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by the loomis sayles macro strategies team

Whats Next for the Credit Cycle? 

LOOKING FOR SIGNS

International airports often have curbside signs that say “look right” or “look left” (i.e., cars drive on this side of road). We have designed this page as your sign to keep an eye on the credit cycle—where economic indicators can coalesce into potential future economic scenarios.

 

Analyzing the credit cycle involves measuring the changing factors that influence its 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 credit cycle.

 

As shown in the table below, we track a few key economic indicators that, in our observation, tend to behave differently in each phase of the credit cycle. We believe the behavior of these key variables indicates the US economy continues to be in the late cycle phase of the credit cycle.

 

Table Source: Loomis Sayles. Views as of 21 November 2023. 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.

Forecasting Economic Scenarios

Using the credit cycle framework, we seek to join art and science and model potential future economic scenarios. We are careful to acknowledge uncertainty surrounding indicators, which can shift in large and small ways and undermine market sentiment and valuations. For example, while we believe odds of a soft landing in the next six months are high, we continue to monitor the potential impact of tighter monetary policy driving the global economy into a downturn.

Looking forward, how will these variables evolve? What economic scenario will emerge? Will the late cycle dynamics we are seeing lead to a soft landing, no landing or hard landing?



Graphic Source: Loomis Sayles. Views as of 21 November 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.

HERE IS OUR READ:

At this point in the cycle, we believe the markets will gravitate to a “soft landing” scenario for the next several months. In such a scenario, we would expect the Federal Reserve (Fed) to be on hold, inflation to decelerate and lower bond yields to provide some organic support to the economy. Economic growth would decelerate—but not contract—while risk appetites remained healthy.

SOFT LANDING Scenario Characteristics

  • Inflation: Disinflation in the US Consumer Price Index (CPI) has been remarkable. It peaked at 9.1% in June 2022 and hit 3.2% in October 2023.1 Inflation expectations have declined and appear anchored thanks to Fed tightening.
  • Interest rates: Global central banks appear to be reaching the peak of the tightening cycle. The Fed seems comfortable remaining at 5.5% and seeing the cumulative impact of its tightening cycle on economic activity. There remains a lag between rate hikes and demand, so there could be more economic drag in the pipeline. Bond yields will ebb and flow around current levels until it becomes clear that the economy is tipping into a downturn, or inflation is dropping below the central bank target of around 2.0%.
  • Labor: In our view, the labor market adjustments underway clearly fall under a soft landing scenario. Job openings and the “quit rate” have declined,2 labor force participation is up and productivity has improved—all contributing to better supply-side adjustments. Globally, the labor market is in solid shape—outside of China.

  • Consumer: Consumer balance sheets continue to remain very strong. While consumer spending may decelerate, it would require a large rise in unemployment to cause a contraction in consumer spending.
  • Corporations: The earnings recession is over in the US. Earnings for the S&P 500 Index experienced three quarters of negative growth. However, the decline was not deep enough to drive the unemployment rate higher. Profits have been negative in China acting as a drag on growth and in Europe, they are just sliding into negative territory. A slump in profits globally, including in the US, is a necessary condition for driving the economy into a downturn.

Alternative Scenarios

One of the factors that helps the Macro team avoid “group think” is our analysts’ constant reassessments of data. Each person across the globe has an opinion based on their perspective and interpretation of the data. While at this point in the cycle the majority of the team conclude the markets can discount a soft landing into 2024 valuations, we consistently listen and learn from the analysts who foresee different scenarios unfolding.

For example, some on the team believe there will be “no landing” because they expect interest rates to stay higher for longer, inflation to be stickier, and economic data to be more resilient—especially as profits in the US rebound. In such a scenario, the economy would keep growing around trend level, the labor market would remain tight and inflation would not decline as quickly as investors expect. As this scenario progressed, we could see markets come to expect the Fed to move rates higher especially versus the almost 100 basis points of rate cuts priced into the market for 2024. At current valuations, we would expect volatility in risk markets to increase as fears built of further tightening toward 6.0% on the fed funds upper bound.

A much less favorable scenario could develop and the economy could go into a downturn. Deteriorating corporate profits and consumer health could tip the economy into recession. Weak demand would contribute to unemployment spikes and a decreasing risk appetite.

NO-LANDING Scenario Characteristics

  • Inflation: The “easy” disinflation story is over and the road to 2% Fed inflation target proves more difficult to navigate. The impacts of extremely loose fiscal policy continue to be felt and elevated pricing in segments of Core CPI, such as core services ex-shelter and shelter, are sticky. Low housing inventory keeps pressure on home mortgage loans and shelter inflation.
  • Labor: The labor market remains tight with demand far exceeding supply. Companies could be reluctant to lay off workers because of future business need uncertainty. This would prevent a large wave of layoffs and lower wage growth, while strikes added pressure. Real wage growth is finally positive as inflation falls; watch for second-round effects.
  • Consumers: Favorable excess savings, elevated cash balances, strong balance sheets and relatively low debt levels paint a favorable picture of consumer health.
  • Corporations: Corporate fundamentals are strong and pricing power is boosting profits while consensus earnings for 2024 are up close to 10%. The large volume of debt maturities only come due in late 2024 to 2025, keeping the sector resilient despite higher yields.
  • Interest Rates: Real rates continue moving up, but still do not signal elevated losses. Longer lags and slower transmission of monetary policy persist.
  • Commodities: Prices at risk of rising higher. Still fragile due to chronic under supply. Potential shocks from Russia’s war with Ukraine (oil) and bad weather (food).

