KBRA Financial Intelligence

Capex Canary, CRE’s Broader Threat, and Election Tailwind

This week, our 3 Things are:

1. Capex canary in the coal mine. The capacity is there, but the willingness?

2. Commercial real estate threat. The federal government is out with a view.

3. Election tailwind. We found one way it materially impacts credit markets.

Alright, let’s dig a bit deeper.

Capex canary in the coal mine.

I’m still a bit surprised at how surprised many are to learn that the slowdown is happening. “What about that jobs number?” they ask. What about all that talk about inflation stickiness and concern that the Fed will not cut at all, they ask.

Well, we have long advised patience. Especially in light of all of that stimulus, call it $10 trillion for argument’s sake. The lagged effects of the fastest hiking cycle in 40 years have stretched out more than what has been typical, because of all of that stimulus. But, unlike stimulus, the effects of monetary tightening aren’t fading away.

The slowdown has been plainly evident in interest-sensitive sectors such as housing and commercial real estate. Production of goods, obviously, has slowed, largely due to the pull-forward of purchases in the pandemic. And now we’re seeing the consumer—actually some consumers (typically lower-income/asset consumers)—hit a wall in their spending. That has shown up in the aggregate retail sales figures, and today’s PCE read, both of which have slowed. To put some aggregate numbers on it, real growth in the second half of 2023 was a robust 4.1%. In the first half of 2024, we’re looking to come in around 1.7%. So, yes, we are slowing.

Now, let’s look ahead. For that, we pay particular attention to what business is doing, or more accurately, what business is spending. Yes, consumer spending is upwards of 70% of economic output, but much of that is on staples that really don’t move all that much through the cycle. It’s discretionary spend that matters on the margin, and that’s where business investment is a worthwhile forward-looking indicator. And business investment has broader implications for employment, so its importance to the overall economy is clear.

And what we’re seeing in business investment is softness. A softness that squares up with expectations of a more challenging growth environment. We see that in the survey data out of the Dallas Fed, New York State, the Philly Fed, the Kansas City Fed. Interestingly, and in the interest of full disclosure, we are seeing signs of life in capex out of the small businesses surveyed by the NFIB.

Still, in the aggregate, we see the slowdown in the actual flow of funds data, where net domestic business investment as a percentage of final sales is trending lower from an already below average 2.3%. This, at a time when pretax profits are at or near all-time highs. “The overarching message from our member CEOs is the economy is steady and stable, but they remain cautious” is how Business Roundtable characterized the environment in its Q2 Economic Outlook that came out two weeks ago. Its outlook for capital spending for the next six months showed 32% of its CEOs expected to increase capital spending, down from 39% in the previous quarter.

We talked recently about visibility, and how it has improved materially from a year ago. What businesses are seeing clearly is that the new normal is not the above-potential growth we saw in 2023’s second half, rather the more moderate growth environment we’re facing today. Think about that in the context of tight credit spreads.

Alright, on to our second Thing—Commercial real estate’s threat to the broader economy.

This week we got the latest large bank stress test results courtesy of the Federal Reserve. The Fed has been conducting these hypothetical exams ever since the global financial crisis as a means to shoring up investor confidence in the sector and deciding which banks are strong enough to return some capital to shareholders.

The Fed models 31 of the largest depositories against certain stresses over a two-year period to see if an institution’s pro forma capital is deemed to be sufficient from standpoints on safety and soundness and capital return. For credit investors, the test results get at just how durable the banking system might be in the face of a “severely adverse” environment, a critical determination because a financial crisis and resultant credit crunch can turn an economic downturn into a financial crisis. That was the GFC.

So, what makes up a “severely adverse” scenario? This year, the Fed describes it as a “severe global recession accompanied by a period of heightened stress in commercial and residential real estate markets, as well as in corporate debt markets.” Here are some specifics driving their model:

• Unemployment rising to 10%

• Real GDP falling 8.5%, peak to trough

• House prices falling 36%

• Commercial real estate values falling 40%

• 3-month Treasury yield falling to 0%

• BBB bond spreads widening 170 bps to 5.8%

• Equity prices falling 55%

Eeesh. Good luck with that.

