KBRA Financial Intelligence

3 Things in Credit: Labor Risks, Tariff Time, and Updated Forecasts

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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.

And … we’re off. Trump 47, where John Authers of Bloomberg described inauguration day as “a day of chaotically erratic messages that sent global markets on a roller coaster.” Ahh, but underneath it all “we’re probably moving from the most anti-business administration to the opposite.” So says legendary investor Stan Druckenmiller. So far, with U.S. stocks at all-time highs and U.S. high-yield credit spreads closing in on all-time tights, it’s all good. Can’t we just leave well enough alone? Not a chance.

This week, our 3 Things are:

1. Labor risks. In search of Goldilocks.

2. Tariff time. McKinley’s revenge.

3. Forecasts. On the economy and the S&P, there is remarkable consensus.

Alright, let’s dig a bit deeper.

Labor risks.

On his bank’s earnings call last week, Jamie Dimon reminded listeners that “the biggest driver of credit has been, and always will be, unemployment.” And no surprise that with unemployment surprisingly well behaved through the Fed’s tightening cycle (keep in mind today’s 4.1% rate is well below the long-term average of 6.2%), credit has been very well bid.

Sure, there have been some weakening of late in labor market dynamics—the Sahm Rule getting breached back in July, the hiring rate falling (excluding the pandemic period) to an 11-year low, average weekly hours worked at a five-year low, continuing jobless claims at a three-year high. But, all things considered, this is a healthy labor market. This is all good for credit.

Now, the past two years remind us that you can have too much of a good thing. Too tight a labor market introduces wage pressure, which is inflationary. The worst outcome of this is a central banker’s worst scenario, the dreaded wage/price spiral. Fear of that developing is what we had back in 2022, which led to the most aggressive monetary tightening in 40 years, which led to the worst bond market in, uh, 250 years, and an increase in one-year recession probability from 15% to 65%. Just in case you forgot.

Remarkably, despite a still relatively tight labor market, wage pressure has come down steadily and is now back within a reasonable range. The three-month moving average of the Atlanta Fed Wage Growth Tracker has come down from a high of 6.7% in 2022 to 4.2% today. That goes a long way to explaining the steady drop in the Quits rate, as potential job movers see less of an incentive to leave their current employment. The direction of travel here, along with strong productivity gains, gives us comfort that wage pressures are under control. The balance of power between workers and employers has swung back to employers.

Still, with the unleashing of animal spirits and the prospects of labor supply limitations under Trump, aren’t there outsized risks of wage growth reversal? Not in the U.S., and here’s why. Have you noticed the increase in layoff announcements lately? Off the top of our head, Meta, Southwest Airlines, Citigroup, Microsoft all have announced job cutbacks. Not to be too cynical here but sending out the message of even a low single-digit paring back of payrolls probably mutes the rank and file’s urge to ask for a raise. Now, top that off with messaging that speaks to the challenges the firm is facing, and you effectively extend that dampener into the future.

That playbook probably goes a long way to explaining an unexpected development this week in the latest consumer sentiment survey from the University of Michigan, where the percentage of those expecting higher unemployment in the coming 12 months rose to 50% in January, up from 40% in December, and 31% a year ago. For what it’s worth, the Bloomberg consensus has unemployment rising in 2025, but only one-tenth of 1% to 4.2% by year-end. All of this should come as welcome news to the Fed (and risk markets), as you simply cannot have sustained inflation (different than transitory) without wage pressure.

Alright, on to our second Thing—Tariff time.

So, I recall listening to what was advertised as an economically-focused speech from then candidate Trump this past summer, and I walked away thinking I found the rarest of things: a bona fide fan of President William McKinley, the pride—next to the NFL’s Hall of Fame—of Canton, Ohio. McKinley is perhaps best known as an enthusiastic deployer of tariffs, something that has made him a source of inspiration to the current president and what we think we know of his economic plan.

