Last year, we published four notes between February and August on the consumer, housing, corporate default risks and commercial real estate (CRE).1 In this note, we review the outlook for the four sectors given the changes since the middle of last year, especially the sharp rise of inflation, the change in Fed policy and the increasing risk of recession.
In our view, the economy has enough momentum coming out of the Corona pandemic to sustain growth this year. However, we think the risk of recession will rise appreciably in the course of next year as monetary and operating conditions tighten.
We expect that the changing environment will impact all parts of the economy, especially interest-rate-sensitive sectors like housing. From a credit perspective, we believe this environment will create more challenges for the business sector than private households. We also expect more bifurcation between different credits. Finally, with the Fed just starting to hike interest rates, we continue to prefer floating rate products.
We were optimistic on the prospect of economic recovery from the Corona pandemic when we wrote the four sector outlooks earlier last year. In our judgment, the overall performance in the four sectors has been as expected and even better in some parts despite setbacks from new Corona variants and supply shortages.
Household finances appeared to us to be in good shape, supporting consumption and housing investment.
Indeed, real personal consumption was in March 4.7% higher than before the Corona Pandemic.2 Housing activity has moderated from the boom that followed the initial Corona outbreak, but remained strong and above the pre-pandemic level, while house prices continued to rise rapidly.3
Our outlook for corporate default risks was more cautious. We thought that corporate default rates were already low in the middle of last year and saw upside risks due to margin pressures and high leverage. So far, this has not happened. In fact, default rates slipped further, to below 1% (see Chart 1).
Source: JPMorgan4
Our outlook for CRE was also mixed. We were optimistic on multi-family, industrial and lodging, yet saw difficulties in the office and retail space. Overall, the CRE recovery has met and even exceeded our expectations (see Table). Retail, in particular, has done better than we anticipated and only office space, as shown, lagged behind the overall CRE recovery.
1) Rent % change over a year ago, 2) % vacancy rate, 3) average daily room rate % change over a year ago, 4) % occupancy rate
Source: Co-Star5
The environment has changed significantly since we published last year’s four sector outlooks. The two key changes are inflation and Fed policy.
High inflation and monetary tightening have negative implications for businesses and households (margin pressure, reduced real spending power, tighter funding conditions). We expect these pressures will reduce growth in 2022 but not result in the kind of operating and financial stress that typically leads to recession.
Source: US Bureau of Economic Analysis12
Source: Freddie Mac and MBA13/sup>
The first quarter GDP report was disappointing, but not a sign of weak demand.14 We believe the main risk of recession in 2022 is not inflation or Fed policy but, rather, from outside the US, notably from Europe due to the war in Ukraine, and from China, which struggles to overcome Corona and a housing bubble.
We expect the risk of recession to rise appreciably in 2023, especially if inflation remains stubbornly high and the Fed is forced to tighten more than currently projected. The pressure is likely to be felt in all parts of the economy and undermine growth, with recession risks likely to be highest in the business sector.
In our judgment, the combination of slowing economic activity, heightened inflationary pressures and full employment will squeeze profit margins. This should become more visible as the impact of Corona-related government support fades. Based on our estimates, government support currently still accounts for about one eighth of the aggregate business sector profit margin.15 We believe this support will be gone by 2023 and consequently will expose the firms with weak operating fundamentals.16
We expect that falling profit margins plus tighter debt and equity market conditions will force more companies to cut production, lay off staff and, in some cases, declare default. The economy may still avoid recession as it is, in or view, less vulnerable than before the financial and the dot-com crises, but we expect the risk will be much higher.
No matter whether the economy slows or goes into recession, we think implications for household and business debt will be different for three reasons.
Source: Board of Governors of the Federal Reserve System and US Bureau of Economic Analysis17
Source: New York Fed Consumer Credit Panel/Equifax (ARM is the share of adjustable rate mortgages)18
Source: JPMorgan; *) Lower-grade business debt is BBB and HY debt plus leveraged loans19
Source: New York Fed Consumer Credit Panel/Equifax20
From an investment perspective, we think our outlook for the economy and credit fundamentals heightens the importance of credit selection, as tightening financial conditions will likely encourage increased credit dispersion. As a result, we expect tail credits to be most vulnerable. Further, as the Fed has just started to hike interest rates, we see continued value in floating rate structures.
We are constructive on credit fundamentals for securities backed by residential assets (RMBS) despite the expected moderation in home price appreciation. We think RMBS has repriced meaningfully into this volatile macro back drop. Floating rate products like GSE credit risk transfer and SFR continue to offer attractive risk adjusted returns, in our view, but recommend picking credits selectively and analyzing structural leverage carefully (for example, looking at equity cushions built up in homes).
Despite overall good household health, we expect more bifurcation between income groups. As a result, we look for markets to tier more visibly between various consumer ABS (credit cards and auto loans vs. unsecured consumer loans) as well as among originators of various loan types based on credit performance. The recent move higher both in risk-free rates and risk premiums makes mezzanine asset-backed debt look attractive to us, as well as floating rate asset backed lending.
We view default risks for high yield bonds and leveraged loans as being similar from a macro perspective. However, as outlined in a previous issue of ZAIS Insights, we prefer CLOs over corporate bonds.21 First, we see the active portfolio management of CLOs as offering better default risk diversification. Second, we expect that floating rate products like leveraged loans and CLOs should continue to benefit from the rising interest rate environment.
Within the CLO space, we favor the BB portion of the capital stack. While potentially susceptible to price volatility, we believe CLO BBs are well protected against our expectation for default normalization within the corporate sector and offer strong cashflows. We also believe there is value to be found in longer reinvest CLO equity from high quality managers who have the ability to capitalize on distress through portfolio repositioning.
We do not believe CMBS spreads have widened enough to attract more buyers in a rising interest rate environment. We expect capital rate pressure from rising interest rates and anticipate diverging CMBS performance, reflecting the uneven lasting impact from the pandemic as well as the varying ability to withstand inflation by passing costs on to tenants. For example, we believe the office sector has yet to fully rationalize the impact of work from home and now faces the prospect of slowing corporate growth. On the other hand, we think that multifamily should hold in better due to abundant investor capital and strong tenant demand.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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