Sentiment Shifts, Earnings on Deck, and Chinese Growth

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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. We’re wrapping up week three of our bout of financial instability. Nasdaq has entered a bull market, the Atlanta #Fed GDPNow estimate for Q1 growth is above 3%, and the market-implied terminal rate for year-end has fallen by more than a point—a point!—this month. What’s not to love?

This week, our 3 Things are:

1. Market sentiment. Here’s a hint: It’s all over the place.
2. Earnings season is back. What will the banks say?
3. Chinese growth. It’s positive … right?

Alright, let’s dig a bit deeper.

Market sentiment after the shock.

So, here we are, in our fourth (and final?) extraordinary year in the pandemic era. Shock, freeze, stimulus, reopening, excess, correction—I don’t have to tell you that it’s been quite a ride economically. The latest leg, financial instability, introduces an unwelcome twist that few saw coming, but one that always seems to present to some degree in downturns. Sizing up the impact of that on #marketsentiment and behavior is the latest task at hand. Here are some thoughts.

• This still feels like a bear market rally in risk … The #federalgovernment stepped in quickly to prevent banking contagion. The episode feels like it actually could fuel investor risk appetite because we’re no longer talking about rates going to 6%; we’re wondering whether or not they will go to 4% by year-end. #Volatility is down in stocks and bonds. And credit went on sale. But we’re not back to “no landing” scenarios. We’re back to waiting. This recession has felt like it is x+2 or 3 quarters away for some time now.
• … But financial conditions will tighten further. We’ve talked quite a bit about this recently. For those scoring credit—lenders, #investors, #accountants—they will be more conservative than three weeks ago. For those driving the economy—consumers and businesses—credit will be less widely available and more expensive, and behaviorally, risk-taking sentiment will eventually grow more conservative. All of this increases #recessionrisk, especially in the second half (x+2 quarters!).
• TARA is firmly entrenched. “There Are Reasonable Alternatives,” #investment-grade credit being one of the more attractive opportunities, with yields north of 5%. This reduces the “search for yield.” We haven’t said that in a long time.
• Industrials will draw a stronger bid. With each #bankingcrisis, a certain investor will say, “Never again.” As in, I will never again be overweight financials late in a cycle. That means, in the wake of the recent bank failures, there will be a strong bid for industrial paper. As one #investor said to me, “Industrials don’t go bust in 40 hours.” Neither do well-run banks, but I’m not going to win that battle.
• New issue supply might reduce. Lower growth and a less certain economic environment should curtail issuance to some extent. M&A activity figures to curtail as buyer and seller expectations drift and future cash flows are more difficult to model.

For #credit to break here, really underperform, we would need significant contagion of financial instability (not likely), a spike in #unemployment (not likely), a significant drop in earnings growth (not likely), or a spike in #inflation (not likely). For credit to outperform from here, visibility into these issues has to improve.

Alright, on to our second Thing—It’s earnings season!

So, earnings season has kind of snuck up on everyone, as we all have been preoccupied with bank deposit flows, the prospects of credit crunch, and, of course, the usual Fed drama. So, let’s bring it back to something easily scored: earnings.

Our first clue, imperfect as it is, is what’s happening with stocks. They’re up. The S&P 500 is up 5.5% year to date, the Nasdaq a whopping 14.7%. Over in Europe, the STOXX 600 is up 7.5%, and the FTSE is up 2.6%. Doesn’t feel all that bad.

Forward multiples in the U.S. are healthy to say the least—18x for the S&P, 27x for the #Nasdaq, better than long-term averages, not reflecting a whole lotta concern about recession. Fundamentalists would say that suggests growth and margins are in fine shape, and the future looks fine.

Huh?

Bears, getting run over at the moment, would say that we’re back to a handful of names powering the broader market, something born out in the S&P 500 Equal Weight Index, which is up just half of 1% on the year. And, at 15x forward earnings, it is trading three multiple points below its long-term average. So, that makes more sense.

And that also squares up with falling estimates for Q1 earnings. The #Bloomberg consensus for the S&P 500 currently sits at $50.86, some 15% below the estimate peak back in June 2022. That would be 6.9% lower year-on-year, and if that plays out, we will officially be in an earnings recession, as this would be the second consecutive quarter of earnings decline, following a 1.6% year-on-year drop in Q4.

