When trying to determine the fate of equities over the next few months (or years) and whether – as some speculated recently – the bull market has already peaked, investors should divert their attention from the stock market and focus on a different asset class: credit.
Why? Because as the sharp swoon in Goldman’s stock this week demonstrated, when it comes to the marginal buyer of stocks, it is all about corporate buybacks, or more importantly, their absence. Recall that last month JPM forecast that thanks to low rates and Trump’s tax reform, in 2018 there will be over $800 billion in corporate buybacks this year, a truly staggering, record number.
But for that to happen, one thing has to be present: a vibrant credit cycle which allows companies to issue hundreds of billions in net IG and junk debt. After all, the bulk of buybacks are funded with new debt issuance (see the latest IBM results), and if the credit cycle cracks – meaning if rates spike enough to cause a buyside panic and halt new issuance – it’s all over for both buybacks, and the bull market in stocks.
To answer the question we present two bank reports, which while similar reach somewhat different conclusions.
The first is from Morgan Stanley, and explains why the bank “thinks a turn in the credit cycle is near.” The argument can be summarized in the three key points (from credit strategist, Adam Richmond):
- First, we believe there has been way too much complacency in the expectation that the Fed pulling back in untested ways after years of substantial stimulus would be “like watching paint dry” as we heard so many times early this year. Very simply, quantitative easing was hugely supportive of credit markets in this cycle, and we have argued that the process in reverse has to cause a few large bumps in the road. At the least, we have made the case that, in this environment, the technicals should weaken and negative catalysts will get magnified. In our view, a key driver is simply that global liquidity conditions are tightening, and markets are coming to the realisation that the process will be rocky. Rising funding stresses, weaker flows, weaker trading liquidity, higher volatility – this is arguably what quantitative tightening feels like and, in our view, these dynamics will continue to pressure credit spreads over the course of the year.
- Second, we argued that these headwinds were occurring with credit valuations very rich – effectively pricing in a very smooth, seamless central bank unwind: Also remember that tight spreads are much easier to justify when volatility is low, and we believe that the vol regime has shifted higher. Put another way, the move in IG spreads from 87bp to 113bp is largely a reset higher in risk premium to account for a higher vol and tighter liquidity environment, but still does not come close to pricing in the medium-term fundamental risks in the asset class, in our opinion.
- Third, markets are very late-cycle, an environment that is often not friendly to credit and where the ‘margin for error’ is naturally lower: We continue to see evidence that argues in favour of a very late-cycle environment. When we think about a turn in the credit cycles, we tend to break it up into two phases. First, in a bull market, leverage rises, credit quality deteriorates and ‘excesses’ build. These factors provide the ‘ingredients’ for a default/downgrade cycle. But they don’t tell you much about the precise timing of a turn. Leverage can remain high for years before it becomes a problem. In the second phase, these excesses come to a head, often triggered by tighter Fed policy, tightening credit conditions and weakening economic growth.
To be sure, Richmond does not want to come out as too alarmist, and notes that he believes that the ingredients for a credit cycle are still in place. However, as to the more important question of timing (and always the tougher question to get right), Morgan Stanley thinks the evidence is mounting that “spreads have hit cycle tights – in other words, that bigger fundamental challenges in credit are 6-12 months away, not 2-3 years down the road.”
Still, Morgan Stanley concludes on a very bearish tone and notes that whereas the bank has often heard the argument that weak growth for much of this cycle has prevented excesses from building – and hence an already long cycle can last even longer – it disagrees and see excesses all over the place, driven in part by years of ultra-low rates.
The bank lays out the details for its “credit cycle end is imminent” call in the table below, and makes the following notable observations:
- Credit markets have grown by 118% in this cycle, and leverage is at unprecedented levels for a non-recessionary environment (remember, leverage tends to peak in or even AFTER a recession). If rated based only on leverage, about 28% of the IG index would have a HY rating.
- Low-quality BBB issuance was 42% of total IG supply in 2017, a record as far back as we have data. The IG index had ~US$700 billion in BBB rated debt in 2008. Today that number sits at ~US$2.5 trillion. Similarly, B rated or below loan issuance is now two-thirds of total loan supply.
- LBOs levered over 6x are now a similar percentage of new LBO loans as in 2007. Covenant quality is weaker across all categories than pre-crisis, while the debt cushion beneath the average loan is much lower.
- Investors have reached for yield in fixed income in this cycle in a massive way. Foreign flows have flooded into the asset class, arguably treating US credit as a rates product, while liquidity needs have risen, with mutual fund/ETF ownership of credit now over 19% versus 11% pre-crisis.
- Excesses are apparent even outside corporate credit, for example, with underwriting quality deteriorating in auto lending in this cycle, while non-mortgage consumer debt is at a high, and CRE prices are ~20% above prior-cycle peaks.
- Around two-thirds of the loan market is no longer captured in our leverage statistics because these companies don’t file public financials, and this does not include all the money that has flowed into direct lending in this cycle.
Finally, here is Morgan Stanley’s checklist of “late credit cycle” indicators, which leads to the bank’s troubling conclusion:
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).
And then, putting it all together, here is how Morgan Stanley sees the all important question of timing, and what happens next:
“We expect idiosyncratic problems to keep popping up, slowly at first, as the Fed continues to withdraw liquidity. Once growth and earnings expectations turn lower, which may characterise 2H18, we expect the process to accelerate, with the market starting to price in rising defaults and rising downgrades, as the ‘cracks’ in credit quickly start to feel bigger and much less idiosyncratic.“
Needless to say, that’s about as gloomy and pessimistic an outlook a bank can have without outright telling its clients and traders to sell everything. Which, for those who watched “Margin Call”, will never happen as no bank wants to go down in history as having started the next financial crisis.
So for readers who find Morgan Stanley’s skepticism nauseating, we present another perspective, this time from the credit strategists at UBS who while generally agree with Morgan Stanley that the credit cycle is (very) late, they disagree that the cycle is about to crack, and is “unlikely to end in 2018.” UBS explains below:
Where are we in the US credit cycle?
The US credit cycle is later-stage, but unlikely to end in 2018. Later-stage credit indicators are present. Corporate leverage is very high, covenant protections are very loose, lower-income consumer balance sheets are weak, and NYSE margin debt is elevated. But the market trades off changes in conditions, not levels. To this point, we do not see an inflection to suggest the credit cycle is turning.
Our latest credit-recession model pegs the probability of a downturn at 5% through Q4’18. Corporate EBITDA growth is running at 5-8% Y/Y, enough to keep leverage and interest coverage from deteriorating. Lending standards and defaults are only tightening and rising, respectively, in select pockets, and the scale of tightening is not enough to engineer broad stress.
Last, but not least, a quick shot to growth from significant fiscal stimulus in 2018 should keep the cycle supported
So who is right? To get the best – if not necessarily right – answer, look not at credit, at least not initially, but stocks, because if the credit pipeline is about to be clogged up, it is the S&P that will be slammed first, long before all other asset classes. To be sure, the recent surge in equity vol over the past month certainly gives Morgan Stanley the upper hand in this debate, at least for now.