A default wave is building, says Deutsche Bank. Here's how bad it may get.

By Steve Goldstein

Critical information for the U.S. trading day

May is coming to an end with the Nasdaq Composite potentially registering a 6% gain, while the Russell 2000 possibly ends with a small loss, emblematic of a year in which the tech index has surged 24% while the small caps have skidded 9%. Given AI mania propelling the techs, and the credit crunch after the regional bank crisis, that split could certainly continue.

But let's take a look at the world of corporate credit, where the SPDR Bloomberg High Yield Bond ETF (JNK) has an average yield to maturity of 8.92%, and the SPDR Blackstone Senior Loan ETF (SRLN) has an SEC 30-day yield of 8.51%.

Deutsche Bank strategists Jim Reid and Steve Caprio just wrote the bank's annual default study, now in its 25th year. Last year's, correctly, called for the end of the ultra-low default era, though the current numbers are certainly not terrible. The U.S. high-yield bond default rate through April rose to 2.1% from 1.1%, and U.S. loan default rates rose to 3.1% from 1.4%. Over in Europe, speculative-grade default rates rose to 2.7% from 1.7%. According to Fitch, the average U.S. high-yield default rate is 3.6%.

But, the Deutsche Bank team say, "a default wave is imminent." By the fourth quarter of 2024, they say the U.S. high-yield default rate will peak at 9%, and the U.S. loan default rate will reach 11.3%. The European speculative-default rate will rise too, though to a less steep 5.8%.

Why? "The tightest Fed and [European Central Bank] policy in 15 years is running into elevated corporate leverage built upon stretched profit margins. This is especially true in the leveraged loan market, where LBO leverage was juiced higher year after year (after year) by zero rates and central bank QE," they say. LBO means leveraged buyouts, performed by the $5 trillion or so private-equity industry.

And don't expect the Fed to run the rescue either, as the central bank continues to fight inflation. (Unmentioned by the analysts, but the debt-ceiling deal effectively kills any potential for U.S. fiscal support through the next election, barring an unusually nasty recession.)

Granted, Deutsche Bank is far from the only outfit calling for a recession. Isn't a downturn, and ensuing defaults, built into prices? Maybe not. The Deutsche Bank strategists say investors might not be ready, given that high-yield bond index quality has improved this cycle, and global loan default rates have been tame for the past 15 years.

They quantify this by looking at the percentage of speculative-grade markets trading at distressed levels. Historically, distressed ratios lead default cycles by about 12 to 16 months. Regressing defaults by distressed ratios, they find the current U.S. high-yield market implying a 3.6% rate of defaults in the third quarter of next year, and European high-yield bonds projecting just over 2.2%.

"In our view, [high yield] continues to trade too rich relative to the economic backdrop and we continue recommending selling into any strength and moving up in quality where possible," the strategists say.

The market

U.S. stock futures slipped, after the third consecutive gain for the S&P 500 . The dollar rose. The Hang Seng was on the cusp of a bear market after Chinese manufacturing data disappointed.

For more market updates plus actionable trade ideas for stocks, options and crypto, subscribe to MarketDiem by Investor's Business Daily.

The buzz

A debt-ceiling vote in the House could happen as early as this afternoon.

The economics calendar includes job openings and the Fed's Beige Book. Fed Governor Phillip Jefferson, President Biden's nominee to become vice chair, is due to make a speech that could be the last opportunity to reset June rate expectations.

HP Enterprise stock (HPE) skidded 9% after the company reported earnings below expectations and guided for revenue at the low end of expectations.

HP shares (HPQ) fell 6% as the computer maker beat earnings estimates but missed on revenue.

Advance Auto Parts (AAP) stock dived as the auto parts seller reported a big fiscal first-quarter profit miss, slashed its full-year outlook and cut its dividend.

Twilio shares (TWLO) rose after a report an activist investor was pressing the company to consider divestitures.

Jamie Dimon for president? Here's what the JPMorgan (JPM) chief says.

Best of the web

Car dealers are worried -- not just because of direct sales at the likes of Tesla, but because electric vehicles generate some 40% less aftermarket revenue.

Belgium is coming to the rescue of expat Americans and their torturous tax compliance burdens.

Most households that receive food stamps have at least one person working.

Top tickers

Here were the most active stock-market ticker symbols.

Ticker  Security name 
TSLA    Tesla 
NVDA    Nvidia 
AI      C3.ai 
GME     GameStop 
BUD     Anheuser-Busch InBev 
AAPL    Apple 
PLTR    Palantir Technologies 
NIO     Nio 
AMC     AMC Entertainment 
MULN    Mullen Automotive 

The chart

In an environment of high volatility and low market liquidity, the risk of what the European Central Bank calls "disorderly adjustments in financial markets" remains high. The chart, showing equity and credit risk premia, comes from the ECB's twice-a-year financial stability review, published Wednesday.

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-Steve Goldstein

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05-31-23 1219ET

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