What the weaker credit cycle may mean for share market investors

The global economy is seeing a deterioration in credit conditions as higher interest rates and tighter lending criteria increase the cost and reduce the availability of debt finance. This will impact corporate earnings for the market in aggregate, but different companies will be affected very differently over the next few quarters.

“There is scarcely anything that drags a person down like debt.”
– T. Barnum (1810-1891), American showman and businessman

What is the credit cycle?

The credit cycle explains how businesses’ and consumers’ access to lending expands and contracts over time. It drives credit spreads (the additional yield over risk-free returns that borrowers pay) and influences asset prices and the volatility of investment returns.

Investors who can borrow, take advantage of the expansion phase of a credit cycle to acquire assets. This includes individuals buying residential property, corporations taking over listed companies, and private equity funds purchasing businesses or real assets.

This activity bids up asset values, bringing asset price inflation. Rising interest rates and tighter lending criteria imposed by lenders eventually reduce the availability of credit, negatively impacting those borrowers who invested late in the cycle. This contraction phase of the credit cycle is associated with economic slowdown as investment falls.

What’s happening now to credit in the global economy?

Interest rates have risen continuously over the last year in most major developed economies. The move away from ‘free money’ has led lenders to tighten their lending criteria and increase credit spreads, which especially impacts lower-quality borrowers.

Stricter bank lending standards slow loan growth. The US Federal Reserve loan officer survey shows lending to commercial property investors, industrial companies, homeowners, and credit card borrowers falling. The picture is similar across other developed economies, with loan growth expected to turn negative in 2023.

Credit spreads have risen in the high-yield bond market, but probably not yet enough to reflect the level of default risk a recession brings. Similarly, banking issues (unrelated to credit) in the US and elsewhere may impact banks’ willingness to convert their liquid assets into illiquid loans to businesses and households. These will further slow the credit cycle.

Which companies will struggle in this environment?

The credit cycle is now contracting, slowing global economic activity. While rising interest rates and higher credit spreads are driving up the cost of borrowing across the economy, all companies will not be affected equally.

Those businesses likely to face the steepest challenges are often known as zombies. These are companies that are heavily indebted and generate just enough net income to meet their interest payments but not to reduce outstanding loan amounts. They are unable to raise new funds to restructure or pivot into more profitable business areas.

These companies depend on low-interest rates to continue, so a significant increase in borrowing costs is likely to kill off many. These are often found in sectors already facing challenges. They include some real estate developers, manufacturers without a technological advantage, and businesses that are sensitive to the consumer spending cycle.

The credit cycle is also impacting consumers directly. Businesses with high exposure to credit-dependent customers risk falling volumes, margin compression, and rising bad debts.

What does this mean for investors?

Companies unable to borrow cost-effectively as the credit cycle weakens will see their finances deteriorate, impacting earnings, dividends, and eventually share prices.

Investors should look for companies with strong balance sheets and moderate levels of debt, which is ideally fixed over many years. Strong levels of free cash flow support refinancing on favourable terms and facilitate new investments which deliver future earnings growth.

Weaker credit environments are hazardous for global equity investors. Well-managed quality growth businesses with strong balance sheets and cash flow growth may be the best place to weather the storm.