All of our leading indicators for credit spreads and volatility point to wider volatility and higher credit spreads over the next two years.  The credit cycle is long in the tooth, and the best predictor of future credit spreads is the lagged growth in lending.

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For a long time, credit spreads have been too low and mispriced. Markets are now transitioning from a phase of complacency to a phase of cautiousness. While there may be short-term spikes and tradeable rises and falls in credit spreads and volatility, the average level should be higher than they are today.

As you can see from the chart below, corporate spreads tend to follow corporate profits, which we can show using the Kalecki-Levy equation. The equation is this: Corporate Profit = Investment + Dividends – Household Saving –  Government Saving – Foreign Savings.  (It happens that in the US the Foreign Saving and Investment terms net each other off, and dividends remain fairly constant over time, so the equation can be simplified).

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