On Alert

Credit is in the spotlight with this week’s announcements of rising credit stress from Zions Bancorporation and Western Alliance Bancorp, adding fuel to the fire that was ignited last week with the First Brands and Tricolor bankruptcies. Zions disclosed a $50 million loss in two commercial and industrial loans, and Western Alliance revealed that it had initiated a lawsuit against one of its borrowers, alleging that the borrower had forged title policies on underlying collateral.

Many investors have been on high alert for trouble in the credit space, concerned that the strong demand for credit-related products may lead lenders to dilute credit standards and adversely impact the underlying quality of the holdings. The growing concerns were ratified a bit last week with the sudden and unexpected bankruptcy of auto parts maker First Brands, which was one of the largest issuers of loans purchased by collateralized loan obligations (CLOs). CLOs are structured credit products that package together corporate loans and sell them to investors as a single security. First Brands had issued over $5 billion of loans that were ultimately held in a myriad of CLOs. The First Brands bankruptcy came soon after the September default of Tricolor Auto, a subprime auto lender, under fraud allegations.

There were ripple effects beyond the direct and contained impact of the credit issues, with the regional bank index falling nearly 6% and the S&P 500 dropping 1% in Thursday’s trading. Importantly, however, there has not been a broader and more serious move in credit markets, where spreads remain relatively tight. Despite all the negative news, high-yield spreads are sitting at just over 300 basis points. Although this is higher than the late September level of 270, it remains quite low by historical standards and much lower than levels reached during the ”risk off” tariff-related stress events this Spring, which took high-yield credit spreads to over 460. We will continue to monitor conditions carefully, noting that this period is another example of the importance of having deep credit research and expertise.

Financial markets continue to look through the impact of the continued U.S. government shutdown, which has lasted 17 days thus far, making this already the third longest funding lapse since 1980. For context, the 2018-2019 shutdown was the longest at 35 days, and the 1995-1996 shutdown lasted 21 days.

The current shutdown is different from prior shutdowns in a number of ways — primarily in the scale of impact. First, while prior shutdowns were partial, today’s is a full shutdown because no appropriation bills were passed before the deadline. Second, the impact on federal workers is also broader, with 1.4 million jobs impacted (900,000 workers have been furloughed and 700,000 are working without pay). Lawmakers have tried to pass a stopgap funding bill. However, the Senate has declined to advance the House GOP bill multiple times, with several failed attempts this week. There doesn’t seem to be an obvious end in sight with both sides opposed to compromise. While Republicans are still calling for a clean resolution, Democrats continue to insist that the Affordable Care Act tax credits be extended.

Investors seem non-plussed so far, but many economists are raising concerns that a prolonged shutdown may impact quarterly GDP growth. Most acknowledge, however, that this would represent a temporary slowdown that would likely be followed by a catch-up period.  

The “risk-off” tone in equity markets this week was reflected in the U.S. Treasury market, which spurred a flight-to-safety trade for some investors. Consequently, the yield on the 10-year Treasury fell below 4% — a level not breached in over a year. Our view is that this is an overreaction: We expect the 10-year Treasury yield to trend back above 4%, where it will reliably remain in spite of the expectations for an additional two cuts to the Fed’s policy rate. The longer end of the yield curve may remain anchored higher as investors weigh the risks of inflation, the uncertainty around the future path of Fed policy, and supply/demand imbalances that may emerge as the U.S. government continues to issue bonds to fund the deficit. Of course, this week’s safe-haven bid has provided a temporary offset.

An additional wildcard that may drive rate volatility is related to the ongoing government shutdown: The shutdown continues to threaten the release of timely and important economic data, including the all-important CPI report that is anticipated to be released next week after a delay. With many of the conventional sources of government data on pause, investors and the Fed itself are parsing through unconventional- and survey-based data for clues.

The Q3 earnings season continues to highlight the resiliency of corporate America, with particularly strong results across the all-important AI-related companies. These companies have contributed significantly to overall earnings and have led the stock market higher. This week, Oracle added to the sense of enthusiasm and optimism with strong results. However, the initial rally in AI-related stocks and sectors proved fleeting as the headlines continue to challenge its durability.

The “Is AI in a Bubble?” discourse is full throated at this point, with many drawing analogies to the 1999 internet bubble. There are certain aspects that rhyme. First, the current level of concentration feels similarly extreme: The largest seven stocks in the S&P 500 today represent 30% of index value, exceeding the 23% corollary experienced in 1999. Second, the “it’s different this time” paradigm shift argument characterized by the earlier period is present today as many investors struggle to justify the concentration and related valuations represented by AI. Third, there are also similarities in capital spending trends and expectations: While massive investment in fiber optics and data centers were made to support internet expansion in 1999, we see similar enthusiasm for AI infrastructure CapEx today.

There are some similarities between today’s AI-driven markets and those of the internet era, but there are critical differences to keep in mind. In stark contrast to many market leaders who had no earnings during the internet bubble years, today’s market leaders in the AI space are highly profitable, generate significant and substantial cash flows, and have fortress balance sheets with high cash levels and low debt levels.