The current US credit cycle is well into its 10th year and things don’t appear to be slowing down. So far, it has exceeded the typical nine years of the prior cycles, baffling many financial experts as to when a reversal might occur. And yet, while it’s clear that we are in the final stages of a credit cycle, it seems that the markets may be playing by a different set of rules this time around, possibly helping this expansionary phase to last even longer.
So, what’s so different now, and what should investors expect from the credit markets going forward?
For one, inflation has remained well below the Federal Reserve’s target of 2% in the US and has been quite muted globally as well. Interest rates are still very low after many years of monetary easing by central banks worldwide. And fixed income has had an incredible run over the past several years, resulting in historically tight credit spreads and rich valuations.
“This is a different cycle than the past,” said Rob Waldner, chief strategist and head of Multi-Sector at Invesco Fixed Income. “It’s much longer already, and we think it’s going to be even longer.”
Waldner explained that typically, “a cycle would involve growth until you get inflation to pick up, and then central bank tightens aggressively and then growth slows and inflation comes down. We have yet to see any inflation pick up. There’s something different going on. There’s disruption that’s keeping inflation down.”
He points to global capacity, technology, and Amazon driving margins down as possible disruptors of inflation. “It’s a big, big difference, because what it means is central banks don’t have to get aggressive in taking away liquidity. So, the cycle is going to continue longer than people think,” he said.
Now, things are slowly starting to change, with the Federal Reserve bound to raise rates three times in 2018 and short-term rates slowly picking up. Experts believe the yield curve will continue to flatten as long-term rates decline due to continued global demand.
In addition, demand for longer-term bonds picked up in the last couple of months due to the recent change in pension mortality rates announced by the IRS, as many pension funds were forced to buy longer-duration investment-grade credit.
Those spreads are now “near long-term tights, whether you measure it in investment-grade credit spreads to Treasuries or high yield relative to investment grade,” said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.
With that, there’s not much room left to go fishing for yield in fixed income markets. As a result, LeBas believes credit spreads 12 months from now will be a little wider than now. Combined with a flat or slightly inverted yield curve, he believes there’s a chance of a recession in 2019, though “not a certainty. Typically, in this portion of the cycle, we get a year to 18 months to at most two years of really low spreads.”
His advice is “Don’t be a hero. If you are buying into credit risk at this stage, stay with very liquid, large issuers, the entities that are going to be readily saleable when the downturn eventually comes.” It’s better to accept lower returns now and be patient for the opportunities that may come with the next credit cycle.
That said, there are other ways to take risk in a fixed income portfolio, he points out. Areas he likes are longer-term bonds, such as A-rated investment-grade bonds, municipal bonds, as well as high-quality short-duration asset-backeds to hideout during a cheapening of risk assets. Also, Treasuries can still serve as tactical trades in the seven- to 10-year part of the curve.
The consensus on the street is that emerging markets should do well in 2018 due to improved fundamentals in the sector. Local-currency ones are especially well-positioned, as the dollar is expected to weaken in 2018.
Lisa Black, head of Taxable Fixed Income at Nuveen, favors countries that have gone through major reforms since the last financial crisis, such as Indonesia, India, Peru, and Russia, where the real rates are high. She’s also cautiously optimistic on the prospects for Argentina.
“Being selective is important, and you need to do your credit homework,” she said. Also, Mexico, Brazil, El Salvador, and Columbia have elections coming up in 2018, and “While that will likely lead to some volatility within the emerging markets, it could potentially offer some investment opportunities,” she said.