Every credit cycle has its own unique features, but we believe it is helpful to summarise the stages that are common across all cycles in order to identify the correct issues to focus on when determining investment strategy. Our debt-equity clock describes both the absolute and relative performance of corporate debt and equity securities across the different stages of a credit, or business, cycle.
Repair is the first stage, which started in 2002 in the current cycle and became more obvious in 2003. Economic growth is weak but recovering and leverage is falling as companies focus purely on balance sheet repair and survival. Corporate bonds outperform equities, although both are doing well by the end of this stage, which represents the start of a cyclical bull market. This process continues into the recovery stage, which is a mid-cycle phase when companies benefit from the restructuring carried out earlier. Both corporate bonds and equities do well.
As things progress, we enter the expansion phase, which is where we place ourselves today. Corporate risk appetite is increasing along with investor confidence, liquidity is ample although already starting to deteriorate as central banks begin to tighten policy. Unprecedented LBO activity is a good example of such risk appetite in the current climate.
Each credit cycle is different, however, and the expansion phase is a good example of this. In the last cycle, it was TMT and investment-grade companies in general that made the biggest mistake with balance sheet leverage. In the current cycle, it is arguably the consumer sector and recent LBOs where too much leverage has been applied – an insight that will help to identify losing sectors in the next stage. Equities outperform corporate bonds during the expansion phase, but the key focus for creditors is idiosyncratic risk rather than large market moves.
Expansion eventually gives way to collapse, when tightening liquidity forces asset prices to decline and investors realise the mistakes made earlier in the cycle. Systemic risk is relatively more important and taking directional credit market bets becomes profitable again as both equities and corporate bonds enter a cyclical bear market. Growth slows sharply and leverage rises – initially unintentionally as asset values and cashflow decline, and then intentionally as companies and investors become risk averse.
Timing the transition from expansion to collapse is simultaneously crucial and difficult. Of the indicators we studied, we found that an inversion of the US Treasury curve is the single best macro clue that this transition is imminent, and we are getting close on this metric. We are also watching free cash generation, the performance of prior LBOs, US housing stocks and of course default rates.
The current messages are not yet conclusive, hence our continuing focus on idiosyncratic rather than systemic risk. We believe the odds strongly favour collapse in 2006, however, so caution is already warranted. Our debt-equity clock explains our current small underweight position on investment-grade credit, where idiosyncratic risk is asymmetrically negative, and our neutral stance on high yield, where capital structure risks are more balanced. In both markets, however, the next big move will be wider, and an outright bearish stance will be the correct one for 2006, in our view.