Mike Crowell, Director of Quantitative Research Risk Analysis, and Megan Wan, Quantitative Analyst, for Loomis, Sayles & Company, joined Keith Black, Managing Director of RIA Channel, to discuss economic conditions and the credit cycle.
The macro team at Loomis, Sayles & Company employs a scenario-based approach to macroeconomic analysis. The current economy still has many influences from the time of the COVID pandemic, which impacted global supply and demand conditions. With record levels of monetary and fiscal policy stimulus, consumer and corporate health reached an all-time high. With strong demand during a time of constrained supply, inflation rose at a pace not seen in over forty years.
Fixed income investors need to be aware of the economy’s current state of the credit cycle, which Crowell explains is in the late cycle of the expansion. At this point in a typical credit cycle, recurring behaviors include strong credit growth at a time of deteriorating corporate profits and slowing growth. Asset valuations are at relatively high levels, signaling caution to investors. The key metric to watch in the credit cycle is how quickly inflation will be decelerating. If inflation falls more quickly, the economy experiences a soft landing. If inflation is more sticky, the Fed is likely to stay involved longer and growth will slow more quickly.
Wan uses the proprietary Credit Health Index (CHIN) as a quantitative model to evaluate the credit environment. Top-down factors in the model include the ISM Manufacturing Index, financial conditions, and the yield curve, while bottom-up factors focus on corporate profitability and default probabilities of individual issuers. The model is currently signaling historical late-cycle behavior but is unlikely to experience a downturn in the short run. A leading indicator of future default losses is high real interest rates. With real rates still low, defaults will likely stay low for the next six months. The team’s proprietary recession indicator shows a low probability of recession in the next six months even though the yield curve is inverted.
Crowell notes that the attractiveness of the credit market is decidedly below average while spreads are tighter than average. Credit spreads are typically wider at this point in the cycle, but had been tightening in 2023. Companies are continuing to add leverage even though profits are likely to decline. Investors may still take credit risk in their portfolios but are encouraged to keep those exposures toward the lower end of their asset allocation range.
The credit risk premium is defined as the current spread reduced by predicted future credit losses. In notorious late-cycle behavior, credit spreads have tightened while default predictions remain stable. Risk premiums are a strong indicator of future excess returns. Tightening risk premiums predict declining future excess returns, with the team’s credit risk premium model suggesting that investors take a lower credit beta.
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