by the loomis sayles macro strategies team
What’s Next for the Credit Cycle?
OUR TAKEAWAY
High inflation, rising interest rates, a stronger US dollar, slowing economic growth and significantly tighter monetary policy help define today’s macro landscape.
The global economy appears headed for a downturn and we believe the clock is ticking on the US cycle as well. Global central banks have been focused on stubbornly high inflation, and they appear committed to driving core levels back to lower targets, which usually induces a downturn and higher unemployment rates.
CREDIT CYCLE indicators
What Is the Cycle Telling Us?
We use the table shown to track important indicators of the credit cycle. While we have been seeing more indicators consistent with a recession, a large drop in corporate profits is a missing ingredient in our view. The cycle appears to be moving out of late cycle and heading toward a downturn phase. While we anticipate a 2023 recession, the exact timing and depth remain uncertain. With our forecast of inflation remaining sticky throughout 2023, we do not believe the Fed will be quick to pivot and cut interest rates until late 2023/early 2024.
Table Source: Loomis Sayles views as of 31 Oct. 2022. 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. This information is not intended to represent any actual portfolio.
POTENTIAL CATALYSTS
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.
Based on spread levels and the terminal funds rate, the market seems to have discounted a scenario of prolonged late cycle with stubborn inflation. What would keep us in this stubborn inflation environment, and what would tip us firmly into downturn? 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 11 Nov. 2022. 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. The information is not intended to represent any actual portfolio.
What Could Prolong the Late-Cycle Phase?
- Low unemployment, excess savings
- Resilient corporate earnings
- Disinflation surprise
- Wage pressure cooling
- Patient Fed
What Could Shift the Cycle Into a Downturn?
- Strident Federal Reserve
- Deteriorating corporate profits, rise in defaults
- Spike in unemployment
- Rise in consumer delinquencies
- Global weakness
Russia’s War with Ukraine
So many critical economic and market developments this year can be traced back in one way or another to the Russian invasion of Ukraine. The combination of higher commodity prices and higher interest rates resulted in a growth shock. While most major economies were hurt by these developments, it appears Europe has found itself at the epicenter of the consequences. Many European countries are critically dependent on Russian energy imports, leaving them vulnerable to a cutoff in supply. This has caused energy prices to surge more meaningfully in Europe than elsewhere, raising European headline inflation metrics and forcing the European Central Bank (ECB) to become more hawkish.
Energy
While the prospects for a downturn remain elevated, we expect OPEC+[1] to continue its effort to protect prices as they care more about price security than market share. This should help put a floor under prices in the $70 per barrel range. A cold winter could potentially cause a spike in natural gas and heating oil prices. This could contribute to a deeper recession in Europe with blackouts and brownouts at best, and a potential humanitarian crisis if there are residential blackouts.
Looking forward, expected levels of oil and natural gas demand appear uncertain. With this unpredictability, companies seem unwilling to invest the billions that are needed in exploring for and developing mega projects required to replace the current base decline. It’s not likely that demand will fall significantly over the next 20 years, but it is possible that demand for oil and gas has already peaked or will peak over the next 10 years. This could lead to paralysis on the part of oil and gas producers as they likely don’t want to ramp up spending or, more specifically, ramp up exploration.
[1] Organization of the Petroleum Exporting Countries.
Global Growth
Our view: The International Monetary Fund projects global growth to be 3.2% in 2022 and 2.7% in 2023.[2] We currently project US GDP growth of around 1.9% year over year in 2022 and approximately -0.5% year over year in 2023.
The details: Global growth has been losing momentum and the outlook remains somewhat grim. We expect the slowdown to continue amid stubborn inflation as policy and financial conditions tighten. Corporate and consumer health remain solid and labor markets remain tight, which to us signals resiliency in the near term. Leading indicators, along with yield curve inversion, suggest that the clock is ticking on the cycle and a downturn is likely in 2023.
[2] Source: IMF.org, 11 Oct. 2022.
Fiscal Policy
Our view: Divided government limits further action on fiscal policy.
The details: Congress either needs to pass appropriation bills or another Continuing Resolution (CR) by December 16, or there will likely be a federal shutdown.
We could see a divided government scenario where there is a chance for a tax "fix" passed in the first quarter of 2023. A deal could include a host of tax items, including a fix for the R&D tax credit, bonus depreciation, interest expensing and a modified version of the enhanced child tax credit.
US Corporate Profits
Our view: Companies are losing pricing power and margins could decline as a result. We expect earnings to contract in 2023.
The details: US earnings are likely to decline 15% from 2022 levels. With the Fed focused on reducing inflation, the pricing power companies have enjoyed will likely fade quickly in 2023—a tough backdrop in the face of sticky wage inflation. It appears companies will have to fix their bloated cost structures, which could eventually lead to layoffs and rising unemployment hitting domestic demand, and thus profits.
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 almost record-low levels—close to 1%.[3] We would expect defaults to rise toward 5% in 2023, a historically low number in a downturn scenario. The corporate sector’s high interest coverage ratios have been providing significant support.
[3] Source: Loomis Sayles, 31 Oct. 2022.
Global Credit Risk Premium/Risk Appetite
Our view: Risk premiums have risen substantially, with the Bloomberg High Yield Index yielding over 9% and the Bloomberg Investment Grade Credit Index yielding almost 6%.[4]
The details: With the odds higher that the credit cycle moves toward a downturn phase, risk premiums could increase, but we have not seen all-in yields like this for a long time. It is refreshing to see yields climb back to levels many investors may view as “normal.” We finally seem to be exiting the low-yield environment characterized by central banks' zero interest rate policy (ZIRP).
[4] Source: Bloomberg, 10 Nov. 2022.
Global Inflation
Our view: Inflation went up the elevator and seems to be peaking. It will likely decline like a dropped feather.
The details: We expect further tightening in global central bank policy and financial conditions. A flurry of recession indicators are flashing red. This could bring inflation down if unemployment rises. But inflation decelerates slowly, and we expect it to remain above central bank targets of around 2% for some time.
The Dollar
Our view: Fed hawkishness should foster continued US dollar strength.
The details: Significant volatility struck the foreign exchange market and sent the dollar rally into overdrive. Things may consolidate near term, but we expect a strong US dollar to continue near term. We look forward to a weaker dollar because that typically coincides with strong risk appetites and better global growth—maybe a story for 2024 and beyond.
Disclosure
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.
Markets are extremely fluid and change frequently.
Commodity, interest and derivative trading involves substantial risk of loss.
Indices are unmanaged and do not incur fees. It is not possible to invest directly in an index.
Past market experience is no guarantee of future results.
MALR029988
October 2022
Investment Outlook
In our view, the majority of positive developments that propelled markets higher earlier in the current credit cycle are now working in reverse.
Higher interest rates, a stronger US dollar, slowing economic growth and significantly tighter monetary policy define today’s macro landscape. The global economy appears headed for a downturn and we believe the clock is ticking on the US cycle as well.
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