Waller Redirect, Income Slowdown, and 2026 Default Forecasts.

[MUSIC] Welcome market participants to another three things in credit. I'm Van Hester Chief Market Strategist at KBRA. Each week we bring you three things impact in credit markets that we think you should know about. At what point do surveys start to reflect economic activity? Let's probably too simplistic a framing of the issues at hand. Take Michigan consumer sentiment survey at its worst levels and at 70 plus years of existence. But the consumer continues to spend, goes a familiar knee jerk reaction. The truth lies somewhere in the weeds as in consumer spending overall remains buoyant, where wealthier household spending is more than compensating for depressing spend from less wealthy households. So we bring this up because another survey out this week, CEO confidence conducted by the conference board has fallen off a cliff. A survey of 141 CEOs made May 14 to the 18th fell from 59 and Q1 to 47. Readings below 50 indicate more negative responses than positive ones. According to the release, CEOs reported that the economy is materially worse now than it was six months ago and expected economic conditions to weaken further over the next six months. This week are three things are one, Waller redirect. One of the Fed's thought leaders says risks have changed. We'll dig into what he's seeing. Two, income slowdown. The raw material that drives the economy is running in the headwinds. And three, 2026 default forecasts. We'll get the latest update from KBRA Analytics, Eric Rosenfall. All right, let's dig a bit deeper. Waller redirect. We have long considered Federal Reserve Governor Chris Waller, one of the most meaningful voices on the FOMC. His research background coupled with what strikes us as a data-driven orientation, rather than an ideologically driven one, makes him a thought leader in our opinion on the committee. So when he updates his view, we pay attention. He did just that last week in a speech titled, "Policy risks have changed." Recall that in a speech given in February, Mr. Waller made a convincing case that the labor market represented a risk at least as important in the Fed's dual mandate as inflation. Now he acknowledges that the conflict in the Middle East and its impact on energy prices may have a lasting effect on inflation. At the same time, he believes conditions in the labor market have improved from what he described as its "weak and fragile state." Today, he makes the point that little or no job creation is now consistent with a stable labor market, given essentially no growth in the labor force. Let's serve as a reminder that the employment side of the dual mandate is maximum employment, not necessarily growth in jobs. And that, none of itself, should be seen as problematic from a risk asset investor's perspective. Taken literally, which we're not sure all committee members do, job growth could be negative, hardly a sign of a robust economy, meeting the Fed's maximum employment mandate, as long as the labor force is shrinking. That aside, given the improvement in the labor market, Mr. Waller says his focus has shifted to the risk of inflation. He believes that markets are underpricing the risk of prolonged high energy prices and how that bleeds into prices for other goods and services. How the events in the Middle East are just the latest in a series of supply shocks that can transform transitory inflation into something more permanent, unanchoring inflation expectations. Now he admits, we always like the candidness, he doesn't believe this is likely, but it is a risk I cannot dismiss. So from his standpoint, inflation is now the driving force into his policy decision. He joins the recent dissenters supporting removing an easing bias from the FOMC statement. That said, he is prepared to be patient in holding policy about he describes as its current restrictive setting, awaiting additional data on inflation and inflation expectations. All right, on to our second thing, income slowdown. So we've been warning of the risk of slowdown in consumer spending and the fuel for said, real disposable income continues to contract. The April print came in at a negative half of 1% month on month, the third month in a row of a negative print, and the sixth month of the last seven where growth has been flat to down. Now for context, in 2024, RDI was not negative in a single month. There's something happening here. What's happening is inflation is reaccelerating while nominal income is slowing. We see that transmitting into slowdown in the spending data as well. Real consumer spending squeezed out a 10 basis point gain in April over March, monthly gains in 2025 and 2024 average 14 basis points and 28 basis points respectively. We see it anecdotally in retailer earnings and guidance. Walmart and Costco continue to perform on the back of higher income shoppers trading down. Target continues to face a stronger headwind due to its middle market customers becoming more cautious facing the chains heavier mix of discretionary goods. Dollar stores catering to the lower prong on the K-shaped economy are seeing sales buffeted by higher gas and food prices. Now putting the consumer pieces together, we have a low rate of unemployment, but little job growth and slowing wage growth. We have the savings rate running down and borrowing ticking up. We continue to see strong stock market gains. Add it all up and the K-shaped consumer remains very much in evidence and that K is getting smaller in totality on the margin. We see that in the macro data with real consumer spending dropping to 1.4% sequentially in Q1, the lowest level since 2022 if you take out last year's tariff impacted Q1. Now we don't want to overstate the risk here, but with consumer spending representing upwards of 70% of economic output and that bottom prong on the K, the bottom 60% of income earners representing a not insignificant 39% of total consumer spending, the margin of error in the economy has gotten a bit smaller. All right, well I know our third thing, 2026 default forecasts. Joining me once again is Eric Rosenfall from KBRA Analytics, who tracks defaults across broadly syndicated loans, high yield bonds and direct lending. Eric generates our default forecast as part of his work with KBRA DLD, our direct lending news and analytical platform. Today we'll discuss changes to Eric's 2026 direct lending default forecast, following BDC reporting for the fourth quarter of 25 and Q1.26 results. Eric, welcome back to the podcast. Thanks, Van. I was worried you wouldn't invite me back if the Nixon barristers your