The expansion phase of the current global credit cycle has been going for 10 years. Many say it's ending. Yes, we’re seeing a worrisome mix of signals that warrants caution. But we don't see any near-term catalysts about to trigger the end of the so-called party. All together, we believe resilient global growth, low rates and stable credit fundamentals suggest credit market performance could improve beyond current market expectations.
Why since the global financial crisis have we continued thinking this credit cycle would likely go on longer than previous cycles? First, the crisis disproportionately impacted developed markets. It seriously dented global wealth and damaged market psychology among individuals, corporations and governments. While we expected areas of the global economy to rebound sharply, like emerging markets (EM), we felt it would take much longer for the developed world to recover. Second, central banks initiated extraordinary measures. During the worst of the crisis, major central banks’ "whatever it takes" posture signaled that they understood the urgency of preserving the integrity of the financial system and repairing market sentiment. Third and last, financial regulators made beneficial changes. They advocated globally for changes that would cap leverage, repair balance sheets and improve liquidity. These changes would add ballast to the expansion and work as a strong tailwind for risk assets.
That said, we do see some signs of late-stage cycle behavior. Weaker covenant packages in underlying securities that expose investors to increased risk, questionable use of lines of credit (revolvers), a growing preoccupation with shareholder returns, and increasing debt-financed M&A activity and leverage creep, which are closely tied to the rapid growth of the BBB rated segment of the credit market. There is also risk that an unforeseen catalyst could trigger a wave of downgrades, but we see no reason for panic.
Given the level of uncertainty in today's market, investors are right to question what type of credit exposure is appropriate. The answer depends on where you think we are in the global credit cycle, assessments of "fair value" for each credit sector and your portfolio risk tolerance. Conventional wisdom says in an environment like ours, a broad market portfolio should have a minimal amount of exposure to higher beta sectors. We believe this assessment misses the mark due to unique top-down and bottom-up dynamics.
Here's our view:
- Investors should consider a healthy allocation to both US and European IG and HY corporate credit. Spreads across these markets have widened lately, but the world of "yield starvation" is back in play.
- The subsectors offering attractive relative value and showing lower sensitivity to tariffs are financials, energy and basic industries. Our emphasis is also on higher quality issuers such as "rising stars."
- A tactical allocation to EM (with an eye on risk across countries) makes sense as USD-denominated sovereign and corporate issuers continue to recover from commodity price collapse and slowdown in Chinese economic activity.
- Structured credit—mortgage and consumer credit—should be considered given our belief that the sector is between the early and middle phase of the credit cycle.
- Keeping in mind that markets may become more volatile in coming months, we favor an allocation to bank loans.
- We favor an allocation to CLOs with an emphasis on highest quality (AAA rated) tranches given their history of resilience during periods of severe market dislocation and compelling carry profile relative to other credit markets.
- Given prevailing market concerns over trade tensions and Brexit, we think it's wise to hold an allocation to USTs.
There have been three credit cycle downturns in the past 30 years, and each was associated with either a sharp tightening in global financial conditions or a protracted economic downturn when corporate default rates rose sharply. We don't see any near-term catalysts that could trigger such scenarios. Barring a full-blown trade war or tail-risk event, we are optimistic that resilient global growth, low inflation, central bank activism and stable credit fundamentals will likely continue to extend the life of this global credit cycle.
For a more complete explanation of the Firm's views, please see our recent paper: A Global Credit Cycle Built for Endurance, where you can also read the Relative Value by Sector analysis as published on our Third Quarter Global Outlook. The authors of this paper, Rob Abad and Michael Buchanan, will also be featured in an upcoming webcast.