Notwithstanding the recent reprieve from the bond sell-off, evidence is mounting of dark forces lurking in global credit markets, the Bank for International Settlements has warned.
While markets have regained their composure lately, the past three months have seen credit conditions in much of the world at times deteriorate to levels typically reserved for recessions and crises.
“We may not be seeing isolated bolts from the blue, but the signs of a gathering storm that has been building for a long time,” Claudio Borio, the head of the bank’s monetary and economic department, said in the bank’s quarterly review.
The BIS, which acts as an intermediary for the world’s central banks, has long been warning that cheap credit has encouraged risky borrowing and lending, sowing the seeds of the next credit squeeze.
Provoked by the extraordinary pressures of the financial crisis, central banks around the world resorted to unconventional stimulus measures and zero-bound interest rates to induce risk taking.
“Debt was at the root of the financial crisis, and it has risen further globally in relation to GDP since then,” Mr. Borio said. Total global debt by households, non-financial corporations and governments since the end of 2007 has risen from less than $110-trillion (U.S.) to more than $135-trillion as of the end of 2015, according to BIS figures. Total global debt from those three sources of borrowing has risen to more than 200 per cent of GDP over that time.
But the vulnerabilities of excessive debt have not, until recently, been fully reflected in capital markets.
“The tension between the markets’ tranquillity and the underlying economic vulnerabilities had to be resolved at some point. In the recent quarter, we may have been witnessing the beginning of its resolution,” Mr. Borio said.
A historically bad start to the year started with China. Concerns regarding Chinese growth sparked a global equity sell-off accompanied by rising volatility, widening credit spreads, declining emerging-market currencies and ever-lower crude oil prices.
The second wave of the sell-off was sparked by the proliferation of negative interest rates, which shifted the scrutiny to the health of banks globally. Pockets of the U.S. credit market nearly froze up and high-yield credit spreads rose to levels indicating that a dramatic increase in defaults was expected.
Investor sentiment has rebounded over the past few weeks, with investors pouring back into U.S. high-yield funds in record amounts, by some accounts.
But beyond the “familiar oscillation between hope and fear,” the indications of a potential turning point in the long-term global liquidity cycle are in plain sight, Mr. Borio said.
International financing flows slowed in the second half of last year, while aggregate international bank claims declined by 0.8 per cent in the third quarter from the prior year, the first such contraction since the start of 2014.
The BIS is not alone in its expectations for the global credit cycle.
“The deflation of the global credit bubble remains the prime driver of our positioning for 2015,” veteran Wall Street strategist Richard Bernstein wrote in late 2014.
And if the days of ultra-easy money are numbered, investors should pay particular attention to the balance sheet, said Patrick Horan, a portfolio manager with Agilith Capital.
He’s been positioning for a tighter credit cycle for several months, avoiding companies borrowing excessively to fuel growth.
Auto parts company Martinrea International Inc. announced its fourth-quarter financial results on Thursday, which included a reduction of trailing net debt to 2.2 times earnings before interest, taxes, depreciation and amortization, with a view to drawing down that debt load to 1.5 times by the end of 2017.
“That’s perfect,” Mr. Horan said. “That’s about the right amount of leverage.”Report Typo/Error