KBRA Financial Intelligence

3 Things in Credit: Hot CPI, Earnings Season, and Event Risk

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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 caught up with the latest edition of Jamie Dimon’s quickly becoming legendary annual shareholder letter/manifesto this week. One particular thread caught my attention—his take on bank regulation. While acknowledging that some “good things” came about post the GFC, he was quick to add that it “would probably be an understatement to say that some [rules] are duplicative, inconsistent, procyclical, contradictory, extremely costly, and unnecessarily painful for both banks and regulators. Many of the rules have unintended consequences that are not desirable and have negative impacts.” Ahh, our tax dollars at work.

This week, our 3 Things are:

1. The CPI print. Is it really shocking?

2. Earnings season. A third consecutive quarter of earnings growth is forecast but peel this onion a bit and you’ll find some troubling undertones.

3. Event risk. It’s been relatively quiet.

Alright, let’s dig a bit deeper.

The CPI print.

I really didn’t feel the need to talk about the so-called hot CPI print this week, until I saw the 10-Year undergo a three-standard deviation move. I wouldn’t have thought that a “miss” of 6 bps (actual core of 0.36% month-over-month versus an estimate of 0.3%) and where the year-over-year of 3.8% came in versus the estimate of 3.7% would be all that earth shattering, but clearly the market was not set up for this.

And when you dig into the data, you find that auto insurance and health care accounted for much of the miss. Then, throw in the shelter components, which lag by a year and where real-time measures are considerably lower, and the rest of core comes in at 0.1%. And by my count, only 29 of the 80 categories came in above 2% year-over-year. For context, other measures are not flashing red. The Cleveland Fed trimmed mean is at 0.3%, and Morgan Stanley’s forecast for core PCE (the Fed’s preferred measure), incorporating inputs from the CPI and PPI, comes in at 0.246% in March, with the annual growth rate at 2.69%.

So, what do we do with all of this?

• Higher for longer. Human beings comprise the FOMC, and I can’t help but think that appearances matter. It will be harder for them to cut post this report than was the case a few days ago. We figure two cuts rest of year, down from 3.

• Higher for longer means the economy is stronger than expected. It continues to grow above potential, and job creation remains strong. That’s not bad for credit.

• Wage growth remains under control, and the inflation story figures to move down as shelter catches up. Let’s not jump to “the Fed’s going to raise rates!”

• A reminder that a borrowing environment of 24% credit card rates, 7% mortgages, and 11% middle market loans is not an economic tailwind! Don’t forget about long and variable lagged effects of monetary tightening when modeling growth.

In other words, the trends remain the same: inflation is coming down, growth is set to moderate, and rate cuts over the course of the rest of the year are not off the table.

Alright, on to our second Thing,

Earnings season.

For all of the obsession with nonfarm payrolls and CPI, no single metric underpins credit markets—all credit markets, secured and unsecured—more than corporate earnings growth. Not only does corporate earnings growth support equity markets (which also bolsters credit sentiment) but corporates rent buildings in CMBS transactions, employ consumers whose borrowings end up in ABS transactions, and pay taxes that support the muni market. You get the picture.

So, as the economy continues to evolve—normalize—post the pandemic, what does this earnings season have in store for us?

As background, using the S&P 500 as our universe, we’ve come out of this cycle’s earnings recession (that’s two consecutive quarters or more, in this case three, of negative earnings growth). That happened in Q4 2022 through Q2 2023. For Q1, analysts are expecting a third consecutive quarter of earnings growth, in this case 4.1% (this is net income by the way, not EPS), driven by stable margins and a 3.5% bump in sales. That’s consistent with the soft-landing narrative. Excluding energy, that number is better still, at 6.9%.

But peel this onion a bit more, and there are some unsettling trends. Despite the recent run-up in commodities, analysts see double-digit declines in energy and materials. The only other sector of the S&P’s 11 that is forecast to have a meaningful year-over-year drop is health care, down 8.5%—its seventh consecutive quarter of contraction. Much of that reflects ongoing weakness in pharmaceuticals and biotech.

Strip out the top five firms in the S&P, and the S&P 495 is expected to contract nearly 1%. We see airlines down 40%, autos expecting to be down 25%, air freight down 23%, real estate firms down 17%, banks down 16%, and food producers down 8%.

Among small business, something we touched on last week, and where the latest NFIB optimism index out this week hit an 11-year low, expectations are for a 14% year-over-year drop—that’s the sixth consecutive quarterly contraction. The NFIB cited numerous economic headwinds, including inflation and the tight labor market. The net percentage of respondents expecting business conditions to be better six months from now (that’s “better” minus “worse”) is a whopping minus 36%.

So, despite the OK large-cap expectation, we’re not out of the woods just yet.

Alright, on to our third Thing.

Event risk.

Remember when debt was (historically) irrationally cheap and abundant? It still may be abundant and it’s really not all that expensive, but this new paradigm in credit—higher for longer—coupled with an administration that is decidedly wary of big business getting bigger, and you have an amelioration of one of investment-grade bondholders’ greatest fears: return-destroying event risk. The merger that results in a weaker credit on a pro forma basis. And if it’s particularly levered, watch out.

Post the GFC, the central bank engineered ultra-low rates of course, which made the cost of downgrade to an issuer very low. So, the thinking typically went, why not lever up? It would be irresponsible to my shareholders not to. That is, unless you could envision a world where quantitative easing was not the norm. Well, it took a while, but that world is here. And the uncertainty as to (i) when the Fed might actually ease, and (ii) what the ultimate impact will be of monetary tightening, making modeling out value creation difficult, certainly more difficult than a few years ago.

Meanwhile, the administration’s crackdown on M&A, something former Treasury Secretary Larry Summers calls “a war on business,” is not likely to change, at least until the election in November. All of this means less event risk. And that’s good for credit.

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

1. The CPI Print. We think it is less of a game changer than the market move implies.

2. Earnings season. The aggregate numbers for the large caps are OK, but expected results underneath are more mixed.

3. Event risk. A silver lining to higher rates.

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