Well, you might be surprised to learn that all 31 banks tested “passed,” where each bank’s modeled losses would not come close to breaching regulatory minimums in their respective capital ratios. That’s good. That gives comfort that the fastest hiking cycle in 40 years is not likely to trigger a systemic financial situation.

We also thought it was interesting to see that the much talked about commercial real estate correction would not be something that could cripple the banking system, even with a 40% haircut to property prices. And, by the way, that’s all property types, something that is far more severe than what we realistically are facing, namely material downdrafts in downtown office buildings, certain malls, and maybe some lodging properties. Interestingly, the Fed, with little incentive to go easy on the banks, assumed a projected loss rate across CRE portfolios of 8.8% over the two-year modeling time frame, which gets at an important point when trying to dimension CRE risk: Loss rates and expectations vary widely across property types!

So what does the Fed say about CRE risk to the banking system? That loss rate (8.8%) “while significant, [is] not a driver of year-over-year changes in the stress test results.” That doesn’t sound so bad. Nor does this: The loss rate happens to be in the same ballpark as the modeled loss rate on regular commercial loans (8.1%). While no one would say there is not significant risk in CRE loans today, this analysis does a really good job, in our opinion, of dimensioning a difficult-to-dimension problem overhanging risk markets today.

Alright, on to our third Thing—Election tailwind.

Elections have been top of mind to thought leaders and investors all year, because we’ve been told that. Countries with half of the world’s population are having national elections this year. Now, I have to admit, there have been enough twists and turns thus far to keep cable news profitable. And that’s saying something.

Generally, politics does not rise to the level of materially impacting risk markets; that’s usually reserved for issues that drive economic supply and demand and issues that impact the financial system. Macro markets—rates and currencies—are a different story, of course, as we are witnessing in France at the moment. And we always need to be on the lookout for stories that spill over from macro markets to risk markets, such as AOCI losses on U.S. bank balance sheets in March 2023 or a return on fears related to Europe’s “doom loop,” where creditization of sovereign debt can hit European banks.

In the U.S., presidential election drama is firmly on the boil, turbocharged by last night’s debate, but will any of this affect credit markets? Well, from a policy perspective, neither party is pushing for fiscal conservatism and neither is shy about tinkering with trade rules. Immigration’s supply of labor could become an issue if we believe Trump’s rhetoric, but materially shifting that will likely take a year or more to effect.

But here’s something election-related that is material to credit markets today: new issue supply. The first half has been a deluge of issuance across fixed income markets, a function of two things: one, strong demand for bonds that haven’t been this yield-y in 15 years, courtesy of the Fed’s rate rise; and two, powerful pull-forward of issuance, with issuers getting ahead of developments in two hot wars and, yes, presidential elections.

Wait, you say—I thought you just said elections generally don’t matter. They don’t, but the conventional wisdom is that they might. And that does show up in stock market volatility, which typically rises for the three months prior to the election. So, there is incentive on the part of issuers to dodge that.

In any event, the supply issue is graphically illustrated by an issuance forecast published this week by JPMorgan Chase. JP is forecasting $590 billion of public investment-grade issuance in the second half, 31% lower than the first half’s $860 billion. That supply reduction is a powerful technical in the market that should keep credit spreads well bid over the balance of the year absent some exogenous shock.

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

1. Capex canary in the coal mine. The reluctance to invest is consistent with slowdown.

2. Commercial real estate threat. The Fed’s bank stress tests suggest this is manageable.

3. Presidential elections. The pull-forward of issuance is creating a positive technical tailwind to credit.

As always, thanks for joining. Don’t forget to check in on KBRA.com for our ratings reports and our latest research.

We’ll see you next week.