KBRA Financial Intelligence

3 Things in Credit: Visibility, Financial Conditions, and Tech Impact

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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.

We’re all data dependent, right? I’m not sure what the alternative is. But I know we got a bunch of data this week, including a game-changing CPI report, new forecasts from the Fed, and the latest temperature read of small business, courtesy of the NFIB. And let’s not forget all of the political drama in Europe that came across the transom. And through it all, markets got better—stocks up, spreads tighter, the 10-year lower. It’s what BofA’s Head of Equity & Quant Strategy described as “kind of awesome.” We might describe it as “kind of toppy.”

This week, our 3 Things are:

1. Visibility. We compare today to a year ago.

2. Financial conditions. The Fed says they’re tight. Are they?

3. Tech impact. Keep an eye on creative destruction.

Alright, let’s dig a bit deeper.

Visibility.

Goldilocks. Awesomeness. Exceptionalism. Markets priced for, well, perfection. All of this exuberance strikes us as a bit irrational, given that we have a global wave of political dislocation, two hot wars, and a path toward a slowing economy. So, what gives?

In a word, visibility. It’s better today than it’s been in some time.

We were talking with MarketWatch this week about volatility in markets. How the Treasury market has settled down, and how stock market vol is at the lowest level since before the pandemic. Investors are now confident, if not complacent. They’re confident that the economy is proving to be exceptional and resilient. They’re confident that inflation is coming down steadily. They’re confident the Fed will not derail the economy. They’re confident that a higher cost of capital is manageable. They’re confident that the financial system has the capacity and the willingness to continue to funnel capital to its most productive use. They’re confident that corporate earnings growth is going to remain positive.

All of that, by the way, is a big improvement over where we were a year ago, in terms of visibility. And with improved visibility comes improved conviction around, in this case, the soft-landing narrative. All good, right?

Because we’re fixed income folks, we feel compelled to remind listeners of the following:

• One, the effects of higher-for-longer in this go-around have a longer tail than what’s been typical in the past. Ordinarily, effects are felt 18 months or so after the first hike. Well, we are now more than two years past that first hike, and we believe the effects are still playing out. That’s because of the extraordinary era we’re in as a result of $10 trillion of stimulus. It’s taking longer to slow

  that

  freight train. Take Powell’s word for it (this from his presser this week): “We think rates are restrictive.” That means every day rates remain at this level, the economy is slowing. Further.

• And two, we’ve only had one soft landing in the past 50 years, 1995. Turns out, it’s really hard for central bankers to thread this needle, finding the right level of rates that cools demand without pushing the economy into recession. And it’s hard to be precise. You’re trying to time two massive and powerfully moving forces, growth and inflation, colliding into one another. And I know there is a dual mandate (at least in the U.S.), but let’s be honest, your goal first and foremost in the eyes of your all-important peers is to tame inflation back to a rigid target, come what may. It’s easy to understand why the Fed overshoots in almost every case.

Now, you have to admit, it is kind of awesome at the moment. But, as always, it’s really about where we’re headed that matters.

Alright, on to our second Thing—Financial conditions.

We hear a lot about financial conditions, something the IMF defines as how easily money and credit flow through the economy via financial markets. The Fed has long talked about the tightness in financial conditions. Markets claim the opposite. So, who’s right?

We looked at a relatively new measure of this difficult-to-dimension condition, one published by the New York Fed. Its index, which points to whether financial conditions are a tailwind to GDP growth or a headwind, is fed by seven variables:

• Fed funds

• The 10-Year Treasury yield

• The 30-year fixed mortgage rate

• BBB bond yields

• The Dow Jones total stock market index

• The Zillow house price index

• The dollar index

Makes sense—those seven seem to capture money flowing through the economy. One element missing from our perspective is bank willingness to lend, easily measured in the senior loan officer survey. But let’s not rain on the Fed’s quants’ parade.

So, let’s see where each of the Fed’s factors is at the moment. Fed funds is high by the Fed’s design, so that’s a headwind. The 10-Year is high compared to the post-GFC era, but we know zero interest rate policy is a thing of the past, so we really should think about this as maybe a touch above normal. Let’s call it a wash, neutral, neither a headwind nor a tailwind. The 30-year mortgage rate is clearly a headwind at the moment, as buyer and seller expectations are in the process of resetting. BBB yields at 5.6%? We’d call that a tailwind. The stock market at all-time highs and historically high multiples? That’s a tailwind. Home prices? Ditto. And the dollar’s strength has many puts and takes—let’s call it neutral with regard to financial conditions.

So, back of the envelope, we come out with financial conditions overall being neutral—some good, some not so good. Which is exactly where the quants at the New York Fed come out. Not surprisingly, we had financial conditions that were strong tailwinds to growth in 2021, strong headwinds to growth in 2022-23, and now are back to neutral. Turns out, neither the markets nor the Fed is right on this issue, at least at the moment. Maybe we should factor in the money supply, which is coming back to trend after pandemic stimulus took it to bubble-like heights. All of that cash is, no doubt, still bidding up risk assets, including credit.

Alright on to our third Thing—Tech impact.

We’ve been blinded by the light. Lulled into a sense of complacency by the power of technology companies that are transforming industries. It’s driven broad-based equity multiples to elevated highs, but underneath the highfliers, away from the bright light, the story is not as compelling.

We saw a fascinating interview this week with Jim Chanos, the now-dialing-back king of short selling. When asked about AI, he provided this context: The internet changed the world, right? Few would disagree. In the decade immediately post the birth of the internet age, call it 1998-2007, the U.S. economy grew 3% a year. In the immediate decade prior to the birth of the internet, 1988-1997, the U.S. economy grew … wait for it … 3% a year. So, the internet did nothing to goose the economy’s growth rate. It did, however, drive big winners and big losers among companies.

We find that to be useful when sifting through what we see in risk markets today. Here’s an interesting data point we tripped across this week, courtesy of Rosenberg Research. The equal-weighted S&P 500 index (our preferred measure of corporate health) as a percentage of the cap-weighted index is at its worst level since March 2009. That differential tells us that the exuberance we see in large cap stocks is derived from a handful of names.

The equal-weighted earnings multiple is 16.8x, a touch above its long-term average. The cap-weighted? 21.1x, well above its longer-term average of 15.9x. What do earnings underpinning those multiples look like? In 2024, the S&P 500 is expected to grow earnings by 9.5% this year. Interestingly, ex-Mag 7, that forecast growth rate is still 5.6%. That’s not all that bad.

Where the real delineation comes in is when looking at smaller companies. Of the Russell 2000, 42% of its companies are unprofitable. The aforementioned NFIB monthly Small Business Optimism Index for May came with this commentary: “For 29 consecutive months, small business owners have expressed historically low optimism and their views about future business conditions are at the worst levels seen in 50 years.”

Not much ambiguity there, from a sector that generates 40% of GDP and employs half of the labor force. We continue to point to the Two Economies, one driven by wealthier consumers and big business, and the other represented by lower income/asset households and small business. We are concerned that the latter is under-accounted for by investors.

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

1. Visibility. It’s pretty clear right now, and that supports lofty valuations.

2. Financial conditions. It’s a mixed bag, but generally constructive.

3. Tech impact. Identifying winners from losers is critical.

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