What I Learned From Howard Marks – Step-by-Step Guide to the Credit Cycle

Understanding where we stand in the credit cycle is crucial for informed decision-making in the financial world.

Whether you're a suit-wearing traditional investor or a crypto hippie (both aesthetics seem to be interchangeable these days), the flow of credit cycles significantly impacts your strategy. This author will explore with you the macro perspective of credit cycles and ways to track them.

This author finds value in Howard Marks ’ explanation of the cyclical nature of credit.?

12 Steps To The Credit Cycle?

1. Good Economy — Growth leads to lenders expanding.
2. Lenders Increase Capital — More resources to lend out.
3. Risk Ignored — Scarce bad news leads institutions to overlook risks.
4. Expansion of Business — Financial institutions increase lending.
5. Credit Eased — Rate cuts and lowered standards make credit more accessible.
6. Poor Lending Decisions — Increased lending to high-risk segments.
7. Defaults Increase — Credit seekers' failures lead to lender losses.
8. Bubble Bursts — Asset values plummet suddenly.
9. Credit Scarce and Costly — Availability drops and borrowing costs rise.
10. Returns on Capital Dip — Fall below the cost of capital.
11. Economic Slowdown — Companies struggle to secure necessary capital.
12. Rate Cuts Reintroduced — Efforts to re-stimulate credit uptake.

Some ways to track this cycle:

1. Monitor GDP growth rates, employment rates, and business activity indices like the PMI.
2. Follow financial institutions' quarterly reports for capital ratios and lending portfolios.
3. Analyze the financial news for changes in underwriting standards and shifts in the CDS market.
4. Track the total loans and leases in bank credit, provided by central banks or financial regulatory authorities.
5. Keep an eye on central bank announcements for changes in interest rates and lending criteria.
6. Examine subprime lending levels, the quality of debt being issued, and credit rating agencies' reports.
7. Monitor default rates, non-performing loan ratios, and bankruptcy filings.
8. Watch asset prices, particularly in overheated sectors, for significant and rapid price corrections.
9. Track the spread between different credit markets, like the LIBOR/OIS spread, and the terms and availability of credit.
10. Review financial institutions' quarterly reports for ROE and compare it against the WACC.
11. Follow economic indicators like industrial production, retail sales, and corporate earnings forecasts.
12. Monitor central bank policy statements and minutes for indications of monetary easing.

The phases of the credit cycle can be summarized as follows:

1. Expansion: Characterized by a healthy economy and growth in lending, this phase sees lenders increasing their capital base and extending more credit. Financial institutions often downplay risks during this period.
2. Peak: As the economy thrives, there's an influx of credit into the market, with rate cuts and lowering of credit standards. This leads to more lending, even to high-risk segments, due to the abundance of capital and the search for yield.
3. Contraction: Eventually, excessive risk-taking leads to defaults, which can cause a bubble to burst. The value of assets drops sharply, leading to a market contraction. This phase is marked by scarce credit availability and increased borrowing costs.
4. Trough: The economy slows down, and companies find it difficult to secure capital. This can lead to a liquidity crunch, where the return on capital falls below the cost of capital, and financial institutions become wary of lending.
5. Recovery: In response to the slowdown, central banks may cut interest rates to make borrowing easier again, aiming to stimulate the economy and start a new credit cycle.

Key indicators influencing the credit cycle:

• Interest Rate Movements rates are often considered the most significant factor affecting the credit cycle phases, as they directly influence borrowing costs and saving incentives, thus impacting economic expansion or contraction.They are a primary tool for central banks to control economic activity.
• Inflation influences the peak and contraction phases as it prompts central banks to adjust interest rates, impacting the cost of borrowing.It's closely related to interest rates and often precipitates their adjustment by central banks, thereby influencing the cost of credit and economic activity.
• A Liquidity Crunch can start during the contraction phase, leading to a reduction in credit availability.This can exacerbate the contraction phase of the credit cycle by significantly reducing the availability of credit.
• Market Contraction is a hallmark of the trough phase, where asset prices fall, and credit becomes less accessible.This is more a feature of the credit cycle than a cause, marking the trough phase with falling asset prices and reduced credit accessibility.