In Times of Disruption, Focus on Fundamentals

06/02/2024 09:01 PM

NEW YORK, June 3, 2024: While markets continue to focus on inflation and anticipating the Federal Reserve’s next moves on interest rates, other fundamental issues are equally important.  New home sales fell 4.7% in April and the median selling price increased 3.9% from the prior year.  Why? Those with 3% mortgages do not want to trade up to 7% mortgages.  For those who are leasing, rent costs have risen for 32 consecutive months. The housing market is suffering from a supply problem, not a demand problem.

Also, Tesla deliveries dropped for the first time since 2020, and Ford announced that it lost $132,000 for each EV sold in the first quarter.  Walgreens announced it was cutting prices on 1,500 items.  These are demand problems, not supply issues.

There was nothing normal about the Covid economy and it looks like there is nothing normal about the post-Covid economy, either.  With increasing uncertainty, yet a very low volatility fear gauge, the focus needs to be on fundamentals.

Last month we began to drill down on the consumer discretionary sector because—to modify a quote wrongly attributed to Willie Sutton about robbing banks—that’s where the risk is. We examined the auto sector, especially the EV subsector.  This month we will continue to drill down on the consumer discretionary sector and extend our focus to the diversified consumer sector.

Figure 1: Average 3-Year Default Probability by Sector

Table 1: Diversified Consumer Services – Average 3-Year Default Probability: Dec. 2019 vs. May 2024

Diversified consumer services is the second- riskiest industry within the consumer discretionary sector.  When you analyze the data in Table 2, you will notice that the riskiest firms are involved in weight loss and education technology.  The riskiest firm is WW International – better known as Weight Watchers. It is closely followed by Allurion Technologies – a firm that sells gastric balloons to help people feel full before they overeat—in third place, and Beachbody—specializing in home fitness and nutrition—in fourth.   All three of these companies have been adversely affected by the “Ozempic Revolution,” as technology, which has greatly disrupted the industry and reduced demand for competing products.

Another group similarly impacted by technology change is the education technology subsector, where former disrupters such as 2U,, Ambow Education Holdings, Coursera and others are feeling the heat from generative AI applications like ChatGPT and Microsoft Copilot.

 Table 2: Diversified Consumer Services with 3-Year KDP >1%

These are just a few examples of how disruption in the post-Covid economy is changing the risk profile for companies and industries at a rapid pace, exceeding the impact of traditional factors like inflation and interest rates.

Contemporaneous Credit Conditions

The Kamakura Troubled Company Index® closed the month at 8.78%, down 0.56% 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 May, the percentage of companies with a default probability between 1% and 5% was 6.48%. The percentage with a default probability between 5% and 10% was 1.22%. Those with a default probability between 10% and 20% amounted to 0.80% of the total; and those with a default probability of over 20% amounted to 0.28%.  For the month short-term default probabilities ranged from a low of 8.39% on May 20 to a high of 9.22% on May 1.

Figure 2: Troubled Company Index® — May 31, 2024

At the end of May, the riskiest 1% of rated public firms within the coverage universe included 11 companies in the U.S. and one in France. This month the riskiest firm is WW International (NASDAQ:WW), with a one-month KDP of 42.71%, up 9.12% for the month.

 Table 3: Riskiest Rated Companies Based on 1-month KDP – May 31, 2024

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate down 0.09% at 0.57%, with the 10-year rate down 0.62% at 9.40%.

Figure 3: Expected Cumulative Default Rate — May 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 14.14%.  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. 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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