KBRA Financial Intelligence

3 Things in Credit: Second Half Themes, Earnings Expectations, and Goldilocks Challenged

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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.

I just saw a headline come into my email box, titled “The Clooney Effect.” That, of course, refers to the actor George Clooney, presumably, not Rosemary, and his influence on whether or not President [Joe Biden] should remain the Democratic nominee. This has been the era where Jay Powell had to factor in the effect of Taylor Swift, and now the world has to pay attention to what George Clooney thinks.

This week, our 3 Things are:

1. Second-half [2024] themes. Moving on from inflation.

2. Earnings season. Pepsi, Delta, and ConAgra report—and reality bites.

3. Goldilocks challenged. Two charts we came across don’t fit the narrative.

Alright, let’s dig a bit deeper.

Second-half themes.

Well, we certainly know where news flow is: round-the-clock coverage of the fallout from the president’s debate performance. Not surprisingly, it found its way into Jay Powell’s testimony before Congress. And, of course, it has been weighing on the mind, and wallet, of George Clooney.

This also comes on the back of snap elections in the UK and France. So, even though risk markets historically aren’t influenced all that much by the hurly-burly of politics, it’s inescapable. And in this instance, it just might be materially consequential. We’ll get to that in a minute. But first, let’s get back to our day job.

In any event, here’s what we are seeing driving credit valuation in the second half:

1. Clear visibility

   . On the economic front, things are, dare we say it, settling down. Despite most midyear reviews out there that caveat their views with a healthy dose of uncertainty, we’re just not seeing it. We’re moving into the rate-cutting cycle, but not because of some emergency need to stimulate, simply to recalibrate rates. The jobs market is sound, growth is slowing, but recession risk feels like a remote risk. Corporate earnings growth is nicely positive. The world is performing better than expected.

2. Inflation’s fading threat

   . We’re clearly moving toward target, not just in the U.S., but also in the UK, in Europe, and in Japan. The rate-cutting cycle has begun, and we see the Federal Reserve joining in in September.

3. Slowing growth

   . To be clear, it’s not all puppy dogs and rainbows; we are normalizing. Second-half 2023’s 4.1% growth in the U.S. is firmly in the rearview mirror, and 2024’s first-half read is likely to come in around 1.7%, and the consensus is looking for 1.6% in the second half. Fading effects of stimulus and the continuing bite of monetary tightening are very real headwinds. Those two effects dampen sentiment. More on that in a bit.

4. Political distraction

   . Europe has settled down (for now), but not so much in the U.S. In any given presidential election year, you can expect to see stock volatility rise 50% leading into the election. It is worth pointing out that if that were the case this year, the VIX still wouldn’t get to its long-term average.

Our view has always been that politics really doesn’t affect risk markets all that much. But this particular election has us thinking otherwise. A recent editorial written by Bob Rubin and Ken Chenault, laying out how a second Trump term would “pose enormous risks to our economy,” is a worthwhile read. This probably is more of a 2025 issue, but it’s worth bearing in mind.

One other very tangible effect of this year’s election, the pull forward of debt issuance in order to get ahead of any volatility. The resultant falloff in supply in the second half should be a positive technical for credit spreads.

So, pull it all together, and you have a rather constructive backdrop for credit markets. Inflation that’s being brought under control without shocking the labor market or the financial system, a Fed that’s methodically moving toward reducing restrictive rates, corporate earnings that are holding up (if a bit uneven), and a global economy that is performing better than expected. Check back with us after November 5.

Alright, on to our second Thing—Q2 earnings.

Earnings, of course, are backward-looking. So, it should come as no surprise that growth and margin trends have largely been favorable, as you would expect from an environment that has been unusually strong due to stimulus. This has been most evident among large caps that have had pricing power. That power has enabled many firms to more than offset higher costs and pull out of the earnings recession we saw from Q4 2022 to Q2 2023.

Looking ahead, the consensus forecast for the S&P 500 for Q2 is calling for year-over-year net income growth of 9.1%, the highest rate since Q1 2022. Ex. theMagnificent 7, the consensus is looking for growth of 5%. On an equal-weighted basis, we’re looking at growth of 7.1%. Revenue growth for the market-weighted index is expected to be modest at 4.6%, so margins are expected to carry the day. And that is the case with operating margins estimated to be 15.7%, the highest level since Q3 2022. You get the picture—all reasonably healthy.

