“Oh, won't you
Gimme three steps, gimme three steps, mister
Gimme three steps towards the door?
Gimme three steps, gimme three steps, mister
And you'll never see me no more.”
-Lynyrd Skynyrd
I turned the TV on the other night and found that I am now signed up for something like ten streaming services. I don’t recall signing up for any of them. I have pointed the finger at other household members, but apparently, I am now living with a group of people with no short-term memory. We also have just about every channel choice. Theoretically, that means something like 500 channels, but I am skeptical of the way the service provider counts them on the guide. I spent an hour and went through all my choices the other night. There seemed to be so many shows I haven’t seen, and I am told are worth watching. Certainly, every streaming service had what seemed to be an outstanding choice. Things I should be eager to watch. New shows with big stars. I eagerly planned a list of shows to watch when I had the time. The anticipation of watching each of these choices was high. And then, I finally got a chance to sit down to watch TV and ended up watching old episodes of….Columbo. I had anticipated a great foray into the land of unearthed small-screen gems, and in the end, I realized I just wasn’t ready to take that step. What can I say? I felt more at home with the low-tech graphics of a 1970s detective show. The anticipation certainly dwarfed the execution.
Sometimes, the anticipation of what is going to occur overwhelms the senses. We become so focused on what may be that we lose sight of what is. March is a month filled with anticipation. We can’t wait for Spring. The anticipation of better weather is high. What it really is here in the Northeast, well, it’s a month of cold weather, rain and maybe even snow. It always seems to disappoint, but that doesn’t keep us from anticipating something different each and every March. Who can blame us? We’re eager to take those extra steps toward the next season. Mentally and physically, we need that. And so the anticipation rises, and you think, well, I’m going to open the door, and it’s going to be flowers and sunshine, and when we open the door, the only thing greeting us is a rumpled raincoat.
There seems to be a lot of anticipation in the market about the soft landing, the strong employment market data, and what many seem to think will be this gradual, seemingly orderly reduction in rates. But let’s take time to walk through some data, take three steps, if you will, through the things we are watching. They tend to indicate to us that perhaps what many are anticipating we are going to see when we open that door may not be the reality that greets us.
Negative Reaction – Consumer Pressure
Negative Reaction is a season four Columbo episode offering. An appropriate title for what we are still seeing in the consumer. We touched upon this several months ago, and we keep watching it, and it doesn’t seem to be going in the right direction. There is a lot of worry about inflation and its impact on the consumer. And so far, the consumer seemingly has continued to push it off and spend. And spend. And spend some more. Eating right through their savings all to keep the economy humming.
But it isn’t just savings. Nope, we are spending even more than that. So we borrow. And we borrow more. A few months ago, alarm bells rang about how much credit card debt we had domestically. Haven’t seen those articles much lately. Not sure why. But that doesn’t mean this has stopped. Indeed, it has continued sloping upward at an even sharper angle. So, we are increasing our debt burden and becoming more and more reliant on using a source of funding that is historically expensive in terms of interest rates and, therefore, even more punitive in this higher-rate environment.
Ah but we can take comfort in the employment strength, right? In fact, there is some indication that wage growth has met inflation. Maybe so. Maybe not. And right now, employment numbers are providing some soothing with what would seem robust activity and low unemployment. This would seem to mask some of the impact of the above, giving credit providers some comfort that even in a higher inflation world, delinquency rates should remain muted. Except that isn’t what we are seeing. In fact, on top of this ever-increasing debt load and a reliance on a more and more expensive source of credit, we are seeing increasing delinquency rates.
Banks and financial services firms seem all over this. You are seeing them reserve in anticipation of a deteriorating consumer credit near-term issue. But the overall impact on the economy can’t be overstated. Employment numbers get a lot of headlines and attention. Still, the fact that consumers are burdening themselves with excessive and expensive debt and eating further and further into savings to continue spending is troublesome. Tack onto that that in spite of strong employment, delinquencies are rising, and it strikes us as a continuing and concerning trend.
