NEW YORK: January 6, 2025: The new year is a time to be thankful for the past 12 months and wish friends, family, and colleagues the best. Many people in the U.S. spend New Year’s Day watching football. Some of us—including me—then start to dream about longer days, warmer weather, and baseball spring training. Which calls to mind famous Yankees catcher Yogi Berra, who is probably remembered just as much for his contributions to the American language. It was he who said, ‘The future ain’t what it used to be.” As we look at what the markets may bring in the new year, his words ring truer than ever.
Figure 1: Troubled Company Index® and S&P 500 Index
2024 was another strong year for the markets. The S&P 500 gained over 20% for the second year in a row. Excitement for everything AI, interest rate cuts, and Trump’s return to the presidency drove the market. The U.S. economy has been resilient, with retail sales exceeding estimates and GDP remaining strong. Unemployment remained around 4%, and inflation, while still above the Fed’s 2% target, moderated. Corporate earnings picked up across sectors. Defaults remain low by historic standards, and margins are tight across asset classes.
Sentiment for the new year is positive, with FactSet data predicting 15% growth year over year for the S&P 500 in 2025.Expected Trump policies include lower taxes and deregulation, although tariffs are likely to be inflationary and result in a higher dollar. Even though the expectation is for fewer rate cuts than previously, markets are beginning the year optimistically.
But as always, there are two sides to every coin. An unintended consequence of the Fed’s cutting rates has been an increase in the 10-year yield and a steepening of the yield curve, as we discussed last month. The curve is now back to 2022 levels, as shown in Figure 2. The Fed rate cuts, signaling a shift to prioritize the full-employment mandate, seem to have been made without synchronization with fiscal policy, as data shows that the budget deficit widened from August to October relative to GDP. With the combination of the core inflation rate above the Fed’s target and rapidly expanding deficit spending, it is not surprising to see the increase in the 10-year yield. The rising yield curve also points to increased fragility in the markets. Signs of an inflation surge could easily push 10-year yields towards 5%.
Figure 2: Yield Curve Steepening
Another key consideration is concentration in the S&P 500, where the ten largest stocks account for 39.9% of the market cap—their largest share in the last 30 years. This is a “show me” market, where companies with earnings misses will be heavily punished. Those that cannot grow earnings–especially leveraged firms– are at risk from higher interest expense. Our Troubled Company Index® (TCI) measures short term default risk, which at 9.17% stands at the 81st percentile. When we look at default risk as measured by a three-year default probability, the index is at the 74th percentile. If we focus only on U.S. firms, the three-year default risk is at the 64th percentile. The percentile is measured from 1990 – 2024, with 100 indicating the best conditions.
The S&P CoreLogic Case-Schiller Index released at the end of the year showed a 3.6% annual gain in October. Home prices in the U.S. have increased an average of 50.9% since 2020. Rent inflation has been even higher. A significant number of households have not directly benefited from the equity markets or home price gains and have been severely hurt by inflation. This can be seen in credit card defaults, which surged to their highest level since 2008 and are up 50% from a year ago. The highest-income households are fine, but the working class is paying for post-covid policy mistakes. Having a third of the households financially tapped out is another risk factor contributing to economic fragility, despite new records in the stock indices.
The bottom line is that company performance will be idiosyncratic, requiring fundamental analysis and close monitoring of individual performance. The steepness of the yield curve and more specifically the yield on the 10-year Treasury is a systemic as missteps in either fiscal or monetary policy can easily send long rates even higher. This poses both default risk and valuation risks given current stock market levels.
Contemporaneous Credit Conditions
The Kamakura Troubled Company Index® closed the month at 9.17%, up 0.40% from the prior month. The index measures the percentage of 42,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.
At the end of December, the percentage of companies with a default probability between 1% and 5% was 6.50%. The percentage with a default probability between 5% and 10% was 1.41%. Those with a default probability between 10% and 20% amounted to 0.92% of the total; and those with a default probability of over 20% amounted to 0.34%. For the month, short-term default probabilities ranged from a low of 8.83% on December 11 to a high of 9.87% on December 18.
Figure 3: Troubled Company Index®, December 31, 2024
At the end of December, the riskiest 1% of rated public firms within the coverage universe as measured by 1-month default probability included 8 companies in the U.S. and one each in Canada, France, Luxemburg and the UK. The riskiest firm was the French IT firm Atos SE (ATO.PA), with a one-month KDP of 50.08%. Last month’s riskiest firm, the Container Store Group filed for Chapter 11 Bankruptcy protected on December 23.
Table 1: Riskiest Rated Companies Based on 1-month KDP, December 31, 2024
The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate of 0.53% up 0.01% from the prior month, with the 10-year rate down 0.06% at 8.85%.
Figure 4: Expected Cumulative Default Rates, December 31, 2024
About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 42,500 public firms in 76 countries that have an annualized one-month default risk of over one percent. The average index value since January 1990 is 14.05%. Since July 2022, the index has used the annualized one-month default probability produced by the KRIS version 7.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.
The KRIS version 7.0 models were developed using a data base of more than 4 million observations and more than 4,000 corporate failures. A complete technical guide, including full model test results and key parameters, is provided to subscribers. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model.
The version 7.0 model was estimated over the period from 1990, through the Great Recession and ending in February 2022. The 76 countries currently covered by the index are Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.
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Editorial contacts:
- Martin Zorn – Martin.Zorn@sas.com
- Stas Melnikov – Stas.Melnikov@sas.com