Now, economists don’t much like tariffs, almost universally seeing them as inflationary and anti-growth. True, a tariff is a one-time price shock (unless it is a progressive one that hikes every year) to which the economy adjusts. The known unknowns around the economic impact are centered on who actually bears the cost of the tariff, since three parties are affected—the exporter, the importer, and the consumer. Then there are the more tactical considerations around deployment. Assuming the tariff is used as a negotiating tactic, how long will the tariff remain in place, and what ultimately will be the cost, both over the near term and long term?

For context, recall Trump 45, when, by year three, he had grown frustrated with traditional negotiation and diplomacy and opted for trade war, or, more appropriately, trade skirmishes. As rhetoric intensified and tariffs implemented, one thing is clear: markets responded with concern. One-year recession probability rose from 20% at the beginning of 2019 to 35% by Q3. Stocks were volatile, with 7% and 6% selloffs in Q2 and Q3, respectively. High-yield credit spreads had three bouts of significant widening in those quarters between 65 bps and 97 bps. And keep in mind, no one was thinking about inflation in 2019, something markets, of course, would become hypersensitive to a couple of years later.

Which brings us to today. Make no mistake about it, Trump loves the disciplinarian, the “stick” nature of tariffs, and we see little chance that he thinks of it as an idle threat. Out of the chute, he’s targeting Mexico and Canada, and in short order he’s added China and Russia to the target list, the latter as a means to bring an end to the war in Ukraine.

Here are two considerations when thinking about Trump 47’s tariffs versus Trump 45’s. One, Trump 47’s, as threatened, would be far more potent in their magnitude and breadth than Trump 45’s. And two, investors, now reacquainted with inflation, have grown to despise it. Indeed, the prospect of resurgent inflation regularly appears among surveys of investors as a top concern heading into 2025. To that point, work done by Deutsche Bank dimensioning the impact of tariffs on inflation deems them to be material, with core PCE reversing course in 2025, rising from an estimated 2.6% over the course of the year to between 3.4% and 3.7%, depending on the pass-through rate to consumers. That is something the Fed, and risk investors, surely do not want to see. Watch this space, and don’t lose sight of 2019.

Alright, on to our third Thing—Updated forecasts.

This week, we got updated consensus forecasts compiled by The Wall Street Journal on the economy and Bloomberg on S&P 500 earnings and year-end price targets. Both are based on data gathered post the election, reflecting all of that animal spirits and Trump’s “revolution of common sense.”

Sticking with the inflation story, average expectations for headline CPI in June 2025 have jumped 38 bps from the previous survey in October to 2.56%, only to see it creep higher still by year-end to 2.69%. Of the 73 economists responding, only six have lowered their forecast since the previous survey. Some 18 respondents (that’s 25%) see inflation at 3% or higher by year-end. Despite inflation staying above target (at least by CPI’s calculation), respondents expect two 25-bp cuts to the policy rate.

Full-year 2025, consensus economic growth is expected to be 2.0%, not much of a bump from the 1.9% forecast back in October. It is worth pointing out that 30 of 75 economists responding (40%) believe real GDP will come in below 2%, but only two (3%) believe growth will come in sub-1%. No one is forecasting a recession, not in 2025, 2026, or 2027. Happy days are here again!

As for the S&P 500, analysts are essentially frozen in time, likely a function of the holidays or Trump uncertainty. Of the 20 strats followed by Bloomberg, only one made a change in the January survey, and that was a 2% increase to full-year 2025 earnings. The median year-end 2025 forecast close of the S&P 500 remains at a lofty 6,600. That’s 8.2% above where we currently stand, and a rich 24x median forecast earnings of $270 a share. The bullishness is broadly-based, with only one forecaster believing the year-end close will be below where we are today. All of this is consistent with The Wall Street Journal survey above—expectations call for well-behaved inflation, with solid economic and corporate earnings growth. And all of that is good for credit.

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

1. Labor risks. Power has swung back to employers and that’s good for inflation concerns.

2. Tariff time. Deploying to change behavior over the long term presents near-term risks.

3. Forecasts. Consensus is based on the status quo. Unfortunately, that’s subject to change.

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