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The Abrupt End of an Era

10/01/2024 06:07 AM

NEW YORK: October 1, 2024: September 2024 was a month for the history books. The Fed started its long-anticipated easing cycle by cutting the federal funds rate for the first time in four years. Leading up to the FOMC meeting, expectations for the size of the cut were roughly split between 25bps and 50bps. The outcome was a 50bps cut, bringing the “higher for longer” era to an abrupt end. This marks a significant departure in the sentiment from the last FOMC meeting, where median expectations called for only one 25bps cut this year.  The committee was not unanimous—it experienced the first dissenting vote since 2005.  Median expectations now anticipate 50bps in additional cuts this year, and another 100bps in cuts next year.  We are witnessing a tug of war between the two parts of the fed’s the dual mandate as it attempts to nail a soft landing.

Table 1: FOMC Fed Funds Rate Forecasts

What changed over the last three months that prompted such significant recalibration? It appears that the balance has shifted from keeping inflation under control to mitigating risks to economic growth. While it is true that inflation has come down from its height of two years ago, it is still well above the Fed’s 2% target (Figure 1). In fact, looking at the last few months of core inflation measures, the rate of decline appears to have stalled.

At the same time, global monetary policy conditions are becoming increasingly more accommodative, and the latest move by China to add significant stimulus to its economy will only add fuel to the inflationary fires.  And in the U.S., a strike by dockworkers could hurt the economy and add inflationary pressure.

Figure 1: Core Inflation Measures

It may be that the Fed has become more open to considering possibility of a higher or more flexible target. However, we view that as unlikely, since you would expect careful preemptive messaging for such a significant change in approach.

Alternatively, it may be that the risks to a soft landing have increased. The latest GDP data suggests that the economy is still robust, and the latest upwards revisions bring the inflation-adjusted growth rate between second quarter of 2020 through 2023 to 5.5% as shown in Figure 2:

Figure 2: Real GDP Annualized Growth Rate Revisions

In the labor market, jobless claims are still near their all-time low levels, reflecting the robust aggregate health of the job market (even though some industries are experiencing considerable disruption, increasing the possibility of structural unemployment). The financial markets continue to set all-time highs, stretching valuations further. With the investment-grade option-adjusted spread running persistently below 100bps, credit markets are pricing in a very favorable environment.

So what could have triggered the 50bps cut? The answer may reside with the health of the consumer. The post-Covid savings rate dip never bounced back to pre-Covid levels. We have highlighted the rapidly rising credit card delinquencies and depleted consumer savings over the past few months. The FDIC’s second quarter banking profile added more pieces to this mosaic. According to the report, the credit card net charge-off rate rose to 482bps, which is 134bps higher than the pre-pandemic average. Looking at the chart of overall delinquency vs. the charge-off rate (Figure 3), we see the smallest gap on record between the two metrics. While no official explanation was given, there are two possible causes for such a pattern. One possibility is that the delinquent asset mix have shifted towards higher concentration of assets that typically have short horizon between entering delinquency and recording a charge-off (such as credit cards, personal loans and overdrafts). Another possible cause is the rise in the transition rates from early to late-stage delinquency and subsequently default and charge-off. It is likely that that both factors are playing a part.

Figure 3: Non-Current Loan Rate and Quarterly Net Charge-off Rate

These signals may be pointing to trouble with the American consumers. As a reminder, personal consumption expenditures make up roughly 70% of GDP, thus they are vital to overall economic health. If the 50bps cut is a response to consumer trouble on the horizon, there is a definite disconnect between current pricing multiples and upcoming economic reality. This risk, however, needs to be considered in a context of another trend: increasing dispersion between single names, driven by disruptive technologies, de-globalization, supply chain dependencies, and other emerging forces.

In June 2021 the Troubled Company Index (TCI) was 6.94%, 208 basis points below where it ended on September 30.  The fed funds rate was 0.125% compared to 5.0% today, while the 10-year Treasury rate was 1.45%, compared 3.65% today.  Clearly the TCI indicates that default risk has risen. And that leads us back to the critical question: Will the Fed be able to successfully navigate to a soft landing?

As a result of this open question, the markets will focus on every economic report looking for weakness.  The floating rate debt is going lower, while the direction of longer-term rates is more uncertain. There continues to be strong demand for high yield both in the bond and the private equity markets. There is also $6.5 trillion in cash sitting in U.S. money market funds, an amount that is likely to decrease with the reduction of rates.   The current environment presents an excellent opportunity for rethinking security selection and realigning portfolios to prepare for potential market volatility.

Contemporaneous Credit Conditions
The Kamakura Troubled Company Index® closed the month at 8.88%, down 0.19% 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 September, the percentage of companies with a default probability between 1% and 5% was 6.62%. The percentage with a default probability between 5% and 10% was 1.36%. 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 0.29%.  For the month, short-term default probabilities ranged from a low of 8.88% on September 30 to a high of 9.77% on September 6.  There were 16 defaults in our coverage universe, with eight in the United States, three in China, two in Thailand and one each in Singapore, Sweden and the UK.

Figure 5: Troubled Company Index®, September 30, 2024

At the end of September, the riskiest 1% of rated public firms within the coverage universe as measured by 1-month default probability included 10 companies in the U.S. and one each in Brazil and France. The riskiest firm was the Container Store Group (NYSE:TCS), with a one-month KDP of 51.42%, up 2.91% for the month.

Table 1: Riskiest Rated Companies Based on 1-month KDP, September 30, 2024

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate of 0.51% down 0.04% from the prior month, with the 10-year rate down 0.10% at 7.41%.

Figure 6: Expected Cumulative Default Rates, September 30, 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 14.09%.  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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