KBRA Financial Intelligence

3 Things in Credit: Tariff Shock, What Will the Fed Do, and Economic Defense

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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.

It’s that time again: earnings season! The ultimate backward-looking indicator. The consensus growth rate for Q1 has come down from 14% or so back in the summer to a still-healthy 7%, largely on the back of reduced expectations for the Mag 7. But that’s not really what the market will be assessing. It will be all about the guidance—how the latest shock, tariffs, is expected to impact future results. Uncertainty. How will businesses respond? What kind of time frames are firms managing to? All coming to a conference call near you next week.

This week, our 3 Things are:

1. Tariff shock. It’s worse than expected. We’ll give you our updated thoughts around what it means for credit.

2. What will the Fed do? We game out the reaction function.

3. Economic defense. How well prepared are consumers and businesses for slowdown? We provide an updated view.

Alright, let’s dig a bit deeper.

Tariff shock.

A couple of weeks ago, we talked about April 2 being “peak tariff,” i.e., the point in time where much of the uncertainty overhanging the global economy is addressed, because we would have disclosure—details—around the administration’s trade policies.

We would have critical information that allows us—businesses, consumers, investors—to better dimension the effects of the administration’s favorite policy tool, deployed as a means to achieving a favorite policy objective. That is, namely, redirecting global trade in the hopes of bringing manufacturing back to the U.S. So, what did we learn? Are we at peak tariff?

For starters, we were quick to point out that it would be naive to think that this would be little more than a negotiating tactic. We believe the administration intends to have tariffs as a key revenue source offsetting another key policy objective, tax cuts. That implies that tariffs are likely to be around for a while. We believe that remains the case, and by the way, that argues against risk market-friendly concessions.

We learned the breadth and depth of the tariffs are worse than expected. The Yale Budget Lab estimates the tariff rates will jump to 22.5%, up from 3% prior to the election. That will eventually leave an adverse mark on U.S. economic and corporate earnings growth, inflation, and unemployment.

Sure, the rates disclosed this week are starting points for negotiation. We do expect some rates will be reduced as part of the process, but we are also aware that retaliation will also take place that will impact demand for U.S. exports. There are sure to be puts and takes here, but net net, this is a material negative to the U.S. economy that is yet to be sufficiently defined.

So, peak tariff? The magnitude of the disruption—the shock, and the aftershocks—is difficult to dimension at this point, so, no. But here’s a useful way to think about all of this.

In simplistic terms, assume a 1% hit to U.S. GDP in 2025. That takes the consensus forecast from 1.9% to 0.9%. One tenet of economic behavior we have long subscribed to is at 2% growth, economic actors—consumers, businesses, investors—cannot see recession; so, they borrow, they spend, they make capital expenditures, they invest in risky assets. At 1% growth, they can see recession. They get conservative. Individuals go from consumers to savers. They hunker down. They pay down debt. Businesses postpone hiring and expanding. That adds up to below-potential growth, and that’s suboptimal for credit.

Alright, on to our second Thing—What will the Fed do?

Yes, we know, the Fed has a dual mandate, pursuing price stability and maximum employment. But let’s face it, Fed officials are judged based on how successful they are at bringing inflation to heel. As we often point out, the legacy of Paul Volcker is useful to recall. He is lionized for breaking inflation in the early 1980s, despite the fact that we experienced 11% unemployment and a double-dip recession in part as a result of his rate hikes.

Which brings us to today. Growth is slowing, and set to slow more, and unemployment figures to rise, albeit modestly. So, the playbook says, jump in and cut. By the way, that is exactly what Chair Powell did three times in Trump 45 (2019) in response to a powerful selloff in risk assets in Q4 2018, triggered by slowing growth amid rising trade tensions. Sound familiar?

Ah, history repeating. But here’s the problem. Expectations are that tariffs will boost the Fed’s favorite inflation measure, PCE, by, call it, 1%. Sure, it might be a one-time price adjustment (something Chair Powell has alluded to), but the pass-through of the tariffs on imported goods to the consumer will also enable domestic producers to raise prices. It’s the stagflation risk that is new to this story, something we didn’t have to worry about in 2019. So that suggests that the Fed “put,” something Chair Powell implied last week is on the table, is now less likely to be exercised over the near term.

That highlights another problem here. We, market participants, the Fed, won’t know the full impact of tariffs for some time, call it the next two quarters. We will, however, get a real-time sense of the impact on risk assets starting next week with Q1 earnings, and, much more importantly, the guidance that will surely come along with it. The Fed probably does not want to be seen as continuing to avoid the elephant in the room—the new administration’s policy leanings. Now there is something very real to act on. The Fed cutting in 2019 pulled the economy up, but only six months after the carnage risk investors suffered in Q4 of 2018. It’s a tough job.

Alright, on to our third Thing—Economic defense.

We woke up Thursday to a business media headline that shouted, “The credit backdrop is terrible.” Wow. That’s quite a leap.

It’s a reminder that this story is ripe for hyperbole. Is the credit backdrop terrible? The answer of course is no. The 10-year Treasury yield breached 4% today; that’s not bad for credit. Investment-grade spreads are 16 bps wider over the past six weeks, but at 93 bps, are some 40 bps inside the post-GFC average. High-yield spreads are more than a point inside its average. Stocks are trading at 19.7x forward earnings, 3 multiple points above its average. Demand for high quality, durable fixed income is up, as this is the kind of market where the income and diversification of fixed income are attractive. This is not a terrible credit backdrop.

Fundamentally, the economy is leaning into these policy headwinds starting from a position of strength. In the aggregate, the consumer has a strong balance sheet, is employed to a very high degree, and has enjoyed wage gains in excess of inflation. Sure, less wealthy consumers are struggling under the burden of inflation, diminished savings, and shrinking availability to credit. Moreover, wealthier households, the true engine of the economy, are also being buffeted by the negative wealth effect of the equity market selloff. But, all told, the consumer is reasonably well positioned to ride this out.

On the commercial side of things, a similar story, consistent with our Two Economies theme, where larger businesses are enjoying strong margins and balance sheets, but smaller businesses and those businesses with deficient business models and/or inappropriate capital structures are struggling. Earnings growth overall is slowing, with consensus coming down toward our long-standing view of +6% for the S&P 500. But again, in the aggregate, the commercial sector is also reasonably well positioned to ride this out.

Needless to say, this is a headline-driven market at the moment. Soon, however, policy effects will begin to impact these solid fundamentals and drive up recession probabilities. The good news, and something very different from the late 1970s and 2008, is that the economy is on solid footing heading into slowdown. And as we highlighted last week, the credit asset class fits nicely into this environment. For now, at least.

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

1. Tariff shock. Watch the behavioral shift that takes place when growth goes from 2% to 1%.

2. What will the Fed do? That “Fed put” is less likely, with tariffs this broad and this deep.

3. Economic defense. The good news is that the economy’s strong starting point makes it reasonably well positioned to ride this out.

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