The overlooked credit risk cycle is the most profound driver of macro and financial market psychology, ignoring signals in the credit markets puts any investor at a disadvantage.
Recent moves in the corporate debt market are suggesting a bullish market for the short-term; this does not impact our long-term and intermediate terms around the progression to a recession.
The interest rate cycle is also confirming strength in access to capital.
First off, because this is my first post about the credit risk cycle (aka credit cycle), I think I need to offer some insight into the knowledge that the debt market provides to the financial markets. We consider credit cycles among the most significant impacts on both the equity market and the fixed income market. And because we are money managers and not economists, we spend plenty of resources to understanding and measuring the credit cycle.
The credit cycle highlights the risks associated with loans and bonds issued in the private sector and the direct impact on the bottom line of companies. It comes down to the availability of capital and the amount of debt financing projects. The availability of debt to finance long-term projects (buildings, machinery, vehicles, and goodwill) is the lifeblood of a company’s ability to grow. This access to capital is mainly available within the debt markets in the form of bonds and commercial paper. The credit cycle measures both the access to capital via debt and the market perception of default risk.
I attribute fluctuations to financial market psychology and the profound influence of psychology on the availability of capital. Whereas economies fluctuate a little and profits a fair bit, but the credit window opens wide and then slams shut dramatically. I believe this volatility in the availability of capital is the most significant driver of the psychological impacts towards the future expectations of a company’s growth. Thus, it deserves a great deal of attention.
Credit as a Cycle Indicator
Market perception of credit risk rises with the fear of default, which is typically highest during a recession. Furthermore, credit tends to be easy to obtain when the economy is growing. The faster the economy is accelerating, the more financing is available, and the lower credit standards are accepted, causing lousy debt issued at the best of times; this relationship makes credit availability cyclical.
Credit spreads are not just useful in the short-term model but act as a fantastic behavioral tool during recessions. A pattern in credit spreads plays out over expansion as borrowers start to accumulating debt in the early days of recovery when lenders are most cautious. By the end of the expansion, the lending train is going full steam, with lots of over-imbibers of credit and lenders more than willing to indulge them.
Take, for example, the spread between Merrill Lynch High Yield II and the 10-Year Treasury (Figure 1). Heading into the tech bubble in 2001, deteriorating (rising) spreads were visible, and extending past the recession until the market finally turned to the positive in 2003. The financial crisis was a little bit different, with the spreads acting normal then suddenly widening rapidly. In mid-2014, the spread was back in contentment territory, suggesting that liquidity was abundant in credit markets.
What are Credit Spreads Telling us Now?
Measuring credit risk relationships in the credit markets is relatively straight forward. There are two methods for measuring risk; the first is a credit spread or the risk added to a corporate bond relative to an assumed risk-free Treasury bond with similar maturities. The second is called a quality spread, which is the difference between higher credit rated bonds and poor credit weighted bonds. Both are useful in gauging access to capital and risk of default.
The option-adjusted spread is an example of a credit spread and adjusts the spread for both options attached to a loan (callable or not) and the interest rate risk.
In 2018 there was a noticeable deteriorating credit condition as the Federal Reserve continued to raise rate dangerously close to other Treasury rates flattening the yield curve. In early 2019 the Fed’s effective fund rate finally exceeded above different rates such as the 2-Year Treasury. This, combined with global slowdown and a trade war, turned the Fed from being restrictive to accommodative. The reaction in the credit market was compression in credit spreads pushing equity markets higher. With some minor responses to a slowing economy in May and July the CCC credit market remained at an elevated risk, but because the BBB spread was lowering recesion risk slowly lowered.
Just recently, credit conditions are making another pushdown, suggesting available access to capital and low risk in the equity markets. The compression in the corporate credit curve in the last month (Figure 2-5) is visible in the credit curve. This drastic of a change in credit spreads is suggesting a risk-on market, for the non-traders risk on means that you add uncertainty to the portfolio in expectation of capital appreciation in risky assets.
I believe that psychology in credit markets is a crucial component for measuring the risk of the overall corporate structure of an economy. Even if growth continues to decline as long as there are enough liquidity and low fear of default, credit spreads will compress, and the market will rise. Without credit deterioration, an immediate risk of a market crash is low.
A warning, the credit cycle can reverse quickly without notice but often provides early warning to events like the financial crisis and the tech bubble. One day the credit availability will suggest everything is fine, but other feedback loops feed data into the market; credit spreads will react without warning, making credit spreads an indicator that we monitor daily.
Omega\(^2\) Financial Stress Index
I monitor the credit cycle by paying attention to the Treasury markets, credit yield curve, the option-adjusted spreads, and the many quality spreads. But I also needed a way to filter through all the indicators into one definitive signal that I can analyze for shifting risk premia in the markets. Testing for changing risk environments was the logic behind creating the Omega Squared Financial Stress Index (O2FSI).
The index is an aggregate of our equity anchor in valuation, several OAS, OAS quality spreads and Treasury rates that I believe the most logical to use to gauge the psychology surrounding non-financial private sector; combined into one index that tells us when we should be adding cyclical risk to the portfolio or preparing for volatility and market shocks. The index is not meant to be an end-all indicator but meant to illustrate the importance of the credit cycle in the main asset classes. Investors usually direct their focus.
When increasing, O2FSI is suggesting two things, one, access to capital is slowing, and or credit risk is rising. Trending down has the opposite meaning; access too capital is increasing, and or the risk of default is lowering. While differentiating between access to debt funding or credit risk is essential for several other analyses. However, it is not crucial for assessing risk because both have the same outcome.
Testing O\(^2\)FSI Index
To test the O\(^2\)FSI index, we assumed that if the index were above the moving average or below on the first of the month, it would remain above or below for the month. Following that assumption, we measured the monthly return annualized then averaged this return if the index was above or below its moving average. Furthermore, we did not want to curve fit the results, so we used a 252 day (1-year) moving average for the analysis without changing it. The results (Figure 8-9) shows that there is a clear, logical shift in risk premia with the change from risk-on to risk-off depending on the trend.
Wrapping it up
Based on a simple test of the O\(^2\)FSI index, there is a clear correlation between asset class performance and the expectation of credit risk. This index confirms a risk-on risk-off framework surrounding financial stress in the markets. The current shift below the 252 day moving average is suggesting asset growth in the short-run. While our viewpoint is still towards the later end of the business cycle and increased risk ahead, without a shift in the capital structure of the credit risk cycle, there does not seem to suggest a large deviation to the downside in the domestic equity markets.
The more time I spend researching, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce significant variations in the availability of credit, with a great impact on asset prices and their feedback loop back on the economy itself.