KBRA Financial Intelligence

3 Things in Credit: Fiscal Deficits, Seeing Around Corners, and Fundamentals Check-up

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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.

Interesting times we work in. The head of our largest bank said the economy is “unbelievable” and “booming.” One of our presidential candidates says the economy is “collapsing into a cesspool of ruin.” A leading Street strategist says “everybody’s been wrong about a lot of things over the past 4-5 years.” And a Nobel Laureate economist says he is “fanatically confused” about the direction of interest rates. I guess we’ll have to figure out all of this on our own. Let’s have at it.

This week, our 3 Things are:

1. Fiscal deficits. What do you mean there’s no free lunch?

2. Seeing around corners. At a time of market ebullience, it’s a worthwhile exercise to think about what could change all of that.

3. Fundamentals check-up. We’ll have a look under the hood.

Alright, let’s dig a bit deeper.

Fiscal deficits.

I got asked the other day what’s the biggest near-term risk that could rock credit markets. My number one, of course, is if the Fed overshoots and keeps rates unnecessarily high for too long. But, as I ran through all of the other potential catalysts, I thought about the bond market and James Carville. You remember, the Clinton-era political strategist that famously said, “if there [is] reincarnation…I would like to come back as the bond market. You can intimidate everybody.” Kind of an odd statement and an even odder wish. But whatever.

We thought about that in the context of today’s Treasury market. We take it for granted, but change is afoot. We all know it bears the weight of policy. And policy has changed. A fondness for fiscal expansion has gripped both parties, more so than ever. And a number of voices are wondering if we’ve entered a more problematic phase.

Two potential problems to think about. One, deficits. Are we at risk for a “Liz Truss moment?” Will Carville’s bond market all of the sudden rise up and react to our super expansionary fiscal policy? What ever happened to Modern Monetary Theory? I thought this was all manageable!

Well, the Congressional Budget Office earlier this year warned in its latest projections that US federal debt is on a path to hitting 116% debt to GDP by 2034. And that’s with unrealistic assumptions regarding interest rates (too low) and recessions (not factored in). Factor in higher for longer and a continuation of Donald Trump’s tax cuts and you get to the mid-120s pretty easily.

BlackRock’s Larry Fink cites a number of ills from carrying that debt burden, including a crowding out of private capital, insufficient resources to fund essential infrastructure and social programs, and, of yeah, persistently higher interest rates. Not exactly a doom loop, but we get the picture. For what it’s worth, current Treasury Secretary Janet Yellen notes that we do need to reduce deficits in order to be viewed as fiscally sustainable. Saying is one thing, doing something is another thing all together.

Not everyone is a Chicken Little on this topic. Economist Paul Krugman notes that, with the exception of France in 1926, no country borrowing in its own currency has triggered a buyers’ strike, Japan being the best example of a developed nation carrying a large debt load for a long time. We would point out that Japan’s interest rates over the course of its “lost [economic] decades” were extremely low in its tightly orchestrated financial world, so the burden was a lot less than what “higher for longer” implies for the U.S. So we’re not sure we take a lot of comfort in that example.

To be clear, there are a lot of puts and takes in the inflation/higher rates discussion that lies in front of us. This won’t affect markets today, but I’ll bet we’ll have a much better view of this a year from now, post the election. And I’ll bet we’ll be talking about this topic a lot more. And that probably won’t be good for credit.

Alright, on to our second Thing, Seeing around corners.

On a day where S&P Global’s US PMI topped every economist’s view in Bloomberg’s consensus (coming in at the highest level since April 2022), it’s hard to think about downside scenarios. Stocks are ripping to all-time highs (and that’s for the S&P 500 equal-weighted index, not just the Nvidia-driven one), credit spreads are at structural tights, and even story sectors such as leveraged finance, CMBS, and marketplace lending have caught a bid. But thinking about the change, seeing around corners is, in fact, what we must do. After all, anyone can be a perma-bull or perma-bear, it’s all about calling the turns.