HARD LANDING Scenario Characteristics

  • Consumer: The consumer is already pessimistic on the economy according to surveys. Excess savings can be run down and higher financing rates for cars and credit cards could cause the consumer to recoil and contract spending.
  • Labor: Labor market weakness IS the recession. By the time it is evident, it’s too late. The first negative non-farm payroll report marks the start of recession.
  • Corporations: Weak demand plus disinflation equals a profit recession. A deep profit recession requires companies to cut costs and that means reducing labor.
  • Inflation: A recession will eventually take care of lingering price pressures.
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Macro Themes in a Flash

Our views on key topics that can influence the credit cycle. 

Fiscal Policy

Our view: Fiscal policy has been an important driver of where the major countries are currently in the global credit cycle. 

The details: Fiscal stimulus has provided significant support for the US consumer and corporate sector since the pandemic. The funding helped shore up private sector balance sheets and left them more resilient to tighter monetary policy.

Consumer

Our view: Excess savings is likely responsible for such a strong post-COVID recovery, but we are likely reaching the end of the line.

The details: Time is ticking on the consumer’s ability to stay afloat. Student loan payments resuming do not help matters either. Slowdown in consumer spending but not going negative.

Global Growth

Our view: The US has remained resilient so far, supported by a strong consumer. Chinese growth has disappointed while European growth is largely stagnant.

The details: The US economy continues to hold in, backed by solid consumption. European growth is essentially stagnant, as major economies have seen GDP hover +/- 0% in recent quarters. Purchasing Manager Indices look weak. China’s growth story remains disappointing. Policymakers have introduced easing measures, but the property sector still faces challenges, along with the broader economy.

Monetary Policy

Our view: Central banks are most likely done tightening. As inflation decelerates toward target levels of close to 2.0%, some may be able to cautiously cut rates.

The details: Monetary policy is working with a lag. In the US, the consumer and corporate sectors have yet to feel the full impact of the tightening cycle. The Fed and other central banks may have stopped hiking, but we are a long way off from interest rates cuts.

US Corporate Profits

Our view: Aggregate corporate health is deteriorating but not crashing.

The details: Our analysts currently see a marginal improvement in profit margins. Their overall outlook is more favorable than it was six months ago. Despite the positive trajectory, we believe caution is still warranted. We see signals that the US corporate earnings recession could be ending, but tighter financial conditions could slow economic growth and pose another challenge to balance sheet metrics.

Credit Risk Premium/Risk Appetite

Our view: Gross Domestic Product (GDP) growth expectations for 2023 have steadily risen to 2.1%,3 which in our view has been a critical factor supporting riskier corporate credits.

The details: Given the "risk-on" environment year to date, we view credit spreads as tight. While a soft landing scenario could allow spreads to remain in a tight range, there remains elevated odds that spreads leak wider over the next 6 to 12 months.

Global Inflation

Our view: We are past peak inflation in major economies like the US and Europe, but questions remain regarding the speed of deceleration from here.

The details: In the US, there is still a long way to go before victory against inflation can be confidently declared. We pay close attention to wages given their tight relationship with service prices. The labor market remains tight in the US, but we have seen some loosening with unemployment up to 3.9%, the participation rate ticking up further, the quit rate falling, and payroll growth cooling.

The US Dollar

Our view: The dollar is expensive.

The details: The relative strength of the US economy has been supportive of the dollar. A risk to a bullish outlook for the dollar would be growing expectations for the Fed to cut rates. There are many emerging market currencies that offer higher interest rates compared to the US.

China

Our view: There are positive signs of recovery, but the pace of recovery remains soft.

The details: China’s government appears to be more focused on deleveraging and supporting the corporate sector while consumers remain very cautious. Household consumption continued to improve through Q3 2023, particularly for services, but the gains were not strong enough to fully offset the shock to goods sectors. Property is still not out of the woods yet, housing sales weakened again in November 2023.

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 Ukraine and the Middle East 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

1 Bureau of Labor Statistics, as of 14 November 2023.

2 Quit Rate represents voluntary separations by employees (excluding retirements).

3 Source: Federal Reserve Bank of St. Louis, as of 21 November 2023.


Disclosure

All insights and views are as of 21 November 2023, 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.

Indices are unmanaged and do not incur fees. It is not possible to invest directly in an index.

Commodity, interest and derivative trading involve substantial risk of loss.

Any investment that has the possibility for profits also has the possibility of losses, including the loss of principal.

Markets are extremely fluid and change frequently.

Past market experience is no guarantee of future results.

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OCTOBER 2023

Investment Outlook

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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The power of our credit cycle framework lies in the common language it provides to help investors identify relative value opportunities across the globe.

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Tom Fahey
Co-Director, Macro Strategies, Portfolio Manager