Keep calm about credit markets

Credit markets have made the headlines but despite a smattering of defaults, the broader picture remains reassuring.

The collapse of Dallas-based subprime lender Tricolor Holdings and, a short while later, the bankruptcy of car parts manufacturer First Brands has caused some lenders to look again at the health of the debt sector.

But in both cases, there were issues confined to the companies – and to some extent, their industries – that brought them down. Tricolor lent to ‘underbanked’ borrowers. These are people who have a bank account but often rely on alternative financial services including money orders and payday loans with many therefore lacking credit scores. There have also been allegations of fraud at Tricolor, which US authorities are now investigating.

Meanwhile, Michigan-based First Brands had accumulated a huge amount of debt following an acquisition spree. The company’s assets and cash buffer became dwarfed by its liabilities, and the supplier of auto parts began to look more like a finance firm. Corporate strategy and the opacity of its financial structure was ultimately behind First Brands’ failure. Elsewhere in the US there has been concern over the creditworthiness of smaller, regional banks - but thankfully, these institutions are not large enough to threaten the broader financial system.

In fact, the growth of private credit has helped diversify the range of lending sources for borrowers, which means the financial system is more resilient today than it was 15 years ago. Overall, there is little evidence that systemic risk is building across the credit sector as a whole. One of the key metrics we monitor is default rates. As US interest rates have risen from the record lows reached during the pandemic, there has been a corresponding uptick in default rates for both public and private credit markets, according to ratings agency, Fitch.

But even with this increase, default rates still remain within the normal ranges of 2%-5% annually, depending on the sector. Although these high-profile bankruptcies have shone a light on the risk of corporate defaults, we have to bear in mind that some degree of default risk has always been among the range of risks that investors in credit must factor in. Of course, less credit-worthy assets come with additional yield to compensate for taking on greater risk.

The lesson to be learned from recent events is the importance of monitoring a company’s fundamentals while invested, in addition to the initial due diligence and diversification. We keep a close eye on a range of corporate metrics including net debt to operating profit and interest coverage (which is a company’s operating profit as a multiple of interest expenses). Both of these remain within historical norms.

Overall, the fundamentals of US and European corporate debt (which makes up the majority of our portfolios’ credit exposure) remains decent – and there’s no compelling reason for investors to immediately divest their credit holdings.

Spotlight on consumer staples

US stock markets have risen strongly this year, but the divergence in performance of different sectors reflects an emerging trend in the economy – one that economists are calling ‘the K shaped economy’.

This economy is one that’s characterised by financially strong corporates, expanding wealth and GDP growth (the upper arms of the K), but is dragged down by less well-performing businesses and a significant cohort of households that are struggling financially (the lower legs of the K).

This divergence can be seen in the weaker stock market performance of consumer staples companies and those with greater reliance on discretionary spending. These are often household names and manufacturers of food, drinks, cleaning products and everyday necessities. Typically, these companies are considered ‘defensive’ as there is stable demand for their products, which means their corporate earnings tend to be less volatile from one quarter to the next, and their share prices are more resilient during market downturns.

But over the past year, the consumer staples sector has underperformed both in the US and globally, relative to the wider global equity market. Valuations in the sector are currently below the average for global equities and earnings growth has been muted. Consumers at the lower end of the income spectrum are feeling the pinch, with the ongoing high cost of living. Some households are trading down from preferred brands to cheaper alternatives, which in turn is affecting companies’ pricing power.

On the manufacturing side, corporate profit margins have been pressured by elevated input costs, and the sector faces headwinds from US tariff policies. Broker estimates for the consumer staples sector are for 6.5% earnings growth over the next 12 months, which is a rebound from the flat to slightly negative growth posted for the last year. The wider US equity market is forecast to produce earnings growth of 12% in the next 12 months.

The fortunes of the consumer staples sector stands out relative to technology and communication stocks. Led by the mega-cap Magnificent Seven – Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla – these sectors have significantly outperformed the wider US equity market.

Earnings growth for these companies has been exceptional; for the third quarter they are expected to achieve earnings growth of around 30% year-on-year.

These firms are benefitting from having scalable business models, high profit margins and robust demand for cloud data services. They have also made sustained levels of investment and are well-positioned to benefit from the continuing build-out of AI infrastructure.

Global stocks supported by corporate earnings

Turning from the US and the K-shaped economy theory, our interest was piqued by this chart (below) showing how rising corporate earnings have supported global stock markets.