With the current economic expansion now in its 109 consecutive month, and rapidly approaching the longest expansion in history with yield curve just 25 bps away from inverting, the two questions asked by most investors are i) are we “late cycle”, and ii) when does the next recession begin.
Where should one look for the answer? Since equities are notoriously late in spotting economic inflection points – and usually do so violently, and in the context of a market crash – the best option is credit. And while there are no clear signs of a turn in the credit cycle yet, some long term investors are already planning for it.
One place to watch is the Morgan Stanley Credit Cycle Indiactor which we profiled in April, and which shows that approximately half of the cycle indictors are already flashing red.
This is what Morgan Stanley said three months ago:
In terms of timing, we think that enough signals are flashing yellow and cracks are forming to indicate a credit cycle on its last legs: For example, looking at credit markets more broadly than just corporates, we have seen signs of weakness and tighter credit conditions in places like commercial real estate. Additionally, consumer delinquencies have risen in various places (i.e., autos, credit cards and student loans). And in corporate credit, one sector after the next has exhibited ‘idiosyncratic’ problems (e.g., retail, telecom and healthcare to name a few). All this is consistent with other signals we watch, some which have been discussed above (i.e., a flattening yield curve, falling correlations in markets, rising volatility, a trough in financial conditions, narrowing equity breadth, rising stress in front-end IG and much weaker credit flows).
Morgan Stanley also laid out what its current model spits out in terms of timing inflection points.
Just as important, when the next credit cycle turns, it won’t be contained solely to credit: there are extensive, and just as important, contagion channels which will be triggered with broad impacts on the general economy.
How should investors position portfolios defensively when all the signals flash red? Here are some thoughts on the question du jour, from UBS’ chief credit strategist Matthew Mish.
According to the UBS banker, in prior credit downturns credit contagion and amplification mechanisms played a critical role in calibrating the magnitude of crises. Assuming corporate speculative-grade debt outstanding is $3.5-4tn ($1tn in leveraged loans, $1.3tn in bank loans, $1.3tn in HY bonds, and (conservatively) $0.25-0.5tn in private debt), roughly 50% of which is rated B and below. Further, as discussed here previously and as UBS notes, elevated multiples, leverage, earnings add-backs and lack of covenants could trigger significant credit losses in the next credit cycle.
Finally, the staggering amount of fallen angel debt may also create supply indigestion with $140-300bn of fallen angel debt annually estimated, a number which in Europe alone may be as high as €800bn according to Bank of America.
What happens to all this record amount of debt in the next crisis, and more importantly what to expect when the cycle ends? According to UBS, in the next downturn mark-to-market losses, downgrades and defaults may all interact to tighten lending conditions, reduce credit supply and increase funding costs.
In short, absent another coordinated central bank rescue, credit markets either become paralyzed, or credit risk and liquidity premia re-pricing can spill over into other markets via lender and borrower balance sheet channels.
In corporate credit, the primary lenders are foreign investors (IG), insurance companies (IG), mutual funds (IG, HY) and CLO vehicles (LL); market share has risen materially for foreign investors, mutual funds, ETFs and CLO vehicles this cycle, which historically were major sellers of corporate bonds in prior downturns.
So when the hammer of the next recession hits, mutual funds/ ETFs will sell to meet redemptions, CLO vehicles will sell lower quality credits as CCC downgrades and defaults rise, and insurance companies already running higher concentrations in low triple B debt will also likely be forced to adjust holdings due to capital regulations.
That is an ideal stylized scenario: in a world in which the market is so brittle it may simply shut down on a 5% down day, a material deterioration in transaction liquidity during stress times (esp. in lower rated spec grade & long-dated fallen angel debt) will dovetail with severe information asymmetries, particularly in the leveraged loan and private debt markets – raising credit risk premiums across the board as investors may be forced to sell what they can, not what they desire.
In other words, a liquidation panic in which will sellers hit any bid for their assets.
Conversely, for consumer debt UBS believes the unwind narrative is different, however with several critical overlapping elements:
We have documented the significant easing of lending standards and robust debt growth across FHA, student and auto loans; and we have estimated that among our proprietary categorization of ‘stressed consumers’ holds total debt of about $1.5tn (vs. 1.8tn in ’07, $0.6tn in ’01, (Figure 16).
We have argued this subset of consumers will be ultra-sensitive to shifts in consumer finances, primarily driven by changes in employment, income, access to credit and unexpected expenses. In a downturn job losses and wage deterioration are inevitable. But we have argued this is not a debt crisis story because of the presence of US government guarantees.
That view is still accurate, but requires some nuance; first, the FHA loan origination channel is fragile. Underlying loan and servicing performance deterioration could impair non-bank liquidity and capital, leading to a significant tightening in credit supply if wholesale funding costs rise or banks pull / reset lines of credit (Figure 17). Second, the auto loan origination channel is also less resilient, sans government guarantees and with heavy reliance on non-bank finance lenders and securitization.
As a result, Mish believes that the key threat in a negative shock to labor or credit markets for ‘stressed consumers’ is not a debt crisis, but a consumption risk. While ‘stressed consumers’ only account for $1.5tn or 11% of total household debt (resi, consumer), they account for a much greater share of consumption. As we showed last summer, once again using UBS analysis, much (but not all) of the ‘stressed consumers’ fall into the bottom 40% of consumers by income. And BLS data suggests this cohort holds $1.4tn in debt (11%), but comprises 22% of personal expenditures.
Furthermore, as we showed several years ago, according to economic literature the poor and borrowing-constrained households have a higher marginal propensity to consume, implying changes in consumption react more strongly to negative shocks (i.e., the delta of their consumption is greater than 22%).
And certain spending categories are more dependent on lower income households: the highest categories are tobacco (38%), reading (26%), housing (25%), healthcare (25%) and food (25%) – predominantly necessities, not luxury goods.
The overarching takeaway according to UBS is that in addition to pure asset disposition risks, there are just as important consumption-channel amplification risks in the next downturn stemming from a dual build-up in debt and leverage across firms in specific industries (e.g., staples, healthcare, media) as well as the consumers (lower income) their sales depend on.
There is some good news: UBS “firmly” believes the end of the credit cycle is not nigh. But when the downturn does come, this is how UBS’ credit strategist will trade it:
we believe the more defensive sectors will be those that are higher quality, shorter duration, and in the energy, large bank and utility sectors.
Finally, considering the disproportionate impact to consumption that will ensue when low-income consumer credit is impaired, perhaps the best hedge to the next recession will be shorting the company that has flourished the most during the current, second-longest on record expansion: Amazon.
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Read more on this topic at: The Only Question That Matters: “Is The Credit Cycle About To Crack” – Here Is The Answer
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