Late Credit Cycle: I reviewed some of the credit cycle indicators which mostly show the cycle is near its end. Some of the indicators will weaken and others will strengthen in the next year, says Don Kaufman, co-founder of TheoTrade.
The chart below is a list of 33 indicators which measure the credit cycle. As you can see, 16 of them are signaling red, which is a danger area and 10 are signaling yellow, which is an area for caution.
This isn’t surprising because the business cycle is 9 years old and the yield curve has flattened significantly in the past few years. I’d be surprised if even more of the indicators aren’t forecasting a recession in the next 2 years. Let’s look at some of them.
NINJA Loans Aren’t Coming Back
The bottom indicator shows there was $72 billion in mortgage originations given to borrowers with FICO scores below 620 in 2017. This is actually lower than in 2010 which shows the situation has gotten better. Lenders haven’t dropped their standards to the level seen in the previous cycle as it peaked at $403 billion.
In the past week, there have been stories about how nonprime loans are the new subprime loans. The reality is low FICO score loans will never re-enter the system like the last cycle because NINJA (no income, no job, no assets) loans are illegal and lenders now know better than to issue them.
Ironically, the easier it is to get a loan, the more expensive housing becomes, so it doesn’t help affordability. Stricter standards limit the systematic risk and help housing affordability.
M&A, CCC loans, C&I Lending, & Buybacks Signal Caution
Another indicator which is in the green is the M&A volumes as a percentage of equity market cap. Usually, the M&A activity peaks right at the top of the cycle as firms use their excess profits to make purchases.
Big purchases have big risk. Usually, the most risk occurs when financial conditions are loose at the end of the cycle. M&A volumes were 11.3% at the most extreme point of the last cycle. Volumes were only 5.2% of equity in 2017, but M&A activity is on pace to have a new record total, so this indicator may switch from green to yellow by the end of the year.
Interestingly, the percentage of CCC loans has been declining since 2013, making it look like the indicator will soon go from yellow to green. The stress in the junk bond market related to the crash in oil made for fewer issuances of that debt. The weakness in the oil market may have extended this business cycle because there was a mini deleveraging event.
The year over year growth in C&I loans is disconcerting as growth in 2017 was 2.4%. The peak last cycle was 18.3%. In this case, high growth is a good thing.
Deceleration doesn’t necessarily mean a recession is coming because growth has been falling for three years. Once growth turns negative, it will be a problem. The chart below compares the high yield spreads with the C&I growth. The declining spreads imply C&I lending growth will increase based on the historical correlation.
If you think high buybacks signal the cycle is about to end, you’ll be very bearish after 2018 because the total buybacks will probably pass the 2014 high. Personally, I disagree with this indicator because buybacks are reflective of profits as well as the choices firms make.
Being bearish because buybacks are up means you think high corporate profits lead to a recession and corporations make bad timing decisions with buybacks. However, profits can reach records several years before a recession occurs.
The latest round of buybacks will be a result of the tax cut. It’s wrong to expect a recession because of the tax cut.
Negative Credit Cycle Indicators
As you can see, the auto loan origination given to borrowers with a FICO score below 620 is at $114 billion. I think it’s good news to see it declining off the peak of $125 billion in 2015. If the auto market weakens and recovers without a recession, this would be another example of a mini-deleveraging event.
Another indicator with a red signal is the commercial real estate price index which is at a record. The chart below shows the updated commercial property price index according to Green Street. As you can see, it looks like it’s topping since the level it fell to in March 2018 is the same level it was at in May 2016.
Don’t be fearful that the next decline will be as bad as the 38.8% decline in the last business cycle. I don’t expect such a bad recession.
The other indicators show the gross investment grade and high yield leverage are high and the covenant quality is weak. That’s the worst possible combination.
The biggest worry I have about the next recession is the prevalence of covenant lite loans because that’s an unknown. Generally, based on human nature you’d expect when borrowers are given the grace to not show their financials to lenders that they take out excessive risk.
This is a similar situation to the NINJA loans. The NINJA loans could work when a small business owner has good credit but can’t show income. However, they were abused by lenders who gave them out too often because they figured house prices would always go up.
As you can see, when the proper restrictions aren’t put in place, too much risk is taken out. The only way to tell how bad the covenant lite loans are is to see what happens during the next recession.
I reviewed some of the credit cycle indicators which mostly show the cycle is near its end. Some of the indicators will weaken and others will strengthen in the next year.
I’d expect most of them to turn red before the recession in 2020. The difference between the 10-year Treasury yield and the 2-year yield ended the week at 47 basis points, implying there’s still room to run in this business cycle.
One thing is clear, the housing indicators won’t get as bad as they did last cycle because there’s no more NINJA loans.
Don Kaufman is editor and co-founder of TheoTrade.
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