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The quarterly outlook for credits: we are on borrowed time

04-04-2016 | Outlook | Sander Bus, Victor Verberk

How much further can the US business cycle be extended? After seven years of economic expansion, profitability and leverage, data suggest that the end of this cycle is nearing. The question is whether we are on the eve of a recession or if the cycle can be stretched for a few more years.

  • The US economy is in its seventh year of expansion, more than the duration of an average cycle
  • Policy makers try to stretch the cycle at the expense of bubbles and imbalances
  • Low productivity growth and adverse demographics result in very low trend growth and low interest rates

In addition to economic worries, we see an increase in political risk, not only in emerging markets, but certainly also in developed markets. Brexit, Donald Trump, the rise of nationalist parties in Europe are all a reflection of the same thing: an angry population. As the middle class feels insecure due to high unemployment, the absence of wage growth, immigration and threat of terror, it is susceptible to populist politicians.

“The future isn’t as bright as it used to be”

The ECB, The PBOC, the BOJ and even the Fed have all become more dovish in the last quarter. Disappointing inflation numbers and financial market turmoil are apparently enough to trigger a strong response. Central banks seem obsessed to keep the economy growing. This is a risky obsession as it causes moral hazard. In the first place it takes away the pressure on governments to implement structural changes. Secondly, although overall capital spending levels are low, it causes overinvestment and overleverage in parts of the private sector. Debt funded excess investment in several Chinese industries but also in the US energy sector is a direct result of overly loose monetary policy. Similar to the run-up to the Global Financial Crisis in 2008 this leads to imbalances in the economy. The recession is delayed but ultimately the damage will be bigger. 

We have come to a point were confidence of market participants in central banks is being hampered, which is reducing the effectiveness of monetary policy itself. The drug is losing its effect and markets respond to fundamental deterioration regardless of monetary stimulus.

The US financial market is still by far the most important market in the world. All other markets are in fact a derivative of the US. It is therefore very relevant to have a good assessment of the US business cycle. The business cycle in the US is in the mature stage. Profitability is under pressure and in order to hide that, companies are falling back to all kinds of financial engineering. We see increasing corporate leverage in the US. Debt is being raised to fund Mergers & Acquisitions and share buy-backs. These are typical characteristics of the final stage of the economic expansion.

‘Angry voters are attracted to populist politicians, posing a threat to stability’

A US recession sometime in the next three years seems unavoidable although we can be sure that monetary authorities will do anything to try to delay it as long as possible. As an investor it is important to closely monitor how much recession risk is being discounted for in credit spreads. Early February, US credit spreads had risen to levels at which a recession was fully priced in; sentiment was extremely negative and recession was the consensus expectation. We saw that as a perfect moment to increase risk in portfolios. In the last six weeks we have seen a strong reversal and spreads have tightened significantly. We believe that this was a bear market rally and that the current strong markets provide a good opportunity to clean up portfolios and reduce risk again.

We can see several exogenous risks that could disturb financial markets later this year. Brexit in Europe, elections in the US and the permanent threat of terrorism are all events that could lead to a risk-off stance in markets. With credit markets that are still fairly illiquid this can lead to violent price action, similar to what we have seen in the first quarter of this year. Central banks will also continue to be a dominant force and are prepared to intervene when markets drop too fast. We advocate a contrarian investment style. Sell when markets are positive and add risk when sentiment is at the bottom.

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