Jim Cielinski: How has risk changed since last quarter? Well, interestingly two things have happened and they’re quite opposite. One, central banks have strengthened their resolve to fight inflation, but at the same time, economic indicators have softened. Leading indicators are actually falling at a very rapid pace, which I think gives rise to the fears, and appropriately so, that central banks need to almost overdo it if they’re going to tame inflation. Inflation has been their number-one focus all year. This has not changed. And I think they’re now saying, “Be prepared for a potential policy mistake that forces growth into a recession.”

The credit outlook has continued to worsen. We always look at the cycle as being a function of three key things. One, is there a lot of debt? Is there too much leverage? The answer is yes. Two, are we starting to see restrictive access to capital for borrowers? I think we’re seeing that as well. The third component has been earnings and cash flow, and this is why, when the cycle turned early in the year, and we talked about the turn, the fundamental story was still relatively positive. We see that now beginning to change. What has been a liquidity-induced downturn in the cycle, now will become a fundamental downturn in the cycle. Earnings will weaken. Cashflow will weaken. As that happens, credit quality starts to weaken, and defaults will pick up. This is the more classic credit cycle that we’ll now be entering. And it’s a function of many things. One, savings have been drawn down. Two, many prices have continued to rise, impacting real earnings. Three, we have true events like energy crises beginning to impact locations like Europe; these will draw down consumption quite sharply, and with the inventory overhang, should lead earnings to fall off quite sharply, I think, in the next six to 12 months.

Now, all three of our key indicators are red, indicating two things. One, the credit cycle is still weakening. But two, we need to start considering signposts for when there could be a turning point. We’re not quite there yet. But I think it’s important to keep in mind that spreads will peak before defaults. As defaults go up, that is now priced in, at least to a large degree, but not completely. So we look for signposts at this stage in the cycle, those indicators for some kind of inflection either in policy, in earnings, or economic growth. So the cycle is well progressed, but now that things are quite negative – and viewed as negative across the markets – always be on the lookout for those signposts that things could be getting better.

Every cycle is a little bit different, and the difference in this particular cycle is the starting point for fundamentals. So earnings and cash flow are going to weaken. But the starting point was actually as strong as it’s ever been as we go into a recessionary environment. And dispersion across sectors is extraordinarily high. Energy fundamentals have actually strengthened this year. Retail, on the other hand, has weakened. Expect more of this. And expect defaults to pick up, but equally, those are lagging indicators; spreads reflect a lot of this already. It’s important to look at valuations as well as the economic story. But with fundamentals weakening, I think you should see more pressure on spreads as we go through this cycle. And volatility, which has been extremely high, is likely to stay there. I think it’s important to realize that that central bank put, about them coming to the rescue of markets, or even the economy when it softens a little bit, is no longer with us. Central banks that are saying they have to do what it takes to address inflation have actually removed that put; they’re not there to rescue you.

I think now you’re really embedded in what is a downturn in the cycle. The market knows a lot about this, though. Valuations are cheaper. Defaults have yet to really pick up, and it’s important to realize that that’s likely to stay a bit more muted than it has in the past. I think a lot of companies were able in the post-pandemic period to refinance debt and push maturities out. There’s no near-term maturity wall that’s going to create a crisis. So I think a shallower default cycle, lots of dispersion across different industries and sectors. So there will be plenty of opportunities with downgrades and upgrades – the fallen angels and rising stars – there will still be those in the market. Dispersion, and volatility, and a weak point in the cycle does spell opportunity, as well as risk.

So what should investors be looking out for? I think what you’ve seen with central banks is a true panic about inflation. This is often their primary remit. They’ve gotten it wrong. They need to now address that. So they are likely – and many of them admit this – they are likely to make a mistake and go too far. This is a bad climate for risk assets. But equally, when they pull back from the precipice, when they say they’ve gone too far and kind of retreat a bit, that will be an important sign, and perhaps for investors a good greenlight indicator to get back into risk assets.