KBRA Financial Intelligence

3 Things in Credit: U.S. Exceptionalism, C-Suite confidence, and Banks, a year later

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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.

Against a backdrop of data-driven angst, where everything seems to rest on Powell’s Macbethian dilemma—“To cut or not to cut”—a risk-taking “ebullience has taken hold in credit” according to a Bloomberg piece this week. “Driven by a wall of new cash and a belief that the U.S. Federal Reserve has served up a soft economic landing,” the piece adds, “normally sober debt investors are joining the ‘everything boom.’” Bank of America strategists described conditions as “bubbly.” For what it’s worth, we’re reminded that investors have to put money somewhere, and U.S. exceptionalism (which will touch on in a moment) and credit (where less-than-robust conditions are ideal) make an attractive couple.

This week, our 3 Things are:

1. U.S. exceptionalism. Efficient capital markets are a big part.

2. C-suite confidence. It’s building.

3. Banks, a year later. Here’s what we learned, a year after the “March events.”

Alright, let’s dig a bit deeper.

The world’s best capital markets.

Coming out of the pandemic, there is a divergence globally in economic recovery. The U.S. is outperforming compared to Europe, the UK, China, or Japan. This strikes us as somewhat incongruous with a variety of public opinion polls, be it consumer sentiment, the outlook for manufacturers or service providers, or small business optimism. But the fact of the matter is, U.S. exceptionalism, at least economically, is on display.

Some of this can be explained by the effects of monetary tightening. The U.S. is less sensitive to higher interest rates due largely to the fixed rate nature of its residential mortgage market, and much of its business borrowers. And this ties into our broader point—the U.S. capital markets are, in our opinion, the best in the world.

What makes an efficient capital market? Well, it probably has a variety of sources, one with banks—large, universal, and multinational; midsized; and small, community based. It will have a vibrant nonbank sector, with credible specialty lenders. It will be anchored by markets, public and private. In a word, decentralized.

Decentralized means capital moves fluidly and rapidly to its most productive use. The U.S. system is decentralized, much more so than any other developed world system. As a result, there is a dynamism to the U.S. economy. It innovates and evolves, and, yes, it creatively destructs, all to the benefit of growth. It does this largely through markets, not banks, and that’s an important distinction. Developed economies with concentrated banking systems that dominate finance—think Canada, France, Germany, Japan—cater to the established. Credit analysts conforming their analysis to bureaucratic standards is hardly a path to innovation or sensible risk taking. The engines of growth, small business, and technological disruptors are hampered. And centralized banking systems, with growth opportunities hampered at home, often stray overseas, chasing more lucrative business, usually with disastrous consequences.

A decentralized system is also able to adjust to changing market dynamics. In the wake of the GFC, when policymakers wisely helped to push riskier lending out of the banks, capital from private sources—equity and credit—was quickly mobilized to step in and fill the void. That move, disintermediating a dozen or so global banks in favor of a thousand institutional investors, has been positive evolution, further strengthening the system.

Now, it is important to add that there is a cost to a decentralized financial system, and that is volatility. The hurly-burly of markets and a plethora of lenders and intermediaries crashing into one another is difficult to control, and occasionally outsized risk develops. And that is a choice that politicians don’t always opt for. Think about it this way—the range of growth in a decentralized financial system can be -1% to +3%. In a centralized financial system, it can be 0% to 2%. Politicians generally don’t get reelected in a -1% growth environment.

Regardless, coming out of pandemic and the most aggressive monetary tightening in 40 years, the U.S. is on firm footing, with a quite reasonable growth outlook, and that has a lot to do with its capital markets.

Alright, on to our second Thing—The C-suite view.

Three up-to-date surveys of the C-suite are out: Business Roundtable’s CEO Confidence, The Conference Board’s Measure of CEO Confidence, and CNBC’s CFO Council Survey, and tone is upbeat.

Business Roundtable’s CEO Economic Outlook Survey is a quarterly composite index of CEO plans for capital spending, employment, and expectations for sales over the next six months. The overall index jumped by 11 points from last quarter to 85, above its historic average of 83 for the first time since 2022. CEO plans for capital investment and expectations for sales are up from the previous quarter by double digits from last quarter. Additionally, plans for hiring ticked up modestly. “This quarter’s survey results underscore the resiliency of the U.S. economy and suggest accelerating economic activity over the next six months,” said Business Roundtable Chair Chuck Robbins, who is Chair and Chief Executive Officer of Cisco. In their second estimate of 2024 U.S. GDP growth, CEOs projected 2.1% growth for the year. This is up marginally from the 1.9% growth projected in their first estimate last quarter.

A little over a month ago, The Conference Board Measure of CEO Confidence™ in collaboration with The Business Council showed similar improvement, with its composite score improving to 53 in Q1 2024, up from 46 in the fourth quarter of 2023. The Measure is based on CEOs’ perceptions of current and expected business and industry conditions.

The Measure is now above 50, a reading that suggests CEOs have become optimistic about what’s ahead for the economy. This is the first time optimism has prevailed in the Measure since Q1 2022.

CNBC’s CFO Council Survey for the first quarter of 2024 shows a dramatic year-over-year change in the view who think the Fed will be able to achieve a soft landing. Some 48% of respondents are in the soft-landing camp, 3x the level from a year ago. That said, CFOs are consistently skeptical that inflation will not return to 2% anytime soon, and that’s the case again in the Q1 survey, with nearly 80% of CFOs saying inflation won’t hit the Fed’s 2% target before 2025 at the earliest. Accordingly, CFOs generally believe the Fed will not move as quickly as the market thinks to cut interest rates. According to the latest survey, the largest percentage of CFO respondents (44%) do not expect a rate cut until September, with equal groups of just under 25% of CFO respondents thinking the cuts will begin in June or July.

Alright, on to our third Thing—Banks, a year later.

So, we’ve just crossed the one-year anniversary of the “March events,” the failure of three midsized U.S. banks, and one giant Swiss bank. What have we learned?

1. The federal response in the U.S. (and, for that matter, in Switzerland) worked to diffuse the situation and prevent contagion. In the U.S., the Federal Reserve and Treasury backstop, along with the steady hand of the FHLBs, worked to establish a firebreak between these highly idiosyncratic stories and the rest of the system. Much-needed reforms, especially to the deposit insurance scheme, remain, however.

2. It was, at the end of the day, three banks that failed out of 4,700—don’t label this a crisis among smaller banks. The business model of commercial banking in the U.S. works just fine.

3. Bank earnings expectations have been adjusted, but it’s not all that material, especially to credit. Large bank and regional bank profitability is expected to fall in 2024, by 7% and 14%, respectively, but both are expected to report reasonable returns on assets at this point in the credit cycle of 87 bps for the largest banks and 75 bps for the regional banks. This data is all drawn from the Keefe, Bruyette & Woods indices.

4. Bank credit spreads remain cheap to industrials. Heavy supply is part of the story, but it really reflects the scars from a year ago. One thing I’ve learned over 40 years of looking at banks is that with each “event,” investors who grew up in the business analyzing industrials revert to deep suspicion when looking at banks. And that reduced buying interest always creates opportunities for investors that know better.

5. The fundamental backdrop is improving. The prospect of lower rates and building confidence in a softer landing is forming a constructive backdrop for banks, both in terms of booking profitable growth and for moderating credit costs from deteriorating loans.

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

1. U.S. exceptionalism. Efficient capital markets are a big part.

2. C-suite confidence. It’s building.

3. Banks, a year later. The model still works, and relative value has improved.

As always, thanks for joining. See you next week.