The increased usage of fixed rate debt across developed market economies between 2020 and 2022 has shielded corporates and consumers from the impact of higher rates. But for how long?
The state of interest rates 2–3 years from now will be a critical factor for corporate credit markets as the maturity schedule for lower-quality corporate credit becomes far more significant in 2025.
In evaluating global central bank performance in fighting inflation so far – while keeping the prospect of a “soft” economic landing alive – I would quote the great Larry David: “Pretty … pretty … pretty good.”
However, as noted in our Q2 2023 Outlook, central bankers cannot claim victory yet. The full impact of the massive interest rate hikes will continue to work its way through global economies in a lagged manner, and there is the risk of increased pressure on credit markets and economies if interest rates remain high for longer.
While financial and lending conditions have tightened across global economies, they have not been overly restrictive. This is an outcome consistent with central bank mandates to fight inflation, as well as avoid causing a recession.
The Bloomberg US Financial Conditions Index (Figure 1) demonstrates that conditions are still slightly above the neutral level (the significant tightening earlier in 2023 was a temporary, idiosyncratic episode related to the US regional bank stress).
Figure 1: Bloomberg US Financial Conditions Index (31 December 2021–26 September 2023)
The latest global bank lending surveys tell us that credit conditions are still tightening, even if modestly. The G-4 Senior Loan Officer Opinion Survey proxy points to a continued negative credit impulse in coming quarters despite modest positive credit growth.1
Even without further tightening in lending conditions, the accumulated credit constraints are expected to hinder economic activity in the next few quarters. Lenders are likely to remain cautious, and there is risk that banks’ willingness to extend credit tightens even further.
Fortunately, consumer, bank and corporate balance sheets in developed market economies have remained healthy despite the rapid interest rate hikes. This resilience can be attributed to the ability of these constituents to issue and refinance debt at very low interest rates following the COVID-19 shock.
The increased usage of fixed rate debt across developed market economies between 2020 and 2022 (both corporate and consumer) has helped mitigate the impact that higher rates have had on debt servicing costs for consumers and businesses. This has been especially beneficial to the US economy, where the mortgage markets are heavily skewed toward the 30-year debt duration.
Indeed, after the refinancing boom of 2020–21, the average effective interest rate on mortgage debt has barely budged since the US Federal Reserve (Fed) started hiking, and remains near a record low.
Bankruptcy data also suggests that consumers and businesses are coping well with higher interest rates. Non-business bankruptcies have barely risen, while business bankruptcies have increased – though they are still below their pre-pandemic level.
All this is consistent with the idea that the increased prevalence of fixed-rate debt is shielding borrowers from high interest rates.2
Despite the economic resilience we have seen so far, over time, higher rates are still likely to take further toll on consumption and business investment as more debt needs to be refinanced.
Such expectations will also continue to dampen demand for new loans. In the global corporate debt sector, greater reliance on fixed-rate financing during 2020–22 is unlikely to provide a lasting shield from central bank tightening as the maturity schedule – starting in 2025 – becomes more significant.3
For investment-grade-rated corporates, materially higher interest rate expense costs will negatively impact profits, and could deter capital expenditure and hiring plans. However, for lower-rated, and more highly levered corporations (high-yield-rated corporates and leveraged loan borrowers), any need to refinance debt at significantly higher rates is more likely to threaten solvency.
The maturity schedule for lower-quality corporate credit becomes far more significant in 2025, and the years beyond, so the state of interest rates two or three years from now will be a critical factor for corporate credit markets, particularly outside of the investment grade universe.
Developed market central banks are signaling the need for sustained higher policy rate, driven by concerns that economic resilience could lead to persistent inflation. Such policies may compress profit margins, slowly erode balance sheets, and bring an end to the economic expansion.
Whether or not a technical recession occurs, we believe that subpar growth will cause a re-examination of the lower-end of the credit spectrum. As such, our credit research team is vigilant in limiting exposure to credit profiles that could be negatively impacted by the more leveraged parts of global economy.
The Fed took decisive action in the wake of the regional banking turmoil earlier this year, which has improved confidence in the banking sector.
The sector’s Q2 results generally exceeded beaten-down consensus estimates as large money-center banks outperformed regional banks, excluding those with a greater focus on capital markets.