Regular listeners by now are familiar with our “Two Economies,” theme, where the aggregate data overall is fine, but a quick decomposition exercise reveals one really healthy economy, that driven by wealthier consumers and bigger businesses, and another of lower income earners and smaller businesses. At the risk of stating the obvious, the former is healthier than the latter. In markets, we are quite familiar with the former, wealthier consumers and bigger businesses. That’s generally who we are and what we pay attention to.

But here are some defining characteristics of the part of the economy we worry about:

• A lot of small businesses are unprofitable. Some 40% of the Russell 2000, double what it was 20 years ago.

• Small business employs roughly half of American workers.

• Small business typically get financing from banks, whose loan underwriting standards remain restrictive

• Small business sentiment, not surprisingly, remains at historic lows.

Meanwhile, over on the consumer side of this economy, we see:

• 18% of credit card borrowers were “maxed out” according to the Fed

• Credit card loan losses are at 13-year highs despite historically low unemployment, and

• Annualized net loss rates of near 20% for lower FICO borrowers from marketplace lenders. This data, by the way, is compiled by KBRA ABS Research. Find out how to access the data on our website, KBRA.com.

Developments in this “other” economy presumably shows up in several broader measures of economic vitality, namely:

• Morgan Stanley’s Quantitative Recession Risk Model, where the current read (44%) is well above recent periods of building angst such as 2019 and 2015-16

• Citi’s Economic Surprise Index, which has hooked down below 0, the demarcation for a preponderance of worse than expected economic data releases

• New York Fed’s Recession Probability in 12-Months Model which is based on the yield curve; needless to say, it is screaming recession

So, as we contemplate notions of immaculate disinflation and Goldilocks outcomes and bask in the nearly 50% rise in the S&P 500 since last October’s lows and the fact that high yield spreads are 200 bps through the long-term average, a reminder that it’s in your interest to try and see around the corner. Let us know what you see.

Alright, on to our third Thing, Fundamentals check-up.

Amidst all of the market buoyancy, favorable financial conditions and better-than-expected economic and corporate earnings performance, it’s easy to lose track of fundamental credit trends.

As is the case with just about everything else we look at, the building blocks of credit—leverage, margins, and earnings growth—have been buffeted by the massive force of stimulus, and the resultant effects of price and interest rate volatility.

Not surprisingly, interest coverage across the firms in Bloomberg’s Corporate Agg Index has fallen, but only back to levels—6.7x--we saw at the end of 2019. Some bemoan the fact that the metric has fallen from 9x in the heady days of 2022, when margins were unusually wide due to stimulus largesse and strong pricing power. But all things considered, and considering the well-behaved default record, we are not all that concerned with where we are. Similarly, leverage has bumped up from pre-pandemic levels but only modestly to 2.7x net debt to EBITDA from 2.6x at year-end 2019.

And, as always, the best defense is a good offense, and we have seen a positive bounce in earnings and margins from the earnings recession—that’s two consecutive quarters or more of negative year-on-year earnings growth—we saw from Q4 2022 to Q2 2023. Adjusted EBITDA margins have held up well through the inflation shock period. In Q1 2024, it was 29.8%, within spitting distance of 30.1% recorded in Q4 2019. Earnings growth came in a much better than expected +7.7% in Q1 (this is for the S&P 500) on sales growth of 4.2%. Results were not as positive among small caps—there’s that "Two Economies" thing again—down a forecast 7.6% in Q1 on flattish revenue growth.

All things considered, not all that bad for credit.

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

1. Fiscal deficits. There’s bound to be a cost to all of this debt.

2. Seeing around corners. Keep an eye out for the often overlooked “other” economy.

3. Fundamentals check-up. After all of that, we’re OK.

As always, thanks for joining. And make sure you listen to our latest Leading Voices in Credit podcast, a discussion with Stuart Aronson of H.I.G. Capital’s WhiteHorse, U.S.' direct lending arm. Great color on private credit from one of the most experienced players in the market.

We’ll see you next week.