QueensGiant Capital Markets 2024 Midyear Review

The markets have proven to be tough but rewarding throughout the first half of the year. The CPI for May 2024 remained constant from April 2024 after an extended period of continued growth, which may be a positive indication that inflation is finally on a downward trend. Many major economies, including that of the U.S., now stand at the end of the expansion phase and are nearing the peak of the economic cycle. We prepare for the closing half of 2024 by identifying potential opportunities and risks influenced by the prevailing market conditions and economic landscape.

Capital Markets

Investors were optimistic as the U.S. stock market reached an all-time high during the first quarter of 2024, driven by the technology sector - particularly artificial intelligence. This run is expected to continue growing with the momentum of continuous technological developments. These past few months have also seen the largest amount of traditional IPO activity since Q2 2021, driven by life sciences and biotechnology. The healthcare, technology, and consumer sectors are expected to lead IPO activity throughout 2024 and 2025.

Growth in Securitization

Securitization volumes increased significantly from 2023 to 2024, indicating a change in market conditions from one year ago. Additionally, investors note that the Federal Reserve may hold off on cutting rates longer than the market anticipated. The high interest rates of the first half of the year seem to have been a contributing factor for the demand of securitized products, offering higher yields in comparison to other fixed-income securities. As of April 2024, ABS issuance increased 44.3% YoY to $131.9B, while ABS trading increased by 20.9% YoY to $2.1B. Securitization volumes of automotive loans and leases are high, encouraged by their short-term nature and highest liquidity among asset classes. Automotive ABS saw $45B in issuance as of Q1 2024, stating a 44.9% increase YoY. Strong sales in the automotive sector for Q1 2024 alleviated pressures from declining auto prices, possibly posing a threat for recovery rates.

Securitization in other sectors also saw a YoY increase. Securitized bonds from student loans grew from the previous cycle, with $2.2B in new securitized bonds this year. However, investors hold some skepticism due to the federal loan forgiveness policy. RMBS issuance has risen up to $17.9B from $15.7B in Q1 2023. The delinquency rate is currently not of serious concern as accumulated home equity should nurture high recovery rates in case of defaults.

Default Risk

Low income consumers are finding it increasingly difficult to stay on track with loan payments, attributable to factors such as increasing prices and high interest rates. Furthermore, credit card standards are anticipated to tighten as banks become more cautious with their lending by decreasing loan volumes and raising borrowing costs. Borrowers continue to be pressured as the Federal Reserve is not expected to cut rates for at least a couple of months. The significant increase in household debt raises concerns as to how low-income borrowers will handle disruptive economic conditions.

The CRE sector also faces immense pressure as interest rates remain high. 4.35% of CMBS are either in REO or have been delinquent for 30 or more days, marking an increase of 5 basis points since Q4 2023. Some economists speculate that a major crisis is on the horizon for the banking sector; defaults on CRE loans are expected to climb as borrowers fail to repay their lenders. Owners of office buildings in central business districts are losing income as their properties face difficulties retaining and acquiring tenants due to the increased prevalence of remote work. Smaller banks are under increased scrutiny as CRE loans mature and cannot be refinanced. This warrants keen surveillance and investigation as risks loom and corresponding opportunities may arise.

Interest Rate and Credit Spread Outlook

Although Powell is optimistic that inflation will continue coming down, a rate cut is likely to be put off until the Federal Reserve feels more certain that inflation is on track toward its 2% goal.

There seems to be no consideration of a rate hike, as the current rate already places enough constraint on the economy. While factors such as strong consumer price reports caused rate cuts to be delayed this year, the Federal Reserve estimates one cut before the end of 2024. Some believe that it will be announced in September and bring the federal funds rate down to 5.00% - 5.25%, while others say that the Federal Reserve may want to push off a rate cut until after the election campaign concludes. This past quarter, the U.S. economy grew at a rate of 1.6% and is expected to continue growing to 2.4%, which is above the non-inflationary growth rate of 1.8%. It can be inferred that the Federal Reserve is hesitant to cut rates too soon in order to limit inflation, as the rate of economic growth is expected to expand above non-inflationary levels.

Credit spreads have tightened over the past few months, benefitting bank loans, emerging markets, high-yield, and corporate bonds. With the possibility of a soft landing on the horizon and optimism toward the resilience of the economy, many expect credit spreads to narrow further. On the other hand, divergence from market expectations should result in wider credit spreads, especially if the increasing trend of corporate bond issuance continues. The upcoming rate cut may be a preparatory action by the Federal Reserve for a weakening economy past the peak of the economic cycle; this indicates expectations for widening credit spreads which should increase the yield of securitized products, further increasing attractiveness to investors.

Conclusion

Issuers and investors in the securitized products space must remain vigilant amidst the evolving market dynamics to protect themselves and capitalize on emerging opportunities. The recent growth in securitizations shows an increase in demand among investors, meaning that issuers can raise capital more efficiently. However, default risks, especially in the CRE sector, pose a threat to issuers who must practice caution in selecting the assets they choose to securitize. Defaults on these packaged assets would lead to decreased cash flows and, therefore, losses for both issuers and investors. The expected rate cut in the coming months presents risks to investors, as well. As interest rates drop, existing securitized products can be refinanced and new products can be issued with lower yields.

During the recession induced by the global pandemic, the federal funds rate dropped to virtually 0%. Beginning in 2022, it has seen an uninterrupted climb of over 500 basis points within a span of two years. If the Federal Reserve can secure a soft landing - a feat that many economists argue has never been truly accomplished - after one of the most volatile periods in history, we will have witnessed nothing short of a miracle.