KBRA Financial Intelligence

3 Things in Credit: Big Bank Color, Net Worth Surge, and Treasury Volatility

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 a week in which Jay Powell described the U.S. economy as “quite strong” with above-potential growth and a labor market that is in the midst of its longest streak ever with unemployment below 4%. And somehow that triggered “sell” orders. Is it possible that we have forgotten how to accept good news? Maybe. Be careful what you wish for.

This week, our 3 Things are:

1. Big bank color. We’ll summarize what some of the largest lenders are seeing in credit.

2. Net worth surge. It’s driving the consumers’ confidence to spend.

3. Treasury volatility. A Fed pivot of the unfavorable kind.

Alright, let’s dig a bit deeper.

Big bank color.

Kicking off earnings season, as always, are reports from the largest banks. And I have to say, I marvel at the equity community and how they tend to ignore what’s going on in credit. Banks that carry trillions of dollars in credit risk, the valuation of which can swing materially as the cycle turns, and yet until banks hemorrhage loan losses the focus is almost exclusively on net interest income, share repurchase and, even less consequential, investment banking revenues. Yawn.

Take Bank of America. Over the last five quarters, net interest income fell into a rather tight range of $14.1 billion to $14.6 billion. Loan losses, however, increased $700 million (nearly doubling year-over-year) in the latest quarter to $1.5 billion. That’s 16% of pretax pre-loan loss provision income, up from 8% in the year-ago quarter. Overall profitability, measured by return on assets, fell from 1.07% to 0.89%.

Loan losses usually are the swing factor in bank credit when the cycle turns for good or not so good. Interestingly, press reports—not analyst questions—focused on the jump in loan losses as part of the explanation for BofA’s stock selling off 3.5% on the news. Now, it is worth noting that BofA actually had a loan loss reserve release of $179 million in the quarter due to a “modestly improved macroenvironmental outlook” compared to the previous quarter. And that loan loss reserve build, or in this case release, is the forward-looking indicator, while actual loan losses are more of a lagging one.

In any event, driving the higher loss number were credit card seasoning, to be expected as accounts mature, and ongoing write-downs of office loans due to what management called “swift revaluations from current appraisals and resolutions.” Management believes losses in the office portfolio are largely reserved for. Good news is also coming out of the consumer book, where slowing delinquencies point to a leveling off of consumer loan losses, “well within” managements “risk appetite and expectations.” Overall, despite the stock selloff, good news on the credit front out of BofA.

JPMorgan Chase also reported a modest reserve release, while its loan losses fell 17% year-over-year. Management did guide that the consensus for reserve build over the balance of the year is “a little too low” based on expected card loan growth of 12% for full-year 2024. Useful context for full-year 2024 card losses was given at a comforting “less than 3.5%” rate.

Overall, “consumers are fine, and businesses are in good shape,” (that from CEO Dimon). Elaborating, Mr. Dimon notes that consumer loan losses are “normalizing a little bit,” while on the commercial side, “confidence is up, order books are up, profits are up.” He adds, however, that the positives are a function in part of unsustainable fiscal and monetary largesse, and that the future has a fair amount of uncertainty hanging over it.

Mr. Dimon is more cautious than many on the economy. “I've never seen anyone actually positively predict [a] big inflection point in the economy, literally in my life or in history.” He ominously points out that if the 10-Year goes up 2%, “all assets, all assets, every asset on the planet, including real estate, is worth 20% less.” He adds if rates go up because the economy is strong then CRE will muddle through. Alternatively, if we have stagflation, it will be “tough for a lot of folks.” OK then.

At Wells Fargo, management noted “consumer credit is performing as we expect. Wholesale credit continues to perform well and our views around commercial real estate have not significantly changed since last quarter. These are all positives.” The “continued strength” in the U.S. economy, which is allowing for an orderly normalization of credit. Loan losses doubled in the quarter from the year-ago period, but only to levels that are within expectations and quite reasonable. The bank did not see further deterioration in the performance of its CRE office portfolio versus the fourth quarter, although it expects additional “uneven and episodic” losses in the coming quarters. As was the case with the other two banks, Wells, too, had a net release to its loan loss reserves.

