals who offer deep knowledge and experience in a diversity of global asset classes and market sectors.
The power of our credit cycle framework lies in the common language it provides to help investors identify relative value opportunities across the globe.