Big Beautiful Summer!

• Consumers and Services sectors are showing strain

• There is renewed focus on fiscal spending and deficits

• Leveraged Loan market is not pricing in macroeconomic risks

This week, several companies announced layoffs or are freezing spending due to macro slowdown and confusion over off-again and on-again tariffs. It is challenging for management teams to strategize and invest amid this uncertainty. 

At the same there has been renewed focus on fiscal spending, putting upward pressure on long term treasury yields. This is partly driven by upward pressure on yields in Japan and Europe. The US has historically attracted large foreign government and institutional investors in US treasuries. However as yields in their local bonds increase, it makes the US less attractive after hedging for currency risk. Overall, treasury yields are generally  stable but have been oscillating with macro data, tariff news, deficit headlines and section 899. This is a trend worth watching as it has implications for deficit financing, mortgage markets and several other markets.

Meanwhile defensive companies like Dollar General, Dollar Tree and Campbell are showing strength. Both the Dollars are benefiting from consumers tactically transitioning down market, driving higher same-store-sales growth and in-store traffic. This is a late cycle behavior, a negative for consumer discretionary issuers.  For example, Marriott confirmed that booking times have shortened, which means consumers are reviewing their discretionary spending buckets. 

Consumer delinquencies remain stable but automotive delinquencies have increased. Apparently, the 60+ day past due bucket for sub-prime borrowers is at a 17-year high. This is partly a function of their low credit scores but is also reflective of increases in car prices over the past few years.  To state the obvious, the lower income population is more sensitive to tarriffs & inflation due to their lower income and limited wealth accumulated from real or financial markets. 

On the macro front, the ADP report showed only a growth of 37K versus 114k estimated and below the 62K last month. These numbers should not be surprising due to policy related uncertainties, the stock market angst and a slew of headcount cut announcements. However, wage gains were very strong at 7% for employees switching jobs and 4.5% for employees staying put. The Services PMI number finally came in below 50. I had expected it to happen the prior month. However,  it was barely contractionary at 49.9 (versus 52.0 consensus). Overall, the economy remains on a solid footing although the trends are weakening both for consumers and services sectors, the two key components of the US economy.

The leveraged loan market remains active and resilient. There were several new issue deals, including for M&A transactions. Despite weakness in macroeconomic data, these deals are expected to clear at or inside of price talk. As one of my sales coverages put it, everyone is hungry for new issue. To put some numbers around this, there were $19 billion of new Collateralized Loan Obligations (CLO’s) issued in the month of May versus only $13B of new loans. This does not include retail inflows and repayments, exacerbating the supply/demand imbalance for loans. As a result, loan spreads remain tight at ~400 bps, despite the macroeconomic and fiscal uncertainties. 

CLO’s are the largest buyers of loans (“Assets”). They fund these purchases by raising capital from banks, insurance companies and other institutional investors (“Liabilities”). The difference between Assets and Liabilities cost drives arbitrage and returns for CLO equity holders. Liability costs remain stable, while Assets spreads have gone up slightly (although tight in my opinion), driving higher equity returns, which will support more CLO issuances. That said, the liability cost may increase as CLO liability investors can generate returns from the Treasuries or investment grade issuers, which are more liquid. This may reduce arbitrage and CLO issuance. This is a trend worth watching. 

In summary, the economy is clearly slowing with the two pillars of the economy - Consumers and Services - showing strain. We may not see a significant impact on the leveraged loan market as it continues to be driven by strong technicals (more demand less supply). Equities on the other hand have shown sensitivity to the headlines and data. However, valuations still remain high as there is expectation that weak data = lower rates = support high equity valuations. I think this view is too simplistic and investors would be better off looking for value investments and defensive allocations. It is going to be a Big Beautiful Summer!

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