Month: June 2023

Surprisingly Strong US Economic Data Keeps Recession Fears at Bay

Purchases of new homes climbed to the fastest annual rate in more than a year, durable goods orders topped estimates and consumer confidence reached the highest level since the start of 2022, according to the Tuesday reports. Another release showed housing prices in the US rose for a third-straight month.

While the data don’t reject the possibility of a recession in the coming year, they do give reason to believe a downturn isn’t right around the corner, let alone a foregone conclusion. The latest reports on retail sales, inflation-adjusted consumer spending and the job market also support that notion. (…)

While homeowners are reluctant to move and take on a greater mortgage, prospective buyers have adjusted to the shift and are increasingly seeking out new construction instead.

Purchases of new single-family homes increased 12.2% to an annualized 763,000 pace last month, government data showed Tuesday. The figure marked the third-straight monthly advance and beat all but one estimate in a Bloomberg survey of economists. (…)

The robust confidence and homebuying data are rooted in what’s still a strong labor market. Unemployment is historically low and job openings are plentiful, though both metrics have been softening in recent months. (…)

Orders placed with US factories for business equipment rose in May for a second month, indicating companies continue to make longer-term investments despite high borrowing costs and economic uncertainty.

Shipments of nondefense capital goods, which are a proxy for actual spending, jumped 3.4%, the biggest increase since the end of 2020. (…)

My comments:

• Home builders are benefitting from the dearth of existing home sellers clinging to their low mortgage, and are buying down mortgage rates for new home buyers. In May, new single-family home sales were 9.2% above their February 2020 level, substantially outpacing starts (-4.0%) and permits (-8.5%). Over time, these 3 series converge.
• Non-defense capital goods orders ex-aircraft are very volatile. They were up in the last 2 months after being down the previous 2. A 3-m moving average shows +1.5% a.r. in May, down from +2.1% in April and March. Flat since August 2022 in spite of rising costs. That said, “core capex” are up nicely from their pre-pandemic levels.

• Consumer confidence, a coincident indicator, remains much lower than pre-pandemic.
• The BLS Job Openings perked up in April but Indeed Job Postings through June 23rd suggest lower levels in May and June.

• Second-Quarter GDP Growth Estimate Decreases On June 27, the GDPNow model estimate for real GDP growth in the second quarter of 2023 is 1.8 percent, down from 1.9 percent on June 20.

U.S. Considers New Curbs on AI Chip Exports to China Restrictions come amid concerns that China could use AI chips from Nvidia and others for weapon development and hacking

The Commerce Department could move as soon as early next month to stop the shipments of chips made by Nvidia and other chip makers to customers in China and other countries of concern without first obtaining a license, the people said.

The action would be part of final rules codifying and expanding the export control measures announced in October, some of the people said. (…)

The new restrictions being contemplated by the department would ban the sale of even A800 chips without a license, according to the people familiar with the matter. [The A800 is a version of Nvdia’s AI chips for the Chinese market that falls below performance thresholds outlined by the Commerce Department]. (…)

The administration is also considering restricting leasing of cloud services to Chinese AI companies, which have used such arrangements to skirt the export bans on advanced chips, some of the people familiar with the discussions say.

The timing of the rule’s rollout is still uncertain, as chip makers continue to push the administration to forgo or ease the new restrictions. The administration is likely to wait until after a visit to China by Treasury Secretary Janet Yellen in early July to avoid angering Beijing, according to a source familiar with the situation. (…)

U.S. officials and policy makers increasingly see AI through a national-security lens. Weapons infused with AI could give U.S. rivals a battlefield advantage, and AI tools could be used to create chemical weapons or produce malicious computer code. (…)

Xi Vows to Protect Foreign Investors in Charm Offensive The Chinese leader pledges the nation will do right by foreign investors.

“Development is the top priority of the Communist Party of China in governing and rejuvenating the country,” Xi told New Zealand Prime Minister Chris Hipkins during his official visit to Beijing on Tuesday.

“We will continue to vigorously promote high-level opening up and better protect the rights and interests of foreign investors per the law,” Xi said, according to the official Xinhua News Agency.

