The financing gap in the S&P 500 remains negative as companies burn through cash to keep the lights on.
Throughout 2022, we have seen a relatively stable financing gap in the S&P 500 companies. In Q2, S&P 500 companies paid out an average $67 billion more than they generated. As many companies have been sitting on large sums of cash accumulated over the past few years, companies are finding it more attractive to tap into their cash reserves than take out debt to fund their operations. Given the turmoil triggered by the Russia and Ukraine conflict, the ongoing supply chain issues, and rising inflation, companies are finding it increasingly difficult to fund their costs solely off their normal business operations. Net debt loads of S&P 500 companies have increased moderately over the year, indicating companies are spending their cash quicker than they are accumulating debt. So long as rates are increasing and corporations have enough cash on hand to operate their business, we could see rising net debt balances and the financing gap staying in the negative territory for the near term.
We expect lending to moderate and delinquencies to increase from their current lows.
The Federal Reserve has steadily increased rates this year leading to an acceleration of lending earlier in the year which we suspect has softened over the summer. According to the most recent senior loan officer survey, banks are tightening their underwriting standards and have begun to see demand weaken as consumers deal with higher rates. Lower demand has begun flowing through our housing price data where even though prices remain at record highs, month-over-month growth declined from 2.5% in May to 0.5% in August. The U.S. mortgage rates have increased to over 6.00% and pushed many buyers, especially first-time buyers, out of the market. An August survey by Fannie Mae found that most respondents expect home prices to decline slightly over the next 12 months which is the first time since 2020 and more interestingly 2012 before that. While borrowers are less likely to take out new mortgage debt in our view, we note that credit card balances are increasing which was also noted by the banks.
Across the board, U.S. banks began provisioning for loan losses again in Q2 2022 which signals that they believe asset quality is likely to take a hit and more loans will start to go bad. However, we have yet to see this flow into the data and we note that delinquencies across loan classes are near post-crisis lows. This is unsustainable in our view and delinquencies are likely to increase as inflation eats at consumer balance sheets and rates continue increasing. We’ve seen data suggesting that 60+ day delinquencies are increasing and we expect these to flow into 90+ day numbers as well which will be negative for the economy. Finally, we note that while student loan forgiveness will probably have some economic effects, we believe that because the forgiveness is on the principal balance and not in the form of a check, forgiveness will likely have a muted effect on delinquencies which is further supported by the extension of the payment freeze until next year.
U.S. household debt to GDP, a key measure of a weakening economy, has topped 80% for the first time since the COVID-19 recession (and the Global Financial Crisis before that).
In normal environments, an increase in household debt also increases consumption and GDP growth in the short term (less than one year) but slows both factors in the long term. These slowdown effects are intensified if debt/GDP crosses the 80% threshold, a level which we have just passed in the most recently measured period, Q1 2022. Many economists believe that rising household debt is a strong predictor of economic downturn, and that this metric could have been used as one of the harbingers of the 2008 recession. However, this figure is being pushed higher by back-to-back quarters of negative GDP growth in the current recessionary environment, versus in normal environments where GDP grows and softens the ratio. While household debt/GDP is an important figure that is certainly worth monitoring, a return to positive GDP growth would raise the denominator and help tame this elevated metric.
Meaningfully elevated correlation of stocks & bonds doesn’t capture whole story.
The correlation of stocks and bonds is higher now than during the global financial crisis; this means that publicly traded securities will rise and fall in tandem, not opposite to one another. While the continued cycle of Fed rates hikes is likely responsible, the market’s confidence in future increases hasn’t subdued volatility. Fixed income volatility is substantially elevated relative to the post-quarantine period, but the Chicago Board Options Exchange’s Volatility Index (VIX) Index is range bound for the same period. This suggests greater concern in fixed-income markets which is consistent with the wholesale tightening of credit spreads but somewhat contrary to the fair valuation of the high yield market. Here we note that investment grade securities tend to be more sensitive to rate movements while high yield bonds may more closely track issuer fundamentals. This is similar to public equities that are currently approximating the average of the prior business cycle. Such a valuation could reflect overly-optimistic projections of future earnings as market prognosticators have warned that investor optimism in earnings is unwarranted, and the recent decline in earnings seems to support this idea.
Softening prices, moderating manufacturing growth, and accelerating non-manufacturing expansion could suggest inflation has peaked.
Recent trends in the Institute for Supply Management’s (ISM) purchasing managers index (PMI) and non-manufacturing index (NMI) reflect moderating expansion in the manufacturing sector and accelerating expansion for non-manufacturing sectors (Ex. 4). Since May 2022, the PMI values have declined from 56.1 to 52.8 and during the same period, NMI values increased from 55.9 to 56.9 (values above 50 indicate expansion within the sector compared to the prior month). For both manufacturing and non-manufacturing sectors, ISM index values also reflect softening prices which, in conjunction with the accelerating non-manufacturing sector expansion, could indicate that inflation levels may have peaked. Softening prices while demand remains strong could reflect a movement towards a more sustainable relationship between supply and demand which could curb medium-term inflationary pressures.