Suitable for Framing – Corporate Profits
A season one episode of Columbo, and kind of the way everyone seems to be looking at corporates right now. And while the raincoat isn’t that wrinkled yet, it’s getting there. However, if you want to look at how corporations have been doing during the past few years, especially post-Covid, one thing is certain: they have been performing pretty well. There is a lot of angst about inflation and pricing, and there becomes a political debate on how corporations’ profits seem to be increasing in dramatic steps during a time when inflation is high. In other words, are they taking advantage of the moment, using inflation concerns as a means to increase prices and pad profits? The fact is, consumer demand doesn’t seem to be waning in the face of higher costs, and corporate profits are up. Well, at least until recently. Because what we are seeing is diminishing profit growth, including negative year-over-year growth prints in four of the last five quarters. With only the fourth quarter of 2023 coming in strongly at 8.2%, a surprise at the time, and yet still far below the double-digit growth numbers we saw immediately after the initial pandemic results.
However you look at it, corporate profitability has slowed and even taken a step back. It should be expected, but if the economy slows down and corporations have to start discounting items in an attempt to lure a stressed consumer back in the door or just to shed bloated inventory, one could see the decreases in those numbers accelerate. That is obviously less than ideal for corporate health and, ultimately, the impact on the credit of those firms.
Short Fuse – Risk Assets and Credit Spreads
It's another season one episode and a good way to think of where this all ultimately leads. Despite what we are watching, the noise we are seeing from the data above in the market seems to be buried in the background, like mood music to keep an episode rolling. In fact, it doesn’t seem to be registering much in terms of risk. It is almost as if everyone in the market anticipates the good times will keep rolling. Corporate credit spreads continue to compress, and risk assets are still in high demand. Indeed, Bitcoin is off its lows and back in the limelight. Every social media app timeline seems to be once again lit with news about Bitcoin. Instant success and wealth, apparently, are back at your fingertips. A revival of interest and assurances that we have seen a return to the directional bet on this segment of risk.
And it’s not just limited to that. According to a Bloomberg article, commercial real estate exposures, which regulators are heavily monitoring for concern of concentration at small banks, witnessed skyrocketing issuance in the CMBS market in the first quarter of 2024 and tightening spreads. In the corporate credit space? We are seeing heavy demand. This is not only in high yield in general but also in strong enough interest that even in the lowest end of the credit stack, the CCC area, we see credit spreads are now well inside their 5-year average.
There seems to be a lot of anticipation about the end of this rate hike cycle. We focus on economic data, especially reports detailing inflation, for clues on what the Fed will do or how soon they will do it. But those three steps above, or three sectors of interest in terms of what we see data-wise, certainly seem to paint a little bit different picture. The market is anticipating, at some point, a return to rate cuts. But the market is also, it would seem, anticipating some sort of natural progression or improvement in terms of inflation data. The steps above, though, seem to indicate that perhaps the pressure to cut rates might be a response to deteriorating credit conditions instead. And that sometimes can be not so orderly.
There is a lot of front-line anticipation in the overall health of the market and, as a result, seemingly a reach for credit that we are a bit leery of. We continue to look at the data above and the overall rate environment and feel the clues are there. There is some weakness building. We do not expect any sort of panic, but we do expect a slowdown. And it could be a little sharper and quicker than anticipated. This has been our view of late, and we don’t see anything that would cause us to change the channel on that. Based on this, we see far more opportunity in rate products, as well as in higher credit quality exposures. Indeed, we would anticipate that any slippage will cause a rate cut response and an increased demand for liquid, higher credit quality securities and risk. There is more opportunity and upside in that position at this point, in our opinion, and ultimately, it should pave the road for possible future overperformance to those who are similarly positioned.
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Definition of Terms
Basis Points (bps) - refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.
Curvature - A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Mortgage-Backed Security (MBS) - A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Collateralized Loan Obligation (CLO) - A collateralized loan obligation is a single security backed by a pool of debt.
Commercial Real Estate Loan (CRE) - A mortgage secured by a lien on commercial property as opposed to residential property.
CRE CLO - The underlying assets of a CRE CLO are short-term floating rate loans collateralized by transitional properties.
Asset-Backed Security (ABS) - An asset-backed security is an investment security—a bond or note—which is collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables.
Option-Adjusted Spread (OAS) - The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Enhanced Equipment Trust Certificate (EETC) - One form of equipment trust certificate that is issued and managed through special purpose vehicles known as pass-through trusts. These special purpose vehicles (SPEs) allow borrowers to aggregate multiple equipment purchases into one debt security
Real Estate Investment Trust (REIT) - A company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors.
London InterBank Offered Rate (LIBOR) - a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
Secured Overnight Financing Rate (SOFR) - a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).
Delta - the ratio that compares the change in the price of an asset, usually marketable securities, to the corresponding change in the price of its derivative.
