"Unique Credit Cycle" Stretching Longer Owing to Lower Risk-Taking

Michael Buchanan

Michael C. Buchanan, Deputy Chief Investment Officer, Western Asset Management (a Legg Mason affiliate)

This is a unique credit cycle. There are unprecedented forces at play that we think are going to create a longer cycle than what we have witnessed historically. This particular cycle is going to be unique, for three main reasons.

1. Regulatory

If regulators were too liberal going into the Financial Crisis, we felt it was likely that pendulum would swing, and we would see very stringent regulation that would favor bond holders. We see a dramatic improvement in the capitalization of both US and European banks, the result of stricter rules governing equity capital markets.

You can see kind of a difference between how the U.S. handled this versus the European banks. The U.S took meaningful charges earlier on, as you see by drop in capital from 2007 to 2008. European banks chose to take a more gradual approach. But both ended up in the same place; very strong capital ratios and dramatic improvement in their balance sheets. Virtually all of these major banks now have record capital ratios. Financials are a very big part of the investment-grade market, so to have a regulator forcing that fundamental improvement gave us quite a bit of comfort in our exposure, not only to financials but into corporates in general. Regulations limiting investment banks’ ability to underwrite leveraged buyouts (LBOs) have reduced the risk of a steep rise in defaults in the near future.

2. Central bank accommodation

It was global, it was unprecedented. Central bank accommodation has helped prolong the favorable credit environment. Central banks have provided historic levels of liquidity. Balance sheets of the BOJ, ECB, Fed and BOC have grown by over USD$10 trillion since 2010. None of these central banks have given any indication they would look to start contracting their balance sheets any time soon. Rather, they remain engaged and focused on maintaining liquidity.

3. Limited excess risk taking by corporate management

For companies, 2007-2008 was an extreme period unlike one that we have witnessed in our lifetimes. Companies saw their competitors, their suppliers, and their customers go out of business by not having control of their balance sheets. It is just going to take longer for CFOs, CEOs and treasurers, to start pursuing those risk-taking behaviors that ultimately lead to a turn in fundamentals.

Corporations generally remain committed to conservative balance sheet management. In the investment grade market an increase in leverage is primarily attributable to two forces. One of these relates to higher quality companies making “like-for-like” acquisitions. These types of acquisitions tend to have fairly predictable and reliable deleveraging characteristics over time. High quality companies with virtually no debt have chosen to take advantage of the low rate environment and add some debt to their balance sheets. These companies remain very high quality and defensive.

In the high yield market, weak commodity prices resulted in a high degree of stress in the energy and the metals & mining industries. These sectors witnessed a very high level of defaults during 2016. But now, with a recovery in commodity pricing, and weaker, vulnerable companies already defaulted, the default rate for the remaining cohort of credits is dropping rapidly. The remaining sectors in high yield have experienced no change in their leverage over the past 5 years and defaults are at historically low levels.

Fed not expected to move to a clearly more hawkish stance

We expected the Fed’s rate hike announced on March 15, but we were more concerned with the Fed’s reasons. What has really changed is financial conditions. They have improved, whether it is what you see in equity pricing, what you see in spread markets in general, what you see with the U.S. dollar. It gives the Fed a little more of a perspective, and we do not think you are going to hear a very different message beyond that.

We do not expect the dots to move much from where they were. We do think that the Fed certainly is aware of some of the pro-business initiatives and policies that are being talked about by the Trump Administration. But the Fed has always been clear that they want to rely on the actual data. So, until they see more clarity, we do not expect them to move to a clearly more hawkish stance. Three hikes this year, in 2017, seems reasonable. That is what the market is generally pricing in.