State of the Union
With the US Federal Reserve continuing to tighten and recession risks rising, we assess the financial state of U.S. debtors from state and local finances to corporates and consumers. We conclude that governments, corporations, and consumers are well-positioned in 2023.
At our Investment Quarterly this month, we further increased the odds that the market prices in a recession in the next six months. With those odds now 60%, we thought it an opportune time to review credit fundamentals. We have written previously about the resilience of corporate fundamentals. In this blog we widen our scope to review fundamentals across US borrowers. We leave the US sovereign to our Rates colleagues and focus here on municipal, corporate, and securitized fundamentals, which represent credit risk across the US. While there are nuances across markets and sectors, the basis of credit analysis is essentially consistent. Here we focus on three aspects: what is the borrower’s cash flow and is it adequate to service borrowing costs? what is the borrower’s ability to repay the debt? what is the likelihood that credit quality will deteriorate?
The municipal market is a broad and heterogenous market with thousands of obligors across all fifty states and US territories. The market spans AAA-rated states, which have the power to levy taxes to repay borrowings, to lower-quality project finance, which is completely dependent on revenues from a specific project, such as a charter school or nursing home, for example. For state and local governments, the US economy and relevant local economy are paramount. Revenues for state and local governments are driven by taxes from income, sales, and property. Strong employment and housing turnover have resulted in significant growth in state revenues. As shown in Figure 1, revenues for US state governments (left chart) show similar trends to revenue trends of investment-grade and high-yield corporates (right chart), with lower variance. We think it’s likely that revenue growth for states has likely peaked. While the drivers of corporate revenue growth are different, as we have written in prior blogs, we think revenue growth for investment-grade and high-yield companies has peaked as well.
Figure 1: Revenue growth has peaked for US state governments and corporates, both IG and HY
The corporate world focuses on cash balances and coverage ratios to assess the ability to service debt and financial flexibility for investment grade and high yield companies. As shown in Figure 2, cash balances across US corporates remain elevated, approaching prior peaks for investment grade companies. It seems likely that company CFOs share our concerns of a coming recession and are therefore retaining cash.
The corollary to cash on balance sheets in the municipal world is known as “Rainy-Day Funds,” which are typically held in reserve accounts and are available to supplement general fund spending. Rainy-day funds, which have grown due to strong tax revenues and federal aid, are meant to be tapped when revenues decline amid broader economic downturns. As shown in Figure 3, reserve account balances in states represent more than 12% of general fund expenditures. While personal income taxes and sales taxes, which comprise the bulk of state revenues, will undoubtedly decline in a recession, these rainy-day funds should be sufficient to offset weaknesses in revenues.
Figure 2: Corporate cash balances remain elevated
Figure 3: Rainy-Day Fund Balances for state governments are strong; net corporate leverage is reasonable
While we are relatively sanguine about the overall financial health and flexibility of state governments and corporates in the US, we expect softening revenue growth in states and peaking cash flow in corporates to result in an increase in downgrades. Indeed, our upgrade/downgrade ratio, which is a composite of Moody’s and S&P rating actions, peaked in 2021 for high-yield companies and earlier this year for investment-grade companies, as shown in Figure 4. Historically, upgrade/downgrade ratios have declined after the ISM Manufacturing PMI peaks; it has fallen from a peak of 63.7 in March 2021 to the latest level of 49, foreboding continued downgrades in the corporate markets
Figure 4: Historical downgrades in the corporate markets
Just as downturns in municipal revenues typically lag declines in corporate revenues (and earnings), downgrades in the municipal market have historically lagged downgrades in the corporate bond market, as shown in Figure 5. That lag was not apparent in 2020 when rating agencies downgraded credits across the board; however, as shown in Figures 2 and 3, credit quality has improved materially since 2020.
Figure 5: Historical downgrades in the corporate and municipal markets
A state of the US credit markets would not be complete without some thoughts on US consumers, who drive roughly 2/3 of US GDP. Similar to state governments and corporates, US consumer debt levels, as measured by the household financial obligation ratio, are modest compared to historical standards.
Figure 6: Relatively modest consumer debt
As shown in Figure 7, we have begun to see an increase in delinquency rates across consumer borrowing, but we note that these, in aggregate, are expected given normalizing patterns of borrowing by consumers.
Figure 7: Delinquency rates ticking up
We remain comfortable with municipal, corporate, and consumer borrowers’ aggregate ability to service and repay debt, despite softening revenues and cash flow in the recession we think is likely. We expect credit quality, as measured by downgrades, to deteriorate in a recession, but not to the extent we witnessed in either 2020 or 2008. There will be pockets of dislocation as the Fed continues to raise rates and tighten monetary conditions, but as lenders of our clients’ capital, our research analysts are keenly focused on the specifics of each borrower across credit markets and our portfolio managers are positioning portfolios accordingly.