Right now, there are many questions about where we are in the credit cycle and what we can expect in the year ahead. This is understandable: For the past eight years we have been experiencing unprecedented monetary easing worldwide. In the developed world, rates are hovering around zero and in many cases have dipped down below zero. At some point, something has to give – doesn’t it?
Well, yes and no. Credit cycles have historically taken a downturn for one of two reasons: either more companies begin to default on debt payments because they have borrowed too much and can no longer support their debt burden, or a liquidity crisis results when companies run out of money. Thankfully, this is not the case right now. There certainly were market jitters last year as oil prices dropped precipitously and bonds issued by energy companies took a beating. But while investors feared that this calamity would spread to the broader fixed-income markets, a spillover effect didn’t materialise. In fact, both investment-grade and high-yield bonds continued to perform well outside of the energy and commodities sectors, and now even energy and commodities bonds have begun to stabilise along with oil and commodity prices. This has helped calm the overall US credit market.
After widening to 220 basis points (bps) earlier in the year, credit spreads have tightened substantially to 128 bps as a result of global demand for yield. Investors from Europe and Japan have been especially eager to invest in investment-grade bonds. Issuance volume has soared in response to this increase in investor interest. Merger and acquisition (M&A) activity has also had a positive effect. Issuance for 2015 was 20% higher than it was for 2014, and this year issuance will see a percentage increase somewhere in the single digits relative to the amount last year.
It pays to be cautious as we look ahead.
Still, it pays to be cautious as we look ahead. We are closely monitoring three unknowns as 2017 approaches. First, the regulatory environment is a key driver of issuance in the financial sector, particularly for banks, and it is constantly changing. Second, it isn’t yet known what the level of M&A financing will be for the year ahead, which affects what issuance levels will be. And finally, the elephant in the room continues to be the US Federal Reserve (Fed) and the path it will choose for future interest-rate hikes. But for now, the Fed continues to be supportive of easy monetary policy, and credit remains abundant. Even distressed energy companies are able to come to the market for financing and find investors willing to lend them money.
However, fundamental growth is not expected to be robust in the US. This stems from much deeper structural forces, such as demographics and productivity. The aging population and a lack of major technological break-throughs have caused both population growth and productivity to decline. However, Trump’s electoral victory and the promised fiscal stimulus under his administration, if well executed, may lead to a cyclical rebound in growth, which bodes well for credit but may result in higher inflation. The recent sharp rise in Treasury yields and a concurrent tightening in credit spreads have reflected this bond market anxiety.
There are challenges outside of the US as well. China has continued to devalue the yuan, exporting deflationary pressure to the rest of the world. And the UK government continues to debate what its exit plan from the European Union (EU) will look like. Brexit has left global investors with many unanswered questions about what the impact will be on the UK and Eurozone economies, as well as on the broader economy. And geopolitical risk looms large as well, with Russia’s involvement in the ongoing Syrian conflict, as well as the rise of populism in much of the developed world.
From a monetary perspective, the path forward is also difficult to predict. Monetary policy is losing much of its initial punch as it becomes more prolonged. For central bankers, the choices are quite limited at this point, with many deciding to “double down” on the accommodative policies already in place. Negative interest rates are no longer rare for government bonds in developed markets, and there are concerns that, if these conditions persist, pensions will be dramatically underfunded as a result.
But enough doom and gloom. As long as the flight to safety exists, there will be consistent demand for US fixed income. Earnings and revenues haven’t fallen off a cliff – in fact, they’ve become more stable. And the lower for longer environment has perpetuated investors’ search for yield, making the small but positive yields in the US even more sought after. So, in the near term, we are in a good place within the credit cycle, whether or not we’re saved by zero.
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