KBRA Financial Intelligence

3 Things in Credit: Delta Exuberance, Q3 Outlook, and Whistling Past the Slowdown

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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 week came news, the likes of which we’ve never seen before, that Grok 4—X’s AI chatbot—is “smarter than almost all graduate students, in all disciplines, simultaneously,” according to Elon Musk. I wonder where he learned to speak with such hyperbole.

This week, our 3 Things are:

1. Delta exuberance. We’ll put a good story in proper perspective.

2. A forward look at Q3. What will shape credit markets?

3. Whistling past the slowdown. Markets have ripped as uncertainty lifts. Don’t lose sight of the whole picture.

Alright, let’s dig a bit deeper.

Delta exuberance.

There was a lot to like in this consumer discretionary bellwether’s Q2 earnings report. Record revenue driven by double-digit margins. Strong nonfuel cost control. Strong cash flow, lower debt. A 25% increase in the dividend. And the headline that got the most attention—restoration of earnings guidance. All the more impressive because this was the quarter where the administration made its reciprocal tariff announcement, which caused many companies, Delta included, to pull its earnings guidance. Put it all together and the stock jumped 12% on the day of announcement. CDS tightened 12 basis points (bps) to its lowest level since March.

This story fits nicely and neatly into the “reduced uncertainty” theme that has driven stocks broadly to all-time highs and credit spreads to near structural tights. Admittedly, the first thing I thought of was—wow, this bodes well for Q2 earnings where S&P 500 companies are expected to grow earnings just 2.8%. That’s a significant downdraft from a strong 13.4% in the previous quarter. Driving that deceleration in the current quarter is that uncertainty we all felt back in April. But Delta’s Q2 report changed all that, right?

Well, at the risk of raining on Delta’s parade, the airline’s year-over-year earnings growth in Q2 is a contraction of 11%. Pretax margin fell 1.4 points to 11.6%. Free cash flow fell 42%. The newly restored 2025 full-year earnings guidance—$5.25 to $6.25 a share—is at least 15% to 29% below the “greater than $7.35” guidance given in January. The stock has clawed back about half of what was lost in Q1.

The good news is that management characterized the environment as “stable since resetting to a lower growth rate earlier this year.” That’s a plus from our perspective for an industry—travel and tourism—that represents 9% of U.S. economic output. It also reminds us that headwinds have not gone away.

Alright, on to our second Thing—The forward look.

So, what factors will drive credit markets in Q3? We explore that in detail in our upcoming report, but here is a summary.

First, the data vacuum we’ve been in will begin to fill. This, of course, refers to the impact of tariffs—something the market has become quite complacent about. That “well over $300 billion” in tariff revenue that Treasury Secretary Bessent spoke about this week (that’s his expectation for full-year 2025) has to come from somewhere. It shows up in the consensus forecast for U.S. GDP growth in 2025, which is currently 1.5%. That, of course, is below the Fed’s longer-term growth estimate for the U.S. of 1.8% and a far cry from the 2.8% achieved in 2024. And yet, credit and stock markets are priced like it’s 2024.

Now, quite possibly, risk investors are factoring in rate cuts to offset the impact of tariffs. But does that make sense? The Fed has said the economy is strong and stable and it has expressed concern that tariffs will likely keep inflation above target. Taken together, below-potential growth and higher-than-target inflation and you have stagflation—albeit modest. And, perhaps more importantly, you have a rates environment that is remaining restrictive. That’s suboptimal. An imperfection encroaching on markets priced for near perfection.

We also believe U.S. exceptionalism will come out of the doghouse. We believe historically high corporate margins allow firms to pick up some of the cost of tariffs. We believe we’ll see American innovation—fueled by the world’s most effective capital markets—continue to drive corporate profits and risk market sentiment, important offsets to the cost of tariffs and concern over the rising federal deficit.

And finally, we believe guardrails, needed to curb the administration’s more aggressive policy instincts and the uncertainty that comes with it, will be evident. The most important of these are markets, where the administration clearly does not want a repeat of the first week of April. We also see Treasury Secretary Bessent playing an important role, providing a much-needed experienced and market savvy sounding board.

Add it all up and you have a constructive, if imperfect, backdrop for credit.

Alright, on to our third Thing—Whistling past the slowdown.

Did you really think that tariff pauses and talk of trade deals would be the end of it? Angst that is. Fear. Fear of the unknown. The weight of uncertainty on risk-taking, be it consumer spending or business investing. The fear that shows up in credit spreads, in options pricing, in the economic data.

We had that in spades in the first week of April. Investors got, in the President’s words, “yippy.” Then we got the Bessent pause. All of the sudden, investors got a strong sense that the administration cares about markets and is prepared to adjust policy statements accordingly. Transactional, not ideological. It took a while to get there, but we’re there. And with it, the “all-clear” to go ahead and resume buying.

The moves in markets since the first real evidence of the administration’s willingness to give—April 9’s tariff pause—are breathtaking. The S&P 500 up 26%, transport up 38%, banks up 38%. The VIX drops from 52 to 17.

On the credit side, investment-grade (IG) spreads 39 bps tighter, high-yield 174 bps tighter, BBB to B differentials from 313 bps to 158 bps.

Underneath it all is this unsettling fact: the behavioral shift has taken place. What caught our eye this week is the Atlanta Fed’s GDPNow real-time estimate of Q2 growth. The headline is a still rockin’ 2.6%. But strip out the noise around trade and government expenditures, and you get down to our preferred measure of economic output, a “core GDP” if you will of personal consumption and business investment. That estimate for Q2 is 1%, down from above 4% a couple of months ago. The 20-year average is 2.3% and we only get down to 1% or so when we are in recession. Now, we would be the first to say that this time is different because consumer and commercial balance sheets are in great shape, because of the wealth creation over the past decade and the ultra-low-cost debt both sectors carry. But don’t ignore what’s in front of you. Growth is slowing, in large part because of the unpredictability, the uncertainty, about the future. And that does not square up with where risk is priced today.

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

1. Delta exuberance. Better than feared.

2. A forward look at Q3. Important data is on the way.

3. Whistling past the slowdown. The behavioral scarring is showing up in the data.

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