[Music] welcome Market participants to another three things in credit I'm van Hesser Chief strategist at KB each week we bring you three things impacting credit markets that we think you should know about you have to love New York fed CEO John Williams for introducing a word in a speech this week he says you might have found on a middle school vocabulary list equipoise it should come as no surprise to you that John Williams and I probably went to very different kinds of middle schools as I admit to never ever coming across the word equipoise Websters defines equipoise as a state of equilibrium which begs the question why not just use the word equilibrium in any event this week our three things are One Bank warnings you'll want to be aware of what Ally Financial is experiencing two small business struggles signals are not reassuring from the sector that accounts for 40% of GDP and three post inflation risks it's time to move your Central Bank Obsession to the back burner all right let's dig a bit deeper Bank warnings Financial institution's most important annual conference put on by Barkley's came and went this week and as always important headlines came out two are worth exploring JP Morgan Chase schooled the analysts on why their earnings estimates are wrongheaded too high by pointing out the obvious that rates are expected to fall significantly 250 basis points or so in 2025 and in that scenario net interest income will be negatively impacted yet analysts had net interest income at JP forecast the Fall by just 1.6% management reminded that the bank is quite asset sensitive meaning its assets repic faster than its liability ities and that the consensus estimate for net interest income has to come down then there was the issue of expense growth management said 2025 consensus which is 93.7 billion was too low due to inflation and I'm assuming higher Tech spend and taken together that means the estimate for 2025 earnings for JP Morgan is being guided lower the stock sold off a not trivial 5% now does that matter to credit well the answer is a resounding no what moves the credit valuation of banks is overwhelmingly the loan loss provision and on that note Management's guidance was reassuring no change in its outlook for credit card losses still a quite reasonable 3.6% up from an expected 3.4% in 2024 management reminded that consumers are in relatively good shape on a commercial lending side of things there has been no deterioration in auto financing Residential Mortgages small business midle Market or large corporate lending there continue to be challenges of course in commercial real estate where quote we haven't seen the bottom unquote yet but the bank is very well reserved for that and lower rates will help management noted that businesses are being careful due to concerns about geopolitics us China relations in particular was highlighted us election and the outlook for interest rates then there is Ali Financial the large consumer oriented Bank its stock sold off 19% Tuesday management said quote our credit challenges have intensified unquote this after what has already been a challenging year for management to forecast accurately what is happening with their loan losses our borrower is struggling with high inflation and cost of living and now more recently a weakening employment picture that sounds ominous to us especially given that unemployment is historically low the problem at Ally is centered in its Retail Auto lending portfolio where in July and August delinquencies are up 20 basis points versus expectations and losses were up 10 basis points above expectations management expects the ladder to grow for context the loss rate in Retail autof Finance over the past 12 months is 204 basis points so this in and of itself is not all that worrisome the equity Market's reaction reflects more of the consequences of unexpectedly higher loan losses namely you have to tight en the credit box further which will lean on growth and ultimately depress margins allies warning is consistent with our two economies theme that we talk a lot about where less wealthy consumers are increasingly vulnerable to economic slowdown at this point in this cycle because the transition from a stimulus fueled lifestyle back to normal is a bumpy one that will contribute to economic slowdown all right onto our second thing small business hunker down now so much for the great rotation remember that moment and it feels like just a moment in July when the Russell 2000 broke out up 12% in a week well it's been volatile since then but the latest survey out of the national Federation of Independent Business won't help summing it up the nfib said quote the mood on Main Street worsened in August as uncertainty continues to rise as expectations for future business conditions worsen unquote small businesses account for roughly 50 % of us employment and some 40% of GDP so sentiment here matters keep in mind the group's small business optimism index has been depressed for some time now 32 consecutive months in fact below the 50-year average but the latest read is particularly somber eight of 10 components in the index deteriorated during the month firms reporting positive profit Trends versus those reporting negative ones were a net negative 37% in August that's seven points worse than July and the lowest since the GFC those expecting higher real sales fell nine points in the month to a negative 18% consistent with a rise in the group's uncertainty index to its highest level at 92 since October of 2020 10 points higher than June and only 4% of respondents think the next three months would be a good time to expand and we've learned by now that small businesses have been hit particularly hard by the effects of inflation the labor shortage supply chain snafus and the rise in rates so the results shouldn't be all that surprising but it does represent a significant headwind to growth as we look forward and it is sure to leave a mark in Middle Market Finance all right onto our third thing risks in a post- inflation World which is where I think we are it's a good time to think about risks risks to 2% economic growth to 7% corporate earnings growth to sub 5% unemployment the pillars of normal and here's perspective underpinning all of this take out the shock of covid and we are in one of the longest periods in recorded economic history of expansion in the US now that says a lot and something that I think is underappreciated in a world of data release Obsession one big risk we see among investors and Company managements is attributing poor performance by companies be it on strategy or execution or both to macro forces more often than not poor performance is the result of poor management decisions into a slowing growth world it is more important than ever to focus on the business model is it competitive is it durable what about the capital structure is it appropriate credit is certainly affected by macro Trends but at the end of the day it really is idiosyncratic there are too many zombie companies out there that survived on super cheap and super abundant debt higher cost of capital should weed many of those out that said on the macro side the aformentioned John Williams mentioned three signs of a shift in economic conditions that he is watching namely the possibility of further weakening in the labor market a sharp slowdown in global growth and volatility in the progression of disinflation he says the future is highly uncertain for what it's worth overall I don't think the future is highly uncertain I would Reserve that description for q42 2008 in the GFC or q1 2020 with Co today with two hot Wars and political volatility there clearly are tail risk but economically we don't see big swing factors out there that investors struggle to demension all right back to Mr Williams risks Mr Williams has long used the analogy of peeling an onions layers to figure out the risk of inflation now let's peel that onion a bit in thinking through his points of uncertainty ordinarily when you have an historically aggressive tightening cycle overshooting by central banks is Far and Away the norm so releasing the break cutting rates at precisely the right time to maximize employment simply put rarely happens why well the incentive is to overshoot peeling the onion we know that today in the aggregate consumer and Commercial balance sheets are in better than normal shape heading into the Slowdown and businesses have had a long lead time to adjust cost structures it means there's a better than normal chance of keeping unemployment low what about declining Global growth that is worrisome the two primary engines of growth the US and China are slowing and China is more problematic given that it is fundamentally altering its economic model away from levered infrastructure and unbridled Tech enabled development we also worry about Germany which looks to be headed towards stall speed at best and the ECB seems to be much more cautious than the FED in terms of getting rates back to neutral his third point of concern disinflation has upside and downside risks according to Mr Williams we worry far less about upside risks given Global slowdown now Jamie Diamond this week keeps playing up the inflationary risks posed by higher deficits and increased infrastructure spending but we think the bigger risk especially over the medium to longer term is deflation related to automation now Beyond those concerns we would add uncertainty around the treasury market what the impact will be of having to finance anal massive deficit in the face of two presidential candidates that show no sensitivity to fiscal responsibility we would also add trade Wars should Trump be elected to potential risks it derailed growth in 2019 and it could [Music] again so there you have it three things in Credit One Bank warnings allies higher than expected bad debt costs suggest that tighter consumer credit will ultimately limit growth two small business struggles signals are not reassuring from the sector that accounts for 40% of GDP and three po inflation risks steering clear of zombie companies and Global slowdown are near-term risks to navigate as always thanks for joining don't forget to check in on kb.com for our ratings reports and our latest research we'll see you next week