To sum all of it up, U.S. consumers and businesses in the aggregate are in good shape, able to endure slowdown, without posing a significant threat to risk premia. What is also clear is that consumers or businesses that are not well positioned, with either inappropriate leverage and/or outsized vulnerability to cash flows, will be more at risk and the fact that this is happening at this stage of the cycle tells you that what’s ahead—back to normal—is different than what we’ve experienced in the easy money era of the past decade or so. Not everybody wins just by showing up.

Alright, on to our second Thing—Wealth surge.

The ongoing strength of the U.S. economy has caught just about everyone by surprise, mostly because we have been trained to look backward at past periods with similar defining characteristics for insight into how the future will play out. In this case, the defining characteristic—the roadmap—is past monetary tightening cycles. But we also need to be aware of something we’re trained not to do, and that is to assume that this time is different. Well, one thing we’ve been consistent on is this time is different, if for no other reason than the amount of stimulus deployed to cushion a shock. That stimulus, call it $10 trillion of fiscal and monetary accommodation, injected into a $27 trillion economy. That’s different.

That means that, at least for now, the transmission of monetary tightening has been thwarted, or at least delayed. As Jay Powell pointed out, the U.S. economy is in pretty good shape. This strength is fueled by excess savings that are still with us. Bank of America says its average consumer deposits are 28% higher than pre-pandemic. It’s also fueled by surging household net worth, driven by strong housing and financial markets. Since year-end 2019, household net worth has risen 34% to an all-time high of $156 trillion. Net worth to disposable personal income is running just off of 80-year highs, as real estate plus investments have eclipsed the 50% of household assets threshold for the first time ever. Rosenberg Research believes that over the past year, the wealth effect—housing and financial—accounts for two-thirds of the growth in consumer spending. Could this change? It could, to some degree. We pointed out a couple of weeks ago that the majority of Street equity strategists expect the market to trade off by year-end, but housing is likely to remain resilient because the supply of new homes remains deficient. All of this argues for spending to remain buoyant, and rates higher for longer.

Alright, on to our third Thing—Treasury market volatility.

This was not supposed to happen. Rates were supposed to fall in 2024, not rise. But here we are. Fixed income was supposed to be a favored asset class in 2024, but here we are. Investment grade is down 2.8% year-to-date and high yield has tipped over and is now down fractionally on the year. This is attributable of course to the unexpected move higher in Treasury yields.

It goes without saying that this is a multifaceted issue, with U.S. deficit dynamics colliding with the relative strength of the U.S. economy, longer-term inflationary forces such as energy transition, and security of everything, and the Fed’s plan to bring down inflation. BlackRock’s Larry Fink notes that the deficit in the U.S. has grown from $8 trillion in 2000 to $34 trillion today. As a result, public debt is crowding out private capital. We are less concerned with that phenomena, as capital will mobilize to its most attractive opportunity. Higher rates strike us, at least over the near term, as more a function of the Fed’s intentions, and Powell made it clear this week that inflation data has proven to be stickier than expected, and that it will take longer to tame back to target.

Bloomberg consensus on the 10-Year at year-end has moved up over the past couple of months but remains below 4% at 3.9%. The latest Wall Street Journal survey comes out in a similar place. That’s well below the long-term average and reflects expectations for a modest slowdown in economic growth, as monetary tightening continues to bite.

For credit, that backdrop is constructive, providing historically attractive yields, and the potential for even a bit of price appreciation from today’s levels. Could it all fall apart? Sure, that tail risk exists, and, for what it’s worth, Jamie Dimon said his bank is preparing for rates being anywhere from 2% to 8% or even higher. We mentioned his comment earlier about what happens to asset valuations should rates spike higher. Let’s hope that’s just rhetorical, if not mathematical, excess, and not a forecast.

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

1. Big bank color. Credit is normalizing, but apart from downtown office loans and some weakness in more vulnerable consumers, the near-term outlook for credit costs remains benign.

2. Net worth surge. It’s driving the consumers’ confidence to spend.

3. Treasury volatility. The trend is not our friend.

As always, thanks for joining. See you next week.