What The End Of The Credit Cycle May Look Like, And How To Trade It

With the current economic expansion now in its 109 consecutive month, and rapidly approaching the longest expansion in history with yield curve just 25 bps away from inverting, the two questions asked by most investors are i) are we "late cycle", and ii) when does the next recession begin.

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Where should one look for the answer? Since equities are notoriously late in spotting economic inflection points - and usually do so violently, and in the context of a market crash - the best option is credit. And while there are no clear signs of a turn in the credit cycle yet, some long-term investors are already planning for it.

One place to watch is the Morgan Stanley Credit Cycle Indicator which we profiled in April, and which shows that approximately half of the cycle indicators are already flashing red.

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This is what Morgan Stanley said three months ago:

In terms of timing, we think that enough signals are flashing yellow and cracks are forming to indicate a credit cycle on its last legs: For example, looking at credit markets more broadly than just corporates, we have seen signs of weakness and tighter credit conditions in places like commercial real estate. Additionally, consumer delinquencies have risen in various places (i.e., autos, credit cards and student loans). And in corporate credit, one sector after the next has exhibited ‘idiosyncratic’ problems (e.g., retail, telecom and healthcare to name a few). All this is consistent with other signals we watch, some which have been discussed above (i.e., a flattening yield curve, falling correlations in markets, rising volatility, a trough in financial conditions, narrowing equity breadth, rising stress in front-end IG and much weaker credit flows).

Morgan Stanley also laid out what its current model spits out in terms of timing inflection points.

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Just as important, when the next credit cycle turns, it won't be contained solely to credit: there are extensive and just as important, contagion channels which will be triggered with broad impacts on the general economy.

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