KBRA Financial Intelligence

3 Things in Credit: Bank Warnings, Small Business Struggles, and Post-Inflation Risks

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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.

You have to love New York Fed CEO John Williams for introducing a word in a speech this week he says you might have found on a middle school vocabulary list: “equipoise.” It should come as no surprise to you that John Williams and I probably went to very different kinds of middle schools, as I admit to never, ever coming across the word “equipoise.” Webster defines equipoise as a state of equilibrium, which begs the question why not just use the word “equilibrium.”

This week, our 3 Things are:

1. Bank warnings. You’ll want to be aware of what Ally Financial is experiencing.

2. Small business struggles. Signals are not reassuring from the sector that accounts for 40% of GDP.

3. Post-inflation risks. It’s time to move your central bank obsession to the back burner.

Alright, let’s dig a bit deeper.

Bank warnings.

Financial institutions’ most important annual conference, put on by Barclays, came and went this week—and as always, important headlines came out. Two are worth exploring.

JPMorgan Chase schooled the analysts on why their earnings estimates are wrongheaded (too high!) by pointing out the obvious—that rates are expected to fall significantly, 250 bps in 2025, and in that scenario, net interest income will be negatively impacted. Yet analysts had net interest income at JPM forecast to fall by just 1.6%. Management reminded that the bank is “quite asset sensitive,” (meaning its assets reprice faster than its liabilities) and that the consensus estimate for net interest income has to come down. Then, there was the issue of expense growth. Management said 2025 consensus ($93.7 billion) was too low due to inflation and, I’m assuming, higher tech spend. Taken together, that means the estimate for 2025 earnings is being guided lower. The stock sold off a not trivial 5%. Does that matter to credit? The answer is a resounding no.

What moves the credit valuation of banks is overwhelmingly the loan loss provision, and on that note, management’s guidance was reassuring. No change in the outlook for credit card losses (still a quite reasonable 3.6%, up from an expected 3.4% in 2024). Management reminded that “consumers are in a relatively good shape.”

On the commercial lending side of things, there has been no deterioration in auto financing, residential mortgages, small business, middle market, or large corporates. There continue to be challenges in commercial real estate, where “we haven't seen the bottom” yet. But the bank is “very well reserved for that,” and lower rates will help. Management noted that businesses are being careful due to concerns about geopolitics (U.S./China relations were highlighted), the U.S. election, and the outlook for interest rates.

Then there is Ally Financial, the large consumer-oriented bank. Its stock sold off 19% Tuesday. Management said, “Our credit challenges have intensified”—this, after what has already been a challenging year for management to forecast accurately what is happening with loan losses. “Our borrower is struggling with high inflation and cost of living and now more recently, a weakening employment picture.” That sounds ominous, especially given that unemployment is historically low.

The problem is centered in its retail auto lending portfolio, where in July and August delinquencies are up 20 bps versus expectations, and losses were up 10 bps above. Management expects the latter to grow. For context, the loss rate in retail auto finance over the past 12 months is 204 bps, so this, in and of itself, is not all that worrisome. The equity market’s reaction reflects more of the consequences of unexpectedly higher loan losses, namely you have to tighten the credit box further, which will lean on growth and depress returns.

Ally’s warning is consistent with our Two Economies theme that we talk a lot about, where less wealthy consumers are increasingly vulnerable to economic slowdown at this point in this cycle because the transition from a stimulus-fueled lifestyle back to normal is a bumpy one that will contribute to economic slowdown.

Alright, on to our second Thing—Small business struggles.

So much for the “Great Rotation.” Remember that moment (and it feels like just a moment) in July when the Russell 2000 broke out, up 12% in a week? It’s been volatile since then, but the latest survey out of the National Federation of Independent Business won’t help. Summing it up, the NFIB said, “The mood on Main Street worsened in August, as uncertainty … continues to rise as expectations for future business conditions worsen.” Small businesses account for roughly 50% of U.S. employment and some 40% of GDP, so sentiment here matters.