China’s attempts to encourage foreign investors have ramped up in recent weeks as it’s become increasingly clear that the economy’s recovery following the end of Beijing’s Covid Zero policies is starting to flag. Efforts in the US and Europe to “de-risk” supply chains by reducing their reliance on China have further clouded the prospects for future growth. (…)

A clampdown this year on foreign consultancy firms that help global investors and multinational firms understand China — part of a nationwide anti-espionage campaign — has weakened the appetite for investment from overseas firms.

That campaign and other government actions likely mean that China’s charm offensive will face skepticism. While Xi has repeatedly insisted that economic development is the Communist Party’s “top priority,” his government has clearly made protecting national security a central focus.

Prior to the consultancy crackdown, abrupt regulatory tightening moves affecting industries ranging from technology to real estate had already been sending foreign capital fleeing from the nation’s financial markets.

A record share of European companies say doing business in China is getting more difficult, according to a recent survey that noted some firms are already following through on plans to divest from the economy. Some American firms have also reconsidered investment.

Bloomberg adds this color in China Shifts Approach Toward De-Risking With Appeals to CEOs:

(…) Beijing’s warmer ties with business leaders compared to some Western politicians was on display earlier this month when President Xi Jinping called American billionaire Bill Gates an “old friend” during a meeting in Beijing. Days later, US Secretary of State Antony Blinken was granted only a brief audience with the Chinese leader in the capital. Xi and Biden haven’t spoken since November. (…)

Senior Communist Party officials also recently rolled out the red carpet in China for the chief executive officers of JPMorgan Chase & Co. and Tesla Inc., and a host of other foreign business chiefs.

While it remains to be seen how business leaders respond to Li’s call to challenge their governments’ economic interventions, he signed deals in Europe last week to deepen China cooperation with Airbus SE, BASF SE, BMW AG, Mercedes-Benz Group AG and Volkswagen AG. Li told those firms that risk prevention and cooperation are “not mutually exclusive.” (…)

Henry Gao, who researches Chinese trade policy at Singapore Management University, said the risk prevention measures Li supported companies pursing was fundamentally different to politicians’ de-risking strategies.

That could lead to both sides talking past each other, but perhaps that was the entire point. (…)

• Billionaires and Bureaucrats Mobilize China for AI Race With US A ChatGPT-inspired global wave of AI activity is only just beginning in the next battle for supremacy in technology.

Billionaire entrepreneurs, mid-level engineers and veterans of foreign firms alike now harbor a remarkably consistent ambition: to outdo China’s geopolitical rival in a technology that may determine the global power stakes. Among them is internet mogul Wang Xiaochuan, who entered the field after OpenAI’s ChatGPT debuted to a social media firestorm in November. He joins the ranks of Chinese scientists, programmers and financiers — including former employees of ByteDance Ltd., e-commerce platform JD.com Inc. and Google — expected to propel some $15 billion of spending on AI technology this year.

For Wang, who founded the search engine Sogou that Tencent Holdings Ltd. bought out in a $3.5 billion deal less than two years ago, the opportunity came fast. By April, the computer science graduate had already set up his own startup and secured $50 million in seed capital. He reached out to former subordinates at Sogou, many of whom he convinced to come on board. By June, his firm had launched an open-source large language model and it’s already in use by researchers at China’s two most prominent universities. (…)

“China is still three years behind the US, but we may not need three years to catch up.” (…)

AI investments in the US dwarf that of China, totaling $26.6 billion in the year to mid-June versus China’s $4 billion, according to previously unreported data collated by consultancy Preqin.

Yet that gap is already gradually narrowing, at least in terms of deal flow. The number of Chinese venture deals in AI comprised more than two-thirds of the US total of about 447 in the year to mid-June, versus about 50% over the previous two years. China-based AI venture deals also outpaced consumer tech in 2022 and early 2023, according to Preqin.

All this is not lost on Beijing. Xi Jinping’s administration realizes that AI, much like semiconductors, will be critical to maintaining China’s ascendancy and is likely to mobilize the nation’s resources to drive advances. While startup investment cratered during the years Beijing went after tech giants and “reckless expansion of capital,” the feeling is the Party encourages AI exploration. (…)

During the mobile era, a generation of startups led by Tencent, Alibaba Group Holding Ltd. and TikTok-owner ByteDance built an industry that could genuinely rival Silicon Valley. It helped that Facebook, YouTube and WhatsApp were shut out of the booming market of 1.4 billion people. At one point in 2018, venture capital funding in China was even on track to surpass that of the US — until the trade war exacerbated an economic downturn. That situation, where local firms thrive when US rivals are absent, is likely to play out once more in an AI arena from which ChatGPT and Google’s Bard are effectively barred.

