Few in the markets will argue that the performance of debt and credit markets during 2006 was as it was expected to be. At the beginning of the year global economies were strong; interest rates were at historically low levels, spreads were tight and there had been substantial growth in all types of securities. It was generally felt that the only way to go was down, and so there was a torrent of negative predictions for the year ahead.
At this time we are looking at a situation where central banks are withdrawing liquidity at the same time that the credit cycle is turning, was the view of Deutsche Banks analysts.  is generally likely to be a weaker year for excess returns than 2005.
The majority of other credit analysts shared this sceptical view that the strong performance of the past few years would not continue into 2006. French bank BNP Paribas outlook for 2006 declared: Higher interest rates coupled with gradually deteriorating credit fundamentals should create a more challenging environment for the credit markets in 2006. It went on to say: Given tight valuations, we anticipate modest spread widening and credit curve re-steepening during .
In fairness, not every analyst was so pessimistic about the year ahead. Credit Suisses outlook publication was far more positive. In 2006, [Credit Suisse] expects more of what we have seen in 2005, it read. In fact, the Swiss bank was so far away from the popular view of an economic downturn in 2006 that its predictions proved overly optimistic, particularly about the US. Our economists see the US having another good year, with growth touching 3.5%, was one example. Another was: Our forex team expects the trend of a stronger dollar and a weaker euro to continue into the early part of 2006. Very few others shared this view, however.
Fast-forward 12 months and remarkably little has changed. World economies remain strong, spreads remain tight and the securities market is still soaring. So this years credit forecasts look more than a little like those for 2006. The 2007 credit outlook published by Lehman Brothers says: We believe the long-awaited turn in the credit cycle is likely to arrive in 2007, ending a five-year run of strengthening fundamentals. It should be noted that this quote was taken from Lehmans outlook for US markets in 2007, rather than being a global outlook. The banks predictions for European markets were slightly more positive but still pointed to a slight curtailment of growth. As credit spreads compress further, we think that the road in 2007 is unlikely to be as smooth as it was in 2006, but the juggernaut should successfully negotiate the bumps.
Lehman goes on to acknowledge that the current credit environment is somewhat reminiscent of the situation at the beginning of 2006. Compressed spreads and market positioning are remarkably similar [to 2006]. This combination makes it more likely that credit volatility will pick up during 2007, it notes.
In fact, volatility rose slightly in 2006, along with event risk, but not along with defaults and spreads, as was expected. In fact, some analysts were forced to reverse the credit cycle from where they thought it had come to last year. Citigroups outlook presentations for this year and last feature a graphic showing the leverage cycle for US and European markets (see charts). At the beginning of 2006, they thought that the period of all-round growth was at an end, and that while equities were still on the rise the credit markets had already begun to decline. This year, it seems that the markets are still yet to reach the point that Citigroups analysts thought they had hit last year. Credit has grown hand in hand with equities. The leverage cycle has not moved backwards; the markets had not reached the point that all signs hinted at last year. And it has hardly moved since.
The leverage cycle, 2006
The leverage cycle, 2007
So will the cycle move this year? Citigroup is sure that it will, and credit will fall against the continuing strength of equities. In fact, so sure is the US bank that in the 11-point conclusion to its outlook for this year the recommendation buy equities was written twice.
The general consensus is certainly for slower growth than in 2006. Granted, the US economy did slow a little last year. Growth did not reach Credit Suisses optimistic prediction of 3.5%, nor though did it fall to the pessimistic marks touted by many other analysts, including Bill Gross of Pimco. In January 2006, in reference to his investment outlook from the previous month, he wrote: It seemed clear to me that 2006 would be a year of slower growth, perhaps 2%. In the event, US growth was about 3%, and to give credit where it is due, it should be noted that some analysts, such as Blackrocks Bob Doll, had forecast this correctly.
Elsewhere, though, economies remained very robust. Consequently, analysts predictions have not moved much either. In some cases, as with Citigroup, there is a feeling that the markets are in a less precarious position than they were thought to be in last year. It remains to be seen if this time next year analysts forecasts will have again stubbornly refused to shift. Certainly some of the cracks seen at the beginning of last year have widened during the course of 2006. But cracked is not broken, and if those cracks have widened, spreads have not, as almost everyone thought they would. One thing is sure in the world of credit analysts: many of them will be wrong. Last year it was the majority. Will this be so again?