Understanding Credit Cycles in Business and Finance

A credit cycle is a natural fluctuation in the economy where borrowing and lending increase during good times and decrease during bad times. This cycle is driven by changes in interest rates and the availability of credit.

As the economy grows, businesses and individuals take on more debt to finance their investments and purchases, which can lead to a buildup of debt. This is seen in the credit expansion phase.

During the credit expansion phase, lenders are more willing to lend, and borrowers are eager to take on debt, causing credit to expand rapidly. However, this can lead to a credit crisis when the economy slows down and borrowers struggle to repay their debts.

The credit crisis can lead to a sharp decline in credit availability, causing businesses and individuals to cut back on spending and investment. This can create a self-reinforcing cycle where reduced spending and investment lead to a further decline in credit availability.

A credit cycle is a fundamental concept in economics that's essential to understand. It's the ebb and flow of credit that interacts with the business cycle and creates a pattern of boom and bust asset price cycles.

The credit cycle analyzes who in the global economy is borrowing and spending, and who is saving and deleveraging. Borrowing and spending is expansionary and helps sustain economic growth, while saving and deleveraging is contractionary and a headwind for growth.

Many factors drive the credit cycle, including who is borrowing and spending, access to credit, financial intermediary balance sheet management, risk appetite, profits, incomes, and liquidity.

A credit cycle is a complex pattern of boom and bust asset price cycles that arises from the ebb and flow of credit in the global economy.

The credit cycle framework analyzes who is borrowing and spending, and who is saving and deleveraging, which are two opposing forces that drive economic growth.

Borrowing and spending are expansionary and help sustain economic growth, while saving and deleveraging are contractionary and a headwind for growth.

Many factors drive the credit cycle, including who is borrowing and spending, access to credit, financial intermediary balance sheet management, risk appetite, profits, incomes, and liquidity.

Unpredictable human behavior, such as fear and greed, influences these variables and makes analysis even more challenging.

Countries, sectors, and companies are simultaneously moving through different credit cycle phases, which increases complexity but can also help identify relative value investment opportunities.

A well-developed framework is integral to tracking the interaction between credit and asset prices.

A credit cycle is a natural part of the economy, and it's essential to understand its phases to make informed investment decisions. The credit cycle has four distinct phases: expansion, downturn, repair, and recovery.

These phases are not random events, but rather they follow the direction of the broad economy. We're currently in the expansion phase, and Western Asset believes there's still runway for growth. This means that credit markets and underlying corporate bond valuations are generally supportive.

There have been three credit cycle downturns in the past 30 years, and each was associated with either a Fed that tightened policy too much, a bursting market bubble, or both. This suggests that downturns are often caused by external factors rather than internal weaknesses.

The current expansion phase will end one day, but it won't pass due to old age. There have to be catalysts, and as of now, no trigger characteristic is in play, nor do we see one on the near horizon. This means that investors should not be overly concerned about a downturn in the short term.

Here are the four phases of the credit cycle:

In our view, reducing credit risk in a portfolio now due to fear of a looming cyclical downturn is not supported by the current environment and available data. This suggests that investors should be cautious not to overreact to market noise.

The credit cycle is a complex phenomenon that can have far-reaching consequences for individuals, businesses, and the economy as a whole. The average credit cycle tends to be longer than the business cycle in duration, taking time for a weakening of corporate fundamentals or property values to show up.

A contraction in credit is considered to have been a primary cause of the 2008 financial crisis. This highlights the importance of understanding the credit cycle to make informed decisions about investments.

The traditional relationship between the Federal Reserve's interest rate policy and the credit cycle has become more complex since the financial crisis. Changes in the nature of the economy have had an impact on the inflation rate that policymakers are still trying to understand.

The credit cycle can be broken down into two main phases: expansion and contraction. During the expansion phase, funds are relatively easy to borrow, with lower interest rates, lowered lending requirements, and an increase in the amount of available credit.

The contraction phase is characterized by higher interest rates and stricter lending rules, resulting in less credit being available for business loans, home loans, and other personal loans.

The credit cycle is influenced by risk and profitability to lenders. When risk is reduced and profitability is high, lenders are more willing to extend loans. Conversely, when risk increases and profitability declines, lenders become more cautious and tighten lending requirements.

