KBRA Financial Intelligence

3 Things in Credit: Chinese Volatility, Private Credit’s Runway, and Bank Lending

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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.

The election’s red sweep is now confirmed, and investor exuberance is in full bloom. The S&P 500 is putting up its strongest YTD performance since 1995, having risen by 25% since the start of the year. According to our friends over at Deutsche Bank, it’s the first time since 1997-98 that it’s on course to post back-to-back annual gains above +20% and only the third time in 100 years. Investment-grade credit spreads have tightened to their lowest level since 1997. Rosenberg Research characterizes the environment this way: “Confidence morphing into epic complacency has hit nearly unprecedented levels.”

This week, our 3 Things are:

1. Chinese volatility. Its economic struggles are a double-edged sword to risk markets.

2. Private credit’s runway. It’s significantly under-allocated, but not likely to stay that way.

3. Bank lending. They’ve got money to go, as long as you’re on the right side of our “Two Economies.”

Alright, let’s dig a bit deeper.

Chinese volatility.

We have long viewed China as a wildcard when it comes to risk markets. In the five years leading up to COVID, China matched the U.S. in terms of being a growth engine for the world economy. It became fashionable to suggest that the day was coming where China would become the largest economy in the world. Its emergence as an important driver of global growth made it a double-edged sword driving, at times, investor risk on or risk off in U.S. markets, depending on the particular release or signal coming out of Beijing. Recall 2015 when fears of China slowing drove significant sell-offs in U.S. risk.

So, you want to keep close tabs on China at all times. And that’s especially true today. President Xi’s ambitious restructuring of China’s economy under his Common Prosperity Policy has introduced substantial risk—and some risk of contagion—into global markets. The pronounced move away from levered real estate development and domestic consumption to manufacturing-driven exports and greater state control has left growth flagging, the banking system weak with losses, and local governments saddled with debt. The IMF lists the vulnerability of the country’s property sector as one of its Downside Risks to the global economy in its latest World Economic Outlook.

True to form, China’s double-edged sword is evident today. Efforts lately by the government to stimulate its economy have given a sugar high to Chinese equities that had been beaten down over the past two years. If successful, the growth spurt could provide some positive offset to normalizing, i.e., slowing global growth. Alternatively, if stimulus proves to be less than consequential, the disappointment could flow into risk markets.

Here’s the other edge of the sword. Regardless of the efforts to stimulate, the Chinese slowdown continues, judging by its recent weak CPI and PPI releases. The slowdown is reflected in commodities prices that have fallen nearly 10% since May, so, in effect, China is turning around and exporting much needed deflation to the rest of the world. The flipside of that, of course—and more consequential—is the downdraft in growth, something that is likely to get worse under the Trump administration’s America First orientation. With risk markets priced for perfection, keep an eye on China.

Alright, on to our second Thing—Private credit’s runway.

The days of private credit being the shiny new thing are long gone. If we stick to the commonly observed (but rapidly becoming obsolete) definition of private credit being direct lending, distressed, junior capital and special situations, the asset class is now larger than high yield and larger than the leveraged loan markets. And yet private credit remains more under-allocated by LPs, at 47%, than any other private market strategy, according to a survey of 190 LPs conducted this summer by Goldman Sachs Asset Management. Moreover, that figure is up substantially from 21% in 2023. That said, some 34% of LPs are “most focused” on deploying into private credit, more than any other strategy.

This squares up with anecdotal evidence I gathered this week at a conference, where four CIOs of institutions with substantial assets under management (one endowment, two insurance companies, and one state pension fund) all highlighted the need to become more invested in private credit. One talked about private’s superior performance relative to public’s through the cycle, driven by higher yields and higher recoveries. Another touted the relative value in the following way: comparing returns—say, 10% in private credit—to equities. Similar returns, but with lower volatility and greater diversification. One mentioned that it has gotten easier to manage exposure in this seemingly illiquid asset class via the now substantial publicly traded BDC market. Another investor mentioned the favorable tailwinds of growth over the intermediate term in the sector as assets continue to get disintermediated out of the banks, and as the European market grows.

Ordinarily, we might not expect this level of enthusiasm for the asset class late in the cycle where losses could build, and Fed rate cuts could eat into returns. But this cycle has an unusual nature, where growth has remained quite solid, but where the Fed feels the need to cut in order to “recalibrate” rates, i.e., remove restrictiveness, rather than cut to “stimulate.” And with just three rate cuts forecast between now and year-end 2025, and losses well behaved in an environment of soft landing and abundant liquidity, real yields in the asset class should prove to be highly attractive into 2025. All of this squares up with LP sentiment expressed in GSAM’s survey, where 75% of respondents expect private credit’s outlook to be the same or better than it was a year ago. And last year was pretty good.

Alright, on to our third Thing—Bank loan risk appetite.

How are bankers viewing the current landscape in credit? Insight into that came this week via the latest SLOOS report, aka the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices. In a nutshell, loan underwriting standards were unchanged and generally favorable for commercial and industrial (C&I) loans to large and middle market firms and tighter for loans to small firms. And on the consumer side, loan underwriting standards tightened a bit on credit cards, but were stable in other loan categories.

Of the banks that reported tightening standards or terms on C&I loans, major reasons cited for the conservatism include a less favorable or more uncertain economic outlook, worsening of industry-specific problems, and a reduced tolerance for risk. In addition, bankers also cited increased concerns about the effects of legislative changes, supervisory actions, or changes in accounting standards; deterioration in the bank’s current or expected capital position; decreased liquidity in the secondary market for C&I loans; and less aggressive competition from other banks or nonbank lenders as reasons for tightening.

Over on the consumer side, banks were more likely to approve credit cards to prime and superprime borrowers, and less likely to approve near- or subprime borrowers. This is consistent with the latest consumer finance delinquency data from the Fed where aggregate delinquency rates ticked higher in Q3 to 3.5% from 3.2% in Q2.

All of this lines up with one of our overarching investing themes, that there are “Two Economies” out there—one where wealthier households and larger firms are performing well and one where more vulnerable households and smaller firms are facing greater headwinds. Overall, however, financial conditions are highly supportive of the strongest economic growth engines in the U.S. and that bodes well for credit markets into 2025.

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

1. Chinese volatility. The country is exporting deflation, but its growth slowdown is a risk for markets.

2. Private credit’s runway. Strong relative value and a reasonably favorable economic backdrop bode well for performance.

3. Bank lending. They’ve got money to go, as long as you’re on the right side of our “Two Economies.”

As always, thanks for joining. We’ll be in Washington next week for our Bank Symposium. We’ll be back to you after Thanksgiving. Enjoy the holiday.