sixers. Ah, well you're right, that wasn't fun. By the way, how are your mets doing? Yeah, this is probably the right time to turn to defaults. Yeah, fair enough. All right, so direct lending loan quality has emerged as one of the most hotly debated top air costs really all financial markets in 2026. Your preliminary 2026 direct lending default forecast was 2%, representing $5.6 billion of volume. Where do you stand today? Yeah, so we are now forecasting a 2.5% default rate based on $7.6 billion of volume. The primary changes reflect the inclusion of affordable care and dental care alliance, both of which are undergoing impending restructurings. Now these two healthcare companies were each marked above 90 at the time of the original forecast. In addition, 48/40 solutions, that's a palette management and recycling company, restructured in January, rather than at year ran 2025 as previously expected. Collectively, these three issuers contribute approximately 1.2 billion of additional default volume. All right, I got it. So what about your default radar, which tracks the particularly vulnerable credits in the market? I assume that total increased as well. Exactly. That is the other driver behind the higher projected forecast. Default radar volume has increased by more than 3 billion since the year and 2025, and now total 17.3 billion based on BDC holdings. The more worries some red list, that now stands at 10.9 billion across 168 issuers. Okay, so how about from a sector standpoint? Healthcare has clearly moved higher as you just discussed earlier. What is that now? And any others have note. Yes, so healthcare is now projected at a 3.5% default rate up from the earlier 2% forecast. That equates to roughly 1.6 billion of volume, or approximately four times last year's total. Industrial manufacturing is also expected to see a roughly fourfold increase in default volume versus last year. The sector's 2026 default forecast has increased to 4.5% from the prior 3% projection. Consumer posts are the highest default volume in 2025. While default activity is again expected to remain elevated, the total impacted volume should decline. Even so, the sector 2026 forecast, that was raised to 3% from the original 2.5% estimate. I got it. Now what about that elephant in the room? I noticed you didn't mention software. What are you forecasting for software? Right, so the software where forecast remains unchanged. Still at 2.5%. Previously forecast in medallia is expected to account for more than 80% of the sector's 2.3 billion in 2026 default volume. Now while the sector is anticipated to generate roughly 10 defaults, most are expected to be relatively small. Given the software universe which exceeds 100 billion, additional large defaults will be required to materially move the needle this year. Furthermore, the market is coming to an understanding that not all software firms are distressed and far from it, and not all defaults happen at once. Given the impact of AI on the sector, we will watch this closely, but sector suffering is shock 10 to absorb that impact over time. So these are still early days in terms of the ultimate default impact to the sector. - All right. Well, you also showed a lower middle market default rate of 3%. Did that change? And how is that tracked? - So yeah, the lower middle market index, which consists of roughly 800 borrowers, totaling 20 billion, and that represents a subset of the 3,000 issuers and 300 billion within the KBRA DLD direct lending index. The lower middle market segment is derived from 12 BDCs that really just focus on that space. Now regarding the forecast, the expected 2026 default rate has actually declined to 2.25% from the earlier 3% projection. Now speaking of software firms, better clouds anticipated 2026 restructure ultimately occurred in 2025, removing more than 175 million projected default volume from this year's forecast. In addition, fair value marks, they held up relatively well during the first quarter, with 35% improving, and only 22% declining compared to the prior period. And it's also worth noting that only four of the 25 defaults that thus far have been recorded in this year involved lower middle market issuers. - All right, so let's move on to implied recoveries. Is that still a bigger concern than the default rate itself? - Yes, the weighted implied recovery forecast, now that remains at 50%, but on an unweighted basis, the results are expected to be material lower. We're looking at about 36%. And the primary driver, it's the default rate or red list, where the majority of the projected defaults are concentrated. Now the average mark for those issuers is currently 55%, but those levels continue to trend lower. In fact, approximately 20% are already marked at 30 or below. So these low levels, they typically reflect idiosyncratic factors, but they also suggest that issuers not seen as winners will suffer. - I got it. Lastly, how about a quick update on broadly syndicated loans and high yield? Now are those markets tracking relative to your 2026 default forecast of 3% and 1.75% respectively? - So we remain on pace in both markets. For broadly syndicated loans, the forecast called for 47 billion into fall volume and year-to-date activity, that stands at 23 billion. For high yield, the forecast called for 25 billion into fall volume and year-to-date activity, that stands at nearly 11 billion. But it is worth mentioning as kind of an overarching comment, that default rates across the various markets, they're relatively well-behaved, reflecting the still-solid economy and favorable rate environment. - All right, terrific. Thank you, Eric, for walking us through that updated forecast. Can you remind our listeners where they can find your research? - Sure, you can follow KBR ADLD on LinkedIn and to receive our defaults weekly in your inbox or access all reports on liquid credit and direct lending, contact Nikki Messino. That's [email protected]. - All right, I think that's gonna be a wrap. Thanks for dropping by, Eric. We'll check your forecast as we always do and look forward to your updates in the future. - Sounds great, thanks, fan. - So there you have it, three things in credit. One, wallet redirect. To cut or not to cut is still a coin flip, but the focus should be on inflation risk. You have to make it to spend it. The fuel for consumer spending is running into headwinds. And three, 2026 to fault forecasts. KBR A analytics updated forecasts are well-behaved. As always, thanks for joining. Don't forget to check in on kbra.com for our ratings reports and our latest research. We'll see you next week.