KBRA Financial Intelligence

3 Things in Credit: Big Bank Color, Labor Sensitivity, and European Update

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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.

This was the week the president went after a true American icon, something that has operated independently for 100 years. No, not that—I’m talking about Coca-Cola’s formula. Apparently, according to press reports, the president had been speaking with the company about using “REAL” (all caps) cane sugar in Coke in the U.S., instead of high-fructose corn syrup, which the company has been using for decades. “You’ll see,” the promoter-in-chief said. “It’s just better.” That sent the stocks of high fructose corn syrup producers Archer Daniels Midland and Ingredion stocks down 6.3% and 8.9%, respectively. It pays to stay on the right side of the political winds.

This week, our 3 Things are:

1. Big bank color. Here’s how credit is performing among the large lenders.

2. Labor sensitivity. What will it take for employment to crack?

3. European update. Our European Macro Strategist updates his views.

Alright, let’s dig a bit deeper.

Big bank color.

Each quarter we look forward to taking stock of what the largest lenders, the big banks, are reporting and forecasting on performance in their loan portfolios. Let’s start with the data.

Loan loss provisions, that amount which banks are setting aside out of current income for future loan losses, was once again well behaved. Despite loan growth of 6% for the combined JPMorgan Chase, Bank of America, and Wells Fargo, the aggregate loan loss provision fell 6%. Nonperforming loan ratios at the three banks remained well below 1%, which is a way of saying that loan quality remains very high.

Color from managements, as always, put some meat on the bone. JPM mentioned that its probabilities attached to adverse scenarios—part of its determination of estimated future loan losses—have decreased. And then there was this candid comment by management: “In terms of the consumer, we continue to struggle to see signs of weakness.” Accordingly, credit card losses, which account for 80% of the company’s total, came in at a quite reasonable rate, 3.4% annualized in the latest quarter, and full-year guidance of a still low 3.6% was reiterated. Management reminded that “consumer credit is primarily about labor markets, and in a world with 4.1% unemployment, it’s going to be hard to see a lot of weakness.”

At Bank of America, a similarly sure-footed story, as they reported their sixth consecutive quarter of total net charge-offs around a low half of 1% of loans (annualized) level. Management did mention that they had what seems to be a bit of a clean-up quarter in its commercial real estate office portfolio. Most of those charge-offs were previously reserved, so it had a modest impact on results. The CRE office story continues to hang around, but it’s never been all that material to the largest banks. Management also noted that loss rate on credit card declined year-over-year for the first time this quarter since early 2016, outside of the pandemic period. The loss on credit card fell 23 basis points to 3.82%, and delinquencies declined for the second consecutive quarter.

At Wells Fargo, credit performance “continued to improve and remained strong,” according to management. It did add, however, that “there is uncertainty, and we should recognize there is risk to the downside, as the markets seem to have priced in successful outcomes.”

Consumer delinquencies continued to improve from a year ago, and commercial credit performance continued to be “relatively strong.” While commercial net loan charge-offs increased $36 million from the first quarter, at a still quite low 18 basis points of average loans, it’s nothing to worry about. Indeed, management explained that losses in our commercial and industrial loan portfolio were borrower specific, with little signs of systematic weakness across the portfolio.

On the CRE office side of things, management noted that related losses decreased during the first quarter, adding that “it will take time for the office fundamentals to recover. Valuations appear to be stabilizing. And although we expect additional losses, they should be well within our expectations.” Reassuring words.

In an environment where economic growth in the U.S. is forecast to cut in half in 2025, that fact that banks are not forecasting higher loan loss risk on the margin might strike some as surprising. Our view is that it reflects the largest banks positioning in the better part of our Two Economies, wealthier households and larger businesses. The data also suggests that regulatory (and market) incentives a decade ago to push riskier lending out into markets has also reduced bank cyclicality, something that reduces systemic risk in the financial system. All of this is good for credit.

Alright, on to our second Thing—Labor sensitivity.

“Consumer credit is primarily about labor markets, and in a world with 4.1% unemployment, it’s going to be hard to see a lot of weakness.” We thought it was worth repeating this comment from JPMorgan Chase as a way of introducing discussion of that 4.1%. Just how stable is it? With the U.S. consumer driving 70% of U.S. economic output (and much of the world’s economic health), how durable is the employment picture in the U.S.?

Thinking through this, I would make the following observations:

• One, with corporate margins in the U.S. at or near 50-year highs, companies have the ability to hold on to or hoard employees. COVID reminded how hard it is to find enough qualified labor. Hold on to what you have. That argues for unemployment holding at low levels.

• Two, growth is slowing and costs are rising via tariffs and inflation. Managements need to keep share prices up, so look for scrutiny on the labor cost line. That figures to start with wages and overtime, but eventually, businesses will move to right-size in the face of slowdown. That argues for unemployment rising.

• Three, the administration’s commitment to reducing immigrant labor will keep unemployment low, although the unemployment rate would rise through a denominator effect.

• Four, the effects of automation, including artificial intelligence, will continue to drive a net decrease in labor headcount and costs. Even though firms struggle to find enough workers with the requisite technology skills—and those found will be costly—on a net basis, companies will need fewer workers. Unemployment will rise.

So, what is the risk? What is the interplay of these factors and how will they sequence? The answers to those questions, and how to invest around the possible outcomes, involve scenario analysis and a bit of crystal balling.

