It’s not the economy, it’s the credit markets

If economic growth is going to peter out, the credit market will be the first to know

If you are looking to figure out the direction of the capital markets, don’t focus on the economy, focus on the credit markets, in my opinion.

I know, I know. It is overstating the case, but only by a bit. The larger rhetorical point still stands.

The fact of the matter is that slow growth regimes have overtaken the world since the Global Financial Crisis (GFC) and I believe easy monetary policy is essentially the only game in town. While we can debate whether monetary policy will solve the world’s problems or not, it is worth noting that if it weren’t for the easy money regime, we would not have come out of the GFC as quickly as we did.

And the transmission channel for easy money policies may be credit growth.

At the expense of sounding a bit pedantic, let’s look at how easy money policies work and why an unstressed credit market is critical to the outcome of these policies. You see, monetary policy, in and of itself, cannot create demand growth, the fodder for economic growth. That is really determined by demographics and productivity growth. Instead, the way monetary policy works is by borrowing from future demand by reducing the cost of capital. So, in an environment where the world currently faces dominant structural issues, you need continued credit growth to facilitate borrowing from the future for monetary policy to be effective.

Furthermore, in the old days, decades before the GFC, the banking system used to create credit growth. But that has not been the case for a while. Instead, in the developed markets anyway, a bulk of the credit growth today is created by the public and private credit markets. The capital regime installed in the global banking system after the GFC essentially ensured that credit markets, rather than the banks, remain the primary source of credit growth.

So, if the credit markets stay well-behaved, demand can continue to be borrowed from the future, and then the global economy can remain relatively stable, albeit growing at a much more subdued growth rate.

In my view, there are no better tell-tale signs of activity in the economy and the equity markets than the behavior of credit spreads.1 The signal may be contemporaneous, but one thing is certain: without a crack in credit spreads and credit issuance, the likelihood that the global economy and markets keel over is pretty small.

Just look at this simple chart of US high-grade credit spreads and the S&P 500 Index.2 The changes in trend, rather than the level of the two series, make my assertion self-evident.

 Figure 1: US Credit Spreads vs the Stock Market

US Credit Spreads vs the Stock Market

To some extent, this is an obvious point, so why should you care?

If you have spent any time in the punditry business, something I’m all too familiar with, the worry of impending doom has been a common theme in the past few years. Whether that is the current trade conflict, Brexit, a slowdown in China, or a potential recession in the European Union (EU), the credit markets have remained reasonably well-behaved. The last two real scares in the credit markets were tied to the China-led commodity bust in 2015-2016 and the foolish Fed tightenings in Q4 2018. In both of these episodes, credit markets were on the verge of giving up the ghost before they were revived by the massive stimulus in China and the Fed pivot in the second instance, respectively. Other than that, it has been relatively smooth sailing.

So, what are the credit markets telling us now? Overall, credit spreads remain relatively tight. That tells me that while growth is a lot lower than what we would like it to be, it is not the end of the world, yet.

However, dispersion within the credit markets has increased. Lower-rated credits are significantly wider than higher-rated credits even after adjusting for their interest rate sensitivity.4 That typically happens at the troughing of the economy and the markets.

Therefore, if growth is indeed bottoming out, as I think it is, the tell-tale sign will come in the form of tightening spreads at the bottom rungs of the credit markets. I believe we will see that happen by the end of the year, and likely a quarter before an actual acceleration in global growth.

Footnotes

1. Credit spreads are the difference (or spread) of yield paid out by a certain subset of bonds (in this case investment-grade corporate bonds) over a comparable maturity treasury yield.

2. The S&P 500 Index is a market capitalization weighted index of 500 large US stocks.

3. The Bloomberg Barclays US Aggregate Bond Index is a broad base bond market index representing intermediate term investment grade bonds traded in the United States.

4. Source: Bloomberg L.P., Barclays as of 10/23/19.

Important Information

Blog header image: Marilyn Nieves / Getty

The opinions expressed are those of the author as of October 23, 2019, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

Krishna Memani serves as the Vice Chairman of Investments for Invesco. In 2009, Mr. Memani joined OppenheimerFunds, which became part of Invesco in 2019. Before he joined OppenheimerFunds, he was a managing director at Deutsche Bank, heading US and European credit analysis. Earlier, he headed global credit research at Credit Suisse; was in charge of high grade and high yield portfolios at Putnam Investments; and was a credit analyst at Morgan Stanley.

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