Credit Cycle

The Credit Cycle is the expansion and contraction in the access to credit over time. Think of it as the financial world's pulse—sometimes strong and pumping money through the economy, other times weak and sluggish. This rhythm of lending and borrowing is a powerful force that profoundly impacts businesses, consumers, and investors. While closely related to the broader economic cycle (or business cycle), the credit cycle is distinct and often acts as a leading indicator, meaning its turns can predict upcoming booms and busts. At its heart, the cycle is driven by human psychology: the swing between greed and fear. When optimism is high, lenders open the taps, and credit flows freely, fueling an economic expansion. When fear takes over, the taps are shut tight, credit dries up, and a contraction or recession often follows. This ebb and flow is one of the most important, yet often overlooked, dynamics for any investor to understand.

Just like the weather, the credit cycle moves through predictable phases. Understanding these “seasons” can help you prepare for what's next instead of being surprised by the storm.

This is the feel-good phase. The economy is recovering or growing, and optimism is in the air.

• Lenders' Mood: Confident and eager to lend. They loosen lending standards, making it easier for both companies and individuals to get loans. Interest rates are typically low or stable.
• What Happens: Businesses borrow to invest in new projects and hire more people. Consumers borrow to buy homes and cars. This easy money fuels a rise in asset prices, from stocks to real estate. Default rates are low because most borrowers can easily make their payments. It feels like the good times will last forever.

The party is now in full swing, and things are starting to get a little wild. Optimism has morphed into euphoria.

• Lenders' Mood: Overconfident. Competition to lend leads to riskier behavior. You might see a rise in loans with very little down payment or weak covenants (borrower promises).
• What Happens: Debt levels become dangerously high. Speculation replaces sound investment. Central banks, like the Federal Reserve (Fed) or the European Central Bank (ECB), may start to worry about overheating and begin raising interest rates to cool things down. This is the point of maximum risk, even though it feels like the point of maximum opportunity to most.

A trigger event—like a major bank failure (think Lehman Brothers in the 2008 financial crisis) or a sharp spike in interest rates—causes the mood to flip from greed to fear.

• Lenders' Mood: Panicked and risk-averse. They slam on the lending brakes, tightening standards dramatically. Suddenly, only the most creditworthy borrowers can get a loan.
• What Happens: Credit becomes scarce. Businesses that relied on rolling over their debt can no longer do so, leading to bankruptcies. Consumers cut back on spending. Asset prices fall as liquidity evaporates and forced selling begins. The economy slows down and often enters a recession. Non-performing loans on bank balance sheets soar.

This is the phase of maximum pessimism. The financial news is grim, and it feels like the sky is falling.

• Lenders' Mood: Terrified. They wouldn't lend money to their own mothers without iron-clad collateral.
• What Happens: The economy is at its weakest. Default rates have peaked. Asset prices are in the basement. Weak companies have been washed out, and only the strong survive. It's during this bleak period that the seeds of the next recovery are sown, as central banks cut interest rates and the surviving businesses slowly start to heal.

For a value investing practitioner, the credit cycle isn't just background noise; it's the entire landscape. Howard Marks, a legendary investor, has said that understanding where we are in the cycle is one of the most critical skills an investor can have. It allows you to shift your posture from aggressive to defensive and back again.

You don't need a PhD in economics to get a sense of the credit climate. Just pay attention:

• Listen to Bankers: Are bank CEOs on TV boasting about record loan growth? (Peak). Or are they talking about “fortress balance sheets” and managing risk? (Contraction).
• Watch Lending Quality: Are advertisements for “interest-only” or “no-doc” loans common? That's a classic sign of a frothy peak.
• Follow the Central Banks: When the Fed or ECB is aggressively raising rates, they are actively trying to end the expansion phase. When they are cutting rates, they are trying to end the contraction.
• Check the Anecdotes: When your taxi driver starts giving you stock tips, or everyone at a dinner party is talking about flipping houses, be cautious. Euphoria is a tell-tale sign of a top.

A value investor uses the cycle to their advantage, leaning against the prevailing sentiment.

• At the Peak (Late Summer): This is the time for maximum caution. Prices are high, and risk is hidden. It's a time to be a seller, not a buyer. Trim positions in companies that have become overvalued. Insist on a large margin of safety for any new purchase. This is when you build your watchlist of great companies you'd love to own at a much lower price.
• In the Contraction and Trough (Autumn/Winter): This is the value investor's hunting ground. When fear is rampant, prices are low, and good assets are being sold for bad reasons, it's time to be brave. This is where fortunes are made, by buying great businesses or distressed assets when nobody else wants them. As Warren Buffett famously advised, this is the time to be “greedy when others are fearful.”