Darkening Credit Markets, Updated Forecasts, and Citigroup’s Consumer Results

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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.

Today we are greeted by an unprecedented IT outage that has crippled businesses around the globe, at least that’s what my Bloomberg says. I can confirm. My mobile order at Starbucks did not register. Not to make this always about the Fed, but just last week Jay Powell said that the number one thing keeping him up at night is threading the needle between growth and taming inflation. That had just bumped his former number one, cybersecurity, down to number two. Might be time to rethink that, Jay.

This week, our 3 Things are:

1. Darkening Credit Markets. A warning or just another myth?
2. Second-Half Forecasts. See if you agree.
3. Citigroup’s Disappointing Consumer Results. A canary in the coal mine?   

Alright, let’s dig a bit deeper.

Darkening Credit Markets.

In the Financial Times this week, we came across a reference to a working paper dated July 8 authored by two academics, Jared Ellias of Harvard Law and Elisabeth de Fontenay of Duke Law, titled somewhat ominously, “The Credit Markets Go Dark.” In it, the authors examine the “recent and dramatic” shift in commercial finance, where increasingly important private credit lenders are bringing the same de-democratization and consolidation trends to credit markets that have been reshaping equity markets. I probably didn’t need all of that to figure out where this was headed—I had a pretty good hunch based on the title.

According to the piece, as the corporate debt markets go dark (or, more private), “we move to a world in which information about many firms and even entire industries will be lost to the investing public. [Furthermore,] shielded from the discipline and scrutiny of regulators, the trading markets, and the general public, corporate debt … is poised to become the dominion of investment funds, some of which are almost unimaginably large. These funds will influence everything from firm operations and strategy to corporate distress, with uncertain consequences for social welfare.”

Wow. There’s rhetorical excess and then there’s rhetorical excess.

Our take is that the piece does a good job of describing the evolution of larger corporate lending over the past 40 years or so. But, in striving to describe the private credit phenomena, the piece badly misleads, in our opinion, the impact of private credit on the broader economy as well as, I guess, social welfare. 

The authors argue that the privatizing of firms’ equity and debt has “profound consequences for the very functioning of the capital markets, the stability of the financial system, and economic growth.” Moreover, they suggest that this “raises the potential for large-scale misallocation of capital and illiquidity.”

Let’s all take a deep breath.  

First of all, let’s put private markets in perspective. Private equity owns approximately 20% of corporate equity in the U.S. That means 80% is owned publicly. Count us among the “not worried” camp when it comes to the threat of entire industries going dark in terms of information available to stakeholders. The piece states that private credit funds originate a “major and accelerating share” of all commercial loans. “Major?” Today, we see private credit’s $1.7 trillion amounting to less than 12% of commercial lending, when including bank C&I loans on balance sheet, investment-grade and high-yield bonds, and leveraged loans. Important? Yes. Worryingly so? No.

Is there risk that investment funds become “unimaginably” large with dominant influence? Highly unlikely. Today, only two alternative asset managers, Apollo and Blackstone, would crack the Top 20 U.S. banks in terms of fee-producing credit assets under management.

Secondly, it is important to understand that private credit has flourished because where it was housed in the past—on bank balance sheets and in ill-conceived, market-dependent commercial finance companies—proved to be suboptimal as they were not sufficiently durable through the cycle. Policymakers and markets have found a better place for private credit to reside, with institutional investors and with alternative asset managers.

Why is this an improvement?

(1) Market-insensitive match funding—Going from the bank model of short-funding longer-dated, illiquid assets to the asset manager model of funding those assets with longer-dated, locked up money greatly reduces impact from shocks.

(2) Improved risk diffusion—Moving illiquid assets from a handful of large banks that cede control to adversarial bank regulators in times of stress to a thousand institutional investors around the world dampens forced selling and sentiment destroying, illiquidity-driven write-downs.

(3) Improved workout dynamics—The ability for lenders to work with borrowers to work out restructurings under sensible, agreed upon timetables is better at preserving borrower value in times of stress when compared to the alternatives.   

We also challenge the authors’ assertion that there is a “near-total absence of truly reliable and comprehensive data, either for the market in aggregate or for the individual loans made by private credit funds.” In some respects, there is more information available from alternative asset managers than was the case when these assets were held by banks and commercial finance firms. And in attracting a wide variety of LPs and, increasingly, retail investors, market discipline is plainly evident.

Finally, the authors acknowledge that the growth of private credit is testament to how well it fits the needs of certain borrowers and investors, many of which were dislocated in the wake of the global financial crisis. From our perspective, it is another example of how the U.S. financial system, decentralized and market-based, is the world’s most efficient in terms of funneling capital to its most productive use.  

This is not a piece that should keep anyone up at night.

Alright, on to our second Thing—Second-Half Forecasts.

If you value the wisdom of crowds, this was an interesting week for you, as we got a series of freshly updated survey results including the monthly update on Street strategist forecasts for S&P 500 year-end index and earnings, courtesy of Bloomberg, The Wall Street Journal’s quarterly Economic Forecasting Survey, Bank of America’s Global Fund Manager Survey, as well as Franklin Templeton’s Global Investment Management Survey. 

