March 2011 - N 01

The credit cycle and the credit-equity link

z Combined growth in corporate debt and profits

Introduction anticipates credit spreads through long-term
cycles. The credit cycle has a close relationship
What are the drivers of the credit cycle? Does the credit cycle matter to the relative with macro stages and may help to explain why
performance of credit vs equities? Is it currently at work and what indication is it giving us on credit usually leads equity at turning points.
the future relative performance of the two assets? The following pages seek to offer a
framework to address these questions, focusing on both Investment Grade and Speculative z Over the last forty years covering the last seven
Grade credit. recessions, the peak in the debt/profit growth
As we will show, combined growth in corporate debt and profits anticipates credit spreads differential led peaks in credit spreads by nine
through long-term cycles. This link may help to explain why credit usually leads equities at months on average.
macro turning points. Interestingly, the most recent cycle does not materially differ from past
ones, and is currently moving within a phase of positive correlation that is friendly to both
z Within this cycle, the credit bubble reduced the
asset classes..
capacity of credit spreads to effectively lead
equities in mature growth stages until the
subprime crisis broke out. However, spreads had
1 How the credit cycle may explain credit-equity finally re-gained their leading role vs equity
relative performance markets in the 2009 recovery phase.

The basic idea is that combined growth in corporate profits and corporate debt drives credit z After the credit rally, we entered a phase of
spreads through macro cycle and in turn, lead equity market performances, too. Therefore higher, positive correlation between credit and
the credit cycle may have some predicting power not only in forecasting spreads moves but equity markets. Both asset classes are
also in defining their correlation with equity prices. supported by strong profits, which are still
growing faster than debt.
Lets start with the credit cycle. Because credit ultimately has to do with companies capacity
to repay debt over time, we have focused on just two simple factors, namely the annual flow
of profits and the amount of corporate debt. As shown in the first graph in the right-hand z The framework used to explain the link between
column page 2, in connection with the macro cycle, the last few decades have shown a Investment Grade credit spreads and equity
recurring relationship between the relative growth of the two variables (data are related to prices works in the case of High Yield credit, too.
US industrial companies). Profits growth tends to anticipate corporate debt growth, and
earnings (left scale in the graph) are rather more volatile than corporate debt (right scale), z In the Speculative Grade world, furthermore,
notably to the downside. credit performance relative to equity
performance seems to be closely related to the
The 2nd graph in the right-hand column page 2 shows that the difference in yoy profits default cycle.
growth and debt growth of US non-financial corporates systematically anticipated turning
points in the credit risk premium, measured by the yield ratio between Baa and AA US
z Spreads are likely to normalise towards average
corporate bonds. On average over the last seven recessions (grey shaded areas in the
long-term levels, while equity performance tends
graph), the peak in the debt/profit growth differential (red line) led peaks in credit spreads by
nine months. to accelerate in central and more mature stages
of recovery, such as the one we are now moving
The two graphs below make a step further, introducing equity markets in the picture and on to.
showing their relationship with spreads over the previous cycle. A very similar pattern
featured US and Euro markets. The simplified link may be divided in four stages: as the
macro cycle matures, share gains are often reached through higher debt leverage, which

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 March 2011 - N 01

ultimately push spreads higher. In this phase, equity still outperform, while credit starts to Debt growth and profits growth:
suffer. Mature phases are followed by recessions and by a return to a positive correlation a recurring relationship
between the two asset classes, as spreads continue to widen and equities fall. Then, again,
Profits grow th (in %, l.h.s.)
it is the credits turn to start the recovery phase, as companies struggle to reduce 60 30
unsustainable debt levels, through higher efficiency, deleverage and credit-holders friendly Debt Grow th (in %, r.h.s.)
50 25
action. In this early recovery stage, called the repair phase, because of the focus on
balance sheet repair, credit typically outperforms equity. 40 20
30
US equity vs US Investment Grade performance: the past cycle 15
20
300 10
10
5
0
250 4 /2 0 0 0 - 1 0 /2 0 0 2 -10 0
US IG Industrial spread (in bp)

-20 -5
1 1 /2 0 0 2 - 3 /2 0 0 3
200
-30 -10

Mar-69
Mar-73
Mar-77
Mar-81
Mar-85
Mar-89
Mar-93
Mar-97
Mar-01
Mar-05
Mar-09
150

4 /2 0 0 3 - 1 2 /2 0 0 4
Source: Fed, Amundi Strategy
100 1 9 9 9 - 3 /2 0 0 0

S & P 500
50
Credit spreads lag debt-profits growth
600 800 1 000 1 200 1 400 1 600
differential
Source: Bloomberg, BoA ML indices, Amundi Strategy

In the fourth and last stage of the cycle, the economic recovery gains strength and growth
leads again to a positive correlation between performances of the two asset classes: this
time both performances are positive on the back of an environment friendly to companies
capital and debt. In the central recovery phase, credit exploits its final potential spread
compression while equity prices accelerate in their upward move.

In the previous cycle, credit led equity between 1998 and Q1/2000 in the mature growth
period, then both suffered during recession (4/2000-10/2002). Spreads compressed while
equity prices fell (repair phase) in the following early recovery phase between 11/2002 and
3/2003: finally positive correlation and positive performances were delivered by both asset
classes in the fourth and last central recovery stage (4/2003-3/2004), which closed the full
circle.

