KBRA Financial Intelligence

3 Things in Credit: Inflation break, Two economies, and Vanishing excess savings

Listen to Van Hesser's insights on: Spotify | Apple | Google

Welcome market participants to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Enough of the “happy talk!”

That’s how J.P. Morgan Chase CEO Jamie Dimon this week labeled market participant views that all is well. Mr. Dimon is not so sure. He thinks inflation could be stickier than the market believes that fiscal deficits are too big, and that geopolitical risks are elevated. And some combination of that toxic brew, he warns, just might cause stocks to sell-off and credit spreads to blow out. A sobering reminder. Alright, no “happy talk” on this podcast.

This week, our 3 Things are:

1. That inflation print. Has the fever broken?

2. Two economies. The aggregate data and market developments are all good. But that’s not the full story.

3. Excess savings. That, which has powered the better-than-expected economy, is gone. So says the San Francisco Fed.

Alright, let’s dig a bit deeper.

That inflation print.

Don’t know if you were aware of this, but we got an updated view of inflation this week. By the way, that’s a little humor.

Yes, we got a fresh backward look at inflation this week, courtesy of PPI and CPI releases. Given that we are not day traders (or even traders), so we try not to get too caught up in every zig and zag in the market. But here are what we think is relevant to creditors. To start off, some observations:

1. Inflation is coming down

   —0.29% growth in core CPI is better than the two previous 0.36%s (which, of course were rounded up to levels (0.4%) that freaked the market). Statistically not a big move, but we’ll take it.

2. Price stability is largely here

   —What is keeping us from target is mostly shelter and various insurance premia. On the shelter front, the real-time year-over-year change from CoreLogic, Redfin, Zillow, Apartment List, and even the BLS’ New Tenant Index are all well below what’s in CPI’s modeled estimate. Change is coming.

3. The labor market is starting to crack

   —Fears of the dreaded wage/price spiral are diminishing. Job openings are falling, and the supply of workers is increasing thanks to immigration.

4. Appearances matter

   —By sticking steadfastly (at least publicly) to this hard target of 2%, rather than a more useful and realistic range (such as the way Canada and Australia do), the likelihood of a policy error—too high for too long—is elevated. Especially if we factor in structural forces out there that are inflationary such as the energy transition, remilitarization, infrastructure, and security of everything. And let’s be clear, after the credibility shellacking Powell & Co. got by being slow to tighten, we need to at least think through scenarios where the Fed looks to rebuild that credibility by overshooting. In the halls of academia, you don’t get skewered by making doubly sure inflation is tamed; you do by having it resurge.

Now, our view.

We would like to believe that the market is correct in forecasting two 25 bps cuts by the end of the year. The first would be in September, the last meeting before the U.S. presidential election. For what it’s worth, we do not believe the Fed will be influenced by the election in its decision-making. We take Chair Powell at his word when he says cuts will occur when they need to occur and for the right reason, normalizing rates after bringing inflation under control. Call it a “recalibration cycle.” Target the 10-year Treasury at 4%. That leaves plenty of room to cut when you need to stimulate, but high enough to create an appropriate cost of capital.

To sum up, signs that inflation is coming under control without materially increasing the likelihood of a harder landing are welcome news for credit markets.

Alright, on to our second Thing, Two economies.

As I was preparing a presentation this past week, I ticked off the basic parameters of what defines our world:

• Economic growth: Above potential, with consensus for 2024 at 2.4%

• Unemployment: 3.9%, the longest period in recorded history below 4%

• Corporate earnings: At or near all-time highs

• Household net worth: At or near all-time highs

• Credit spreads: At or near all-time tights

• Equity multiples: 25% above the long-term average

That’s quite a list. It’s easy to get caught up in the euphoria, the “happy talk,” with its no landing forecast. After all, isn’t that what the data shows?

It does, but the picture’s incomplete. Peel that onion a bit and you find:

• Credit card loan losses at 13-year highs

• 40% of the Russell 2000 is unprofitable

• Housing permits and starts remaining depressed

• Retail sales have slowed considerably

So, what we see is a tale of two economies, one featuring large companies and wealthier consumers and a second one of smaller firms and lower income earners.

Now it goes without saying that the former drives the aggregate data. But let’s not ignore small business that employs half of American workers, nor the bottom 60% of income earners that account for some 40% of total consumer spend. These consumers and these businesses are the ones hit hardest by inflation and by the medicine deployed to treat inflation, higher rates and tighter credit. This is where an overleveraged consumer is cutting back spend or a vulnerable small business is postponing capex. This is going to leave a mark on economic growth, which by the way is exactly what the Fed is hoping for!

For credit investors, it’s a reminder to be aware of these populations when thinking through your asset class and individual name and sector allocations.

Alright, on to our third Thing, The end of excess savings.

It’s no secret that the economy has performed better than just about anyone expected. And a lot of that has to do with excess savings, the stockpile of savings Americans built up courtesy of stimulus and the spend-limiting effects of the pandemic. Interestingly (or disturbingly), the estimate of that pile of excess cash was materially increased by your government in 2023, due to a change in their methodology. I’m not sure that actually changes the stock of excess cash, but it did provide a convenient explanation for why the economy continued to power through the effects of monetary tightening.

In any event, the San Francisco Fed now concludes that excess savings are not only gone, it has turned negative. From a peak of $2.1 trillion in August 2021 to -$72 billion today. The central bank’s economists say excess savings “was only one of many possible factors that helped consumers maintain robust spending levels.” Phew! I got worried there for a moment. So, what are some of those other factors?

Well, according to the central bankers, one is the tight jobs market, which has driven wage growth sufficient to offset inflation. But wait a minute, the jobs market is tight because of robust spend, right? So if spend falls away, I’m not sure businesses will continue to give employees raises. So I don’t give much credence to that.

Another factor cited is the wealth effect of gains in investment and real estate holdings. Alright, this one I believe in, and those gains figure to be enduring. It is always up for debate just how much spend happens due to a buildup in net worth, but, judging from my own behavior, I do spend more. So we’ll go with that.

A third factor is borrowing capacity. I also agree with this, given that the wealth effect does create additional borrowing capacity. But the real question is, just how willing are consumers to increase borrowing? Folks usually spend out of income. And, we would be remiss if we did not take into account the reality of our aforementioned Two Economies. Needless to say, not everyone has a growing stockpile of investment and real estate gains.

When thinking through this topic, we also consider alternative sources of data, notably the banks, where Bank of America and Capital One specifically have noted that their consumer depositors continue to hold more in the way of savings today than they did pre-pandemic. Those “excess” savings are coming down, but at ~130% of pre-pandemic levels in BofA’s case, that excess is still available to provide a smoother glidepath, i.e., a softer landing, back to normal.

In any event, the point is consumer spending is set to slow, and anecdotally, this week’s soft retail sales figures point to that. As we know, spend is a function of ability and willingness. Ability—the stock of available savings--is reducing. And that feeds into willingness, the confidence to spend. We saw the University of Michigan consumer sentiment weak print last week call willingness into question (though some of that reflects a methodology change), but the key driver of spend is always driven mostly by job security. That’s still strong, but it is cracking. Add all of this up and you get economic slowdown. We aren’t expecting a hard landing, but the days of above potential growth, which we’ve enjoyed over the past year, are just one more thing set to normalize.

So, there you have it, 3 Things in Credit:

1. That inflation print. A step in the right direction for creditors.

2. Two economies. Don’t let the aggregate data cause you to lose sight of vulnerable elements in the economy.

3. Excess savings. It had to end at some point, and we’ll miss it when it’s gone.

As always, thanks for joining. We’ll see you next week.