KBRA Financial Intelligence

3 Things in Credit: Animal Spirits, Mid-Market Loan Quality, and Higher for Longer II?

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

In what was one of the least surprising FOMC release days in recent memory, we got to witness a very human moment in the press conference when Fed Chair Powell was asked if he would leave his post ahead of his term ending in 2026 if the President-elect asked him to. Powell steeled himself and delivered a stern one-word response: “No.” Sounds like Chair Powell is not going anywhere.

This week, our 3 Things are:

1. Animal spirits. Reward, then risk.

2. Mid-market loan quality. KBRA’s latest research reveals an interesting turn.

3. Higher for Longer II? The rates outlook comes with a cost.

Alright, let’s dig a bit deeper.

Animal spirits.

Deregulation and deportation. Tax cuts and tariffs. America First.

I won’t bore you with yet another round of navel-gazing about what the election says about America. But, in a word, the aftershock is seismic.

And in a sentence (albeit a lengthy one), two takeaways from an economic perspective: One, businesses (and investors) hate the cumulative effect of regulation, especially when driven by ideological rather than economic considerations; and two, people hate inflation.

Now, the economic effects to come depend to varying degrees on whether or not there is a Red Sweep, whether the GOP can add control of the House to go with its control of the Senate, and, of course, the White House. Time will tell. That will clearly impact the outcome of any legislative changes, with the tax code clearly topping that list.

In any event, the election has clearly unleashed animal spirits, not dissimilar from what we experienced in the wake of Trump’s first election win back in 2016. Think of it this way. Business managers anticipate—and spend to prepare for—higher levels of activity. Consumers, especially those enjoying the wealth benefit of investment portfolio gains, are feeling flush, ready to spend, anticipating lower taxes and wage gains. Investors, feeling the tailwind building, are scrambling to find beaten down names and sectors—I’m looking at you, banks and small caps—where Trump’s cornerstone initiatives, most notably deregulation and America First, have boosted the tailwind. All of this figures to drive growth higher over the near term, taking our estimate for 2025 U.S. GDP estimate from 2% to 2.5%. That’s well above the Fed’s longer-term growth estimate in the U.S. of 1.8%.

So, what’s the downside to this growth jolt? Well, it’s inflationary. Expect to feel that impulse as businesses scramble to find resources needed to increase production. Think of the rising costs of materials and labor. Over time, markets in both figure to become tighter still due to tariffs and planned reductions in migrant labor, the latter achieved through both deportations (that’s hard to do and will take a while), and, more likely, limits on immigration. And you can probably add fiscal deficits to the inflationary impulse, although the effects are debated. To the extent that higher fiscal spending drives up the price of goods and services, yes, that is inflationary.

Are there offsets to inflation? Yes. Deregulation is deflationary, as is the continued rise of technology and automation.

But, net net, we think Trumponomics shakes out as inflationary, something that at a minimum contributed to the recent rise in rates, as markets responded over the past month to the increasing likelihood of a Trump victory. And it’s a safe bet that any growth boost will result in fewer rate cuts from the Fed. Sure enough, the implied rate based on fed funds futures at year-end 2025 have risen by a point over the past month and now sits at 3.7%. As for the 10-year, if we thought, preelection, the 10-year would bounce in a range of 3.7% to 4.3%, you can probably move that up to 4% to 4.6%. By historical standards, that level is still low and plenty constructive in terms of fueling economic growth. But the uncertainty around how all of this will lean on rates over the near term figures to keep Treasury market volatility elevated, a suboptimal condition for credit markets.

So, given all of that, let’s revisit our opening sentence:

“Businesses hate regulation … ”: That, will get better quickly, and that’s good for credit.

“People hate inflation … ”: That, might not be tamed after all. That will take time to develop, but if, and when, it hits, that won’t be good for credit. We’ve seen that movie before.

Alright, on to our second Thing—KBRA mid-market asset quality.

This week, KBRA released its Private Credit: Q3 2024 Middle Market Borrower Surveillance Compendium, with the curious title asking if “The End Is Near?” The “end,” in this case, refers to where we are in the direct lending credit cycle, as in the end of loan quality deterioration. Specifically, our research notes that “while lower top line growth give us some pause, largely all other credit metrics appear to be trending in a positive direction.” The piece adds, “Based on the data, it is beginning to appear, that overall, KBRA’s portfolio of private credit assessment obligors may have made it through the worst of elevated rates on solid ground.”

The study is based on the performance in the three most recent periods of 1,384 unique sponsored middle market borrowers assessed through Q3 2024. Findings note that the slowing economy is evident as 24% of all borrowers experienced a revenue decline over the latest 12-month period, up from just 14% in the prior LTM period. Nevertheless, “median obligors’ profitability margins are expanding, which is starting to have a positive impact on interest coverage ratios and leverage.” Specifically, the piece notes that “75% of assessed obligors have interest coverage ratios (ICR) above 1.0x, and with each passing quarter, that percentage has grown.” Moreover, “with the Fed set to continue lowering rates, we postulate that many of the metrics used to gauge the overall health of the private credit direct lending industry will continue to trend upward, i.e., improve, from here.”

The piece is just the latest from our Private Credit group. You can find it, and all of their research, on our website, KBRA.com, on the Corporates tab under Sectors.

Alright, on to our third Thing—Higher for Longer II?

Those animal spirits we talked about are clearly driving risk markets to new heights, caught up in the euphoria of Trump II. Interestingly, this seismic change heightens the prospects of Higher for Longer II. The first iteration appeared in the back half of 2023, as inflation was proving to be stickier than hoped. That caused a selloff in risk. As mentioned earlier, market expectations today are for fewer rate cuts than was expected a few months ago, leading to a policy rate closer to 4% by year-end 2025 than the sub-3% level we were expecting back in June. From a risk markets perspective, Trump’s bump has overshadowed, for now, the rates bump. But are we naïve enough to believe markets will continue to look through what could be Higher for Longer II?

The impact of higher rates continues to lean on the economy. Home sales are falling off again as mortgage rates climb back over 7%. Delinquencies and losses on credit cards and auto loans are at levels we don’t see when unemployment is in the low 4’s. And notwithstanding the improvement we’re seeing in sponsor middle market borrowers in the aggregate, there still are pockets of vulnerability out there. Corporate borrowers electing to PIK (i.e., defer debt service) has risen to 9.5% at BDCs, according to Bloomberg—that’s up from 4.1% pre-pandemic. Safe to say that the higher cost of capital is going to continue to lean on companies with deficient business models and/or inappropriate capital structures.

The other consideration here is that all of that U.S. sovereign debt issued to mitigate the effects of first the GFC, and more recently COVID, has created a massive funding burden that threatens to raise the cost to, if not crowd out, other borrowers.

So, keep an eye on Higher for Longer II. It’s likely to leave a mark on Trump II’s economy.

So, there you have it, 3 Things in Credit:

1. Animal spirits. A growth spurt comes with a cost.

2. Mid-market loan quality. KBRA’s latest research reveals an interesting turn.

3. Higher for Longer II? Underneath the euphoria lies a higher policy rate.

As always, thanks for joining. If you’re interested in banks, you’ll want to find your way to Washington, D.C., on November 20 for our Bank Symposium. Find out how to sign up on our website under the Events tab. Hope to see you there. On the podcast, we’ll see you next week.