The credit cycle is close to the end. Risky assets, including credits, are vulnerable. Central banks risk falling behind the curve. Sander Bus and Victor Verberk, co-heads of the Credit team at Robeco, are becoming more careful. They prefer safety and stay up in quality to benefit from further decompression and higher risk premiums.
The global economy delivers another good quarter in terms of growth. It even seems that capital investments are finally contributing to growth. “This has been the main disappointing economic variable to date in this business cycle,” says Victor Verberk. “Moreover, it looks like the different economic blocs have synchronized their cycles,” Sander Bus adds. “Except for China, all of them are showing an upturn. Chinese credit to GDP has reached levels we last saw in crisis situations in countries such as Korea, Japan and Thailand.”
Central banks falling behind?
Verberk and Bus highlight a topic that is in sharp contrast with the last two years: the risk of central banks falling behind the curve. “The biggest question mark in this cycle is why inflation is so low,” says Verberk. “Considering the reduction of the economic output gap, we could expect some inflation scare soon at central banks. We believe inflation might be at a secular turning point.”
In any case, all central banks combined will massively reduce monetary stimulus during 2018. “The only thing that would keep us from expecting increased market volatility,” says Bus, “is a scenario in which other market participants, such as commercial and retail banks, take over the purchasing of fixed income assets. In our view, the numbers are too large to expect such a perfect scenario. All this holds for all risky asset classes.”
Once in a while, Verberk and Bus take a helicopter view. “We try to think outside the box, outside this economic cycle with all daily noise influencing us,” says Verberk. “Guess what, that does not make us more relaxed. Ever since we abandoned the Bretton Woods system in the 1970s, we actually created fiat money, leaving it fully in the hands of central banks and politicians. This has created an ever increasing amount of financial shocks. Central banks managed by academics, overestimating themselves and the control they have on an economy, solve economic problems with lower interest rates.”
In Bus’ view, central banks have been right for the wrong reasons in their loose monetary policies. “A massive labor supply shock of over one billion Chinese entering the labor force since the 1980s has been disinflationary. This created the debt super cycle we started writing about ten years ago. Solving debt issues with more debt will eventually create more rather than fewer financial shocks. We live in an era in which we should expect a regular cycle of crisis, releveraging, boom, excesses and bust again.”
Studying economic history
“Just by studying economic history and organizing this Credit Quarterly Outlook,” Verberk remarks, “we as a credit team have created a certain degree of understanding of the events around us. That is why we call this outlook a love letter to economic history. We keep informing our clients in an honest way about our views on the credit cycle, even when we think it is close to the end. And now risky assets are vulnerable, maybe even more so than government bonds.”
Credit positioning: careful beta, up in quality and minding tail risks
Despite the fact that fundamentals are improving in economic terms, Verberk and Bus are becoming more careful. “Asset price corrections do not always require a recession,” Bus warns. “There are some extreme things we worry about. When five FAANG stocks drive up the S&P 500 index by over 20%, when inflation is so low even though unemployment tells you different and when credit markets face a net selling system of central banks, beta positioning should be careful. Then we are well positioned to benefit from the volatility that is to come. The opportunity loss of not owning enough beta exposure is just too low.”
“It is darkest before dawn but all looks bright before darkness too,” Verberk adds. “Remember 2007. Since then debt levels and dependence on low interest rates have increased ever more. We just need some kind of shock to reprice risky assets. It has happened so many times before, and it will again. This is the lesson history teaches us. We live in an era of financial shocks based on too much debt and overconfident central bankers.”