The sector’s earnings remain relatively strong, with revenue and pre-provision profit up nicely year-on-year (YoY), though on a QoQ basis they have been weakening on higher funding costs and a lower-yielding asset mix.
Looking ahead, guidance has been generally lowered in relation to net interest income (NII) and net interest margin (NIM), and some banks cited green shoots in certain non-interest income categories (i.e., investment banking, trading, and wealth). There also is a renewed focus on expenses, which should be a key element for banks in FY 2024.
During the September conference season, large banks generally reiterated guidance from July – that the pace of incremental weakening in NII is slowing, and that the deposit mix and deposit cost trends are showing some stability.
While this has renewed hopes that deposit beta guidance revisions are in their final stages, and that NIMs could stabilize in the near term, higher rates are the most significant risk for future earnings, given headwinds posed to growth, margins and credit in a higher-for-longer environment.
Aside from rates, loan growth, outside of cards, remains fairly muted, driven both by demand (i.e., slowing economy, higher rates) and reduced supply of loans. The latter increasingly reflects a more defensive posture taken in recent quarters around capital, reserves, and liquidity/funding.
Part of the defensive posture taken by banks revolves around new regulations, some of which were proposed this quarter. This includes the new Basel III “Endgame” capital rules for banks with assets greater than USD 100 billion, as well as new long-term debt (LTD) rules for regional banks of similar size.
While the latter seems more manageable than some had expected, proposed capital rules look quite onerous, especially for the largest G-SIBs. It is worth watching whether there would be an active effort from the sector, as well as a bipartisan group of lawmakers, to fight back against the new capital rules. The feeling is that these rules will drive activity out of the regulated banking sector, put the US at a competitive disadvantage vs. foreign banks, and hurt credit availability in the economy (and liquidity in the financial markets).
On the macro front, the ‘‘good news” is that, while the likelihood of an imminent recession appears to have declined of late, banks are still preparing for tougher times, with reserves accounting for 5%–6.5% unemployment vs. 3.8% in August.
If a potential recession is pushed out, credit deterioration could remain gradual. In the interim, consumers remain healthy due to a solid labor market and low debt, but a bifurcation is emerging across Fair Isaac Corporation (FICO) bands and renters vs. homeowners, and the end of student loan forbearance is a headwind. Overall, problem loans remain historically low, but are starting to trend higher with office corporate real estate (CRE) an area to watch, despite manageable exposures and a long runway.
Q2 European bank earnings season was largely more of the same from Q1’s record return on equity (RoE). Retail revenues are still massively elevated YoY and have been the star outperformer from rate hikes. Loan losses remain below historical averages, more than offsetting the increased costs related to inflationary impact.
The strong earnings season was capped off by the “good” European Banking Authority (EBA) and UK stress test results.
Gross domestic product (GDP) and home price stressed declines were more stringent than in past years. More importantly, the 2021 EBA test was run under –0.5% rates and rates are now +4.0%. Under negative rates, banks’ depressed revenues provided scant cushion against stressed losses. The banks now have a much larger recurring revenue buffer to offset losses. Together with lower starting non-performing loans (NPLs), the banks demonstrated resilience in the adverse test scenarios and no remedial capital actions were required.
Higher rates have been unequivocally positive for European banks, but the majority of that benefit has now been achieved. H2 2023 NII will not be as strong as H1 2023, as the impact of passing on higher rates to depositors picks up speed.
Economic data is softening as rate hikes are having their intended impact on credit demand and economic activity. Credit costs will have to rise to more normal levels. This modestly more challenging outlook is expected to be manageable – within the expectations of a normal late-stage rate hiking cycle. European bank credit quality remains supported by the banks’ buffer of improved profitability, which they lacked under negative rates.
Most of the major banks missed consensus estimates in Q2 2023 as revenue growth was offset by expense growth, driving negative operating leverage. While pre-provision earnings rose, results were mixed sequentially, with NIMs flat, loan growth slowing, and credit costs rising to more “normal” levels.
Impaired loans and net charge-offs were generally higher, but they remain below pre-COVID-19 levels, and though delinquency trends are slowly trending up, the pace has been quite modest. Fundamentally, Canadian retail banking NIMs improved, whereas there was generally compression in US segments.
With expense growth an overhang, efficiency is a renewed focus. The upshot this quarter has been the regulatory capital ratios (i.e., CET 1), which again trended higher, climbing ~25 bp on average and hit ~13% pro-forma for known M&A. Banks remain conservative here, with OSFI’s December Domestic Stability Buffer (DSB) update looming large.