Large AI models could eventually behave much like the smartphone operating systems Android and iOS, which provided the infrastructure or platforms on which Tencent, ByteDance and Ant Group Co. broke new ground: in social media with WeChat, video with Douyin and Tiktok, and payments with Alipay. The idea is that generative AI services could speed the emergence of new platforms to host a wave of revolutionary apps for businesses and consumers. (…)

Ford to Lay Off at Least 1,000 Contract, Salaried Workers The cuts are expected to significantly affect engineers in North America.

(…) This latest reduction of Ford’s white-collar workforce includes employees in its electric-vehicle and software side of the business, the company spokesman confirmed.

The cuts will also affect workers in the automaker’s gas-engine and commercial-vehicle divisions, he said. (…)

The salaried job cuts at Ford come weeks ahead of the scheduled start of negotiations with the United Auto Workers union over a new four-year labor contract for its hourly factory workers.

The automaker, along with rivals Stellantis and GM, face an especially tough round of talks with a higher-than-usual risk of a strike, analysts say, citing a hard-line stance taken by the UAW’s new leadership team. (…)

Axios:

Through May, there were about the same number of strikes in 2023 as last year — but the number of workers who walked out went up 80%.

Then this month — really in the past week — there was a lot more action:

• About 3,000 Starbucks workers are on strike this week over gay pride decor and accusations of unfair labor practices.
• Two large strikes in the manufacturing industry got underway — 1,400 members of the United Electrical Workers union at a locomotive plant in Erie, Pa., and one involving about 6,000 workers at a Boeing supplier in Wichita.
• Smaller actions sprung up, too: 84 Amazon drivers at a warehouse in California went on strike, demanding the company recognize their newly certified union. And cooks and cashiers at a McDonald’s in Oakland, Calif., walked out.
• Also in June, hundreds of workers at Gannett walked off the job, as well as 250 members of Insider’s newsroom.
• Meanwhile, the writers’ strike continues.

Starting back in “Striketober,” in 2021, mounting labor unrest was really about the pandemic, Johnnie Kallas, a Ph.D. candidate at Cornell University’s School of Industrial and Labor Relations, who works on its labor action tracker. But now?

• “Workers just feel a lot more empowered,” he said. “The increase in strikes speaks to ongoing discontent not just with wages, but disrespect and contentious negotiations, which are especially pronounced at Starbucks.”
• Unionized workers have struggled to come to a first contract with the coffee company, which has been hit with nearly 600 unfair labor practice charges from the National Labor Relations Board.

For all the renewed energy, unions still play a far diminished role in the U.S. compared to where they were decades ago.

Two major collective bargaining agreements are about to expire.

• Later this summer, 150,000 autoworkers from GM, Ford and Stellantis are set to begin what’s expected to be fairly contentious negotiations for their new contract; the existing one expires on Sept. 14.
• UPS is negotiating a contract with its 340,000 drivers right now — it’s the biggest collective bargaining agreement in North America. The union already voted to authorize a strike if the parties don’t come to terms by July 31 when their contract expires.
• Considering the number of workers these two unions represents, if either walks out that would mark a pivotal moment for labor in the U.S.

Data: Cornell ILR School Labor Action Tracker; Table: Kira Wang/Axios Visuals

Canada: A welcomed deceleration in core inflation

Annual inflation as measured by the consumer price index (CPI) fell sharply in May thanks to both a negative base effect (a sharp rise in May 2022 was removed from the calculation) and a moderation in the monthly momentum.

Indeed, the all-items CPI rose by only 0.1% between April and May after seasonal adjustment, the smallest increase in 6 months. The transportation, clothing & footwear and household operation categories all contributed to the monthly moderation in inflation. Conversely, some components have remained above historical norms, notably food prices, which remain surprisingly strong despite weak global commodity prices.

The housing component also continued to hinder the normalization of inflation, especially rents and mortgage interest costs, which continue to rise at a brisk pace.

The trend in annual inflation is welcome and should improve further next month as another strong increase that occurred in June 2022 is removed from the calculation (negative base effect). While inflation is approaching the upper part of the Bank of Canada’s target range, the Bank has expressed concern about a sustained return to the midpoint of the target. This prompted the Bank of Canada to resume its rate hikes earlier this month.

