KBRA Financial Intelligence

3 Things in Credit: Good Things Fading, Bankruptcy Trends, and Thresholds That Shift Sentiment

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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.

I admit to being a bit taken aback by a recent comment coming out of Oaktree’s Howard Marks, where he said the “outlook is as unpredictable as ever, if not more so.” He made the comment in response to client feedback. Mr. Marks said “most of the people he speaks with tell him they’re unusually uncertain about what lies ahead in terms of the economy, central bank behavior, fiscal management, politics, and geopolitics.”

I get it, there’s a lot to think about. I guess I’m more in the camp of the authors of Oaktree’s latest Insights piece, who acknowledge that “economic and corporate fundamentals remain healthy.” I guess Mr. Marks’ point is that there is the potential—lots of potential--changes coming on the economic, geopolitical, and market structure fronts. Something to look forward to.

This week, our 3 Things are:

1. Good things coming to an end. We’re still not normal, but we’re headed there.

2. Bankruptcy trends. A recent shift in trend is noteworthy.

3. Thresholds. Things, that when crossed, shift sentiment.

Alright, let’s dig a bit deeper.

Good things coming to an end.

Nothing I can think of has rocked the economics intelligentsia more than the durability of the US economy over the past year or so. Tighten monetary conditions at the most dramatic rate in 40 years and the stimulus-driven economic frenzy must, the thinking goes, grind to a halt. And because monetary tightening is the bluntest of blunt instruments and the incentive for credibility-obsessed central banks is to naturally overshoot, a recession will surely follow, right?

Instead, the US is growing well above potential, despite the rate (and QT) shock. And now comes, sadly, the predictable. Alternative narratives of “no landing.” One particularly memorable rant stuck with me, this from one of the highest profile strategists: “There is not one shred of evidence that monetary tightening is impacting the economy!” Wow. Identify the elite in the room.

Cooler heads with a broader perspective know there is plenty of evidence—hard evidence—of slowing. Take housing. Not house prices, but the economic activity that goes with a healthy and active housing market. Really, take any interest-sensitive sector. Take small business, where a cyclical high of 40% of firms are unprofitable, and where half of America is employed. Take lower income consumers, where inflation bites hardest—trust me, they’re not excited about disinflation, they need deflation. And, needless to say, they have not participated in the household net worth surge driven by soaring residential real estate and stock markets.

So, there has been slowing. It’s just been more than offset by extraordinary growth. So the question now, of course, is just how durable is extraordinary growth? Because, in the Fed’s case, you know it is going to continue to favor the “breaking inflation” part of its dual mandate. Chair Powell said as much this week.

From a macro standpoint, we are seeing a contraction, really a correction, in M2, the money supply. All of that stimulus created a stunning bubble in M2, some 25% above trend in December 2021 according to our good friends over at Deutsche Bank. Well that’s now down to 6% above trend and is expected to return to trend by year-end.

This is a big part of the support for that extraordinary growth we’ve seen in 2023-24. In particular, we see it in excess savings, which has proven to be much more durable that than was initially estimated. A more reliable measure has been actual deposits at Bank of America, which are still elevated at 130% of pre-pandemic levels, but something that is clearly coming down. The macro folks over at Deutsche Bank have excess savings running out by year-end.

And if we look to BofA’s data on consumer spending, growth has already hit a wall, which does confirm that most of whatever excess savings is left, is with higher income folks, who are increasingly less inclined to spend. We see that in the latest consumer confidence data from The Conference Board.

So, pulling this all together:

• The benefits of stimulus figure to finally run out by Q4 2024.

• There is room to run for growth, but it is slowing, and we don’t believe we’ll end up in recession. Ironically, a gradual slowdown in 2024 reduces the potential of a hard landing in 2025 under the weight of higher for longer.

• Don’t overlook what’s happening in small business and lower income consumers. It’s not pretty, and it matters.

All that good stimulus is quickly fading.

Alright, on to our second Thing, Bankruptcy Trends.

We have been watching closely bankruptcy data, both at the consumer and commercial sector levels, for obvious reasons. And the data was increasingly worrisome.

On the commercial side, the year over year growth in business bankruptcies historically correlates closely with year over year growth in real GDP. And the bankruptcy data in Q4 2023 was not good—up 85% from Q4 2022 to the highest level since 2012. This kind of rise is not consistent with growth, in fact, just the opposite. Increases of this magnitude are typically seen only in recession. But then something interesting happened. Bankruptcies in Q1 fell by a material amount—33%--sequentially. Filings were flat to the year ago level, and the latest data is consistent with--ready for it--2+% growth. What’s changed?

Well, digging into the soft-landing narrative, you find that financial conditions have eased, meaning financing—the kind of financing that can keep a struggling business alive--was more easily accessed. Another reminder that we are not falling off a cliff.

Over on the consumer side, similar benign news. Quarterly bankruptcies are 17% higher than the pandemic era lows but running at about half the rate we saw in 2018-19. You might think that is attributable to the unusually tight jobs market, but we had that back in 2018-19 as well. Wages are higher and household net worth, including the aforementioned excess savings phenomena, has soared, which probably explains a lot, something we see in the consumer’s historically low financial obligations ratio.

In any event, well behaved bankruptcy filings are another reminder that the soft landing scenario, at least for now, is playing out.

Alright, on to our third Thing, Thresholds.

As we gamely march on through these “unusually uncertain" times, we often think of tripwires. What data thresholds need to be crossed in order to “think different,” to borrow one of Ad-lands more wretched taglines. It is worth mentioning that we’ve crossed some of what many thought were red lines only to find muted market or economic reactions. Things like a negative yield curve or a decidedly negative trend in Conference Board’s Leading Economic Indicators. Even Claudia Sahm has weighed in on her Sahm Rule recession indicator, saying this time might be different. In any event, here are a few thresholds we think are worth watching.

Nonfarm payrolls <100k—The most obvious byproduct of above potential growth is the job growth supporting it. We dipped below this threshold twice in 2023, March and October. The last time it was negative was December 2020. Market sensitivity, well, depends. It could be bad news is good news, i.e., bring on the cuts, or bad news is bad news. In this case, we think markets would lean more to risk on, the cuts are finally here.

Oil >$100—Generally not good for markets. A tax on consumers (gas above $4 a gallon weighs on consumer sentiment). Margin pressure on businesses, and, in all probability, an indication of escalating geopolitical tensions. None of that is welcome.

10-Year UST > 5%--Interest-sensitive industries—housing, capital goods—would continue to be impacted, as would levered consumers and businesses. Long duration asset valuations (growth stocks and commercial real estate) would suffer. And financiers have to go back to their drawing boards. Deals that worked in a “low rate with cuts-expected” environment have to get re-done, and not all will work under a higher cost of capital. This would not be good.

CPI Supercore MoM < 0.4%--Services inflation ex-shelter, the most labor-intensive measure of inflation. The path to monetary easing. Eventually, we’ll get there. Hopefully, it won’t be at the end of a central bank policy error.

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

1. Good things coming to an end. Normal didn’t feel all that good in 2019, and we might be headed back there.

2. Bankruptcy trends. All in all, well behaved.

3. Thresholds. Keep an eye on that 10-year.

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