Financial Industry Insights from Advisors Asset Management


AAM Viewpoints — Credit Trends: Are We About to Hit the Inevitable Skids?


There is increasing chatter in the markets relating to a confluence of events that could lead to the reversal of our currently benign credit environment. Issues such as parts and labor shortages, a COVID-19 resurgence, inflation, job numbers, and even China are being bandied about as alarm bells on the credit quality front. 

Globally, credit quality continues to recover, mirroring a continued economic recovery and also supported by friendly markets and the vaccines’ success in reducing the sensitivity of economies to COVID-19. Default rates are approaching record lows, corporate net cash flows continue their inexorable climb, and while corporate debt levels are getting higher, debt as a percent of market value (net worth) has been generally stable and recently has been coming down. Finally, corporations have been successfully taking advantage of the accommodative markets and pushing out debt maturities — over the past year, companies refinanced, paid down, or otherwise reduced maturities over the next 18 months by 19%. Maturities in 2023–2024 also declined by 4% as companies lengthened their maturity profile improving their liquidity and consequently their credit profiles.

moody's 12-month global speculative grade default rates | speculative default rate

corporate net cash flow

nonfinancial corporate business; debt as a percentage of net worth

U.S. maturity wall - financial and nonfinancial corporates

However, despite the recent improvements in credit quality, growing extant negative credit factors on the horizon cannot be ignored. Inflation pressures and supply chain bottlenecks extending through 2022 could put pressure on corporate margins and force central banks to tighten monetary conditions sooner due to resultant inflationary pressure. As we reach an inflection point for monetary policy and central banks start their gradual path toward normalization at different paces around the world, pressure on high yield credits that have heretofore been dependent on accommodative markets could build — elevated debt levels could heighten credit vulnerability for weaker corporates and emerging markets exposed to rapid shifts in market conditions. China's regulatory policy reset could create increased uncertainty over the credit and growth trajectories of the country with potential spillovers to the rest of the world. The increasing pace of the transition to a low carbon economy could cause significant disruption in energy markets, as is already being seen in Europe. On a more positive note, the economic disruptions caused by COVID-19 appear to be becoming more manageable as infection rates decline and vaccination rates improve.

Of growing concern are parts of the supply chain that are experiencing shortages that are resulting in economic disruption and adding to inflationary pressures. Shipping freight rates have risen to a 13-year high driven by strong demand related to economic growth, port congestion, and container shortages. Port congestion is linked to surging demand for imports as the U.S. economy has reopened — retailers and manufacturers have rushed to place orders and restock their inventories, but the global shipping system is struggling to keep up. Through September 2021, cargo handled at the Port of Los Angeles alone is up 30% this year so far, compared with the whole of 2020.

number of vessels around los angeles and long beach ports

global container freight rate index

supply chain disruptions and bottlenecks are continuing

Strong demand, low gas stocks, and supply constraints — particularly in Europe — have caused gas and electricity prices to surge, even ahead of the winter season. The situation is not helped by nuclear and coal power generators coming off stream and a lack of investment in new gas assets as part of Europe’s ambitious energy transition program.

The scarcity of semiconductor chips has continued longer than expected and will likely persist at least through the first half of 2022 until new production capacity comes online. This has the potential to keep prices elevated (especially among automobiles) and feed into contract renewals in the coming months and threaten to eat into corporate margins and consumer spending.

China's corporate debt of $27 trillion is equivalent to 31% of the global total, making it too big to ignore. Its debt-to-GDP (gross domestic product) ratio of 159% is markedly higher than the global rate of 101% and twice the United States' 85%, implying substantial financial and economic contagion risk. The central government's decision to reduce financial risk in the economy, especially in speculative activities (for example, real estate), has triggered liquidity stress for highly leveraged corporates. S&P estimates that three fifths of Chinese entities are in the global quartile with the worst risk — 58% of China's corporates are highly indebted (the global quartile with the highest credit risk), sharply above the global rate of 38%. If the Chinese corporate sector were to destabilize, it would have global spill-over ramifications.

global nonfinancial corporate debt by geography

While these growing pressures are something to be monitored, we don’t think a credit correction is on the near-term horizon. Bear in mind that most of these aforementioned issues are demand driven – shortages are due to the release of pent-up demand that appears unabated, pressuring the supply chains. Growing demand is a sure sign of an improving economy, highly correlated to corporate credit quality. Any slowdowns in sales are not due to the lack of liquidity or demand of the consumer; in fact, household net worth appears to be at record levels, certainly not indicative of being at the precipice of a bygone credit era.

households; net worth, level

Much is being said of the slowdown in the pace of automobile sales that may be a harbinger of a weakening overall credit environment. It is true that automobiles sales are slowing (but still growing albeit at a reduced pace from initial expectations), but this is not due to lack of demand, but rather a lack of supply of chips needed for new cars.

chip shortage slows recovery in sales volumes

This is evidenced by the fact that automobile prices are elevated and continue to increase as strong consumer demand and less discounting are maintaining automotive margins despite lower global light vehicle production and sales.

automaker margins reach record with lower discounts to car buyers, chips going to only most-profitable models

We can see a similar situation in new and used home sales. While the National Association of Realtors (NAR) reported in September that existing home sales receded 2% in August (at a seasonally adjusted annual rate), the median existing-home sales price rose at a year-over-year pace of 14.9%, to $356,700. That price increase indicates that demand has not abated due to an economic slowdown, but more likely the result of consumers being, per NAR, “more measured about their financial limits, and simply waiting for more inventory.” The same situation can be seen among restaurants, automobile traffic trends, and air travel (for which passenger traffic is approaching 80% of 2019 levels) – there is pent up demand, not a lack of it.

In terms of corporate credit quality, 2nd and 3rd quarter earnings results year-to-date (YTD) have been quite strong as companies — while acknowledging the impacts of parts and labor shortages and resultant inflation — have been largely successful in raising prices thus passing through inflationary pressures onto the consumer (of whose household liquidity is quite strong) – witness the automotive and housing sectors. In the 2nd and YTD 3rd quarter results, quarterly profit reports from S&P 500 companies have blown past Wall Street’s expectations. According to Factset, with 8% of S&P 500 companies reporting actual results in YTD 3Q21, 80% of S&P 500 companies have reported a positive EPS (earnings per share) surprise and 83% of S&P 500 companies have reported a positive revenue surprise. The blended 3Q21 YTD earnings growth rate for the S&P 500 is 30.0%. If 30.0% is the actual growth rate for the quarter, it will mark the 3rd highest (year-over-year) earnings growth rate reported by the index since 2010. Thus, corporate credit quality appears to remain strong despite the aforementioned pressures.

In terms of a possible China contagion, the Chinese government has demonstrated a strong resolve addressing the credit strains simmering among Chinese corporates. The situation is coming to a head now primarily because of the government's policy to reduce financial risk, especially of speculative activity, in its economic system. The Chinese government has implemented debt and leverage growth limits among the weakest sectors trying to contain any damage. While many of the Chinese government’s policies could inflict pain on the weakest sectors there, we believe it will likely contain the spread of damage globally.

While there are many factors resulting in the slowing (but still healthy) pace of economic growth, this does not appear to be a harbinger of weakening corporate credit quality as consumer demand remains high and household balance sheets strong, allowing some absorption of inflationary pressures that are being passed on to the consumer. Slowdowns are not demand driven which would indicate economic and credit problems, but are supply driven as demand remains strong.

CRN: 2021-1004-9501 R

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