A New Credit Cycle For The U.S. Economy And What It Means For Investors

Credit cycles play a key role in the pricing of financial assets. Throughout history, periodic jumps in default rates – from the railroad crash in the late 1870s, the bank panic of the 1890s and the Great Depression, to the dot-com crash and global financial crisis – have placed downward pressure on asset prices.

The reason for this clustering of defaults is related to the nature of the credit cycle. When the return on capital increases faster than the cost of capital, the net result is increased credit creation in pursuit of higher profits. This process leads some firms to overextend themselves, resulting in their inability to pay back their debts due to a shift in the macroeconomic environment. This is why the default correlation jumps during stressed periods.

Equity valuations fall during periods of higher default correlation, hence avoiding equities during these periods remains central to successful asset allocation decisions. However, once the default correlation returns to normal conditions, the firms that have survived the shock have the opportunity to ride the next cycle potentially reaching higher valuation levels. Hence determining the starting and endpoints of credit cycles is critical for investors.

One approach in determining whether a new credit cycle has begun is to look at the correlation of equity returns which tend to jump in times of stress. As is shown in exhibit 1, when the asset correlation jumps above 0.3, equity returns tend to fall. While there are specific market reasons for equity correlations to jump, the end of a credit cycle is also marked by a jump in defaults which occurred during the dot com crash and following the default of Lehman. The global COVID-19 pandemic has also resulted in a jump in defaults.

Exhibit 1: Asset correlation and equity performance – U.S.

(Click on image to enlarge)

For equity valuations to rise in a new credit cycle, the outlook for profit growth needs to be positive combined with an increase in consumer and corporate leverage. Although the ex-post Wicksellian Differential fell in 2020 from 5.52% to 4.05% – derived from the weighted average return on capital minus the BBB cost of funding – markets were up overall. This can be largely explained by the ex-ante data demonstrating the rising profitability of the technology sector, which is heavily weighted in equity indices.

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