In this respect, May’s core inflation data may allay some of its fears. After a spike in April, the average of the monthly variation in the CPI trim and the CPI median was 0.22% in May, the smallest increase in 9 months. Going forward, we continue to expect a marked slowdown in economic activity over the coming months, in a context where the real interest rate is now the most restrictive it has been since 2009.

This should be sufficient to ease wage pressures in the Canadian economy, while deflation in global manufactured goods prices should eventually translate into lower prices for consumers.

Goldman Sachs views: Energy and Core Goods Push Down Headline Inflation but Services Inflation Remains Elevated

• Headline CPI inflation declined 1.0pp to +3.4% yoy in May—the lowest level since June 2021—in line with consensus expectations.
• CPI ex food and energy inflation declined to +4.0% yoy in May (vs. +4.4% in April), and the average of the BoC-preferred CPI-trim and CPI-median edged down to +3.85% yoy from an upwardly revised average of +4.25% in April.
• On a three-month average annualized basis, CPI-Trim was roughly unchanged at 3.8% relative to an upwardly revised April value, while CPI-Median declined to +3.6% (vs. +3.8% in April).
• Seasonally adjusted CPI ex food and energy inflation declined to +0.2% in May from +0.3% in April.
• Sequential core goods inflation was essentially flat in May, down from +0.7% in April. Sequential inflation for passenger vehicles also moderated to -0.2%.
• On the other hand, sequential services inflation edged up to +0.4% in May (vs. +0.3% in April) despite a marked slowdown in rent inflation (flat, vs. +1.2% in April) and a large negative contribution from telephone services.
• The rent index has been extremely volatile since 2019 and we think that underlying pace of inflation for rents remains much more elevated than what this monthly sequential prints suggests. Owned-accommodation inflation remained elevated at +0.6% (vs. +0.4% in April) due to another strong print for homeowners’ maintenance and repairs and continued strength in mortgage interest cost inflation. Sequential inflation in homeowners’ replacement cost remained negative at -0.4% in May but we expect that the recent uptick in house prices should put upward pressure on this component in the coming months.
• The BoC will likely revise up their inflation forecasts at the July meeting based on accumulated evidence since the last MPR. We therefore continue to forecast that the BoC will hike in July by 25bp and see risk that further policy tightening will be necessary to return inflation to the BoC’s target, although today’s progress on inflation and the softer May employment report raise some risk that the BoC moves more cautiously.

The FRED series for Canada’s headline CPI below ends in April. The dashed line is where May is at +3.4% vs +4.1% for the U.S.

Taiwan Sends Vice Premier to Japan for First Time in 29 Years

Bank of England Outpaces Peers With Rate Rise of Half Percentage Point Lending rate rises to highest level [5%] since April 2008

(…) Norway’s central bank also increased its core lending rate by half a percentage point Thursday, while Switzerland hiked its benchmark rate by a quarter point. Both warned of further increases in the coming months.

The European Central Bank, the Bank of Canada and the Reserve Bank of Australia have all raised rates by a quarter percentage point in recent weeks. The Federal Reserve kept its key rate unchanged but also signaled it isn’t done raising rates. (…)

Policy Error?

Source: BCA Research via The Daily Shot

Three Uncomfortable Truths For Monetary Policy (IMF)

Excerpts from Gita Gopinath’s yesterday speech at the European Central Bank’s annual conference. You can jump to the last paragraph for the clear message.

(…) Uncomfortable Truth #1: Inflation is taking too long to get back to target.

Inflation forecasters have been optimistic that inflation will revert quickly to target ever since it spiked two years ago. (…) inflation sits well above previous forecasts. (…)
Despite repeated forecast errors, markets remain particularly optimistic that inflation in the euro area and most advanced economies will recede to near-target levels relatively quickly.

These disinflation hopes—likely fueled by the sharp drop in energy prices—underpin expectations that policy rates will decline soon, despite central bank guidance to the contrary. Surveys of market analysts paint a similar picture and suggest that inflation is likely to come down without much of a hit to growth. It is useful to bear in mind that there is not much historical precedent for such an outcome.

