Last November we outlined our rationale for taking a more cautious stance on credit markets, centered on the premise that, despite policy rates being at zero, we were already experiencing a meaningful tightening in financial conditions due to the strong appreciation of the U.S. dollar and rising corporate yields. In addition, we emphasized how bank loan officer surveys from the Federal Reserve pointed to the first tightening in lending standards since 2011, validating the cautious message being sent by credit spreads.

The Q1-2016 survey was released this week, and it revealed that additional tightening in corporate credit conditions occurred over the past quarter. For commercial and industrial (C&I) loans, a larger majority of respondents indicated a tightening in lending standards (i.e., from a net 7.4% to 8.2% of respondents). This is worrisome. As illustrated in the chart below, it seems loan officers have begun reacting to deteriorating corporate fundamentals, exemplified by the substantial increase in leverage. The historical correlation between the debt cycle and lending standards suggests this tightening process may run further, especially considering this is occurring at a time when the U.S. economy is decelerating, and the Federal Reserve has officially started raising interest rates.

Historical Correlation of the Debt Cycle and Lending Standards - OppenheimerFunds

In other words, we believe the corporate sector is now facing several headwinds, which are increasingly difficult to navigate through. A slowing economy does not bode well for future revenue growth which, coupled with a tightening in financial conditions, complicates the sustainability of accumulated leverage.

As a result of economic and financial developments over the past two months, we reiterate our defensive asset allocation stance, with a preference for higher credit quality and shorter credit duration. Finally, we favor overweighting government bonds while carrying a modest equity underweight.

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