Risks and Opportunities In The Year Ahead

01/02/2024 08:41 AM

NEW YORK, January 2, 2024: During the holidays, as I was going through old boxes in my garage, I discovered a treasure trove of my old record albums.  I had forgotten how iconic album art was back in the day. Among the albums was the Grateful Dead’s “American Beauty,” which contains the song “Truckin’,” recognized by the Library of Congress in 1997 as a national treasure.  As we look back on 2023 and prepare for 2024, several lyrics from the song stand out:

What a long, strange trip it’s been – A pretty accurate description of 2023.

Truckin,’ like the doodah man
Once told me, you got to play your hand
Sometimes, the cards ain’t worth a dime
If you don’t lay ‘em down – Gives us some insight for what we can expect in 2024.

There were fifteen defaults in our coverage universe during the month. There were seven in the U.S., three in China, two in Sweden and one each in Germany, Korea and the UK. For the year, we registered 80 defaults in the U.S., more than three times as many as last year’s 23.

Contemporaneous credit conditions declined slightly in December, with the Troubled Company Index® closing the month at 8.92%, up 0.15% from the prior month and up 0.84% for the year. 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 December, the percentage of companies with a default probability between 1% and 5% was 6.33%. The percentage with a default probability between 5% and 10% was 1.26%. Those with a default probability between 10% and 20% amounted to 0.98% of the total; those with a default probability of over 20% amounted to 0.35%.  For the month short-term default probabilities ranged from a low of 8.46% on December 26 to a high of 8.93% on December 18.

Figure 1: Troubled Company Index® — December 29, 2023

At the end of December, the riskiest 1% of rated public firms within the coverage universe included 11 companies in the U.S. and 1 in the U.K. The riskiest rated firm continued to be Tupperware Brands Corporation (NYSE:TUP), with a one-month KDP of 50.64%, up 0.77% for the month.

Table 1: Riskiest Rated Companies Based on 1-month KDP – December 29, 2023

The Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate down 0.10% at 0.66%, with the 10-year rate down 0.35% at 10.23%. The implied forward default rate continues to predict an increase in the one-year default rate for both 2024, 2025 and 2026.

Figure 2: Expected Cumulative Default Rate — December 29, 2023

Stas Melnikov and Martin Zorn
SAS Institute Inc.

“What a long, strange trip it’s been,” indeed. As we close out the year with record highs in the markets, it is hard to remember that that three of the four largest bank failures in U.S. history happened earlier in the year, or that UBS effectively saved Credit Suisse through its acquisition. We also saw unprecedented increases in global interest rates as central banks strived to tame inflation. The Federal Reserve alone raised rates 11 times from March 2022 through July 2023, for a collective increase of 525 basis points. We ended the year with two regional wars and no reduction in global tensions. Clearly, the days of the “peace dividend” have passed.

The banking sector remains under pressure, even though bank stocks have enjoyed a positive run, along with the rest of the market toward the end of the year. Corporate defaults continued to increase, and credit underwriting remains tight by historical standards (Figure 3).

Figure 3: Senior Loan Survey – Commercial Underwriting Standards

Technology continued to grow rapidly and disruptively, with AI coming to the forefront and seven technology stocks accounting for the majority of gains in the S&P 500 Index (Figure 4).

Figure 4: The S&P 500 Rise, Driven by the “Magnificent Seven”

We have witnessed the longest inverted yield curve in the U.S. since 1980, but the expected “imminent recession” never came. Consensus has shifted towards achieving a soft landing, but as the Chinese proverb says, “Maybe so, maybe not. We’ll see.” Geopolitical risks and macroeconomic uncertainty remain.

As we look towards 2024, one of the most significant challenges will be managing risk models. Managers should be prepared for a significant number of known risks, as well as a number of “known unknowns” that must be simulated to ensure that a rapid response is ready to deploy.

Uncertainty is a risk, of course, but it is also an opportunity for those who are prepared to deal with it. From the Grateful Dead to Kenny Rogers (“The Gambler”), musicians have popularized the need to play the hand you are dealt. While we do not know what the next card will be, we certainly know which cards are face-up. We will look at the most significant risk factors below, as they are likely to be the keys to building a fortress-like balance sheet and profiting from uncertainty.

Inflation and Interest Rates
Equity prices have been on a tear as inflation has come down and the market has shifted its focus to a rate-cutting cycle. Inflation psychology is much slower to move than the reported numbers, as higher prices continue to take a larger bite out of paychecks. If inflation is truly vanquished, may we see a year in which bonds outperform equities? Or will the real price impact of inflation from the past two years result in lackluster growth and profit margins? Apart from inflation, will large government deficits—fueled by Covid spending and national security concerns—combine with the fragility that has been seen in the Treasury market and push rates higher, despite the best efforts of central banks?

Banking Sector and Spreads
While concerns for the banking sector moderated through the year, risks remain real.  Banks continue to carry large unrealized losses on their books. (Figure 5) FDIC reports show they have lost $1.1 trillion in deposits since the beginning of 2022, when rates began to rise (Figure 6).

Figure 5- FDIC -Quarterly Unrealized Securities Gains and Losses, Updated October 2023

Figure 6: FDIC Quarterly Change in Deposits, Updated October 2023

Households continue to liquidate savings, maintaining spending levels through increased credit card borrowings. While still low by historic standards, delinquency rates are creeping up (Figure 7) and need to be monitored.

Figure 7: Delinquency Rate on Credit Card Loans, December 2023

Beyond the household sector, the largest risk lies in commercial real estate. According to the data firm CoStar, the vacancy rate in the U.S. office market currently stands at a record 13%. It is forecast to rise to 15.7% by the end of 2024 and peak above 17% by the end of 2026.  Hybrid working arrangements are here to stay, and many loan extensions will be expiring in 2024, leaving building owners with a stark choice: sell properties at a steep discount or hand lenders the keys.  A strong economy needs a strong credit market. With pressure on the banking sector, one would expect that spreads—especially for high-yield assets—will widen. Rollover risk will be a critical factor for managers to model.

Global Trends
While many of these examples focus on U.S. economic conditions, they also provide insight into global conditions. Economic recovery in Europe will likely be more challenging than in the US. Economic news from Japan appears to point to a shift from three decades of stagnation to mild economic growth. This may be one of the global bright spots of 2024. China is likely to see some improvement, but it faces structural headwinds from real estate, demographics, and politics. Two important trends to watch are the demographic differences between developing markets and emerging markets and the continued departure from globalization to the creation of new trading blocs.

Other trends that will impact lending and investing include decarbonization and energy transition, the widescale adoption of generative AI, and biomedical advancements. Will these technologies continue to evolve rapidly, or will regulation (which always has unintended consequences) negatively affect progress?  The broader question may be, whether economies can continue to accelerate without a significant decline in interest rates or an expansion of credit—especially if the headwinds and tailwinds of the previous year continue.

The key to risk management is not to predict what will happen, but to be prepared for what may happen. We wish all of our readers the best for a successful and profitable 2024.

About the Troubled Company Index
The 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 14.20%.  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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