Credit Musings: October 24, 2022

Oct 24, 2022

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Public Trust Credit Team

Turbulence in the Chinese markets.

Today, China released its third quarter GDP figures showing a mixed bag of results. China has been battling intensified economic slowdown due to the extended COVID-19 lockdowns implemented earlier this year as part of their Zero-COVID policy in which some cities populations were forced to remain in their homes for weeks or even months on end. We are seeing the beginning of a gradual recovery with the Q3 GDP figure published at 3.9%, beating economists’ forecasts of 3.5%. This also comes as reassurance compared to the Q2 year-over-year GDP growth of 0.4%. However, the Q3 results are not as promising as China’s GDP figure in Q1 of 4.8%. The first three quarters of 2022 bring China’s total GDP growth to 3%, well short of the 5.5% full-year target. The International Monetary Fund continues to dampen China’s GDP figures in the near-term as well, highlighting weakened consumer confidence and property sector slowdown. Chinese new-home prices collapsed at the most dramatic level in 7 years this September. Retail sales, a common measure of consumer spending, rose a weaker-than-expected 2.5%, a drop from the 5.4% figure published for August. In current event news, the sitting Chinese leader Xi Jinping secured an unprecedented third consecutive term as leader of the Chinese Communist Party. This immediately caused ripple effects in the Chinese markets, leading to the biggest single day sell-off in the Hang-Sang index since the Global Financial Crisis. The Hang-Seng index saw a stark decline of 6.4% in Monday trading as foreign investors withdrew $2.5 billion from the equity markets, the biggest single-day outflow in the trading link Stock Connect channel since its inception in 2014. Chinese internet and technology companies faced the most severe impact due to speculation that Xi Jinping will institute more stringent crackdowns on the private sector. As China maneuvers even more toward state-owned rather than private-owned enterprises, it needs to be careful not to deter too much foreign capital that plays a vital role in the overall economic health of the country. It will be an uphill battle for China to increase consumer confidence and continue to bolster its GDP figures, particularly in the near-term.

Tumultuous political and economic climate spurs U.K. prime minister transition after only 6-week tenure.

Rishi Sunak, the U.K.’s former treasury chief, is set to become its next prime minister.  Sunak succeeds Liz Truss whose six weeks as prime minister were extremely tumultuous. Her proposed tax-cut plan and increased spending programs introduced significant turbulence in financial markets and ultimately resulted in her resignation.

Sunak inherits a pressured political climate and a country battling significant economic headwinds. In his first televised address as the U.K. leader, Sunak warned that the economic crisis that the U.K. faced was “profound.” One of Sunak’s advantages coming into the contest to succeed Truss is the perception that he is strong on economic policy due in part to his background as an investment banker at Goldman Sachs, receiving an M.B.A. from Stanford, and his service as the U.K.’s treasury chief. His economic aptitude will likely be put to the test as the U.K. continues to contend with high inflation, the second-order impacts from the Russia-Ukraine war including possible energy shortages, and the potential pressures on U.K. businesses and households during an economic slowdown. It will remain prudent to monitor the impact that his leadership will have on the U.K. economy and the global economy at large. 

U.S. corporates expected to have weak earnings setting-up a divergence between high yield (HY) and investment grade (IG).

This week roughly one-third of the S&P 500 will report earnings and results are broadly expected to be poor. According to Factset, revenues for the index are projected to grow 8.5% from a year earlier while earnings are expected to advance just 1.5% due to rising prices, margin compression, and waning consumer demand. The spotlight this week is on the “Megacap” tech companies like Apple who are on track to report their third straight quarter of earnings declines and makeup over one-fifth of the index. Slowing economic activity, persistent inflation, and rising rates have starkly changed the economic environment which is setting up a widening separation between IG and HY companies. Highly-rated companies still have strong balance sheets and have been judicious with debt as rates have increased, meaning their leverage has not grown materially and interest coverage remains strong. However, HY companies that don’t have the option of not borrowing or pushing off their borrowing are beginning to see interest expense take up a larger and larger portion of their operating profits. This sets up an environment where IG firms can slow or stop borrowing completely which should be positive for spreads, whereas HY firms will continue to need funds and will likely continue to see their spreads widen. Rates tend to be felt more harshly the lower-rated a borrower is and the quick step up in rates this year combined with slowing activity will lead to stress in this market. However, we still believe the balance sheets of investment-grade companies are very strong and can withstand further deterioration in credit conditions.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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