Let’s start with the latest view on where the S&P 500 Index and underlying earnings are headed. Strategists continue to capitulate to this bull market that has run harder this year than just about anyone thought it would. And I will point out that this market has run while the outlook for rate cuts—once seen as necessary fuel for making this market go—has been materially reduced from last year’s end. As we said at that time, you don’t want six cuts in 2024, that would suggest an urgent need to stimulate.

In the latest month, another four strategists among the 19 Bloomberg tracks, raised their year-end estimate for the index. Nevertheless, eight of the 19 expect stocks to fall between now and year-end. Also worth noting is that since April, those that have increased their year-end estimates outnumber those that have cut by 12 to zero. All the while, median full-year 2024 earnings per share is essentially unchanged among the group, $241 up from $240 in April. It’s all multiple expansion.

The bullishness squares with the latest survey of economists by The Wall Street Journal.  Expectations for economic growth in the U.S. among the 70 economists surveyed have bounced from 0% in last year’s Q4 to 1.8% now forecast for 2024’s Q2, which happens to be smack on the Fed’s longer-term rate for the U.S. In other words, we’re back to normal. Now, don’t get too complacent as growth is expected to tail off modestly in the second half, down to 1.5% expected in this year’s Q4.

Unemployment is expected to peak at a low 4.25% in June 2025. And the consensus expectations for the probability of recession to occur within the next year has fallen from 63% in October 2022 (by the way, that’s when the S&P was 36% lower than now) to just 28% today.

The latest survey of global fund managers by Bank of America shows a reasonably broad consensus, 68%, that a soft landing is in the offing. Just 11% of investors see a hard landing on the way.

The number one tail risk cited by respondents? Geopolitical risk, cited by 26% of respondents, displacing inflation. That means 74% don’t see it as a top risk. It’s another way of saying, there is nothing out there that is particularly worrisome at the moment. Here’s where there is broad consensus, the 10-year is going higher in the event of an election sweep. So say some 77% of respondents.

For a look at credit, we look to the Franklin Templeton Global Investment Management Survey which shows year-end 2024 credit spreads widening a touch, IG to 98 bps and high yield at 336 bps. Those levels, of course, remain well inside historical averages.

Alright, on to our third Thing—Citigroup’s Disappointing Consumer Results.

Coming into Q2 earnings, we were on the lookout for any cracks in consumer behavior, and a great place to look is in the consumer banking businesses at the large banks. All things considered, which includes a favorable economic backdrop and the ongoing normalization of credit costs, our expectation was for still solid performance in the consumer banking.

A surprise came from Citigroup, where its consumer banking unit, which accounts for about a quarter of the firm’s net revenue, posted a 52% year-over-year jump in loan loss provision that drove a 73% drop in the unit’s pretax income. Return on tangible common equity was sub-2%. Spending growth was largely concentrated in the highest quality customer strata, FICO 740 and above. That all sounds like a slowdown.

The net charge-off rate in Citi’s branded cards reached 3.82% up from 2.47% in the year-ago quarter, and 6.45% in retail services cards (private label and co-brand) from 4.46% a year ago. Those loss rates, where the combined portfolio is just 14% subprime and where unemployment is still at historically low levels, are evidence of how this cycle is playing out.

Management noted that there is a divergence in performance and behavior across FICO and income bands: “Lower FICO band customers are seeing sharper drops in payment rates and borrowing more as they are more acutely impacted by high inflation and interest rates.” The good news is that early-stage and 90+ day delinquencies did manage to roll over modestly from the previous quarter, and management did reiterate its full-year net charge-off guidance for branded cards at 3.5%-4% and retail services closer to the higher end of 5.75%-6.25%.

So there is confidence that losses are peaking, but that also implies continuing weak profitability as growth slows, in part due to the slowing macro environment and in part due to the impact of Citi tightening its credit box.

While the bank did build reserves by $382 million in its personal banking unit, it did release $306 million in reserves against everything else. That’s reassuring.

Over at Bank of America, it had a small net release in loan loss reserves overall, and a small increase in its consumer reserve. In its card business (comparable to Citi’s branded card) net charge-offs hit 3.88%, up from 2.6% a year ago. So its loss experience is not all that different from Citi’s. BofA’s card delinquencies also rolled over this quarter. Combined credit/debit purchase volume increased 3.3% year over year.

At J.P. Morgan Chase, card net charge-offs hit 3.5%, up from 2.41% a year ago, and its delinquencies also rolled over this quarter. Reserves in its consumer unit (which also includes home and auto lending) were built by $579 million due to loan growth and updates to certain macroeconomic variables. In management’s words, “it’s normalization, not deterioration. [And] it’s in line with expectations.” Full-year card net charge-offs are expected to be around 3.4%. Card volumes were up 8% year on year.

Overall, the big bank results are consistent with our Two Economies theme, where credit deterioration in the lower income/asset households is peaking as credit underwriting standards were tightened over the past year. Unfortunately, that is also slowing growth.

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

1. Darkening Credit Markets. This is not something to worry about.
2. Second-Half Forecasts. Expectations for a soft landing have strengthened, which is keeping credit well bid.
3. Citigroup’s Disappointing Consumer Results. Much of Citi’s issues are idiosyncratic. Consumer loss numbers in the aggregate are proving to be manageable.    

As always, thanks for joining. Don’t forget to check in on KBRA.com for our ratings reports and our latest research.

We’ll see you next week.