Chancellor: U.S. credit cycle close to overheating

A Specialist trader watches his chart while working on the floor of the New York Stock Exchange
A Specialist trader watches his chart while working on the floor of the New York Stock Exchange July 8, 2014. REUTERS/Brendan McDermid/File Photo

LONDON, July 30 (Reuters Breakingviews) - There is plenty of evidence that the American stock market has entered a highly speculative phase. Just look at the rising numbers of day traders, the wild ride of cryptocurrencies or the new issuance boom by special purpose acquisition companies and all manner of loss-making companies. By most established investment metrics, the S&P 500 Index is close to an all-time peak. Yet valuation measures don’t predict how long irrational exuberance might last. The credit cycle, however, provides more useful information about market timing. In the United States, credit indicators are flashing somewhere between amber and red.

The notion of the credit cycle goes back at least to the mid-19th century. Victorian banker Lord Overstone described its latter stages as consisting of “excitement, – over-trading, – convulsion, – pressure, – stagnation, [and] – distress.” Given the financial nature of the modern economy, this appears even more relevant today. The Bank for International Settlements has developed a model which it claims helps to predict financial crises and economic downturns. From an investment perspective, peaks in the credit cycle are normally followed by severe bear markets.

The BIS model measures the extent to which private-sector credit and home prices have departed from trend. By this yardstick, the U.S. financial cycle looks to have entered dangerous territory. In May the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index hit a record high, up 16.6% over the year. The last time house prices rose this rapidly was in the late stages of the real estate bubble that burst in 2008. Nonfinancial credit in the United States has also been expanding at a blistering pace. Last year, household and corporate debt climbed by 13.7 percentage points relative to GDP, the BIS says.

Lending standards become progressively looser over the course of a booming credit cycle. In 2019, around one-quarter of corporate bonds issued in the developed world failed to earn an investment-grade rating, according to the Organisation for Economic Co-operation and Development. Since then, credit quality has continued to deteriorate. In the first quarter, a record amount of junk debt was sold in the United States. High-yield bonds have accounted for 27% of total American bond issuance this year – the highest level in a decade, according to S&P’s Leveraged Commentary & Data. Spreads on junk bonds have also tightened, falling to a 10-year low in early July.

It’s not just fixed-income investors that have relaxed their guard. The Federal Reserve’s survey of senior loan officers reveals that banks have pivoted from extreme caution last year to relative abandon today.

Inflation surprises generally occur towards the end of the cycle when the economy is running out of slack. U.S. inflation numbers are noisy and heavily influenced by transitory measures, such as the recent surge in secondhand car prices. The BIS observes that inflation hasn’t been the main driver of the business cycle since the Fed under the late Paul Volcker tamed inflation nearly 40 years ago. Nevertheless, the fact that American consumer prices have been rising at a faster pace than at any time since the 2008 financial crisis is another worrying signal.

Not all financial indicators are flashing red, however. During credit booms, households and corporations tend to spend more than they earn. The British economist Wynne Godley was able to accurately predict economic downturns by looking at the extent to which households and businesses were running financial deficits. At such moments, the risk of a credit crunch, accompanied by severe economic disruption, becomes elevated. Prior to the 2008 subprime crisis, the private-sector financial balance was negative in several countries, including the United States. Today, by contrast, American households and corporations are flush with cash – thanks in large measure to Washington’s enormous fiscal deficits.

The spread between short- and long-term rates is another common input into credit cycle models. Past U.S. recessions have often been preceded by an inversion of the yield curve when monetary tightening causes short-term interest rates to rise above the yield on 10-year bonds. In early 2006, for instance, the U.S. yield curve inverted just as problems with subprime securities were emerging. The yield curve flattened again in 2018 after the Fed continued raising short-term rates. The subsequent stock market slump induced Chair Jay Powell to rapidly change course.

Although long-term U.S. interest rates have fallen in recent months, the Fed funds rate remains pegged at zero. As a result, the spread between short and long rates remains in line with its average level over the past decade. Thanks to rock-bottom interest rates, another credit cycle indicator, known as the debt-service ratio, which measures interest payments and debt amortisation relative to income, remains below average in the United States.

What should investors take away from these conflicting signals? First, it would be rash to assume that we are in the final stage of the market mania. It’s possible that credit conditions will continue heating up for some time to come. Secondly, the financial system appears vulnerable to even a slight rise in interest rates. Despite today’s low interest rates, the cost of servicing U.S. corporate debt has reached its highest level in 20 years. American companies are more leveraged than at the time of the last financial crisis, and the quality of their outstanding debt is much lower.

Professional investors fret about leaving the party too early, but they must also be careful not to overstay their welcome. Work by the National Bureau of Economic Research suggests corporate bondholders face abnormally poor returns after periods when credit quality has deteriorated. The worst stock market returns have occurred at times, such as 1929 and 2008, when both market valuations were elevated and the credit cycle had overheated. Those conditions obtain in the United States today. Investors may be in for a rough ride when things finally turn. It’s not all doom and gloom, however. Emerging markets are currently trading at lower valuations and their financial cycle is not unduly elevated. Their party probably has longer to run.

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Editing by Rob Cox and Oliver Taslic

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