Credit Research Outlook 2020

While we certainly don’t want to sound like a broken record, we unfortunately, or fortunately since it means that the credit cycle has not come to an end, find ourselves in the same situation that we’ve been in at the end of the past two calendar years. As economic historians will tell you, recessions are typically caused by either tightening of monetary policy, tightening of fiscal policy, bursting of a credit or debt bubble, bursting of a housing or asset price bubble, and/or a banking crisis. We believe the risk of each of these is low in the near term. However, we believe that the risk of a cyclical downturn driven by an exogenous shock (for example, global trade uncertainty) is moderate. It is unclear if reactive monetary and/or fiscal policy would be able to provide enough of a buffer to prevent a recession and a pronounced downturn in the credit cycle.

As we approach the end of 2019, financial markets (both debt and equity) are striking a relatively optimistic tone, despite evidence that suggests that the credit and business cycles are in the latter stages. In some ways, we can understand this optimism. After all, in our opinion, there has been evidence that we are in the later stages of the cycle for more than two years, so perhaps this sustainability and perseverance is, by itself, a cause for optimism. Further, there has been some tangible positive news on the trade front, with the potential for the postponement or even abandonment of the potential tariff increases for China in December and the potential action on European autos. With regards to economic data releases, there has been some relief that the weakness in the global manufacturing sectors have not yet led to recessionary data in non-manufacturing and consumer sectors in most developed economies. Perhaps the biggest driver of positive financial market performance has been the pronounced U-turn taken by global central banks to a definitive easing monetary policy stance during the year. Indeed, trade tensions and monetary policy are easing simultaneously for the first time in more than two years.

Will these factors be enough to assure the sustainability of the current cycle? Our credit research team has our doubts that central bank policy easing will be enough to sustain the cycle on its own. From a fundamental economic perspective, further monetary policy easing will only improve economic growth trajectories if private credit creation accelerates because of it. While the global flow of private sector credit creation has been stable in 2019 (perhaps because of more accommodative central banks), there is little to suggest that lower rates have boosted demand to borrow in developed markets¹. An increase in the private sector credit creation may ultimately occur, if monetary policy remains exceptionally accommodative. This will also require further improvement in the global economic data, in our opinion. The US and China may sign a Phase 1 trade deal and tariffs may be rolled back somewhat. We don’t think, however, this will not be enough to reverse a recession in manufacturing and capital expenditure business spending. Morgan Stanley has estimated that trade tensions and their impact on corporate confidence and capital expenditure have cost the global economy 90 to 100 basis points (bps) of growth momentum thus far². At the same time, relatively strong employment and wage conditions, high household savings rates and historically low aggregate consumer debt-to-income ratios have supported the service and consumer-oriented sectors of many developed market economies, creating divergent paths for various components of these economies (Figure 1).  

In our view, this divergence cannot continue for much longer without materially increasing the probability of a US and/or global recession and in turn, ending the business and credit cycles. At minimum, a pause in trade tension escalation seems required to end this divergence.

As our team’s investment universe is more concentrated in debt issued by large banks and financial institutions, we always consider the condition of the credit cycle in that context. Heading into 2020, we need to consider the risk that trade tensions via weakened global growth trajectories and aggressive central bank easing will negatively impact banks’ earning capacity. While earnings are a more important consideration for equity analysts and investors, the ability of banks’ to organically accrete capital through earnings is an important factor in fundamental credit assessments.

In general, slower economic growth and lower interest rates are negative for bank earnings, especially if or when lower rates do not spur demand for private credit. Given the persistence of low and negative rates in Europe and Japan, earnings capacity in those sectors are particularly challenged, which weakens the first line of defense against bank balance sheet devaluation in the event of weaker global growth, as strong operating income levels help absorb higher credit losses, preventing banks from generating earnings losses and the erosion of its balance sheet’s book value.

In last year’s Credit Research Outlook, we identified the European banking sector as the most vulnerable in our focus universe to the end of the credit cycle. The same factors we identified last year as rationale for vulnerability persist for 2020. The inefficient and inadequate structure of the European financial and political systems, as well as the prolonged period of ultra-low to negative interest rates for the continent’s banking system. The risk associated with these factors could be mitigated if progress is made in improving the structure of the European Union. For example, near-term prospects of progress towards completing the development of a full banking union with Pan-European deposit insurance are only modestly better than they were a year ago.

Yet another theme from last year’s Global Cash Outlook is despite the risk factors outlined, we reiterate that we broadly view the global banking sector as a source of strength in mitigating macro-economic impacts when the cycle ends due to the significant evolution of banking regulations since the Global Financial Crisis. These regulations, especially as they pertain to systemically important banks, assure that bank capital buffers are materially higher, and funding and liquidity conditions are more stable. Even European banks have materially improved their credit profiles in these capacities. Indeed, when the cycle does end, and the most leveraged areas of the corporate credit markets suffer material degradation, we believe that the strength and soundness of the reformed banking system will prevent systemic impacts and broad contagion. As such, we also believe that credit events are more apt to be idiosyncratic or industry-specific than systemic.

For the last two years, our Credit Research team motto has been: “Don’t worry about the end of the credit cycle: be ready for it.” To us this means continuing to select cash investment counterparties that are best-equipped to maintain their fundamental credit profiles when a downturn inevitably occurs.