Looking ahead, we expect the next 12–18 months to remain challenging regardless of a recession as disposable income is being negatively impacted by rates, offset by excess savings and a solid labor market. The major banks continue to boast above-average profitability relative to global peers but the bias for future earnings revisions appears lower.
At present, the banks cite slower mortgage growth, strong commercial loans growth, a moderation in term deposit inflows/substitutions, and securities repricing as underpinning a slightly more optimistic outlook. Still, all eyes are on 2025/2026 mortgage refinancing waves, considering the growing consumer vulnerability if rates are higher for longer. We expect higher credit costs to eventually be a more material drag but improvements in loss absorbency in recent quarters are positive. Still, higher CRE impaired loan trends are worth watching.
One of the major Australian banks reported its half-year results this quarter, while others provided trading updates. Recall that last quarter, Moody’s affirmed their “Stable” outlook for the four major banks.
In general, themes continue to be fairly constructive for credit investors even as management teams are turning a bit more cautious on the increasingly challenging environment. Fundamentally, higher rates and decent loan growth have served to boost pre-tax pre-provision profitability – the first line of defence – which has grown at a double-digit pace from last year.
On the other hand, NIM benefits have peaked and sequential results were weaker, with expenses being higher. On credit, trends remain benign, including delinquencies, losses and impaired loans, in part reflecting a historically strong labor market and high levels of excess savings.
So far, while initial evidence suggests that borrowers moving from fixed to variable rates are performing in line or better than the overall book, we think early 2024 will be more of a “tell.” On capital/funding, CET 1 ratios trended up and remain top-tier globally, while deposit trends were mixed, but still generally up.
For banks, earnings are slated to weaken moving into FY 2024, driven by a more challenging environment and higher credit costs.
On rates, the RBA held the cash rate flat at 4.1% in early September, but additional hikes remain possible given services/wage inflation and home price growth, driven by robust population trends, which are expected to continue for some time.
Note that since residential mortgages are mostly based on variable rates in Australia, the impact of hikes on consumer budgets hits faster. The most acute pain from higher rates is likely to be felt at the tail of the population distribution than the average, in our view, and especially on renters and recent buyers that have higher debt and/or lower cash buffers. More broadly, risks are mitigated by low unemployment, high savings, additional scope for fiscal support, and various structural elements of the housing market.
The Big-3 Japanese banks reported a solid start to their fiscal year in Q2, with each bank already tracking ahead of its full-year profit guidance.
While higher rates have boosted profitability for international lending, potentially boding well for domestic lending, non-JPY loan growth was weaker this quarter.
Pre-provision operating profit of the Big-3 was driven higher by fee and commission income, as well as market revenue offset by lower NII.
RoE was stronger on average but also included several non-recurring items. Credit quality remains solid, with NPL ratios down or only modestly higher this quarter. While valuations on foreign bonds rose sequentially, valuation gains on domestic stocks rose by more, driving an overall improvement in available-for-sale security gains.
Looking ahead, consensus now sees lower probability of a recession in Japan than was the case in spring. The Bank of Japan (BoJ) adjusted its policy rate in late July to allow the 10-year Japanese government bonds (JGBs) to fluctuate +/- 0.5%, while it will purchase 10-year JGBs at 1.0% every business day, effectively revising the Yield Curve Control.
This led to outperformance of the rate-sensitive banking sector, as higher rates should benefit NII, though unrealized securities losses are also an important consideration.
Looking ahead, while Japan’s domestic operating environment continues to be hampered by structural challenges (low rates, population, overbanking and inefficiency), which hurts bank profitability, the BoJ’s actions could be a near-term tailwind. Still, this in the context of the country grappling with a 42-year high in core inflation in June. The BoJ’s effectiveness in its inflation fight should be watched carefully.
1“Tightening Bank Credit, Resilient Economies,” Michael Hanson and Nora Szentivanyi, Global Data Watch, J.P. Morgan Global Economic Research, 25 August 2023.
2 “US Economics Update,” Capital Economics, 26 September 2023.
3 “The Corporate Debt Maturity Wall: Implications for Capex and Employment,” Ronnie Walker and Sienna Mori, Goldman Sachs Economics Research, 6 August 2023.
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