Among large caps, earnings growth is expected to be broad among sectors, with eight of 11 reporting better year-on-year outcomes, five of which figure to report double-digit increases, specifically communication services, consumer discretionary, information technology, health care, and utilities. On the downside, sectors in earnings recession (two or more consecutive quarters of year-on-year earnings contraction) include passenger airlines, telecom services, autos and parts, specialty retail, food products, banks, real estate management and development, life sciences, air freight, communications equipment, and materials.

So what did we learn from Q2 reports from Delta, Pepsi and ConAgra, the first three out of the chute? Well, all three underwhelmed to some degree versus expectations. All three are consumer products companies, so we’re getting an early read into the consumer—how they are dealing with the cumulative effects of inflation and, if we believe sentiment indices, how they are factoring in that gnawing sense of discomfort regarding the future. And, by the way, we are always cognizant that rapidly changing consumer preferences are also in play, so it’s not all just macro.

At Pepsi, earnings beat by 6% and were 9% better than a year ago, but revenue growth of 1.9% underwhelmed. Two comments caught my attention, one from management and one from an analyst. Management acknowledged that “there is a cohort of consumers that have become more price-conscious.” That echoes the “Two Economies” theme that we often talk about. Meanwhile, an analyst at Bernstein made this observation: This quarter is an “abrupt end to the strong period of growth enjoyed during the COVID-19 era.” Ahhh, normalization. Remember what normal looks like??? Pepsi found out.

Over at Delta, everybody’s favorite airline stock, adjusted Q2 EPS missed by 1%, and was down 12% year-over-year, and the company warned that the third quarter will be as much as 17% below the consensus estimate. Why? Competition. “Excess supply has led to heavy discounting,” says the company. That’s interesting color given that air travel is at record levels and every plane, seemingly, is full. Too much capacity built up during the post-COVID boom. That would be the “not normal” post-COVID boom.

Food producer ConAgra beat by 7%, while EPS came in 2% lower than a year ago, and sales and revenue guidance disappointed. Management talked about a challenging environment and consumers’ transition back to normal. Again, back to normal in this case implies a downdraft.

Alright, rounding out the earnings picture, checking in on small caps. The Russell 2000 is looking at a 25% contraction in earnings year-over-year. That’s the seventh quarter in a row of negative year-over-year growth for the small caps. This is shaping up to be a noisy earnings season.

Alright, on to our third Thing—Goldilocks challenged.

As we were compiling things that helped to define how to think about the second half, two charts kind of stuck in our craw. One compares consumers’ view of its current situation versus their view six-months out. This comes from Conference Board data.

So, if you take the index’ measure of expectations LESS that of current conditions, we are at or near 50-year lows, meaning consumers feel pretty good about where they are, and pretty bad about where they’re headed. Historically, each time we see this differential, we have ended up in recession. It makes sense. Prosperity ends via a shock—interest rates rise, credit tightens, a bubble bursts, the price of energy spikes. Consumers do a good job of sniffing out the turn, usually because of anecdotal evidence around them—they feel less secure in their job, less secure in their ability to make ends meet. It doesn’t have to be all consumers, just enough to make a difference. That is the slowing of growth we’re seeing.

A second chart plots the Citi Economic Surprise Index, which measures economic data releases relative to market expectations, versus the equity multiple. Ordinarily, the two correlate well. That also makes sense. Shareholders naturally curb their enthusiasm when the economic data turns decidedly weaker.

In a noteworthy development, however, these two have decoupled in 2024. Dramatically. The forward multiple on the S&P 500 is close to 22x, near its cyclical high, while the economic data is underwhelming. Something has to give. It feels like some air should come out of priced-for-near-perfection valuations in risk assets.

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

1. Second-half themes. The focus moves from inflation to growth.

2. Earnings season. Pepsi, Delta, and ConAgra reflect a return to normal.

3. Goldilocks challenged. The data acknowledges the inflection point of that return to normal.

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