It’s not the economy, it’s the credit markets
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
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
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
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
To some extent, this is an obvious point, so why should you
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,
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
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.
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.
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