The world economy continues its broad-based and synchronised acceleration in economic activity. All major developed markets have moved back into an “expansion” phase of the business cycle, while emerging markets remain on a gradual “recovery” path that began in early 2016 (see Exhibit 1). This macro backdrop has justified a moderately long risk posture in our portfolios during the past few months, and we believe it will continue to support risky assets in the near-term.
Despite this positive economic momentum, we see warning signs in the credit cycle. Specifically, growing corporate leverage and the resulting tighter lending standards could increase credit market vulnerability. As a result, we have reduced our exposure to certain areas of the credit markets, particularly high yield bonds. Below, we explore the potential issues facing credit markets and discuss our rationale for the portfolio changes, as well as our broader portfolio positioning going forward.
Rising Vulnerability in Credit Markets
Despite the good economic momentum, the current business cycle is very extended, a fact that is reflected in the expensive valuations of several asset classes as well as the build-up of leverage in the corporate sector. Corporate leverage typically follows a cyclical pattern that precedes changes in credit conditions by several quarters and is followed by a re-pricing of credit spreads. As illustrated in Exhibit 2, today the non-financial corporate credit cycle has reached cyclical highs, surpassing the 2008 peak and approaching the peaks of 1989 and 2000. All three of these episodes coincided with recessions.
Leverage itself is not the catalyst for credit market turmoil, but it is an indicator of deteriorating fundamentals and may signify a rising vulnerability to external shocks, such as a slowdown in economic growth and/or a tightening in credit conditions. The debt cycle also strongly influences long-term lending-standard cycles: As more debt accumulates in the system, credit standards become more stringent, creating headwinds to economic growth and increasing debt roll-over risk.
Lending standards for commercial and industrial (“C&I”) loans have stabilized, but are still recording the sixth consecutive quarter of net tightening despite the recent outperformance of credit markets. In addition, bank lending surveys for commercial real estate and consumer loans show tighter lending standards reminiscent of pre-recessionary episodes (see Exhibit 3 and Exhibit 4).
In our opinion, it will be important to monitor these lending surveys over the next few months, as additional rate increases by the U.S. Federal Reserve (Fed) will likely contribute to further credit tightening. The potential for regulatory relief in the United States, however, could offset rising interest rates and boost the availability of credit in the coming quarters.
During the past few weeks, we have begun to adjust our portfolios to better reflect the growing risks in the credit cycle. Specifically, we have substantially reduced our high yield corporate bond exposures in favor of loans, where we see comparable spreads for less interest rate risk.
We have also made some moderate adjustments to reflect additional concerns arising from a tightening Fed, softening in oil prices, and uncertainty around fiscal policy and European elections. Coupled with the rising risks in the credit cycle, these factors could be headwinds to global growth and lead to increased volatility down the road. Therefore, additional portfolio adjustments are as follows:
- We slightly reduced our exposure to equities to realize some gains from their impressive post-election run, while also reducing overall risk.
- Outside of equities, we are still slightly underweight duration and maintain long exposure to the U.S. dollar.
In addition, we continue to see attractive income and total return opportunities in emerging markets local debt, given attractive real yields, stable inflation and cheap currency valuations in most high yielding markets.
As always, we continue to closely monitor the developments in the credit cycle as well as the political and policy landscapes to assess risks to the macro outlook and financial markets. While fundamental risks are increasing, we don’t yet see a clear catalyst for increased volatility and broad-based underperformance in risky assets in the near term.1 We look forward to keeping you updated as our positioning evolves.
1 Barring a surprise “populist” outcome out of the French election in April-May.↩