Why are CLOs pricing in a worse recession than Moody’s?
The Q2 earnings season kicked off in the US last week with the big global banks leading the way as usual, and despite a slightly mixed picture bank results so far have been resilient overall. However, like us, many market participants will have been just as interested in what the banks had to say about the state of the US economy and the strength of the US consumer as they were in the actual results. After all, these banks have an incredible amount of data coming in from almost every cohort of the US economy, and in real time, so it’s certainly worth taking heed of their commentary on these matters.
Yet again, the message we received was that the consumer remains in good shape, and a consumer-led recession doesn’t seem to be imminent. Some highlights:
In addition to these positive comments on the consumer, Moynihan also noted BofA had seen improvements in asset quality, while JP Morgan’s CFO, Jeremy Barnum, went further and said “We’ve looked a lot, very carefully, into our actual data and there’s essentially no evidence of any weakness,” citing “very strong credit performance” despite rising interest rates. JP Morgan did however note that lower income households were not as resilient as its typical ‘prime’ customer.
So with consumers seemingly refusing to roll over and rein in spending, where does that leave the Fed?
Moynihan probably put it best in one of his interviews when he described the consumer as “the greatest benefit and the greatest trouble to the Fed,” adding that the three months to the end of June was the highest debit card spending on record the bank had seen.
This is a difficult conundrum for the Fed to deal with. How do you weaken a consumer seemingly determined to enjoy some post-pandemic spending enough to slow the economy and put a lid on inflation? Strangely, the evidence that some businesses are slowing hirings – with Apple joining the trend on Monday – is probably welcome news, as it’s likely that a higher unemployment rate will be part of the solution if the Fed is to engineer its soft landing.
It is also pretty clear to us that this is not just a US phenomenon. The holiday season is in full swing in Europe as well, with plenty of evidence that flights, hotels and restaurants are packed to capacity, and there is also evidence that this spending is extending into 2023 reservations. It seems pent-up demand will not slow this summer, and it looks increasingly likely that we will need to wait for the autumn for demand to soften, which suggests inflation is also unlikely to slow significantly in the short term.
All this evidence of strong consumer health does rather beg the question: why are spreads in fixed income pricing in not just a recession, but a fairly severe one? There is no question that investors are weary given the very difficult first half of the year, and mutual fund flows are yet to provide much support. In addition, central banks still need to try to tame inflation, which does weigh on sentiment, but risk-on spreads are pointing to a significant recession and high default rates, neither of which are being forecast at the moment, and that is also not what is being experienced on the ground through bank lending markets.
Are the banks wrong? Or have credit markets just backed up too far on negative fund flows? We think it is most likely the latter, but a change in sentiment will be needed to rectify this disconnect between valuations and fundamentals.