Optimism > Fundamentals

• Equities and credit markets remain strong

• Valuations remain rich, underestimating macroeconomic risks

• Underlying data on profit margin performance from issuers and underemployment metrics merit watching.

Equities are up ~3% over the past 5 trading sessions on the back of the end of the middle east war, likely removal of the 899 provision (revenge tax) and generally okay economic data. The leveraged loan and high yield markets had another strong week in line with the equity markets.  

Secondary bids on leveraged loans were up > ¼ point this week. Bids were getting lifted at >par, as a result of lack of net new issuance and ramping CLO’s (CLO’s are the largest buys of loans). For the record, this has been the story over the last several years - lack of sufficient new issue in syndicated markets exacerbated by the growth of private credit, supportive issuer fundamentals and strong demand from CLO’s. As a result, pricing has compressed. This week, some issuers reduced pricing by 50 bps, allowing them to improve/preserve cash flows in the face of economic uncertainties. In the high yield market, CCC-to-single B yield differential has narrowed by 115 bps over the past year. CCC to BB yield differential has narrowed by 119 bps, indicating a risk-on market, despite the macroeconomic uncertainties.

Speaking of macros, May existing home sales growth of 0.8% beat estimates of -1.3% but this was the slowest May since 2009, driven by high mortgage rates, affordability and economic uncertainties. Consumer Confidence dropped to 93 from 98 and missed a very optimistic consensus of 99.8. No dearth of headlines on tariffs and war to bring the sentiment down. This in turn drove headlines on layoffs and reduction/withdrawal of guidance by issuers. This week, Fedex reduced its guidance, citing uncertainties and elimination of the de minimus exemption that had allowed low value shipments (<$800) into the US without duties or taxes.

Despite the above, the headline unemployment numbers have stayed low/stable at ~4%. Labor participation rate remains stable at 62% - 63%. The Job Quality Index (JQI) which is the ratio of higher quality stable jobs to lower quality less stable jobs was 85 which is in line with recent months/quarters. Average hourly earnings have increased by +4% YoY in recent months, helping offset inflationary concerns (and also driving inflation). While this is adding to cost pressures for companies, they have successfully passed these to consumers over the past few years. Everyone seems to be happy, driving Chairman Powell’s decision to leave short term rates unchanged.  That said, the underemployment number is creeping up.

During Trump’s first term, the underemployment number improved dramatically from 11% to 7% prior to spiking up during covid. That number stayed somewhat stable during Biden’s term but is slowly weakening and stands at 8% currently. This is a good metric to watch. Underemployment is a slow poison. It means workers are working part time, their jobs are not a match for their strong qualifications and/or they are underpaid. 

In funding markets, the long term treasury yields seem to be stable following comments from Powell of possible rate cuts if inflation stays low. Other factors like capital relaxation for banks which will drive higher capacity for banks to buy treasuries and easing regulations on stable coins, which are backed by short term T-bills are directionally expected to reduce cost of borrowing for the government. However, the exact impact is difficult to quantify and intuitively is expected to be minimal. 

To close out, now that the middle east war is over and the ceasefire is holding up (thankfully), the focus will move to tariffs again and the deadlines are approaching fast. There is complacency in markets. Valuations remain rich and value trades are getting challenging. Metrics to watch will be consumer delinquency rates, health of the services economy, underemployment and profit margin performance.

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