KBRA Financial Intelligence

Rate Cuts, Hot GDP, and Two Economies’ Delinquencies

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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.

A conversation this week on Bloomberg Television caught our attention. Sebastien Page, Global Head of Multi-Asset Strategy at T. Rowe Price discussed how his investment committee avoids groupthink. He makes each member come to meetings with their view on particular topics already formed, allowing each member’s view and expertise to emerge, relatively free of interpersonal meeting dynamics. Sounds like it leads to a more fruitful group discussion.

So, in the spirit of Mr. Page’s construct …

This week, my 3 Things are:

1. Rate cuts. Here are some grounding points around this upcoming paradigm shift.

2. Where is the slowdown? Q2 GDP blows away the consensus. Does that change things?

3. Consumer loan deterioration in a low unemployment environment. This cycle is different.

Alright, let’s dig a bit deeper.

Rate cuts.

We’re getting there. Trust us, it will happen. This week’s stronger-than-expected GDP report, complete with a hotter-than-expected inflation component, is no doubt going to take a July cut off the table, despite an impassioned plea this week to cut rates immediately from former head of the New York Fed and leading hawk Bill Dudley. Mr. Dudley, long in the higher-for-longer camp, “changed [his] mind” based largely on what he sees as weakening in the labor market. He says “dawdling unnecessarily” increases the risk of recession.

Despite all of the manufactured drama surrounding rate cut scenarios, whether the Fed cuts in July or September does not mean all that much to credit. What does matter to credit investors is why the Fed decides to cut.

The Fed cuts rates for one of two reasons: to recalibrate rates or to stimulate. Recalibrating rates is done to reduce restrictiveness due to “mission accomplished.” The mission, of course, is taming inflation. Cutting rates to stimulate happens when the FOMC is seeing something that suggests economic slowdown beneath long-term potential. Today, the Fed is preparing to recalibrate. After 525 bps of hikes and choosing to leave rates at that high level for an unusually long 13 months, with real rates now at or around 2%, and with inflation within sight of target, the case can certainly be made that it’s time to recalibrate. Still, with this week’s GDP report well above long-term potential, it’s OK to dawdle until September.

So now that we know that the rate cycle is imminent, how do markets react to cuts? Our good friends at Schroders went back and examined one-year asset class returns from the date of the first cut in the past 22 rate cutting cycles going back to the Great Depression. It is worth noting that in 16 of those 22 events the U.S. economy was either in recession or entered one within 12 months. In those 16 cases—call them recession cases—you might be surprised to hear stocks on average returned 8% in the year following the first cut while corporate bonds returned 7%. I guess that is intuitive in that markets are forward looking, so the asset class had already repriced and investors were looking forward to the recovery. This is not to suggest that it’s always smooth sailing. In six of those 16 events, stocks lost between 10% and 45% in the year following the first cut. So, no great surprise, it depends on the perception of just how bad the downturn might be.

Now, in the years where the first cut came when the economy was growing (as it is now), stocks returned a whopping 17% on average, while corporate bonds returned 4%. So, with one-year recession probabilities down around 30%, and a soft landing likely in our opinion, the history here—as we head into a recalibrating rate cycle—provides plenty of comfort in terms of risk asset performance.

Alright, on to our second Thing—Where’s the slowdown?

Well, this didn’t quite fit the narrative.

U.S. GDP growth in the second quarter, backward looking for sure, came in at 2.8% annualized—double that of Q1 and well above the 2% consensus. For context, 2.8% is a full point above the Fed’s estimate for longer-term growth in the U.S.

To be clear, relatively robust economic growth is not bad for credit, but at this point in this cycle, where markets are expecting slowdown and the rate cuts that come with it, it works against what the Fed was hoping to see. The increase was driven by a rebound in consumer spending, which increased 2.3% in the quarter, down from 3%+ in 2H 2023, but up from Q1’s 1.5%. And an 11.6% jump in business equipment reflects some needed vibrancy in the commercial sector.

Depending on your perspective, this was either an unsettling reversal of expectations that introduces more uncertainty into the mix, or a reminder that the path to 2% inflation target is not a straight line. We are clearly in the latter camp. It certainly feels like investors have hit that long-awaited inflection point, where those long and variable lagged effects of monetary tightening have finally flipped sentiment.