Here's a summary of the key factors that contribute to the credit cycle:

Understanding the credit cycle can help investors and businesses make more informed decisions about their investments, ultimately leading to more stable economic growth.

The credit cycle is a crucial aspect of the economy, and understanding its key factors is essential.

The credit cycle is one of the major economic cycles identified by economists in the modern economy. This means it's a significant factor to consider when making financial decisions.

A credit cycle tends to be longer than the business cycle because it takes time for a weakening of corporate fundamentals or property values to show up.

Here are some key factors to consider when looking at the credit cycle:

Navigating the credit cycle requires understanding its different phases. The US economy remains in the expansionary phase, while countries like the UK and Germany are in the recovery and recessionary phases, respectively.

Expansion is characterized by rising debt levels as companies grow through mergers and acquisitions, often to improve earnings and diversify revenue streams. This can lead to persistent inflation as excess leverage pushes up asset prices.

Debt becomes more costly as central banks hike interest rates to counteract inflation, weakening fundamentals as businesses struggle to meet higher input costs or pass inflation onto consumers.

The nimble investor can find substantial value in certain parts of the market, but it's essential to be selective.

More than 60% of the high yield market trades below 300 basis points. The US market is overrepresented within this category, making it especially expensive compared to Europe.

In Europe, you'll find significantly more spread to be had in less cyclically sensitive businesses. This is because many European companies are family-run organizations with less aggressive financial policies.

The US market is considerably more cyclical than Europe, with a high degree of fixed costs and price-taking companies dominating the landscape. This makes it challenging for these companies to influence market prices.

The sector has come under a huge amount of stress given the insolvencies in the US and at Credit Suisse during 2023. This has created mispricing that doesn't consider the fundamental improvement seen from a large number of banks since the GFC.

Excess spreads in European financials are broadly unjustified, given the more stringent regulatory backdrop and higher interest rate environment. This is particularly true in regions like Iberia, where floating rate mortgages are commonplace.

While some traditional lenders in Europe are attractively priced, SME lenders and investment banks are not as attractive. This highlights the importance of taking a nuanced approach to every asset class and doing thorough homework and analysis.

Corporate treasury behavior has undergone a significant shift since the Global Financial Crisis (GFC). Companies are now refinancing debt obligations that mature as far as two and three years out, rather than waiting between one and three months.

This change in behavior is a direct result of the GFC, where companies faced difficulties refinancing debt due to the capital markets seizing up. In December 2015, the loan market had $194 billion in maturities coming due in 2018 and 2019, but by January 5, 2018, that amount had shrunk to $44 billion, an 80% decrease.

Companies are also increasing their cash reserves, remembering the fickle nature of the commercial paper market during the crisis. In the wake of the GFC, corporations have notably increased cash on their balance sheets, reducing their reliance on short-term funding sources.

Having a higher level of liquidity is a double-edged sword, however, as it also reduces the risk of a market disruption negatively impacting business operations.

We're currently in the expansionary phase of the credit cycle, and the US economy is leading the way. The wide availability of credit is encouraging companies to grow, often through mergers and acquisitions (M&A) to improve earnings and diversify revenue streams.

The expansion phase is characterized by rising debt levels, which can lead to persistent inflation as asset prices increase. This can be a challenging time for businesses, as they struggle to meet higher input costs and pass inflation onto consumers.

In the US, the expansionary phase has been a long and stable period, with companies taking advantage of low interest rates and easy access to credit. This has allowed them to grow and invest in new opportunities, but it's also led to a buildup of debt.

As the expansion phase continues, it's essential to be mindful of the potential risks, including the possibility of a slowdown or even a recession. However, for now, the fundamentals look solid, and the economy is expected to continue growing.

The stage of the credit cycle can be a valuable tool for investors to make informed decisions.

In fact, some investors study the credit cycle to guide their investment decisions, which can help them navigate the ups and downs of the economy.

A boom in real estate prices can be a sign of excessive credit, which may lead to a subsequent recession.

Investors can assess the likelihood of a recession by examining the credit cycle, as long periods of excessive credit often precede a recession.

Understanding the credit cycle can help investors avoid making decisions based on short-term gains, and instead focus on long-term sustainability.

Here are some key points to consider when evaluating the credit cycle and its impact on business and investment: