Investors at a Crossroads

05/02/2024 06:55 AM

NEW YORK, May 2, 2024: Inflation numbers created anxiety about the future Fed actions and questions about the soft-landing thesis.  These concerns weighed on markets, with the S&P 500 down 4.2% in April as mid and small cap performance was much worse.  European and Latin American markets were also down, and the S&P Asia 50 was the only sector to eke out a gain for the month. With the rising expectation of no rate cuts or even a hike in the U.S., we are at a crossroads, with investors debating how long rates will stay high, whether we will see central bank monetary policy diverge, and how a changing economic view will interact with evolving technology, global events and credit markets.

We are already seeing renewed interest in bank balance sheets, with investors analyzing unrealized losses and determining what portion of them may be classified as “Other-Than-Temporary Impairment.” (OTTI). U.S. BEA data showed a rise in consumer spending, led by non-discretionary expenditures on gasoline, energy, and healthcare (Figure 1).

Figure 1: Changes in Monthly Spending, March 2024

Credit card delinquencies are edging up, and BEA data also showed that personal expenditures have now exceeded disposable income.

Motor vehicles were at the lower end of consumer spending. We will examine this sector more closely below. Our analysis focuses on GICS Sector 2510 – Automobiles and Components.  We are examining U.S.-based firms so that we do not have to control for foreign exchange, differences in accounting or reporting frequency.  Table 1 provides the list of all public US Auto and Auto Component firms listed by their 1-year default probability.

You saw in Figure 1 that spending on motor vehicles trailed other sectors, which makes sense in view of rising interest rates and increasing uncertainty about wage growth and the overall economic outlook.  The auto components sector tends to be volatile and cyclical, and the auto sector is heavily capital-intensive.  There is further bifurcation between the EV segment and old-line manufacturers.  We are approaching another crossroads as these firms compete and the market differentiates between winners (or at least survivors) and the rest.  The default risk of each should be another input into determining the potential winners and losers. 

Table 1: 1-month KDP, US Auto and Auto Component Firms

The five firms at highest risk are all small, specialty EV companies.  Each has specific issues related to long-term viability and access to sufficient capital.  Year to date we have seen two defaults in the sector with Fisker Inc. being the most notable. The unrated segment is definitely not for the risk-averse.  Table 2 focuses on the rated segment of the sector.

Table 2: 1-month KDP, Rated US Auto and Auto Component Firms

An interesting comparison is to look at Tesla compared to Nikola, shown in Figure 2.  Nikola went public by merging with a SPAC, to initial excitement.  But in addition to the typical challenges faced by startup EV firms, Nikola saw its ex-CEO indicted and convicted of fraud and still faces existential threats, including delisting. Yet there are still advisors who suggest it as a turnaround play.  As you can see below, even though its default probability has come down, the firm is still above the 90th percentile for the sector. Compare that to Tesla’s default risk.  Comparative analysis like this is critical for auto startups, as the consolidation of the industry will likely happen quite rapidly. 

Figure 2: Nikola and Tesla Default Risk Compared to the Industry Segment

Last month we stated that firms which: a) have a limited ability to adapt to economic and industry changes, b) are highly leveraged, or c) have low growth and margins will all see increasing defaults.  The auto sector is a great example. These are cyclical, interest-sensitive, high-capital businesses undergoing both regulatory and technological change.  Any lender or investor considering this sector must do their research and analyze all available data to be in a position to make the best possible decision.

Contemporaneous Credit Conditions
The Kamakura Troubled Company Index® closed the month at 9.34%, up 0.21% 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 April, the percentage of companies with a default probability between 1% and 5% was 6.90%. The percentage with a default probability between 5% and 10% was 1.27%. Those with a default probability between 10% and 20% amounted to 0.84% of the total; and those with a default probability of over 20% amounted to 0.33%.  For the month short-term default probabilities ranged from a low of 9.00% on April 1 to a high of 9.77% on April16.

Figure 3: Troubled Company Index® — April 30, 2024

At the end of April, the riskiest 1% of rated public firms within the coverage universe included 10 companies in the U.S. and one each in France and the UK. This month the riskiest firm is Skillsoft (NYSE:SKIL), with a one-month KDP of 42.40%, up 30.98% for the month.

Table 3: Riskiest Rated Companies Based on 1-month KDP – April 30, 2024

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.03% at 0.66%, with the 10-year rate up 0.24% at 10.02%.

Figure 4: Expected Cumulative Default Rate — April 30, 2024

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 14.15%.  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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