A love letter to economic history

And yet again, the global economy delivers another good quarter in terms of growth. It even seems that capital investments are finally contributing to growth. This has been the main disappointing economic variable to date in this business cycle. Moreover, it looks like the different economic blocs have synchronized their cycles. Except for China, all of them are showing an upturn. Chinese credit to GDP has reached levels last seen in crisis situations in countries such as Korea, Japan and Thailand.

Central banks falling behind?

This brings us to a topic that is in sharp contrast with the last two years: the risk of central banks falling behind the curve. The biggest question mark in this cycle is why inflation is so low. Considering the reduction of the economic output gap, one could expect some inflation scare soon at central banks. We will explain why we believe inflation might be at a secular turning point.

In any case, all central banks combined will massively reduce monetary stimulus during 2018. The only thing that would keep us from expecting increased market volatility is a scenario in which other market participants, such as commercial and retail banks, were to take over the purchasing of fixed income assets. In our view, the numbers are too large to expect such a perfect scenario. All this holds for all risky asset classes.

Once in a while, we also take a helicopter view. We try to think outside the box, outside this economic cycle with all daily noise influencing us. Guess what, that does not make us more relaxed. Ever since we abandoned the Bretton Woods system in the 1970s, we actually created fiat money, leaving it fully in the hands of central banks and politicians. This has created an ever increasing amount of financial shocks. Central banks managed by academics, overestimating themselves and the control they have on an economy, solve economic problems with lower interest rates.

Central banks have been right for the wrong reasons in their loose monetary policies. A massive labor supply shock (over one billion Chinese entering the labor force since the 1980s) has been disinflationary. This created the debt super cycle we started writing about ten years ago. Solving debt issues with more debt will eventually create more rather than fewer financial shocks. We live in an era in which one should expect a regular cycle of crisis, releveraging, boom, excesses and bust again.

Studying economic history

Just by studying economic history and organizing this Credit Quarterly Outlook, we as a credit team have created a certain degree of understanding of the events around us. That is why we call this outlook a love letter to economic history. We keep informing our clients in an honest way about our views on the credit cycle, even when we think it is close to the end. And now risky assets are vulnerable, maybe even more so than government bonds.

The Market Cycle: Mapping our view on market segments

Source: Robeco, Morgan Stanley, December 2017

Where are we in the credit cycle?

There are several indicators that the cycle is maturing. It is hard to predict the exact turn of the cycle, but, as the market cycle graph shows, all segments of the market are close.