Eur equity vs Eur Investment Grade performance: the past cycle

200

180
e q u it y c r e d it
160
1 1 /2 0 0 2 - 3 /2 0 0 3 e q u it y c r e d it IFO components work as credit
Euro IG non financial spread (in bp)

140 4 /2 0 0 0 - 1 0 /2 0 0 2 and equity markets

120

100

80

60 4 /2 0 0 3 - 1 2 /2 0 0 4
1 /1 9 9 8 - 3 /2 0 0 0
40
e q u it y c r e d it
20 e q u it y c r e d it
D J E u ro S to xx 6 0 0
0
150 200 250 300 350 400 450

Source: Bloomberg, BoA ML indices, Amundi Strategy

These four stages are well shown in the opposite IFO chart: the combination of current
conditions and expectations declared in IFO components by German companies:
interestingly, IFO expectations work very much in the same way as credit in leading IFO
current conditions on one side and equity prices on the other.

Source: Bloomberg, Amundi Strategy

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2 So where are we now in the cycle? The current debt/profits cycle

Net spending in capex, share buyback and M&A (l.h.s., in

Moving on from past experience to the present picture, the opposite graph shows that the US$ bln)
Net Debt growth (in %)
current phase is developing in favour of both asset classes, since profits are rebounding
2 000 40
strong while net debt growth is still subdued. Profits Growth (in %)
1500 30

1000
Current Investment Grade-Equity link: positive 20
3 500
correlation and performances 10
0
0
Within this cycle, the credit bubble reduced the capacity of credit spreads to effectively lead -500
equities in the mature growth stage, until the subprime crisis broke out. -1000 -10

-1500 -20
Eur equity vs Eur Investment Grade performance: the current cycle

dc-00
dc-01
dc-02
dc-03
dc-04
dc-05
dc-06
dc-07
dc-08
dc-09
400
1 0 /2 0 0 8 - 7 /2 0 0 9
350
Lehm an Source: Fed, Amundi Strategy
Euro IG non-financial spread (in bp)

c o lla p s e : th e
300 p e a k o f th e
c r is is , th e n c r is is d e e p e n s : e q u ity
c r e d it a n d c r e d it fa ll to g e th e r
250 o u tp e r fo r m s
e q u ity 1 /2 0 0 8 - 9 /2 0 0 8
200
s u b -p r im e c r is is
150 s ta r ts : e q u ity
8 /2 0 0 9 - 1 1 /2 0 1 0 o u tp e r fo r m s c r e d it
E q u ity a n d
100 8 /2 0 0 7 - 1 2 /2 0 0 7
c r e d it b a c k
p o s itiv e ly
50 c o r r e la te d

2 0 0 5 - 7 /2 0 0 7 m a tu r e g r o w th : e q u ity o u tp e r fo r m s c r e d it
0
100 150 200 250 300 350 400 450
D J E u ro S to x x 6 0 0
Source: Bloomberg, BoA ML indices, Amundi Strategy

However, as the above graph on the current cycle shows, the current equity-credit cycle is
moving within a phase of positive correlation that is friendly to both asset classes. Once
again, credit led equity in the post-crisis recovery phase and then they both moved in the
same direction. In a very similar way of what happened in the previous cycle, the balance-
sheet repair phase, mostly managed in 2009 through debt reduction and cash
accumulation, recently entered a central growth phase, or profits recovery phase: Debt
growth bottomed in the last few quarters and is gently starting to rise again, but in presence
of a strong performance in profits. As earnings are growing faster than debt, this phase is
usually credit-friendly, as in 2003/2004.

4 What about Equity-High Yield credit relative

performances and perspectives? The default cycle
matters
In this section we investigate the High Yield debt equity link, applying the same
methodology based on the recurring relationship between earnings and debt growth, used
in previous sections for Investment Grade credit. As the two previous graphs show, the
pattern is very similar for both the previous and the current cycles.

Credit outperformance vs equity looks very much related to the default cycle: bonds
outperform equity before and around the peak of defaults, and then its the turn of equities
to lead relative performances: the last graph in the right-hand column page 4 shows that a
further downward move in the default rate expected in 2011 should support equity
outperformance over speculative grade during the next quarters. This signal is in line with
the recovery of M&A activity, too.

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 March 2011 - N 01

US equity vs US High Yield performance: the past cycle US equity vs US High Yield performance:
1 200 H Y s p re a d s the current cycle
1 9 9 9 - 3 /2 0 0 0
1 000

4 /2 0 0 0 - 1 0 /2 0 0 2
800

600 1 1 /2 0 0 2 - 4 /2 0 0 3

400
5 /2 0 0 3 - 1 2 /2 0 0 4
200

S&P 500
0
600 800 1 000 1 200 1 400 1 600 1 800 2 000

Source: Bloomberg, BoA ML indices, Amundi Strategy

US equity vs US High Yield performance: the current cycle

2 500 H Y s p re a d s

2 0 0 5 - 7 /2 0 0 7
2 000
8 /2 0 0 7 - 9 /2 0 0 8

1 0 /2 0 0 8 - 7 /2 0 0 9
1 500
8 /2 0 0 9 - 1 /2 0 1 1

1 000
Last

500

S & P 500
0
600 800 1 000 1 200 1 400 1 600 1 800

Source: Bloomberg, BoA ML indices, Amundi Strategy

Conclusions: a friendly environment for both asset

classes, but equity is likely to outperform both
Investment Grade and High Yield bonds in the next
quarters
After the credit rally, we entered a phase of higher, positive correlation between credit and
equity markets. Both asset classes are supported by strong profits which are still growing
faster than debt. The best of the credit rally is behind us and the cycle is increasingly
spiraling along the X-axis in above graphs. HY spreads are likely to normalise towards
average long-term levels, while equity performance tend to accelerate in central and more
mature stages of recovery, the one we are moving on to.

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Contributor

Editor
Philippe Ithurbide Head of Research, Analysis
and Strategy - Paris
+33 1 76 33 46 57

Contributor
Sergio Bertoncini Credit Strategy - Milan

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Chief editor: Pascal Blanqu

Editor: Philippe Ithurbide
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