a storm is blowing
The slow, but steady deterioration of the credit cycle remains one of the biggest headwinds facing both investors and the economy over the next 12 to 18 months. Certainly, as a result of a resilient economy, well-capitalized consumer and corporate balance sheets, as well as low near-term risk (so far), both households and the corporate world have been able to hold up relatively well compared to several decades past. Are. -High interest rates. But, as the credit cycle continues (albeit slower than expected), cracks are slowly beginning to form.
At the center of credit creation and thus the credit cycle are the lending standards themselves, and as we can see below, the percentage of banks tightening lending standards across the board has reached cyclical highs.
Not surprisingly, tight credit conditions are gradually creeping into the economy. Lending conditions for small businesses are at their worst in a decade, according to the NFIB Small Business Survey, while interest costs are near decade highs. Credit requirements are also increasing (though from a secularly low level).
Meanwhile, household credit conditions appear to be tightening. The percentage of respondents who find it more difficult to get financing than a year ago is at its highest point in more than a decade, according to the New York Fed’s household survey. The probability of households not being able to make interest payments in the next three months is also increasing, although still at a moderate level.
Given the backdrop of rising credit card interest rates over the past 18 months, the slow but steady deterioration of household credit conditions should not be surprising.
Such dynamics follow a period where we have seen a significant increase in consumer debt, primarily in the form of credit card debt, as nominal wage growth has lagged inflation throughout most of 2021 and 2022.
Thus, the default rate for credit card loans is increasing, especially those offered by smaller regional banks.
Meanwhile, consumers are also feeling the pinch with regard to car repayments. As recently noted by Bloomberg, “Americans are falling behind on their auto loans at the highest rates in nearly three decades. The percentage of subprime auto borrowers who are at least 60 days past due on their loans rose to 6.11% in September, the highest in data dating back to 1994.
Of course, the sector of the economy that is most sensitive to higher interest rates and deteriorating credit conditions is commercial real estate. Crime rates are increasing for almost all types of commercial properties, with offices being hit particularly hard due to the combination of higher rates and the habit of working from home. The fact that most commercial real estate loans are issued by regional banks makes matters even worse. The balance sheets and lending capacity of such banks have been hit much harder than their larger counterparts during this long-term cycle, culminating in the Silicon Valley Bank crisis earlier this year, which prompted the Fed to close its term funding facility. Bank balance sheets were forced to backstop through. (The usage of which has reached a new high this month).
So then, are we in a credit cycle?
As we have seen, credit conditions are clearly worsening across the board, but at this stage, they are far from recession levels.
Perhaps the best leading indicator of where the credit cycle is headed is the yield curve. The inverted yield curve reduces bank interest margins, reducing the incentive to lend and thus tightening lending standards.
Stringent lending standards lead to a decline in credit growth. This is true for both commercial and industrial loans…
Plus, more consumer loans.
Therefore, as the lack of credit increases, the delinquency rate increases, especially this happens when the economic condition worsens and the need for credit increases. The exception to this was the COVID-19 induced recession, although this was likely due to the unprecedented monetary and fiscal response that mitigated almost all of the negative impacts associated with the worsening credit cycle (much of which is still being felt today).
Regrettably, we should expect to see some sort of increase in delinquency rates as well as default rates in the coming quarters.
And of course, perhaps most importantly for investors, the negative effects of such dynamics should eventually show up in the form of rising credit spreads. After all, credit spreads are a direct relationship between the credit cycle and the financial markets, namely equities and volatility. According to Bloomberg’s Simon White, “The corporate balance sheet explains the relationship between credit and volatility. As credit expands, credit growth increases, financing business investment and consumer spending. But when loans come due, they often need to be refinanced. It emphasizes both sides of the corporate balance sheet. Since equity is just a thin layer of capital on the balance sheet, it must tolerate adjustments, which means equity volatility increases. The lead time in the relationship is explained by the average maturity of the loan.
One of the primary reasons why deteriorating credit conditions and higher yields have not yet fully filtered into the real and financial economies is due to the significant levels of short-term financing that has been raised by corporations during times of record low interest rates (i.e. it was done. , 2020-2022). Thus, the corporate debt burden is, for the most part, easily met by cash flows.
However, as these low-interest rate loans mature and businesses gradually begin to refinance these loans with today’s higher interest rates, we should expect the negative effects of the credit cycle to emerge. As we can see below, nearly a fifth of US corporate debt is set to mature in the coming 36 months, at a time when yields are at their highest in a decade.
As such, we should expect to see a rise in credit spreads at some point in the next six to 12 months. My credit spread model (which uses inputs such as the ISM Manufacturing PMI, bank tightening standards as well as various consumer and small business surveys) suggests spreads should be significantly higher than current levels. While this is probably true to some extent, the model is undoubtedly biased upward as the survey data is heavily influenced by inflation rather than underlying fundamentals.
Despite this, it is clear that spreads will increase at some point, with interest rates indicating the same.
As well as global monetary policy conditions.
However, it is also fair to say that markets are pricing higher yield spreads for the relative completeness of the business cycle.
Consequences of credit cycle slowdown
Deteriorating credit conditions and rising credit spreads have a significant impact on investors. The relationship between credit spreads and equity volatility is perhaps most important with equities. As we can see below, rising credit spreads are generally related to lower returns in the equity market over time.
And not surprisingly, higher credit spreads equal higher volatility.
One way this is revealed is through corporate earnings. The sustained narrowing of credit spreads that we have seen over the past year has been very supportive of corporate profits, and is likely to continue to be so until spreads eventually widen.
Of course, the worst affected sector in such times is usually banks. Tighter lending standards typically result in banking sector performance worse than the broader market with a lag of about 12 months.
Other sectors that are particularly sensitive to the credit cycle are industrials and real estate, which are both cyclical and capital intensive.
And finally, tightening credit conditions almost always increases unemployment. Unemployment is typically the last shoe to fall in both the business cycle and the credit cycle, as laying off workers during bad times is usually the last resort for employers.
Don’t be afraid, this won’t be a GFC-style credit crisis
Although a downturn in the credit cycle is clearly an adverse period for the economy, we should not expect this recession to be anything different from normal. Don’t expect any GFC-type credit crisis.
As things stand, both households and corporations are as well placed to deal with higher interest costs and tighter credit conditions as they have been at any other point in recent decades.
In fact, as we can see below, debt serviceability for mortgages remains at secular low levels, similar to household debt overall. And while we have seen a significant increase in consumer debt service payments/total consumer debt as a percentage of disposable income (as I noted above, and the increase of which will put the greatest stress on households during this credit cycle downturn), we Still only close to average level.
Meanwhile, household net worth and checkable deposits remain well above their respective long-term trends, especially the latter. Thanks to the tremendous bull market over the past few years, households are in such a strong position that they should be able to ensure that any credit cycle downturn does not develop into a full-blown credit crisis.