The challenge to the world's credit cycle comes from both ends. An increasingly sluggish growth outlook creates downward pressures on earnings and internal cash generation. The slowdown is fairly widespread. In addition, the cost of funding is on the rise.
Credit, as an asset class, tends to perform best just coming out of a downturn when a growth recovery, coupled with balance sheet discipline, drives significant improvements in credit profiles. It can still do well in the middle parts of a cycle provided growth is stable and funding conditions benign, although carry is a more important return driver and idiosyncratic risks pick up as balance sheet trends become more mixed.
However, the downside skews begin to emerge in the later stages of a cycle when leverage has already increased and the cycle turns more adverse, and that is happening in Asia right now.
This is critical in our current benign default environment... because the combination of highly leveraged firms, slowing GDP and rising real rates was exactly what created the spike in defaults in 2007-2009 (that only the largest monetary policy bailout in history was capable of kicking down the road).
Periods where the gap between real GDP and real rates is narrow or negative represent particularly challenging funding conditions for corporates: either cash generation is poor or funding costs high, or both. As a result, these are often the periods where default rates tend to rise.
The rise in cost of funding is broad-based and has many drivers making it difficult to reverse even if UST yields stabilise. The rise in the cost of funding is ‘real’ – higher rates are no longer balanced by high inflation – and the rise now means that the gap between real GDP growth and real rates is the narrowest since the downturns in 2008/09 and before that 2001/02.
Source: Morgan Stanley