Economic Resiliency—But for How Long?

07/02/2023 08:15 PM

NEW YORK, July 3, 2023: Neither concerns about the global economy nor interest rates prevented U.S. equities from posting gains in the second quarter.  For the first half of the year, all global indices ended higher. The S&P 500, for example was up 16% for its best first half since 2019. For the quarter among global indices, the S&P All Australian 50 was down 0.51% and the S&P Asia 50 was down 3.16%, while the S&P Latin America 40 index led the gainers up 15.89%. Given that experts have been predicting a recession, we will examine this apparent economic resiliency and its implications for risk management in our commentary.

Contemporaneous credit conditions continued to improve in June, with the Kamakura Troubled Company Index® closing the month at 8.58%, down 0.37% from the prior month. The index measures the percentage of 41,500 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 June, the percentage of companies with a default probability between 1% and 5% was 6.2%. The percentage with a default probability between 5% and 10% was 1.16%. Those with a default probability between 10% and 20% amounted to 0.84% of the total; those with a default probability of over 20% amounted to 0.38%. Short-term default probabilities ranged from a low of 8.43% on June 6 to a high of 8.89% on June 1.

Figure 1: Troubled Company Index® — June 30, 2023

At the end of June, the riskiest 1% of rated public firms within the coverage universe included ten companies in the U.S. and one each in Germany and Luxemburg.  The riskiest rated firm from the prior month, data center operator Cyxtera Technologies, Inc. (NASDAQ:CYXTQ) defaulted on June 6 as a result of its bankruptcy filing.  The iconic food storage firm Tupperware Brands Corporation (NYSE:TUP), with a one-month KDP of 50.37%, had been up 15.62% over the past three months, but is now the riskiest rated firm. There were ten defaults in the KRIS coverage universe in June, with nine in the U.S. and one in the UK.

Table 1: Riskiest Rated Companies Based on 1-month KDP – June 30, 2023

The two-year default probability provides a more forward-looking view than the one-month probability.  As we look further out on the curve, the impact of higher interest rates and the inverted yield curve are captured in sectors still adjusting to rate environment. Strong employment and equity market gains have so far cushioned the short-term impact of the central bank’s rate actions.

Figure 2:  2-Year Term Default Probabilities – U.S. Market, June 30, 2023

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate down 0.21% at 0.65% with the 10-year rate down 1.27% at 8.63%.

Figure 3: Expected Cumulative Default Rate — June 30, 2023


Stas Melnikov and Martin Zorn
SAS Institute Inc.

The markets have seen strong economic resilience despite a rapid increase in interest rates. Some have referred to this environment as the “non-recession recession.” Others have wondered whether we may be experiencing rolling recessions, with some areas already feeling pain and others feeling pressure, even though the underlying economy is doing well.  Central bank models were late in capturing the persistency of inflation, and are now being challenged as employment appears to be unaffected by higher interest rates[1].

Actual defaults in our rated coverage universe have increased slightly from 21 for the trailing twelve-month period ending June 30, 2022 to 27 for the trailing 12 months ending June 30, 2023.  The defaults by sector for the two periods have been very different. In the earlier period, the real estate sector experienced the most defaults while in the more recent period, the highest default sectors shifted to health care and telecommunications.

Figure 4: Trailing 12-Month Defaults for Rated Companies, 7/22 through 6/23

Figure 5: Trailing 12-Month Defaults for Rated Companies, 7/21 through 6/22

The latest forecast from the World Bank and KPMG Economics supports a soft-landing economic thesis, with slowing in global economies, but not a recession.  We know the euro zone fell into a technical recession earlier in the year, and emerging economies including Argentina, Pakistan and Türkiye are suffering from hyperinflation and the possible risk of default.

Figure 6: KPMG Economics and World Bank Real GDP

If we look at the S&P500 index, 10 companies contributed to 89% of the most recent gain.

As we stated above, some sectors have experienced more stress than others.  Banks are a primary example.  Consumers locked in long-term low rates, and Covid-related government stimulus deposited into savings accounts have taken longer to deplete than predicted. The rebound in the stock and bond markets has supported continued spending and market liquidity to a greater extent than the Fed predicted.   The result is a steeper and longer inverted yield curve, and in this environment, the sector most at risk is banking.  This is plainly seen in the KDP risk among the top U.S. banks, which have already experienced three failures this year, with several institutions remaining at elevated risk.

Given its reliance on market confidence, the banking sector is subject to default contagion, and its actions can also trigger defaults in leveraged sectors as they curtail lending.  Up to this point in this cycle, governments have successfully intervened to restore confidence, as their actions in the UK, Korea, and most recently with uninsured deposits in the U.S. make clear.  However, we should remember that the markets breathed a sigh of relief when Bear Stearns was acquired by JP Morgan only to see their relief change to panic when Lehman Brothers was left to fail.

At some point, higher interest rates are bound to have a more significant impact, and the inverted interest curve still warns of an economic slowdown. Higher interest rates take time to exact impact on the real economy. While the opinions on the length of the lag vary, the estimates are typically around 1-1.5 years[2]. Thus, the full economic impact of interest rates increases is still yet to unfold. The banking sector was the first area to be impacted due to the short duration of the liability side of the balance sheet. Other sectors will follow.

Clearly, interest rates and the management of interest rate risk remain extremely important. So does rollover risk, given upcoming contractual maturities. In any case, the reliance on market liquidity makes stress testing critical. For companies to successfully navigate the current environment, it is very important to have a strong balance sheet.

Finally, we cannot finish a commentary about the importance of financial modeling without touching upon artificial intelligence.  The fast-growing technology is becoming a powerful force and could be helpful in the current financial environment, where we are seeing apparent breakdowns in factor correlations. However, risk managers need to up their game in model risk management.

SAS is here to provide you with software solutions, models and advice to help navigate risk landscape in today’s volatile markets, as well as manage the risks of the models you are already using.

About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 42,100 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 14.28%.  Since July 2022, the Kamakura 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. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, Kamakura Risk Manager. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model.  Related data includes market-implied credit spreads and prices on all traded corporate bonds traded in the U.S. market.  Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities yields in Australia, Canada, France, Germany, Italy, Japan, Russia, Singapore, Spain, Sweden, Thailand, the United Kingdom, and the United States, plus a 13-country “World” model.  All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow.

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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[1] It is worth noting that the NY Fed yield curve-based recession model estimates probability of recession over next 12 months at 71%.