Following the ebb and flow of credit cycles is a useful tool that offers an outlook on the durability or fragility of the financial system. Traditionally split into four parts - from credit expansion to credit contraction, balance sheet repair to recovery - credit cycle frameworks can help investors tailor their investment strategy and adapt portfolios to different market conditions.
Yet recent market movements as a result of COVID-19 suggest the credit cycle may be temporarily deviating from this traditional path. Following this year's contraction in credit markets in Q1, the cycle would normally be moving towards a ‘balance sheet repair' stage. This would be reflected in businesses reducing debt on their balance sheets as they prepare for a recessionary economic environment. However, ongoing monetary and government stimuli as a result of the coronavirus this year has in fact encouraged businesses to take on more debt.
Central bank stimulus effect
RWC portfolio manager Clark Fenton explains: "Whilst the economy has, we think, probably troughed, the amount of central bank stimulus, both monetary and fiscal, is so great that it is having an influence on the direction of the credit cycle. Currently, the provision of liquidity means many corporations are re-leveraging their capital structures. They are emboldened to speculate. With this additional debt, we believe they are heading towards over-extended leverage again rather than moving towards balance sheet repair."
Fenton, who manages the RWC Diversified Return Fund, uses the credit-cycle framework as a guide for how much and what kinds of risks to take in the portfolio. The Fund's investment philosophy prioritises this alongside portfolio construction and also seeks to harness alternative return streams to offer genuine diversification.
"[The credit cycle framework] is an investment tool designed to identify risks either increasing or dissipating in areas of the financial system and positioning accordingly. At points of stress we prioritise strategies that do well when financial conditions tighten so investments in our portfolio do not correlate as much when markets start to deleverage."
To date the fund has positioned the portfolio for a number of different phases of the credit cycle successfully. Over a period of 12-18 months since Q4 2018, the fund transitioned to a more defensive stance having judged that the over-extended leverage phase of the credit cycle had begun. This conclusion was based on the continued increase in leverage, particularly corporate credit, while earnings and cash flows declined. Furthermore, the reaction from companies as central banks attempted to normalise monetary policy concerned the manager. Fenton explains: "The Federal Reserve tried to normalise policy, a decade after it had begun in Q4 2018. However, the market reaction was terrible, and highlighted just how much corporates had become ‘addicted' to QE and the wave of ‘easy and cheap' money."
Early defensive positioning
The move to a defensive stance early held the portfolio in good stead as the market started to contract as a result of the coronavirus. Having been so defensively positioned, the portfolio was able to take profits in Q1 2020 and more recently reverted to a much more ‘neutral' stance in terms of positioning, says Fenton.
Going forward however, caution will be needed, notes Fenton: "Normally we would expect companies to be hoarding cash or issuing equity after the mass deleveraging in Q1. Some companies have, of course, done this. But it is still hard to understand if the economic damage thus far will create permanent job losses and business insolvencies in the coming months. At the moment it doesn't seem like that is being allowed to happen nor is it being priced into financial markets. Hence the credit cycle isn't following its normal progression yet."
Click here to read more on how the RWC Diversified Returns Team aim to take gains at cycle extremes from reversals in market sentiment and provide genuine diversification for investors
The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment