KBRA Financial Intelligence

3 Things in Credit: Exuberance, Labor Strength, and Walmart’s Outlook

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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.

So, this is for all you Rip Van Winkles out there. You’ve been asleep since New Year’s and you’ve awakened to find U.S. stocks are up half of 1%, the investment grade index is up 1.4%, and the high yield index is up 2.5%. The VIX remains under 20 and the 10-year is 5 bps tighter. Nothing like a smooth transfer of power.

This week, our 3 Things are:

1. Exuberance. Is it irrational?

2. Labor strength. Here’s where it might crack.

3. Walmart’s outlook. The challenge of dimensioning tariff effect.

Alright, let’s dig a bit deeper.

Exuberance.

Risk premia are back to levels we saw pre-election, with credit spreads well through long-term averages and the S&P 500 forward multiple more than 5 multiple points above its long-term average. So, building on my intro—all is well, right?

Well, not so much. Not only is the economy set to slow back to trend on its own, but the drag of trade and other policies has not gone away. As we wrote in our recent U.S. Forward Look, we expect uncertainty created by the new administration’s policy leanings to drag growth down to 1% for full-year 2025.

More specifically on policy, we think the effective tariff rate settles in around 15%. While that’s a much more palatable outcome than where we were prior to the recent negotiations with China, that level is still a healthy bump up from 3% at year-end. The 15% level consists roughly of a 10% universal tariff staying in place (the UK deal suggests as much) plus a host of more targeted strategic tariffs on countries and individual sectors, and, of course, something more punitive for China. Remember, the administration’s motivation for tariffs is not just to redirect trade. It also needs to raise revenue to pay for tax cuts, and that figures to limit just how much tariffs can be cut through negotiation.

In any event, we are surprised to see some market observers seemingly discount or ignore altogether the drag on growth tariffs represent. Maybe the clawing back of the negative wealth effect at the bottom of the stock market selloff in early April is part of that calculus. But the uncertainty spawned by what is still a tariff shock (along with everything else that has “flooded the zone”) hasn’t gone away by any means. We see that, for example in small business optimism, which fell in April for the fourth consecutive month. We see that in the relatively soft April retail sales data. We see that in Walmart’s guidance that prices are going to have to be raised.

Here's what we see at the moment. Growth decelerating to half potential. Inflation reversing course and moving further away from target. Two-thirds of the S&P 500 unwilling to provide earnings guidance. Geopolitical risk rising. Economic headwinds have formed and are mounting. Meanwhile, risk premia moving back to where they were prior to those headwinds rising strikes me as incongruous. In other words, a 2% 2025 growth environment is priced into current risk premia, not the 1% growth we are forecasting. Look for risk premia to build as we learn more about the impact of policy.

Alright, on to our second Thing—Labor concerns.

Pick one thing to watch—now, then, always—it’s the labor market. When times are good, consumers are ready, willing, and able to spend, which makes businesses bolster their labor forces to meet rising demand (let’s leave AI out of this discussion for now). And the labor situation is obviously important to the Fed—one of its two mandates.

What’s truly noteworthy about this labor market is how durable it has been, having been recently tested by the most aggressive interest rate hiking cycle in 40 years. The fact that the economy did not topple into recession in 2022 was remarkable, given the history of monetary tightening cycles, and attributable to what was still a powerful growth impulse leftover from massive pandemic-era stimulus.

That stimulus, of course, is now gone leaving growth to slow via two forces: (1) normalization that should bring us back to trend and (2) policy uncertainty, mainly related to tariff impact. As mentioned, our view calls for 2025 GDP in the U.S. to come in at 1%, roughly half potential.

That means the jobs market has to weaken, right? It should be mechanical. But will it?

You can make the case that businesses, with margins just off of 50-year highs, are inclined to hold on to workers knowing how difficult and costly it is to hire and train workers should growth pick up again. Moreover, growth in the labor force is unclear in light of immigration limitations that is a policy priority for the new administration. And then there is the issue of skills mismatch, where the qualifications a particular business’s needs may or may not be available. So, add it up and you still have a tight labor market. And that’s good. After all, it’s the conditions that underpin the jobs market—those high business margins, the strength of the consumer in the aggregate—that lead us to believe that the U.S. will avoid recession in 2025.

But, if we think about scenarios—downside scenarios—where might the labor market come under stress?

One sector that bears watching closely is trade-related jobs. That includes retail, wholesale, warehousing, and transportation. Together, those industries account for 18% of the total jobs market. With the effective tariff rate expected to settle at or around 15%, the trade “shock” figures to leave a on mark on the sector’s employment.

A second sector to watch is leisure and hospitality, which accounts for another 11% of jobs. This quintessential consumer discretionary sector figures to be vulnerable in a slowing economy, and the falloff in foreign visitors to the U.S. adds to the sector’s woes. And sure enough, the falloff in spending on lodging and airlines was among the most pronounced in the Bank of America Institute’s latest Consumer Checkpoint.

For now, essentially at full employment, all is well. Stay tuned.

Alright, on to our third Thing—Walmart’s outlook.

“All of the tariffs create cost pressure for us.” That was Walmart CEO Doug McMillon’s honest and candid assessment of what his retailing behemoth is facing. He added, “Given the magnitude of the tariffs, even at the reduced levels announced this week, we aren't able to absorb all the pressure given the reality of narrow retail margins.” He made this point in terms of timing: “The cost pressure from all the tariff-impacted markets started in late April and it accelerated in May.” In terms of adjusting supply chains, he noted the company can move production “where that’s possible,” adding that it “isn’t easy or fast.” He noted that Walmart is positioned to manage the cost pressure from tariffs “as well or better than anyone.”

Reading between the lines, “narrow retail margins” imply the goods Walmart sources generally come from manufacturers with comparative advantage. That’s likely to change. “All of the tariffs create cost pressure for us” suggests that if Walmart, the largest retailer in the world, can’t push much of the tariff cost on to its suppliers, nobody can. As far as timing, it is clear that we are just beginning to see the higher costs flow into results. And in terms of adjusting production, that can only be successful in spots and it takes time. His comment that Walmart can adjust better than anyone is a reminder that every other retailer will struggle more with this macro environment.

CFO Rainey walked through the challenge of providing earnings guidance. Various scenarios are needed, factoring in a variety of assumptions—as to persistence and level of tariffs, elasticity of demand as well as the overall macro environment. The company believes that good-faith discussions will ultimately result in tariff rates lower than early April, but acknowledges that adverse outcomes are possible, which could impact performance “significantly.”

As for the upcoming quarter, “The operating environment is highly fluid and it makes the very near-term exceedingly difficult to forecast.” In addition, accounting issues for inventory are likely to result in volatile reporting over the next three quarters.

What do we make of this?

Reiterating an earlier point, tariff effects are just beginning to flow into results. We’ll see it creep into the economic hard data, as it did with retail sales this week. Progress in achieving trade deals, or at least agreements in principle, will be important offsets to emerging concerns over the tariff impact broadly to corporate earnings. In addition, increased clarity around the administration’s growth agenda, including tax cuts and deregulation, could also steady investor sentiment.

Risk markets in the U.S. are once again priced nearly for perfection. Maybe that has as much to do with reduced relative value elsewhere, or maybe it’s just the return of “FOMO” and/or renewed belief in U.S. exceptionalism. In any event, it’s likely to be a busy and noisy (and volatile) summer.

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

1. Exuberance. A lot is about to unfold. We believe it pays to be defensive.

2. Labor strength. It underpins lofty risk valuations, and it’s likely to be tested once again.

3. Walmart’s outlook. Higher costs across the economy figure to slow economic growth.

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