Examining capitalism's Achilles' heel
In today's Fundamentals briefing, LGIM strategist Chris Jeffery (photo, right) discussed the global credit cycle and its importance when looking for more vulnerable parts of the global economy.
"The business cycle is widely understood – many of us are familiar with the concept of periods of expansion and recession – and changes in that cycle often act as an inflection point for investment markets. The credit cycle looks at the demand and supply of credit. It matters because analysis shows that changes in the credit cycle can amplify changes in the business cycle," explained Chris.
The credit cycle isn't easy to map out. Looking at the ratio of private debt to GDP over the past 60 years shows a long-running increase in total debt levels. Given that this coincides with a period of strong growth, the rise of debt on its own is obviously not the swing factor.
"We found that it is the pace of credit growth that can be an indicator of trouble ahead. When credit expansion goes into overdrive, the danger of a credit-enhanced recession increases. This is precisely what we saw in 2007-08," said Chris.
Fast credit growth appears most likely to be damaging when it is coupled with high debt service costs. Analysis shows that these have fallen considerably in developed markets since 2009, as companies and households have paid down debt.
"Emerging markets look more worrying. There has been an explosion of debt and inflation is still pretty high, leaving interest rates and debt service costs higher. China, Brazil and Turkey look the most exposed of the major emerging market economies. Investors should take note: we like emerging markets on a medium-term view, but this analysis makes us cautious in the near term," said Chris.
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Fundamentals: Examining capitalism's Achilles' heel (PDF: 434KB) NOTES TO EDITORS
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