For the quarter, 83 firms have issued negative guidance versus just 25 that have issued positive. By sector, double-digit drops forecast for the current quarter include a 31% drop in materials, 19% in health care (that’s mostly pharma), 17% in communications services, and 12% in information technology. The only sector expected to show double-digit gains in the current quarter is energy, up 12%. Common themes running through the results are excess margin correcting, and slower growth creeping in.

We would expect materials sector profitability to fall, reflecting pressure across the commodity complex, although the rise in energy doesn’t fit that narrative. Go figure. Technology profitability is expected to be under pressure, consistent with all of the layoff announcements, yet tech stocks and credit are well bid. It feels like that is just a correction from over-hiring and overearning through the pandemic period. There is talk of tech once again being a safe haven, something that speaks to certain names in the sector exhibiting attributes typically seen in utilities and consumer staples, rather than those we usually associate with higher beta behavior and performance.

Much attention, of course, will be on the banks. For what it’s worth, earnings are expected to have risen 10% in Q1 for S&P 500 banks, which, of course includes the largest banks. Regional bank earnings (those included in the KBW Regional Bank Index) are expected to have fallen 10%.

We don’t expect much drama around reported results, as they are of course backward looking. One forward-looking data point will be the all-important loan loss provision. That is creeping up, but we are not expecting material or alarming increases there. Yes, we are seeing higher delinquencies and losses on the consumer side of things, but given the strength of the jobs market and the benefit still of excess savings, those increases in bad debt costs at the banks, which cater to wealthier strata of consumers, are expected to be modest.

Expect all of the attention to be on deposit flows and related net interest #margin pressure as well as the outlook for loan growth and loan losses. All of this will be among the most closely analyzed messages across all sectors in this #earnings season. Expect to hear the word “resilient” quite a bit. That seems to be the word of the crisis chosen by regulators in their carefully chosen talking points.

Overall, this should be a relatively sound earnings quarter, acknowledging that we are in earnings recession. Investor focus will be on how bad might it get when that “x+2” recession hits.

Alright, on to our third Thing—Chinese growth.

We got some interesting color this week from the head of Maersk—the world’s second largest container shipper—on the strength of the Chinese economic rebound. The newsflash is … it’s disappointing!

Strong Chinese growth in the wake of the country’s much ballyhooed reopening from its zero-COVID policy is expected to be an important offset in 2023 to decelerating growth in the advanced economies, and yet signs on the ground (and on the seas) suggest otherwise. “There was this hope,” Maersk’s CEO said, “that as #China reopens after Covid we would see a really strong rebound. I think we’ve not seen it yet.” He added that the Chinese consumer is not in a splurging mood right now. He cited Maersk customers’ feedback that useful context might be 2003, when the Chinese economy was hit hard by severe acute respiratory syndrome or SARS. Chinese consumers did not simply flip and switch and assume what the Maersk CEO characterized as a “roaring 20s” type mood. It took a while to get over the shock.

To be fair, China has set a growth target of just 5% for 2023, its lowest target ever (it did not set a target in 2020) and well below its average annual growth of 8.4% over the past 20 years. And while the IMF has been cautious around China’s growth prospects in the medium term, the Fund does expect China, along with India, to be a major engine of growth in the global economy in 2023.

We bring this up for two reasons that are relevant to credit markets. One, China is an important driver of global growth, through its own demand and its role in contributing to global supply chain efficiency. And two, news of China slowing had been instrumental in recent sell-offs broadly in credit, most notably in 2015-16 and 2018. While markets may be growing accustomed to slowing Chinese growth as the new normal (the IMF believes the country’s growth will slow to 4.5% to 4.75% between 2023 and 2027), we believe it serves as important ballast to the slowdown in 2023 in the U.S. and #Europe. Disappointing growth could be one more source, an unexpected one, of headwinds in 2023.

So, there you have it, 3 Things in Credit

1. Market sentiment. It’s relatively positive at the moment. Check back in a couple of quarters.
2. Earnings season. Expect cautionary guidance overall, and defensive commentary from the banks.
3. Chinese growth. Too much change all at once is weighing on its recovery.

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