Setting aside forecasts, the fact is that inflation is too high and remains broad-based in the euro area, as in many other countries. While headline inflation has eased significantly, inflation in services has stayed high, and the date by when it is expected to return to target could slip further. (…)

The combination of tight labor markets with a still solid stock of household savings and residual pent-up demand may be behind the resilience in activity we have seen so far.

Second, despite the large increase in the nominal policy rate, financial conditions may not be tight enough which impedes monetary policy transmission. (…) real rates using market-based measures of inflation expectations are still quite low, and near-term real rates using household measures are likely negative.

Lastly, the pandemic has likely lowered potential output and productivity, which would also help explain some of the upward pressure on inflation.

What is worrisome is that sustained high inflation could change inflation dynamics and make the task of bringing inflation down more difficult. Given the massive decline in real wages since the pandemic, some wage catchup is to be expected. All else equal, if inflation is to fall quickly, firms must allow their profit margins—which have shot up during the past two years—to decline and absorb some of the expected rise in labor costs. But firms may resist this, especially if the economy remains resilient, while workers may demand payback for their real wage losses. Such dynamics would slow inflation reduction and likely feed into expectations and increase susceptibility to further upside cost or resource pressures. (…)

Ultimately, it is up to central banks to deliver price stability irrespective of fiscal stance. With underlying inflation high and upside inflation risks substantial, risk management considerations in the euro area suggest that monetary policy should continue to tighten and then remain in restrictive territory until core inflation is on a clear downward path.

The ECB—and other central banks in a similar situation—should be prepared to react forcefully to further upside inflation pressures, or to evidence that inflation is more persistent, even if it means much more labor market cooling. The costs of fighting inflation will be significantly larger if a protracted period of high inflation boosts inflation expectations and changes inflation dynamics.

There are also some downside risks to inflation that could arise, for instance, from the recent unwinding of supply chain disruptions and fall in energy prices. The effect of the recent tightening in monetary policy is still working through the system. While central banks must be vigilant about not easing prematurely, they should be prepared to adjust course if a chorus of indicators suggest that these downside inflation risks are materializing.

Uncomfortable Truth #2: Financial stresses could generate tensions between central banks’ price and financial stability objectives.

If inflation persists and central banks need to tighten much more than markets expect, today’s modestly tight financial conditions could give way to a rapid repricing of assets and a sharp rise in credit spreads. We’ve seen during the past year how, under some circumstances, policy tightening can come with significant financial stresses, including in Korea, the UK, and more recently in the US.

For the euro area, tighter monetary policy may also have diverse regional effects, with spreads rising more in some high-debt economies. Higher rates can also amplify other vulnerabilities arising from household indebtedness and a large share of variable rate mortgages in some countries.

This brings me to the second uncomfortable truth:, Financial stresses could generate tensions between central banks’ price and financial stability objectives. This is because, while central banks can extend broad-based liquidity support to solvent banks, they are not equipped to deal with the problems of insolvent borrowers. (…)

While central banks must never lose sight of their commitment to price stability, they could tolerate a somewhat slower return to the inflation target to avert systemic stress. (…)

Such a shift in the reaction function could leave the central bank behind the curve in fighting inflation – as, for instance, happened when the Federal Reserve decided to ease policy in the mid-1960s on fears of a credit crunch, even as inflation pressures were building.

Put simply, while separation is achievable in principle, it is challenging in practice, and must not be taken for granted. (…)

Uncomfortable Truth #3: Central banks are likely to experience more upside inflation risks than before the pandemic.

(…)
Looking forward, central banks are likely to experience more upside inflation risks than before the pandemic for two sets of reasons. Some of the upside risk reflects structural changes affecting aggregate supply—heightened by the pandemic and the war in Ukraine—and that may result in larger and more persistent shocks. In addition, we have also learned the lesson that the Phillips Curve is not reliably flat.

Turning first to structural changes, there is a substantial risk that the more volatile supply shocks of the pandemic era will persist. Despite a considerable easing of pandemic-related supply pressures, the restructuring of global supply chains that was intensified by the pandemic and war, coupled with geo-economic fragmentation, may cause ongoing disruptions to global supply.

Many countries are turning to inward-looking policies, which raise production costs, and, ironically, make countries less resilient and more susceptible to supply-side shocks (WEO, April 2022). (…) the number of new restrictions on trade and foreign direct investment (FDI) imposed on EU countries ratcheted up markedly during the pandemic. EU countries have also increased their own restrictions on in-bound trade and FDI.