Commercial Mortgage-Backed Security (CMBS) - fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
Floating-Rate Note (FRN) - a bond with a variable interest rate that allows investors to benefit from rising interest rates.
Consumer Price Index (CPI) - a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
Gross Domestic Product (GDP) - one of the most widely used measures of an economy's output or production. It is defined as the total value of goods and services produced within a country's borders in a specific time period—monthly, quarterly, or annually.
Perp - A perpetual bond, also known as a "consol bond" or "perp," is a fixed income security with no maturity date.
Nonfarm payrolls (NFPs) - the measure of the number of workers in the United States excluding farm workers and workers in a handful of other job classifications. This is measured by the federal Bureau of Labor Statistics (BLS), which surveys private and government entities throughout the U.S. about their payrolls.
Net Asset Value (NAV) - represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities.
S&P 500 - The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.
German DAX - The DAX—also known as the Deutscher Aktien Index or the GER40—is a stock index that represents 40 of the largest and most liquid German companies that trade on the Frankfurt Exchange. The prices used to calculate the DAX Index come through Xetra, an electronic trading system.
NASDAQ - The Nasdaq Stock Market (National Association of Securities Dealers Automated Quotations Stock Market) is an American stock exchange based in New York City. It is ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange.
MSCI EM Index - The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,382 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Nikkei - The Nikkei is short for Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange.
Shanghai Composite - is a stock market index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange.
Bloomberg U.S. Agg - The Bloomberg Aggregate Bond Index or "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
MOVE Index - The ICE BofA MOVE Index (MOVE) measures Treasury rate volatility through options pricing.
VIX Index - The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX).
Dow Jones Industrial Average - The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.
Hang Seng - The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong.
STOXX Europe 600 - The STOXX Europe 600, also called STOXX 600, SXXP, is a stock index of European stocks designed by STOXX Ltd. This index has a fixed number of 600 components representing large, mid and small capitalization companies among 17 European countries, covering approximately 90% of the free-float market capitalization of the European stock market (not limited to the Eurozone).
Euro STOXX 50 - The EURO STOXX 50 Index is a market capitalization weighted stock index of 50 large, blue-chip European companies operating within eurozone nations.
CAC (France) - is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant stocks among the 100 largest market caps on the Euronext Paris (formerly the Paris Bourse).
Duration Risk - the name economists give to the risk associated with the sensitivity of a bond's price to a one percent change in interest rates.
Federal Open Market Committee (FOMC) - the branch of the Federal Reserve System (FRS) that determines the direction of monetary policy specifically by directing open market operations (OMO).
United States Treasury (UST) - the national treasury of the federal government of the United States where it serves as an executive department. The Treasury manages all of the money coming into the government and paid out by it.
High Yield (HY) - high-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
Investment Grade (IG) - an investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.
Exchange Traded Fund (ETF) - an exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock.
Federal Family Education Loan Program (FFELP) - a program that worked with private lenders to provide education loans guaranteed by the federal government.
Business Development Program (BDC) - an organization that invests in small- and medium-sized companies as well as distressed companies.
Job Opening and Labor Turnover Survey (JOLTS) Report - is a monthly report by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor counting job vacancies and separations, including the number of workers voluntarily quitting employment.
Sifma - The Securities Industry and Financial Markets Association (SIFMA) is a not-for-profit trade association that represents securities brokerage firms, investment banking institutions, and other investment firms.
Duration - A calculation of the average life of a bond (or portfolio of bonds) that is a useful measure of the bond's price sensitivity to interest rate changes. The higher the duration number, the greater the risk and reward potential of the bond.
Home Equity Line of Credit (HELOC) - A home equity line of credit (HELOC) is a line of credit that uses the equity you have in your home as collateral.
Government-Sponsored Enterprise (GSE) - A government-sponsored enterprise (GSE) is a quasi-governmental entity established to enhance the flow of credit to specific sectors of the U.S. economy. Created by acts of Congress, these agencies—although they are privately held—provide public financial services.
Qualified Mortgage (QM) - A qualified mortgage is a mortgage that meets certain requirements for lender protection and secondary market trading under the Dodd-Frank Wall Street Reform and Consumer Protection Act, a significant piece of financial reform legislation passed in 2010.
Trust Preferred Securities (TruPS) - hybrid securities issued by large banks and bank holding companies (BHCs) included in regulatory tier 1 capital and whose dividend payments were tax deductible for the issuer.