Market Pricing Anticipates a Global Soft Landing

12/04/2023 12:18 AM

NEW YORK, December 4, 2023: Global stock markets recorded their best month in three years on hopes for interest rate cuts.  Global bonds also had a very strong month with the ICE BofA index of global investment-grade bonds in major markets posting its best month since 1997.  The Federal Reserve’s favorite measure of inflation, the PCE price index, rose less than 0.1% in October, with the annual core inflation rate down to 3.5%–the lowest since April 2021.

There were 19 defaults in our coverage universe during the month, up from 14 last month.  Nine were in the U.S., two in Germany, and one each in Canada, China, Ireland, Korea, Sweden, Switzerland, South Africa and Thailand.

Contemporaneous credit conditions reversed their decline and improved in November, with the Kamakura Troubled Company Index® closing the month at 8.68%, down 1.58% from the prior month. The index measures the percentage of 42,100 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 November, the percentage of companies with a default probability between 1% and 5% was 6.26%. The percentage with a default probability between 5% and 10% was 1.26%. Those with a default probability between 10% and 20% amounted to 0.85% of the total; those with a default probability of over 20% amounted to 0.31%.  For the month short-term default probabilities ranged from a low of 8.56% on November 24 to a high of 9.99% on November 1.

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

At the end of November, the riskiest 1% of rated public firms within the coverage universe included 12 companies in the U.S.  The riskiest rated firm continued to be Tupperware Brands Corporation (NYSE:TUP), with a one-month KDP of 54.85%, down 15.76% for the month.

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

The term structure of default provides more insight into future movements than a point-in-time view.  The shape of the curve is insightful much in the same way that analysts use yield curve differentials to drive strategies.  In Figure 2, you can see that even with improved forward expectations for default, the three-year default probability remains elevated compared with the thirty- year timeframe.

Figure 2:  Expected Cumulative Default Rate – U.S. Market, 3-Year, November 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 0.25% at 0.76%, with the 10-year rate down 2.12% at 10.58%. The implied forward default rate continues to predict an increase in the one-year default rate for both 2024 and 2025.

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

Stas Melnikov and Martin Zorn|
SAS Institute Inc.

The equity and bond markets had a strong run in November as inflation numbers removed pressure on global interest rates.  While market expectations appear to support a global soft landing, it is too early to make that call.  Geopolitical risks, along with macroeconomic uncertainty, remain.

Small capitalization firms generally lack the staying power of integrated global firms, so they represent a sector that deserves more attention from a risk perspective.  These firms are also more dependent on bank loans, as they lack access to the capital markets.  To gain insight into this sector, we look at the default probabilities for unrated companies in the Russell 2000 index.  Table 3 lists the riskiest 1% in this cohort.  Looking at the expected cumulative default for this sector, we find the default risk is higher than among the large cap companies—which should not be a surprise.

Table 3:  3-Year KDP US Unrated Small Cap

Measurements such as the Troubled Company Index are excellent tools to gain insight into general trends.  If market performance continues to be strong in December, we would expect sentiment to shift towards a risk-on approach to investing.  Given the unrealized losses that many banks still have in their investment portfolios, we expect that bank credit appetite will remain weak.

This environment is favorable for the stronger small cap companies, especially given the underperformance of the sector year-to date.  It also offers an opportunity to sell financially weaker issues that may be benefitting from the rally. The ability to examine the term structure of default is critical.  The three- year default data will provide good insight into rollover risk as the current economic and credit cycle unfolds.

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 14.21%.  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.

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.

About SAS
SAS is the leader in analytics. Through innovative software and services, SAS empowers and inspires customers around the world to transform data into intelligence. SAS gives you THE POWER TO KNOW®.

Editorial contacts: