Christian Baylis of Fortlake was one of the highest-rated sessions on our recent Sydney Manager Walking Tour, and his subject has only become more topical since. In the first of a series of follow-up videos we went back to him this week, the day before the RBA meeting, to ask what a late-stage credit cycle means for consumers, for corporates and for portfolios.

Start with households, because that is where the compounding has already happened. Baylis makes a point rarely made in the press or by the Bank: everyone is looking forward but few people talk about the past overshoot and the ongoing impact it is having on consumers. Inflation has compounded at roughly 4.5% against a 2.5% target for five and a half years, leaving the price level about 10.5% higher than it should be. On his arithmetic that costs every Australian household around $14k a year, the true cost to society of missing the target, borne by 28 million people rather than the 3.3 million with a mortgage. Real incomes per person have not risen in five years, productivity has gone backwards, and interest costs as a share of household income are the highest in three or four decades. His explanation for why Australia is the developed-market outlier on rates is simply that we went soft on inflation and this is the price.

The global corporate economy is also K-shaped for a related reason. Hyperscalers are issuing debt on an unprecedented scale — US$1.5 to 2.2 trillion, roughly the size of the entire high yield market — and will pay almost any spread, because losing the race is existential. That crowds weaker borrowers out of the oxygen. Triple-C spreads are near their widest since the GFC and the pandemic, around 1,800 to 1,900 basis points, and at their widest ever against double-Bs. Covenant-lite issuance in leveraged finance has gone from 10% to 90% to accommodate the direct-lending bid, and weak covenants are now ricocheting up into the broadly syndicated market. CLO managers, capped at 7.5% triple-C exposure, are forced sellers into poor liquidity, a prisoner's dilemma about whether to sell before or after the downgrades. Baylis expects recovery rates nearer 10 to 12 cents than the 30 to 40 the market assumes, because technology issuers have intangibles rather than hard assets. The refinancing wall in single-Bs lands in 2028–29, and rating agencies downgrade once it is inside twelve months.

For portfolios, the reassuring argument, that moving risk off bank balance sheets deleverages the system, does not survive contact with the fact that CLO managers, running twelve to thirteen times leverage, buy around 70% of direct lending deals. The leverage has moved rather than gone, from depositors to pensioners. Baylis's expected sequence is familiar: rates rise far enough to prick the balloon, distressed capital structures reorganise, unemployment follows, and central banks then cut to soften the blow, at which point duration does the defensive work and investment-grade credit becomes the workhorse again. He does not expect a return to zero; higher lows. The Fortlake strategy, with its positive exposure to the default cycle is one of the few levers that we have now that can provide genuine diversification in an adverse economic scenario, especially if that involves the kind of inflation, at least in the first instance, that  challenges the fundamentals of government bonds.   

More generally, advisers may wish to consider what their defensive sleeve is being paid to do between here and there. The honest message to clients is that the next three to five years will not resemble the last ten, and that reaching for yield is the one thing this cycle punishes may punish the most.