Monday Musings: Quarterly Credit Update

Jun 04, 2021


Public Trust Credit Team
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Large U.S. corporations have strongly bounced back and are on a good footing moving forward. In a trend we view as unlikely to continue, financial policies shifted to be more debt-holder friendly in 2020

Corporate earnings are nearly back to their highs before the COVID-19 pandemic while forward earnings expectations show a very strong Q2 as compared to a year ago. For debt investors, COVID-19 saw a drastic change in financial policy that shifted some risk onto equity investors from debt investors –  in fact, it was one of the largest decreases in returns to shareholders since the Global Financial Crisis (GFC). Coupled with record borrowing in 2020 and increasing cash balances, this led to a very meaningful decrease in net debt loads across the S&P 500. However, we see this trend as unlikely to continue; guidance from Q1 suggests that companies are again willing to return capital to shareholders after protecting their balance sheets in 2020, leading us to believe that we have hit a trough on shareholder returns, and they are likely to increase moving forward.

The influx of cash on balance sheets has led to most M&A deals being done in cash this year and a stark decrease in premiums paid compared to last year

We have seen evidence that banks are largely not ready to participate in M&A and that the equity run-up of 2020 coupled with a still uncertain outlook for some industries will keep M&A volume down this year. Despite rates being so low, high valuations will likely stymie transformative acquisitions, meaning that small cash bolt-ons are the most likely source of deal volume which tend to carry lower premiums.

Equity valuations and spreads have us thinking about the possibility of a “regime” change in the markets

A regime change in the markets is best described as a new normal – one that cannot necessarily be compared apples-to-apples with a previous market cycle. Even though the U.S. has been in a recession since February of 2020, equity valuations have not made a meaningful revision to the levels seen post-GFC. Forward P/E multiples for the S&P are at ~15x, substantially higher than the ~10x we saw companies average post-GFC. One explanation for this is a reconstitution of the index as tech now accounts for 30% of the index versus 18% in 2009, and in general, tech tends to have higher valuations. When coupled with spreads, we have to wonder whether the U.S. will enter expansion at levels we would normally expect at the end of an expansion. This is the basis of a regime change; when the new business cycle is likely called by the National Bureau of Economic Research (NBER) this year, corporations will be starting from a relative position of strength, potentially leading to permanently higher valuations and tighter credit spreads than we are used to seeing during expansion.

How the pandemic impacted business and consumer loan demand and what to expect as the recovery accelerates

At the onset of the pandemic, commercial and industrial (C&I) loan balances experienced a significant spike as a result of companies drawing down on existing lines of credit and participating in the Paycheck Participation Program to secure liquidity. The decrease in observed balances following Q2 2020 is primarily attributable to those businesses repaying the loans originated from credit lines with demand largely remaining muted since. In aggregate, the U.S. banking sector saw a decline in total loans for the first time in 10 years in 2020. Despite a still booming housing market, real estate loan balances are little changed over the past year, the product of nonbank mortgage originators gaining significant market share; original bank lenders securitizing most new mortgages; and the continued trend of mortgage prepayment owing to a surge in refinancing. Increasing demand for auto loans in the first quarter is beginning to drive growth in other consumer loans.

However, outstanding credit card balances continue to trend down. A poll taken by the New York Federal Reserve following the second round of government stimulus payments found that marginal propensity to consume was particularly low amongst respondents with 29% of funds used for consumption compared to 36% saved and 35% used to pay down debt, namely card balances. According to the latest Senior Loan Officer Opinion Survey (April 2021), banks are starting to ease their underwriting standards across almost all lending categories after having tightened them significantly from Q2 2020 through Q4 2020. As the economy continues to strengthen, we expect this recent paradigm shift to translate into higher consumer loan balances in subsequent quarters, particularly against the absence of additional stimulus checks and households having built up a significant savings buffer over the past year.

Domestic home price appreciation seems to increase with each report

According to a publication in April by the National Association of Home Builders (NAHB), the dramatic increase in lumber prices has increased the cost of a new single-family home by nearly $36k while also adding approximately $13k to the market value of an average new multifamily home – equating to an increase of $119 a month in rent for a new apartment. A trend that started in Q2 2020 and has continued into 2021, the NAHB Home Building Geography Index revealed a shift in new home construction to low cost and low-density markets, mainly due to the COVID-19 pandemic. These phenomena can be witnessed in the month-over-month growth in the Case-Schiller 20 City Composite, with March 2021 reaching 1.60% growth compared to the prior business cycle average of 0.35%. Additionally, NAHB notes that inventory levels remain low at a 4.4 month supply with roughly 316k new single-family homes for sales, approximately 33% lower than April 2020. With strong demand for housing, lower inventory levels, and a significant uptick in lumber prices, we do not anticipate home price appreciation to trend down any time soon.

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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