Last updated: 10:47 / Wednesday, 29 January 2014
On The Lookout, MFS

Three Worries for 2014, and They’re All About Credit

Three Worries for 2014, and They’re All About Credit

So far in the cycle the US economy has done well without the extra adrenaline of private credit creation. In other words, growth has been occurring organically since 2009 without consumers adding debt to their balance sheets to buy goods and services, or companies radically expanding bank borrowings and issuing new bonds to boost sales. Profits have been the key to sustaining this situation.

Not everything is going swimmingly, however. There are signs that the low volume of private credit creation could be changing for the worse. The potential use — or misuse — of credit could indicate what might happen during the next phase of the business cycle.

Let’s consider three concerns about credit that should keep investors on the alert, and where we are now:

Private credit acceleration can bring bubbles

Private credit growth reaching 6% to 8% of US GDP has historically been a warning sign of an aging and decaying business cycle. Why? Too much credit causes the economy to grow beyond the capacity that is in place, and bubbles become a concern. When that happens, too much capacity may come on line, often leading to a recession and a cooling in profits, which is generally preceded by a stock market collapse.

Now, credit growth is low, and the US Federal Reserve’s efforts to create some credit growth have not been working as planned. The velocity of money — or the movement of cash and bank lending throughout the economy — is still slow, but speeding up.

Excess corporate issuance can impair credit quality

When corporations use credit to drive earnings growth, their credit quality goes downhill and their ability to repay debt deteriorates. Buyers of riskier credit bonds expect a spread over safer Treasury securities. As that spread widens, credit issues underperform Treasury benchmarks.

Now, companies are starting to issue more debt in the bond market, and we are beginning to see significant increases in commercial and industrial loans. While this is quite normal, it usually occurs in the early part of an economic expansion, when credit can help to revive growth. As debt burdens increase, however, credit quality can become impaired, especially in the high-yield market. For now, credit measures are still solid, but the key measure of debt to cash flow is starting to rise for the first time in this cycle.

Credit can be linked to inflation

Credit growth can lead to economic growth, but if credit accelerates too quickly, it can lead to inflation, which is usually not welcomed by investors. In the initial phases of inflation, stocks can go up and credit quality can improve. However, when wages start to increase, profits begin to fall.

Now, there is no sign of inflation pressures building, nor is there any evidence of excess capacity in US factories, shops or the labor market. Yet this benign environment can change if credit expansion accelerates.

Credit is not a bad thing; rather, it is necessary to fund current needs against future income. Consumers and corporations alike have legitimate reasons for borrowing to finance big-ticket items, such as automobiles, and to expand inventories and capital plant, such as computers, software and factories. The growth of credit can help kindle the expansion phase, but as the business cycle progresses, the growth and use — or more precisely, misuse — of credit can lead to contraction and even recession, which is the worst outcome for investors.

Now, the use of credit in the United States is within normal bounds, but the lure of credit could ruin the investment story of 2014 if accelerating credit growth is accompanied by deteriorating credit quality. Credit excess is a storm warning, something we at MFS watch keenly. And we think it may make sense to build some conservatism into stock and credit portfolios, just in case.

Extract from James Swanson’s blog On The Outlook – James Swanson is Chief Investment Strategist at MFS Investment Management