The increasing physical and transition risks from climate change are also likely to amplify short-term fluctuations in inflation and output. Delays in achieving Paris Agreement goals increase the risk of a disorderly transition and serious disruptions to energy supply, which could boost inflation sharply and create more difficult tradeoffs for central banks.

The pandemic has also taught us more about the Phillips Curve. Evidence increasingly shows that nonlinearities may become pronounced at high levels of resource utilization, so that inflation is more sensitive to resource pressures. Difficulties in measuring economic slack may also make it harder for policymakers to gauge the point at which inflationary pressures will escalate.

(…) Central banks may need to react more aggressively if the supply shocks are broad-based and affect key sectors of the economy, or if inflation has already been running above target, so that expectations are more likely to be dislodged. They may also need to react more aggressively in a strong economy in which producers can pass on cost hikes more easily and workers are less willing to accept real wage declines. And they should be confident that the shocks are mainly supply-driven, rather than fueled by strong demand.

While the focus now is on high inflation, what we’ve learned about the Phillips Curve also has important implications for the monetary policy response to future periods of below-target inflation. Some refinement may be needed to the “lower-for-longer” strategies—used widely after the Global Financial crisis—that typically involved maintaining policy rates at the effective lower bound until inflation reaches or overshoots its target. Lower-for-longer strategies may still be desirable under some conditions, particularly for an economy in deep recession and facing chronically low inflation.

But the pandemic experience suggests that policymakers should be more cautious about calibrating policy to generate a persistent fall of unemployment below the natural rate U* when inflation is running only modestly below target—say between 1.5 percent and 2 percent. And there could well be a case for preemptive tightening under these conditions if resource pressures appear tight and there is a material risk that new shocks—such as fiscal expansion—could push the economy to overheat.

By allowing for a more gradual pace of tightening, a preemptive approach would also reduce the financial stability risks likely to accompany a rapid exit from low rates (the second uncomfortable truth).

Refining monetary policy strategies also calls for adjusting the use of tool. Forward guidance is a helpful tool, and conditional promises can enhance its impact. But such promises should be tempered by escape clauses if developments unfold much differently than expected. The forward guidance provided by central banks during the pandemic may have been too much of a straitjacket and prevented a faster reaction to inflation surprises.

The costs and benefits of quantitative easing (QE) should also be reconsidered. QE will likely remain a critical tool should central banks face circumstances like the post-GFC period in which unemployment runs high and inflation low even though policy rates have hit their floor. But there should be more wariness of using QE—and accompanying it with forward guidance promising low policy rates—when employment has largely recovered, and inflation remains only modestly below target. Maintaining QE in such circumstances increases the risk that the economy will overheat and that policy will be forced into a sharp U-turn.

So, when we consider the monetary policy of tomorrow, it is important to recall today’s lessons: First, take a closer look at supply shocks before deciding to simply “look through” them. Second, be careful about running the economy hot, and be ready to act preemptively if it does—even if inflation isn’t yet burning brightly. Third, make sure that forward guidance is coupled with escape clauses; and fourth, be more cautious about deploying QE outside of a recession.

To conclude, now is the time to face the three uncomfortable truths that I’ve outlined. Inflation remains sticky; financial stresses could make price and financial stability a difficult balancing act; and more upside inflation risks will likely come our way. I am heartened by the actions that the ECB—and many other central banks—have taken to tackle inflation. But the battle won’t be easy—financial stresses may intensify, and growth may have to slow more. Even so, we know that we can’t have sustained economic growth without a return to price stability. The good news is that while low inflation may seem elusive, it is certainly no stranger, and central bank actions can deliver it. Unlike the characters in Godot, we are not waiting for a potential stranger to arrive; we are inviting an old friend to return.

Not waiting for Godot, fixed income investors are already in risk management mode as Almost Daily Grant’s reports:

Full faith in credit?  Nearly two-thirds of this year’s junk bond supply has been backed by specific collateral, PitchBook-tabulated data from last week show. That’s far and away the highest proportion since at least 2005, surpassing the 37% share seen in 2009 following the acute phase of the financial crisis. With post-pandemic policy tightening pushing benchmark borrowing costs to decade-plus long heights, investors “want to be a little more defensive in an uncertain environment, so they’re buying this secured paper,” Randy Parrish, head of public credit at Voya Investment Management, commented to The Wall Street Journal.

