A new credit cycle is starting

The development in stock markets has been cautious as the earnings season has progressed. Of Big Tech, Microsoft announced a better-than-expected result as the company successfully pushed AI into its product portfolio. In turn, another tech giant called Google fell short of expectations. Alphabet is getting behind in cloud and AI, while the ad-driven business is under intense competitive pressure. However, stock price reactions remained sub-zero, indicating challenging valuations as I wrote in my last post. 

It's now super week for the earnings season and in the next post, I will briefly review the earnings season summary for the US.

But let’s get back to the present: in this post I will talk about the Fed's interest rate decision and move on to the credit cycle phase. The optimistic view is that a new credit cycle is about to start, fueling economic growth. Finally, I have some interesting data on how rising interest rates affect the profitability of US companies.

A new credit cycle is starting 

The economy runs on debt. Large investments, such as buying a home for the average person or building a new production plant for businesses, are rarely made with years of cash saved up. No, they are paid from future income by borrowing today.

Thus, taking on debt speaks volumes about the state of the economy. In the US, it looks like a new credit cycle may be starting. Something similar might be happening in Europe.  

First, let's have a gander across the pond. Many still fear a US recession, but it seems that the momentary weakness of 2022 was indeed a hiccup, and the expansion of the economy will continue for now. Bank loan growth slowed down, especially during the small bank crisis in spring 2023. On an annual basis, the total amount of loans has even shrunk slightly, which is rare. The last time this happened was during the financial crisis. However, the contraction has been moderate, and loans seem to be gathering momentum for a new upturn.



The leniency of bank credit managers sends the same message. According to the Fed's gauge, the percentage of banks tightening credit criteria fell in the fourth quarter of last year.

 

Even the more speculative firms will get funding after a short dry spell. In other words, it seems that investors want to lock in a higher return on their money before further interest rate cuts. 

In general, monetary conditions have loosened. The Bloomberg index of financial conditions is on the loose side, as it will be in 2021. Of course, some indicators still point to tight conditions, such as the inverted yield curve. With long loans yielding less than short ones, the banks' business model is under pressure. Yet credit seems to be flowing.

Indeed, sectors dependent on borrowing, such as construction, seem to be recovering. For example, housing starts are growing again on an annual basis, although they are well below the level of previous years for the time being Cyclical building stocks, such as the Pulte Group, have also rocketed. The market is not always right, but it would be odd if construction stocks were to rise while credit lines in the economy were clogged and an imminent recession was imminent.

According to one strategist, we are at the beginning of a new credit cycle rather than on the cusp of an immediate recession in the US.

Also in Europe, where high interest rates and tightened bank lending criteria have almost stifled credit growth, credit appetite seems to be cautiously recovering this spring. Although it’s too early to say at this stage. According to an ECB survey, a large proportion of banks continue to report a slowdown in loan demand. One of the main reasons for the weakening of loan demand is the rise in interest rates. The situation is expected to improve this spring, but in this economic downturn, banks have been consistently surprised by the weakness in loan demand. If the ECB is able to cut interest rates as inflation eases, one would think that the economy would get a nice boost from rising demand for credit.

 

Are rising interest rates eating into companies' results?

Sometimes investors are stressed about how rising interest rates are eating into the performance of listed companies. I read a brilliant paper by the pseudonymous Jesse Livermore that looked at how higher interest rates are hitting listed companies. The outcome was less dramatic. The answer is, not very much at all. However, there were such delicious data points in the study that make it worth digging deeper into.

The rise in debt service costs won’t hit companies' results immediately, as the debt maturities of the large companies in the S&P 500 index are spread far into the future. Many companies borrow long term loans at fixed interest rates. Thus, the rise in interest rates will hit them slowly. By 2030, only 38% of all debt will have matured, by which time interest rates may already have fallen. If debt were rolled over at current interest rates, the impact on the S&P 500's performance would be just under 6% in 2030, all else being equal.



The exception among sectors is real estate investors, who have a huge debt load coming due in the next few years. Others will get off scot-free from rising interest rates. It’s hardly a coincidence that this sector hasn’t performed very well since interest rates started to rise, while the debt-light technology sector has reached new highs.

The next observation is a very interesting one. This graph dissects the cumulative total return of the S&P 500 index into components, such as the evolution of sales, operating margins and valuation multiples. Over the past 40 years, equity returns have been helped by rising valuation multiples, which have accounted for about a quarter of returns. The second quarter has come from widening margins. The net profit margin of companies in the S&P 500 index was less than 5% in the early 1980s, whereas today it’s a record 10%. During the pandemic, the margin stood at 11%, but it has been eroded slightly by rising interest rates.

Looking at these graphs, an investor might be tempted to think that rising margins are an inevitable historical trend. However, that is not the case. The last time inflation spiked and interest rates rose to more than a decade high, the net margin on the S&P 500 index actually shrunk from 8% to less than 5%. Stocks are known to have returned nothing for two decades from 1966 to 1983, when inflation is taken into account.

Should interest rates remain higher than expected for longer than expected, they would pose a greater threat to equities. The study estimates that a 10% interest rate would put a 3 percentage point annual brake on earnings growth. This would indeed put a brake on future stock returns. Of course, interest rates depend on inflation, and the market certainly doesn’t expect high inflation for the next 10 years. Thus, this risk is remote for the time being.

Thank you for reading the post! Read analysis and make good stock picks!