The data has been tilting toward slowdown. Starting with probably the most important indicator, the other half of the Fed’s dual mandate: the labor market. What The Wall Street Journal has called the “hottest jobs market in decades” has clearly come back into better balance, with jobs available to unemployed coming down, the quits rate coming down, and supply increasing via immigration. All of this has let some of the air out of wage growth pressure, presumably giving the Fed confidence that inflation is coming under control.

A better-balanced jobs markets is reducing the froth we saw in consumer spending. Q2 earnings reports noting consumers pushing back against higher prices by trading down or curtailing discretionary spend are now commonplace. That sentiment is evident in the more cautious forward look expressed by businesses in surveys from the ISM and the small business NFIB as well as the Fed. And in the hard data, we’ve seen muted capex despite fairly robust recent earnings growth. And in markets, we see falling commodity prices and freight metrics.

So, why haven’t credit markets reacted all that much? It’s actually quite telling. Starting with the level of spreads. They’re tight, given that we’re on the precipice of slowdown. Markets are telling us three things: (i) investors believe a hard landing remains a tail risk; (ii) yields are expected to remain attractive, i.e., rates will remain relatively elevated; and (iii) new issue supply will fall off in 2H. Will shareholders get a little anxious about top decile valuations heading into slowdown? Quite possibly. But the parameters of this slowdown do not figure to impact credit all that much.

Alright, on to our third Thing—Consumer loan deterioration in the Two Economies.

By now, regular listeners are well aware of our “Two Economies” theme, where wealthier households and larger businesses are performing relatively well, while many lower-income/asset households and smaller businesses are struggling. At a presentation this week, I showed a chart that broke down households into quintiles in terms of share of current spending, and wealth gains since the beginning of the pandemic, the latter courtesy of Oxford Economics.

Not surprisingly, the spread between the wealthier cohorts and the less wealthy ones is stark. For instance, the top two quintiles—the wealthiest 40%—account for 62% of spending and 81% of wealth gains. That, of course, has the effect of driving the aggregate data, such as consumer spending, to healthy rates that mask the drag of the bottom 60%. You might say, “well that’s fine, I invest based on the aggregate data.” That might serve you well, but losing sight of the less wealthy consumers and smaller businesses can eventually come back to bite. Remember, small business employs one-half of American workers and accounts for 40% of economic output.

We were reminded of the less wealthy’s struggles this week when seeing fresh data from the large banks on credit card delinquencies from the Federal Reserve Bank of Philadelphia, which hit its highest level in the 12 years the Bank has been tracking the data. Balances 60+ days past due hit 2.6%, eclipsing 2.4% reached in 2012. Those numbers don’t sound all that alarming, but remember unemployment was 8% in 2012, versus 4.1% today. We see similar trends in KBRA’s consumer lending indices. And data from the Federal Reserve Survey of Household Economics and Decisionmaking show that some 27% of renters have some bills not paid in full, including 11% that have unpaid water, gas, or electric bills. In a speech a month ago by Lisa Cook, a member of the Fed’s Board of Governors, she noted that signs of strain continue to emerge among consumers with low to moderate incomes as their liquid savings and access to credit have increasingly become exhausted. She pointed out that auto delinquencies are at a 13-year high. When 96% of the workforce is employed!

What’s behind this? Stimulus. Many consumers found their financial wherewithal significantly enhanced by stimulus. They elevated their spending lifestyle, burned through excess savings, and eventually credit availability. The interesting thing in this cycle is that lenders saw this in 2022 and tightened their credit boxes. We are now seeing problem loans peaking in 2024 ahead of the downturn. The good news is that lenders can absorb these higher losses while their first line of defense—earnings—is still strong. The bad news is that economic growth from borrowing-driven spending of the bottom 60% of earners (which account for 39% of total spending) is diminishing. The seeds of slowdown.

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

1. Rate cuts. A recalibration should not be ominous.

2. Where is the slowdown? Hard and soft data suggest it’s still on the way, despite Q2’s unexpectedly strong GDP print.

3. Consumer loan deterioration in a low unemployment environment. It was caught early, but there will be an impact to growth.

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.