Risk aversion is similarly on display in the floating-rate realm. Issuance of syndicated leveraged loans registered at just $31.3 billion from January through May, marking the weakest primary activity since 2009, when the loan market stood at less than half of its current $1.4 trillion size.

Underscoring the changing market dynamics: only a solitary single-B-minus rated loan backing a leveraged buyout has priced in 2023, compared to 14 such issues in the same period last year.  That comes as the share of single-B-minus issues within the Morningstar LSTA Leveraged Loan Index has ballooned to nearly 30% from 14% on the eve of the pandemic. Meanwhile, borrowers looking to refinance are paying a pretty penny to do so, with the market-wide 9.68% average effective yield representing the highest since Y2K.

Accordingly, it is perhaps no surprise that fewer than 13% of loans outstanding in the Morningstar gauge in April 2022 had been repaid 12 months later, half of the ratio seen last year and the lowest such share since 2009.  The raft of aging vintages may portend building distress, PitchBook notes, as loans have historically defaulted at a 1.4% rate within one year of origination but at a 5.4% clip by year four.

(…) UBS strategist Matthew Mish wrote Wednesday that he anticipates private credit defaults will reach as high as 10% early next year, compared to 8% and 6% for leveraged loans and junk bonds, respectively, as the impact of higher rates takes hold within the opaque asset class (the Proskauer Private Credit Default Index reached 2.15% in the first quarter, up from 1% in the last three months of 2021).  A recession-induced easing cycle could help bring private credit defaults to 5% by late 2024, Mish reckons, though “if rates stay higher for longer and ultimately lead to a less mild recession, we could see a longer cumulative default scenario.”

Analysts at Moody’s express similar concern, warning on Friday that private credit now faces its “first serious challenge.” Loan vintages from the euphoric 2021 era, “when optimism was high, the credit market was most frothy and there was greater tolerance for looser covenants,” could prove particularly problematic, the rating agency believes, as its in-house liquidity stress indicator has risen markedly from a year ago.  Lenders can likewise expect lower recovery rates in the case of future defaults, owing to the steady erosion of covenant strength during the lengthy post-crisis bull market.

FYI:

• Almost half of market participants in a Bloomberg survey expect at least two more rate hikes. That’s a remarkable shift for a market that was pricing in cuts in 2023 as recently as this month.
• A soft landing now appears elusive, though the US may be stuck in a pre-recession limbo for the rest of the year. That’s probably why many investors see fixed-income outperforming commodities and stocks. (Bloomberg)

• Ford plans to fire hundreds of salaried US workers—mostly engineers—this week, people familiar said. 
• Goldman Sachs has started cutting managing directors across its global operations as part of a cost saving drive amid a dealmaking slump. It’s slashing around 125 positions, including some in investment banking, after deal values fell more than 40% this year to $1.2 trillion. These cuts follow reports of similar cost saving exercises at other banks. JPMorgan cut around 40 investment bankers, according to reports last week, while Citigroup is planning hundreds of cuts across the company this year.
• Over the last 12 months the budget deficit has been 8% of GDP (6% ex student loans) while the unemployment rate has averaged 3.6%. Historically this low an unemployment rate is associated with a balanced budget. @jasonfurman

TECHNICALS WATCH

It has now been more than three months since the S&P 500 has pulled back at least 3%, one of the longest such stretches since World War II, Deutsche Bank research shows. The average weekly move for the benchmark has been less than 1% in either direction since the end of March, according to FactSet. In late 2022, the index averaged swings of roughly 2.6% each week.

Others say technical dynamics in the stock and options market have pushed volatility lower. One measure of how tightly stocks within the S&P 500 are moving together, known as correlation, has fallen to some of the lowest levels on record in the past three months, according to Deutsche Bank, a sign that stocks and sectors are moving in dramatically different directions.

This “has been a key driver of lower index [volatility] and suggests a decline in the pricing of macro concerns,” the firm’s analysts wrote in a recent note to clients.

Correlations within stocks haven’t been this low since late 2017 and early 2018, around the time a burst of volatility known as “Volmageddon” jolted markets. If stocks across the S&P 500 start moving in lockstep once again, that would drive volatility higher. (…) (WSJ)