Dealing with Structural Evolution

Dealing with Structural Evolution

12/02/2024 07:02 AM

Dealing with Structural Evolution

NEW YORK: December 2, 2024: Equity markets have been behaving as if U.S. economic growth is the main theme. In fact, U.S. equities have been outperforming other asset classes for over a decade. As a result, the 90-day correlation between stocks and bonds have returned to negative territory. If inflation concerns resurface, which we think they will, this correlation will likely revert to positive territory in sudden swings.

Figure 1: Correlation Between Stocks and Bonds

The 10-year move following the rate cut has been unprecedented, as you can see in Figure 2. Higher long-term rates are exacting a toll on leveraged companies as rising interest expenses hurt reported net income.

Figure 2: 10-Year Note Yield Change After the First Cut

Another impact of the rising 10-Year yield is growing volatility, potential crowding out effect, which could reverse the shrinking spreads on risky loans and negatively impact their refinancing. The level of implied volatility in the US Treasury markets measured by the MOVE Index continues to be elevated at a level rarely seen outside of a recessionary period.

Figure 2: ICE BofAML MOVE Index

The increase in long-term rates reflects ongoing U.S. deficit spending, which is clearly evident in Figure 3. Critically, this is a spending problem, not a revenue problem, as shown in Figure 4. The combination of the deficit and the Fed's leveraged balance sheet reveals the limits of fiscal and monetary policy in the event of an economic slowdown. This calls into question whether the rate cuts were a mistake, or whether they further amplify the constant negative revisions in reported economic data.

The bottom line is this: The U.S. spending and deficit cycle has created a structural problem for long-term rates that will not be easy to reverse and is subject to further pressure from inflationary risks.

Figure 3: Federal Deficit - Monthly

Figure 4: Federal Receipts and Outlays

The resulting bear steepener in the US treasury rates has not been seen in quite some time. What will the impact be on bank balance sheet strategy? With respect to inflation, the bond market has a history of being in front of equity markets. Does the current reversal reflect the fact that persistent inflation has not been stamped out? Higher long-term rates with weakening economic conditions have a history of leading to higher default rates. The increased MOVE Index is a warning to actively monitor market conditions and portfolio structure and be prepared to move quickly and proactively.

Contemporaneous Credit Conditions
The Kamakura Troubled Company Index® closed the month at 8.77%, down 0.61% from the prior month. The index measures the percentage of 42,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the end of November, the percentage of companies with a default probability between 1% and 5% was 6.35%. The percentage with a default probability between 5% and 10% was 1.34%. Those with a default probability between 10% and 20% amounted to 0.84% of the total; and those with a default probability of over 20% amounted to 0.24%. For the month, short-term default probabilities ranged from a low of 8.48% on November 7 to a high of 9.10% on November 1.

Figure 4: Troubled Company Index®, November 29, 2024

At the end of November, the riskiest 1% of rated public firms within the coverage universe as measured by 1-month default probability included 9 companies in the U.S. and one each in Brazil, Canada and the UK. The riskiest firm continued to be the Container Store Group (NYSE:TCS), with a one-month KDP of 43.01%, down 8.86% for the month.

Table 1: Riskiest Rated Companies Based on 1-month KDP, November 29, 2024

The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate of 0.52% up 0.03% from the prior month, with the 10-year rate up 0.15% at 8.91%.

Figure 5: Expected Cumulative Default Rates, November 29, 2024

About the Troubled Company Index
The Kamakura Troubled Company Index^® measures the percentage of 42,500 public firms in 76 countries that have an annualized one-month default risk of over one percent. The average index value since January 1990 is 14.06%. Since July 2022, the index has used the annualized one-month default probability produced by the KRIS version 7.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.

The KRIS version 7.0 models were developed using a data base of more than 4 million observations and more than 4,000 corporate failures. A complete technical guide, including full model test results and key parameters, is provided to subscribers. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model.

The version 7.0 model was estimated over the period from 1990, through the Great Recession and ending in February 2022. The 76 countries currently covered by the index are Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.

About SAS
SAS is the leader in analytics. Through innovative software and services, SAS empowers and inspires customers around the world to transform data into intelligence. SAS gives you THE POWER TO KNOW^®.

Editorial contacts:

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