Starting with growth, it would have to undergo more of a shock, in our opinion, rather than the slowdown already forecast to cause firms to layoff materially more workers. Currently, growth is expected to hold steady in 2026, getting to 1.6% in the U.S., not far from potential of 1.8%. That’s probably not enough to get hiring managers to deviate from their “little hiring, little firing” mode of the moment. But survey data out of the NFIB and the regional Federal Reserve Banks indicate a growing wariness of the hiring part of the equation, the first step toward the labor market softening further.

For something more dramatic, you would need to see growth hit a wall, a scenario that could be driven by unexpectedly high inflation, which would, in turn, bring about the Fed remaining on hold or even tightening. Another scenario would involve something material on the geopolitical front. Both feel like tail events at the moment.

Over the intermediate term, the automation/AI trend is more ominous. The speed at which the technology will disrupt/recast traditional jobs is difficult to dimension at this stage. But it’s hard to imagine that the impact will be limited to the margin. And the speed at which these forces are advancing, and the status they are taking on as strategic imperatives among corporate managers, suggest that the dislocation among the current workforce will be inelegant when it intensifies, worsening the skills mismatch. And that argues for structurally higher unemployment in the intermediate term.

Alright, on to our third Thing—A European update.

I’m joined by KBRA’s European Macro Strategist, Gordon Kerr, who has just published the latest version of his quarterly report, The Forward Look, which highlights key factors driving European credits in Q3.

Van: Gordon, thanks for coming on. You have recently published your Forward Look. What are some of the key themes you are seeing ahead in Europe?

Gordon: Thanks for having me on, Van.

Yes, in our Forward Look, I outline that the outlook for European economies is somewhat improving. This is not a roaring comeback—this is more a gradual uptick. It will still take time to materialize, and there are a number of caveats to this expectation, but the tailwinds are gathering. Much discussed defense and infrastructure spending plans are starting to trickle through the system, especially in Germany, which has traditionally kept a tight fiscal stance. They have yet to show up in the data as of yet, as the execution of the plans is still being debated, but their first signs are emerging with improvement in sentiment indicators.

Germany is the driving force behind the improving outlook. The efforts here to inject stimulus and reignite the industrial heartland will have an impact. Germany isn’t just any European economy—it’s the engine. The country is the largest trade partner for 17 of the 27 European Union member states and a top three trade partner for all but one. When Germany flexes its economic muscle, the effects ripple across the continent.

Currently, European recession probabilities remain elevated, but they have been declining and are being held up based on the pace of the turnaround in growth and high levels of uncertainty. Consider Germany: At the beginning of the year, recession odds were above 50%. Today, they’ve dropped to around 40%, and we would argue should fall further. France tells an even more dramatic story—recession probability halved to 30% in June from 60% in May.

Van: So, what do you see as the risks to this turnaround? Where can things go off the rails from here?

Gordon: I hate to say it, but the biggest risk comes from you guys across the pond. The largest headwind to a European turnaround is the ongoing trade tensions, particularly with the U.S. The lack of a finalized EU-U.S. trade agreement keeps uncertainty high and investment cautious. On top of that, trade tensions with China have added to the mix. This uncertainty is likely to hold back investment and activity, even with the backdrop of a shifting investment focus into Europe as dollar diversification continues.

This all feeds into increasing costs for corporates, potentially impacting margins. Potential new tariffs and still elevated input prices (from the Russia-Ukraine conflict, which had an impact on power prices and general goods inflation). Added to this you have financing costs, albeit lower than a year ago; they are still elevated from the zero bounds we had several years ago. All of this pressures corporate margins. While defaults aren’t surging, we don’t expect significant improvement either.

Lastly, in correlation with the corporate financing element I just mentioned, we have the ongoing risk from bond vigilantes. They are back! Governments spent heavily during the pandemic and forgot to turn off the taps, and that’s pushed sovereign debt levels higher. As a result, borrowing costs are rising, which could weigh on future fiscal flexibility.

Van: Thanks, Gordon. You mentioned the bond vigilantes, which impact across individual European countries differently. How do you see the regional differences emerging?

Gordon: Yes! This is a key element that we see continuing to play a role in the months ahead. Europe is made up of many individual countries, and they are all undergoing different cycles. The largest economies are the ones that appear to be most at risk from budgetary constraints that could hold back growth plans. Here in the UK, the chancellor has had a challenging period as the government looks to support growth and spend more money (as liberal governments tend to do), while battling with sticky inflation and a severe lack of available funds.

France is improving, with declines in bankruptcy rates and ongoing stimulus plans—albeit alongside a challenging budgetary situation, and, according to some, a degree of elevated levels of corporate stress. Government bond yields have risen as the government looks to balance its books.

Germany, as we’ve discussed, has been under pressure—from energy shocks to falling Chinese demand. But policy is responding, and that gives hope for a turnaround. It has raised the cost of borrowing in Germany with higher rates, but the ability to spend is within reason.

So in summary, Europe isn’t in full recovery yet, but the pivot is real. It’s slow. It’s uneven. And it’s subject to shocks. But the tailwinds are starting to gather. From a market standpoint, sentiment has improved. Credit spreads are tight. Equity markets are pricing in better earnings. Economic releases have been surprising on the upside. There is still value to be found, but selectivity is essential—especially given the lingering risks from geopolitics and trade. There are a number of large caveats to this, but if Germany’s turnaround holds, the European story could shift faster than many expect. Anyway, jump on the website and have a read of the full report.

Van: Thanks, Gordon.

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

1. Big bank color. Credit quality in loan portfolios is holding up remarkably well.

2. Labor sensitivity. Near-term risk of softening is building, but the real issue is technology’s impact over the intermediate term.

3. European outlook. The pivot to a more powerful growth platform is underway, but change will take time.

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