KBRA Financial Intelligence

3 Things in Credit: Commodities downdraft, Financial conditions, and Choiceful consumers

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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.

Are we at “peak euphoria?” That’s the question Goldman is asking. The Investors Intelligence poll currently shows a 41-point gap in its survey between bulls and bears. Anything above 40 maps to “extreme greed.” Speaking of extreme greed, that’s exactly where CNN’s Fear & Greed index is pointing. And another strategist on Bloomberg this week described the current mentality permeating the market as “everything is awesome,” citing the recent moves in bitcoin, and the stocks of small cap growth, and unprofitable companies.

Over in creditland, IG is down 1.8% on the year, and High yield is up all of 20 bps, and prospective Fed cuts keep getting cut and pushed out. Not exactly the stuff of euphoria.

In any event, this week, our 3 Things are:

1. Commodities downdraft. Historically, that move can be good or bad, we’ll give you our thoughts.

2. Cost of equity vs. cost of debt. What does the Fed make of this?

3. A “choiceful” consumer. What that means for all-important spending.

Alright, let’s dig a bit deeper.

Commodities downdraft.

We are often asked about geopolitical risk, (1) because it’s prevalent, (2) it’s headline-y, and (3) it’s difficult to dimension. It seems like it should affect markets. It usually doesn’t, except when that event, that risk materially affects supply and demand of a commodity or a currency. We watch commodity prices because it can disrupt trade flows, and it can impact global growth and inflation. In fact, to the latter point, commodities represent 38% of CPI. So we pay attention.

With all of this as background, it is noteworthy that commodity prices in the aggregate have been on a significant downward move since its recent peak back in June 2022, when geopolitical risk, the Russian war on Ukraine, hit Europe’s commodity superstore. Since then, commodity prices, as measured by the Bloomberg Commodity Index, have fallen 29%.

The price of energy, both oil and natural gas have led the way, in part because of the West’s multifaceted response aimed at reducing reliance on Russian sources, and in part because of the economic slowdown everywhere it seems but the US. And therein lies the double-edged sword of commodity prices.

When rising, commodity prices threaten to stoke inflation. When falling, they signal slowing global growth. Usually the latter trumps the former, meaning slowing growth historically has been a much greater threat to prosperity than inflation. Today, however, with all eyes on central banks and their potential pivots, taming inflation and reducing the likely drag of restrictive interest rates just might be more important to risk markets than slowing global growth. So the recent downdraft is a positive for credit overall, if not energy and food producers.

Alright, on to our second Thing, Equity Cheaper than Debt?

It’s easy to forget just how distorted capital markets have gotten over the past 15 years. Massive quantitative easing by central banks post the Global Financial Crisis drove interest rates to unnatural, unsustainably low levels in an effort to, quite frankly, battle deflationary forces and a stalled global economic growth engine. Credit spreads eventually became tight and compressed across the credit curve. The cost of downgrade had never been cheaper.

But every good party comes to an end. The fastest hiking cycle in 40 years, needed to tame inflation, has driven the cost of capital higher, and, quite possibly back toward normal, if we even remember what that was. But a funny thing happened along the way. Cost of equity got cheaper than the cost of debt.

What??? That’s not supposed to be the case! Equity carries a higher risk to investors since shareholders are subordinate to bondholders and are not guaranteed a capital gain or dividend payment.

But this week I tripped across a Bloomberg piece highlighting work done by Robert Buckland, a long-time Citi equity strategist now at a startup, Engine AI, who shows that the cost of equity for the S&P 500, as measured by the earnings yield (that’s EPS over stock price) is now lower than the cost of debt. That hasn’t been the case on a sustained basis since the dotcom era of the late 1990s-early 2000s. That earnings yield today is around 4%, while investment grade yields are about 5.5%.

That suggests that companies should be issuing equity more often. Now, I’m not suggesting, in the face of record-setting bond issuance, that we’re going to see the equity new issue business rise up off the mat. Mr. Buckland’s calculation is just one more data point that suggests that the era of cheap and easy debt is over, and that corporate treasurers, in certain sectors, will find very viable financing options in the equity market. The broader point here is that financial conditions—a function of debt and equities markets—are plenty accommodating, according to the various indexes out there tracking this. It follows logically that for the Fed to pivot, to cut rates, it will likely need to see financial conditions tighten.

Alright, on to our third Thing, A choiceful consumer.

We are keeping close tabs on the US consumer—the growth engine of the world-- as it adjusts its spending. In the past, we’ve taken notice of decelerating spend—Bank of America Institute has been a useful and insightful source of data on that front. Their data shows that total credit and debit card spend per household fell year over year in January two tenths of 1%. A year ago, it had risen 15% over the prior year to give you a sense of the momentum.

In addition to consumers pulling back on their spending, latest quarterly earnings from bellwethers such as Walmart, Target, Macy’s, etc. tell us that consumers continue to shift demand toward staples, and they are pushing back on price increases. Walmart’s CFO described the consumer as being “choiceful.”

We’ve spoken recently about the challenge all of this presents to the consumer sector in general, and to its margins more specifically. We remind folks that we do not expect the consumer to fall off a cliff. In fact, if we compare the consumer discretionary SPDR ETF with the staples SPDR ETF, discretionary has outperformed staples since the recent market low last October. It’s clear that, for now, leftover excess stimulus savings, real wage growth, the confidence that comes from a tight job market continue to provide a relatively smooth glidepath back to normal. That might not sound like something to get excited about but considering what’s going on in the rest of the world, and all that we’ve come through here in the States, that continues to provide a fairly constructive backdrop for credit.

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

1. Commodities downdraft. In this go around, taming inflation is more important to risk assets than slowing growth.

2. Cost of equity vs. cost of debt. Taken together, we have loose financial conditions, and that won’t help the Fed in its rate cutting.

3. A “choiceful” consumer. Consistent with slowdown, not recession.

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