Soft Landing or Rolling Recession

08/01/2023 12:05 AM

NEW YORK, August 1, 2023: Has the Federal Reserve managed to steer a path towards lower inflation, higher rates and a soft landing, or are we seeing some sectors suffer while others continue to perform? Market performance indicates that the overall economy is doing well. The latest release of the Federal Reserve Bank of Atlanta’s GDPNow report is more positive than past releases. But at the same time, headlines in a recent Wall Street Journal edition included “FDIC Scolds Banks for Manipulating Deposit Data,” “Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts” and “Banks Are Going on a Diet.” In our commentary we will examine how to navigate the uncertainty.

Contemporaneous credit conditions continued to improve in July, with the Troubled Company Index® closing the month at 8.29%, down 0.29% 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 July, the percentage of companies with a default probability between 1% and 5% was 6.09%. The percentage with a default probability between 5% and 10% was 1.13%. Those with a default probability between 10% and 20% amounted to 0.75% of the total; those with a default probability of over 20% amounted to 0.32%. Short-term default probabilities ranged from a low of 8.13% on July 3 to a high of 8.48% on July 27.

Figure 1: Troubled Company Index® — July 31, 2023

At the end of July, the riskiest 1% of rated public firms within the coverage universe included nine companies in the U.S. and one each in France, Germany and Luxemburg. The riskiest rated firm was Audacy Inc. (OTC:AUDA) with a one-month KDP of 31.13%. There were nineteen defaults in the KRIS coverage universe in July, with fourteen in the U.S. two in Sweden and one each in France, Germany and the UK.

Table 1: Riskiest Rated Companies Based on 1-month KDP – July 31, 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 and the rollover risk of existing debt have a greater impact on credit quality. Employment and the equity markets have remained strong, cushioning the short-term impact of the central banks rate actions.

Figure 2: 2-Year Term Default Probabilities – U.S. Market, July 31, 2023

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate down 0.05% at 0.60% with the 10-year rate up 0.18% at 8.81%.

Figure 3: Expected Cumulative Default Rate — July 31, 2023

Stas Melnikov and Martin Zorn
SAS Institute Inc.

News headlines about deposit data, commercial real estate workouts and banks shrinking their balance sheets to increase capital positions caught our attention in July. The banking sector is critical to economic growth–especially for small business–and it is a sector that is dependent upon market confidence.

The role of banks is to take in demand deposits and other short-term liabilities and use them to finance longer-term, relatively illiquid loans. The difficulties in today’s commercial real estate sector reflect changes in the interest rate environment, compounded by post-pandemic concerns about the utility of non-residential properties, especially offices. Many central business districts are a shell of what they once were. Some properties in areas where there is now too much office space may need to be restructured into other uses to conform to future demand, given the changes in workplace norms and perceptions surrounding the attractiveness of certain cities.

Transparency requires mark-to-market valuation, while good policy requires counter-cyclical, rather than pro-cyclical regulatory intervention. A soft landing requires threading the needle to accomplish both goals. Counter-cyclical policy would encourage the redevelopment of underutilized assets into uses that will have more future utility—for example, converting excess office towers into condos.

Other post-Covid behavioral adaptations are also driving the reset in macroeconomic- driven correlations. Higher personal savings rates have increased consumer spending and resulted in economic growth. However, once the extra savings have been spent and credit cards begin to be maxed out, the threat of defaults rises. As you can see in Figure 4 below the combination of government support and pandemic-induced lockdowns drove savings rates off the charts. Post-lockdown revenge spending has supported many sectors. Savings withdrawals have slowed the impact of interest rate increases, but eventually they will dampen demand. These factors help explain why some sectors have continued to do well and why the overall economy continues to grow.

The U.S. household sector continues to benefit from positive job growth and rising incomes, resulting in further positive economic growth, but it is a different story in Europe. Understanding these shifting economic expectations and differences among sectors and geographies is essential for effective portfolio management.

Figure 4: Personal Savings Rates

In times like these, it’s critical for lenders and investors to be nimble. Sector analysis and predictive modeling can help them obtain the knowledge they need to act quickly and confidently. Updating models and testing correlated factors are equally important for gaining the foresight to adjust your portfolio in advance of market movements. As in musical chairs, you do not want to be the one standing when the music stops, but while it’s playing, you definitely want to be on the dance floor.

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 14.26%. 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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