Spread Risk, U.S. Bubble, Holiday Spending
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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.
I have to admit, the headlines rolling across my Bloomberg this week are a bit out of the ordinary. “Macron Asks French Lawmakers Not to Topple the Government.” “Military Rule Returns to South Korea as President Declares Martial Law.” To borrow from Buffalo Springfield, there’s something happening here. What it is ain’t exactly clear. Well, I guess that’s one way to bring Treasury rates down.
This week, our 3 Things are:
Alright, let’s dig a bit deeper.
Spread Risk
Spreads are tight. Historically tight. I’m sure that comes as no surprise to you. The reasons have to do with solid and improving fundamentals, the strong consensus that the landing will be soft (if at all), and attractive yields given the rate rise and the richness of stocks.
We are often asked what could drive spreads materially wider. Here are some thoughts.
From a fundamental standpoint, we’re in good shape. The U.S. consumer, in the aggregate, is quite healthy. Household net worth is at record levels, having risen 40% from the start of the pandemic, driven by buoyant investment and residential real estate markets. A still tight-ish labor market gives him or her job security and wage gains that exceed the rate of inflation.
The aggregate data tells us that corporate leverage has increased, but that’s really not what causes a broad shift in investor sentiment. That’s usually weakness in the first line of defense, earnings. And on that front, the backdrop is positive. The consensus earnings growth estimate for full-year 2025 for the S&P 500 is holding firm at 15%, on revenue growth of 6% and historically high operating margins of 16.5%, a function of surging productivity and cautious management of expenses.
Underpinning corporate performance is a financial system that is in good shape, with low levels of problem assets at both banks and nonbanks—and markets, both public and private, where financial conditions are quite favorable.
Shocks that would catalyze material spread widening would include a material falloff in nonfarm payrolls, a financial crisis, or a geopolitical development that would dislocate markets and/or cause a disruption to supply/demand in energy. From where we sit, none of those seem all that likely over the near term.
From a technical perspective, the appeal of fixed income remains strong, driven by the highest yields (at least in IG) since the GFC. The flipside of that argument is that spreads represent just 15% of your yield, the balance comes from the Treasury piece, and that’s what makes us nervous.
With a 6% fiscal deficit, and much of Trump’s policy leanings inflationary, risk investors should be on guard. Resurgent inflation would wreck everything. The resultant selloff in rates will undermine stock valuations and, yes, widen credit spreads. The good news is that it will take a while for inflation catalysts to drive prices higher, and there are safeguards, presumably, against Trump’s worst instincts, including bond vigilantes, something his pick for Treasury Secretary, the more pragmatic Scott Bessent, understands.
That’s a cool hand we’re likely to need.
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Alright, on to our second Thing—U.S. Exceptionalism--The "Mother of All Bubbles?"
We often talk of U.S. exceptionalism, less in the way the term was coined originally as a way of describing the country’s governance, and more as a way of recognizing the American economy’s superior ability to innovate and grow. And much of that, in our opinion, is the result of having the world’s most efficient financial system, decentralized and markets based, one that funnels capital and funding to its most productive use better than anyone else’s.
Lately, there has been a lot of talk of U.S. exceptionalism when talking about the extraordinary performance of the U.S. equity market, which accounts for nearly 70% of global stock market value despite the U.S. economy representing just 27% of global economic output.
One of our favorite market observers, Ruchir Sharma, chair of Rockefeller International, and former chief global strategist of Morgan Stanley Investment Management, described this phenomenon this week as “The Mother of All Bubbles.” He believes America, from a shareholders’ perspective, is “over-owned, overvalued, and overhyped to a degree never seen before.” That, I suppose, is debatable. U.S. economic growth since the pandemic has been significantly higher than its developed world peers, at 8.7% cumulatively, compared to Italy at 3.3%, the U.K. at 2.9%, Germany at -2%, and Japan at -2.2%.
Mr. Sharma also makes a claim that we do not fully agree with. Investors, he says, believe the upcoming return of Donald Trump and his plan to “raise tariffs, lower taxes, and cut regulations will further inflate U.S. markets.” Investors believe, in our opinion, that risk markets have risen because of expectations for deregulation under the new administration, especially in energy and financial services, and because of the unleashing of animal spirits. In addition, equity markets have also been goosed by the return into stocks of merger premia, which the Biden administration had all but snuffed out. Few believe higher tariffs will drive markets higher, and we are skeptical that Trump 47 will be able to further cut taxes materially (above and beyond making his expiring tax cuts permanent) due to the aforementioned bond vigilantes and the presence of deficit hawks in Congress.
Investment relative value is derived from many factors that ultimately dimension risk and reward. And few would argue that U.S. risk assets, stocks and bonds, are not trading at lofty valuations. But strip out the cap-weighted effects of the Mag 7—which do, by the way, produce phenomenal earnings, have dominant market positions, and R&D superiority—and U.S. stock valuations are far less bubbly. And that makes any correction far less likely to trigger a broader selloff in risk assets such as credit.
Alright, on to our third Thing—Holiday spending.
‘Tis the season for forecasts of consumer holiday spending. If we look at the backdrop, we, and forecasters, know that growth in real after-tax incomes has slowed this year but remains positive. We know households have dipped into savings in order to maintain 3% spending growth. We know household net worth has risen smartly in 2024 on the back of gains in investment portfolios and home values. So, the aggregate data suggests that this will be a healthy holiday spending season.
Yet we hear a lot of anecdotal evidence that consumers are more anxious than a year ago—that they are happy to spend, as long as they are getting a deal. The National Retail Federation is forecasting year-over-year growth of between 2.5% to 3.5%. That’s below, by the way, the 3.8% median growth rate registered over the past 20 years. The NRF commented somewhat confusingly that “We remain optimistic about the pace of economic activity. Household finances are in good shape and an impetus for strong spending heading into the holiday season, though households will spend more cautiously.”
Mastercard, forecasting 3.2% growth, gave a bit more color, noting that the consumer is feeling “slightly more stretched.” While real incomes and net worth have grown, job creation is “has cooled.” The company recognizes the differing cohorts underneath the aggregate data, echoing our by-now-familiar “Two Economies” themes. Value-conscious consumers, impacted by economic pressures, view discounts and promotions as essential, while wealthy households are free to spend. Most consumers fall in between those two bookends. Add it up and you have a below median growth expectation. Visa, observing similar trends, is forecasting 3.9% growth.
Interestingly, consumers seem to be feeling flush. According to surveys by Deloitte and Bank of America, consumers believe they will increase their holiday spending by 8% and 7% respectively.
The important takeaways from our perspective are that the engine of U.S. growth, the consumer, remains in solid shape overall. Wealthier households, those that drive a disproportionate amount of spend are overwhelmingly employed, have enjoyed wage gains that have offset the bite of inflation, have manageable levels of debt and a low level of debt service burden, and are feeling flush from gains in the home and investment portfolio values.
The durability of this story is relatively strong. It is, as always, largely dependent on the growth in corporate earnings, that which supports asset values, job creation, and wage gains. And with consensus calling for 15% earnings growth for the S&P 500 in 2025, we figure to be on solid ground.
So, there you have it, 3 Things in Credit:
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.