INSIGHTS

On August 09, 2021

AAM Viewpoints – Credit: What Can Possibly Go Wrong?

"At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide."
– Abraham Lincoln, 1838

When we think about these halcyon days of credit quality we’re are currently experiencing, our thoughts go to Abraham Lincoln’s words, that, while spoken in an altogether different context, reminds us that despite the currently and improving fundamental strength of corporate credit quality, danger may be lurking from within, and we may be the authors of the end of the cycle. Government policies regarding COVID-19 responses, labor shortages, interest rates, and inflation will likely have pivotal impacts.

Corporate credit strength is currently near record levels and continues to improve. Moody’s reported that the global and U.S. trailing 12-month speculative grade default rates through June 2021 continues to plummet. The global default rate dropped from 4.9% in May to 4.0% in June while the U.S. default rate dropped from 5.5% in May to 4.1% in June. The global default rate marks six consecutive months in which the global rate has declined from its cyclical peak of 6.8% in December 2020, and the first time since the peak that it fell below the historical average. The U.S. default rate has consistently declined from the 8.4% rate in December 2020 (the peak was 8.7% in August 2020).

Moody’s is now forecasting that the global and U.S. default rates will finish the year at 1.7% and 1.6%, respectively, both near historic lows amid a strong economic recovery and abundant liquidity in the capital markets.

S&P notes that the number of positive rating actions for financial and nonfinancial corporate issuers rose in the second quarter of 2021 as the economic rebound fueled better-than-expected demand for most sectors and financing conditions remained extremely favorable with ample credit available for most issuers. In fact, net rating actions reached an all-time high in the second quarter, with upgrades (121) greatly outnumbering downgrades (51).

Meanwhile, the Federal Reserve reports that non-financial corporate financial assets through 1Q21 (1^st quarter of 2021) are at record levels.

So, what could possibly slow, or even reverse, the inexorable momentum of this strengthening credit freight train?

• The Delta Variant: There is growing fear in the market that the delta variant of COVID-19 will result in renewed government mandates forcing business shutdowns despite growing vaccination rates; although to date, there have only been new mask mandates while vaccinations are successful in preventing serious illness. But even without shutdowns, there is anecdotal evidence that certain sectors of the economy are being impacted. Most recently, there are reports that businesses are canceling conventions – the New York Auto Show was just canceled, and Deutsche Bank also just decided to shift an in-person conference back to virtual. If this trend were to continue, there could be ancillary impacts on businesses related to these sectors – restaurants, airlines, and other services. That said, case counts – although rising – are not yet at the peak levels experienced in early 2020.
  
  
  Moreover, there is a difference between rising cases and serious illness. The U.S. has more than 80% of adults with immunity between vaccines and natural cases, which should minimize serious illness as cases rise. Rising cases may not be enough to justify lockdowns if serious illness is not resulting. In other words, U.S. policymakers need to decide whether they are concerned over cases or serious illness. Additionally, politically, American voters are more likely to be more resistant to new restrictions. As cases rise in the coming weeks, policymakers need to be careful not to overreact, although an overreaction on the part of politicians is certainly not out of the question.
  
  
• Shortages: Parts, chips, and labor shortages are headwinds to economic growth. In fact, in the current earnings season, mentions of shortages on earnings calls has sharply grown indicating growing concern.
  
  In fact, all the automobile manufacturers are citing chip shortages as headwinds to sales and responsible for delayed production. This past week, General Motors said its three North American full-size pickup truck assembly plants would be shut down next week due to the global semiconductor chip shortage while extending downtimes at many other plants. According to Alix Partners, the global auto industry will produce nearly four million fewer vehicles than planned this year because of the shortages, losing about $110B in sales. Microchips are crucial for making a wide range of products. They are in smartphones, gaming consoles, household appliances, alarm clocks, and cars. According to Moody’s Analytics, the main problem “is that new supply is hard to come by and the surge in demand is not going to be abating anytime soon.” The global shortage of chips is threatening the economic recovery. The manufacturing of transport equipment fell by a striking 16.5%, which was due to the shortage of microchips that power the electronics that make up most modern-day cars. And while semiconductors in the U.S. account for 0.3% of the nation’s GDP (gross domestic product), the components they go into make up a massive 12%. According to Goldman Sachs, the slowdown in chip availability could, in theory, hit U.S. GDP by as much as 1% in 2021 while resultant price increases could hit 3% for affected goods. While that GDP impact may not seem much in today’s high GDP growth numbers as the economy recovers from shutdowns, in a more normalized environment, this becomes much more significant.

• Labor shortages, likely caused by a combination of generous unemployment benefits and skills mismatch, is nonetheless impacting industries in manufacturing, retail, and transportation the most. The labor shortage is apparent in the following chart showing the gap between job openings and hires is near-record levels:

  

  According to the National Federation of Independent Business (NFIB), 46% of small business owners reported job openings they could not fill in the current period, down two points from May but still above the 48-year historical average of 22%. Small business owners continue to struggle to find qualified workers for their open positions while raising compensation at a record high level. A net 39% (seasonally adjusted) of owners reported raising compensation (up five points), a record high. A net 26% plan to raise compensation in the next three months (up four points), adding to inflationary pressures. If anecdotal stories regarding labor shortages at port facilities and truck companies, while airlines, restaurants and hotels can't fill open jobs, this would stifle efforts to capitalizeon resurgent consumer demand and thus impact economic growth.

• Inflation: The latest debate – is current inflation transitory or longer term? As the global economy has regained its footing, prices for goods and services have risen — in many cases far faster than economists had anticipated. Labor shortages and supply-chain disruptions snarling the global shipping industry have added to inflationary pressures. According to the NFIB, inflation is the single most important problem.

The U.S. consumer price index (CPI) jumped in June – over the last 12 months the all-items index increased 5.4% before seasonal adjustment. This was the largest 12-month increase since a 5.4% increase for the period ending August 2008. Currently, it appears transitory factors are boosting inflation. The reopening of the economy is a one-time event that is boosting several components of the CPI, including lodging away from home, vehicle rentals, and airfares along with admissions to sporting and other events. Additionally, the monthly hike in consumer prices translated into negative real wages for workers. Real average hourly earnings fell 0.5% for the month, as a 0.3% increase in average hourly earnings was more than negated by the CPI increase. However, if this inflation turns out to be long term in nature while driving up wages, higher interest rates may occur while purchasing power is eroded. Despite interest rates having been in a secular downtrend, aggregate corporate interest expense is near an all-time high, as companies have loaded up on debt. Any secular shift higher in rates means interest expense will continue to grow and dig into companies’ cash flow. A higher interest rate environment presents a challenge to corporations and while some may be able to handle it, it undoubtedly will not end well for others. 

While the credit environment remains quite benign, one should not be too complacent as there are potential cracks in the story that have the potential of widening and ending the current credit cycle.

CRN: 2021-0809-9381 R