Keep in mind, the group’s Small Business Optimism Index has been depressed for some time now (32 consecutive months below the 50-year average), but the latest read is particularly somber. Eight of 10 components in the index deteriorated during the month. Firms reporting positive profit trends versus those reporting negative ones were a net negative 37% in August, seven points worse than July and the lowest since the GFC. Those expecting higher real sales fell nine points in the month to net negative 18%, consistent with a rise in the group’s Uncertainty Index to the highest level (92) since October 2020, 10 points higher than June. Only 4% of respondents think the next three months would be a good time to expand.

We’ve learned by now that small businesses have been hit particularly hard by the effects of inflation, the labor shortage, supply chain snafus, and the rise in rates, so the results shouldn’t be all that surprising. But it does represent a significant headwind to growth as we look forward, and it is sure to leave a mark in middle market finance.

Alright, on to our third Thing—Post-Inflation Risks.

In a post-inflation world, which is where I think we are, it’s a good time to think about risks: risks to 2% economic growth, to 7% corporate earnings growth, to sub-5% unemployment, the pillars of normal. And here’s perspective underpinning all of this. Take out the shock of COVID, and we are in one of the longest periods in recorded economic history of expansion in the U.S. That says a lot, and something that I think is underappreciated in a world of data release obsession.

One big risk we see among investors (and company managements) is attributing poor performance by companies, be it on strategy or execution (or both), to macro forces. More often or not, poor performance is the result of poor management decisions. Into a slowing growth world, it is more important than ever to focus on the business model. Is it competitive? Is it durable? What about the capital structure? Is it appropriate? Credit is certainly affected by macro trends, but at the end of the day, it is idiosyncratic. There are too many zombie companies out there that survived on super cheap and super abundant debt. Higher cost of capital should weed many of those out.

That said, on the macro side, the aforementioned John Williams mentioned three signs of a shift in economic conditions that he is watching, namely the possibility of further weakening in the labor market, a sharp slowdown in global growth, and volatility in the progression of disinflation. He says the future is “highly uncertain.” Overall, I don’t think the future is highly uncertain. I would reserve that description for Q4 2008 and the GFC or Q1 2020 with COVID. Today, with two hot wars and political volatility, there clearly are tail risks. But economically, we don’t see big swing factors out there that investors struggle to dimension.

Alright, back to Mr. Williams’ risks. He has long used the analogy of peeling an onion’s layers to figure out the risk of inflation. Let’s peel the onion a bit in thinking through his points of uncertainty.

Ordinarily, when you have an historically aggressive tightening cycle, overshooting by central banks is far and away the norm. So, releasing the brake (cutting rates) at precisely the right time to maximize employment, simply put, rarely happens. Why? The incentive is to overshoot. Peeling the onion, we know that, today in the aggregate, consumer and commercial balance sheets are in better-than-normal shape heading into the slowdown, and businesses have had a long lead time to adjust cost structures. It means there is a better-than-normal chance of keeping unemployment low.

Declining global growth, on the other hand, is worrisome. The two primary engines of growth, the U.S. and China, are slowing, and China’s is more problematic given that it is fundamentally altering its economic model away from levered infrastructure and unbridled tech-enabled development. We also worry about Germany, which looks to be headed toward stall speed at best. And the ECB seems to be much more cautious than the Fed in terms of getting rates back to neutral.

His third point of concern, disinflation, has upside and downside risks, according to Mr. Williams. We worry far less about upside risks given global slowdown. Now, Jamie Dimon this week keeps playing up the inflationary risks posed by higher deficits and increased infrastructure spending, but we think the bigger risk, especially over the medium to longer term, is deflation related to automation.

Beyond those concerns, we would add to the list uncertainty around the Treasury market. What the impact will be of having to finance a now-massive deficit in the face of two presidential candidates that show no sensitivity to fiscal responsibility. We would also add trade war should Trump be elected to potential risks. It derailed growth in 2019, and it could again.

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

1. Bank warnings. Ally’s higher-than-expected bad debt costs suggest that tighter consumer credit will limit growth.

2. Small business struggles. Signals are not reassuring from the sector that accounts for 40% of GDP.

3. Post-inflation risks. Steering clear of zombie companies and global slowdown are near-term risks to navigate.

As always, thanks for joining. We’ll see you next week.