Credit markets flash warning signs: beginning of cracks in the system? 5/17/23

0:02Right now on fast one of major averages posted big gains today and the banks are bouncing back One of our traders says there are new signs of stress in the system coming from the credit markets. The details and the ripple effect straight ahead. Plus, Elon Musk sounding the alarm on China saying in CNBC's exclusive interview that Beijing's rising tensions with Taiwan should be a concern for everyone. Is he right? We'll debate that. And later, building a mystery. Mortgage rates keep climbing, but so do the builders. We'll go inside Wynn's winning hand today and then the monster options action for Bausch Health.

0:32I'm Melissa Lee. This is Fast Money. We're live at the Nasdaq Market Side on the desk tonight. Karen Feynman, Michael Cantopoulos, Dan Nathan, and Julie Beal. We begin with the markets posting strong gains. The money center and regional banks leading the charge. Semis and travel stocks also marching higher. While the equity markets are cheering, the credit markets are starting to sing a different tune. Small private companies are now defaulting at an alarming rate, according to new reports from UBS. And repeat bankruptcies, companies that have defaulted once and are now defaulting for a second time, they're also on the rise, reaching their highest level since 2009 and near all-time highs.

1:06Add in that, lending standards are nearing historic levels of tightness, and one of our traders fears trouble could be right around the corner. Michael, this is your expertise, and you say this is a red flag. Sounds pretty bad, doesn't it? It does. It is a red flag. I mean, let me start with what I think the big issue in markets are today. Like, everybody either wants to think we're in recession or that recession is never going to happen. And we're not in recession currently, right? But it clearly is the beginnings of a slowdown. And we're seeing that the 500 plus basis points of hikes that the Fed has, you know, basically enacted here is having an effect in the market.

1:45You're seeing lending conditions tighten. That's what's supposed to happen. That's why the Fed tightens. It's to bring down lending conditions. And as lending conditions tighten, spreads widen, CapEx slows, what happens? Companies start to default. The weakest links always go first. And that's what we're seeing. We're seeing the weakest links go first. Yeah. Karen, you sort of have been of this belief for some time and we're starting to see the cracks now. Right. Well, so I've been thinking that the high yield spread, that this credit spread would widen. And so I'm sure at HYG is kind of a hedge to many things.

2:20But I have been surprised with how little it has actually worked. And so, you know, as Michael said, we're starting to see the worst ones. I feel like if your business is doing OK, even if your balance sheet isn't great, there's almost always a way out. There's a way to extend. There's a way to issue equity, something for some of the ones. I don't know if we talked about specific names of the ones you're talking about. It's not it. It's a business problem and a balance sheet problem. And so I would have thought we've seen more of it, but we haven't. And I don't know, with rates maybe calming down a little or certainly the idea that the end of hiking is near, maybe some will be able to roll over debt that I wasn't expecting you would be able to.

3:03Well, remember, Karen, I mean, we had seven bankruptcies this weekend alone. But they were all tiny companies. They were tiny companies. Until we see a really big bankruptcy. Well, that's how it starts, though, right? As a tiny bankruptcy? Well, certainly, yes. No, small companies tend to lead large companies, right? In any sort of environment. And I think that's what we're starting to see. I mean, seven bankruptcies in 48 hours is nothing to sneeze at when you haven't had any bankruptcies really for the last year. And so that's very concerning to me. And then you enter into a situation where all of these hikes start to take effect.

3:36And you have the regional banks that are pulling back on lending even more. And what does that mean for credit? I just don't think it means good things. Yeah, and I just say through the lens of the stock market, and we've been talking about small caps, right? So they have the issue with the highest cost of capital or access to credit right here. And so we're seeing that reflected and unchanged on the year, the Russell 2000. But it's also look at SPAC land. I mean, look at that. That was an outgrowth of just kind of this zero interest rate environment here. How many SPACs have we seen go from 10 basically to zero?

4:06You know, there's dozens, if not hundreds of those. And I think that that's not the same thing that we're not talking about. But a lot of those are going to be delisted. And a lot of investors, when they see a stock that's delisted, they think of it as going away. It's like a bankruptcy. There will be reorganizations. And then the other thing before all of this happened with Silicon Valley Bank, there were lots of very prominent VCs calling for mass extinction events in the private tech market to start this year. Well, before there were any issues with Silicon Valley Bank, because basically how these companies were created and how they got funded and what they were doing was not going to be sustainable.

4:38So we hear that expression, zombie companies were really kept alive in the zero interest rate environment. And that's what I think this all culminates into what you're talking about. It doesn't matter that there were seven small companies. It is going to be a trend. I think every company tries to hang on for as long as they can. But sooner or later, if we're going to have higher for longer and we're going to have tougher access to capital, it's just not going to work out great, small or big companies. Julie, small and mid-cap is your neck of the woods, your area of expertise. and that is exactly the area that will have a little bit more difficulty securing the financing.

5:09Yeah, I think that's absolutely right. But to pick up on Dan's point, you know, the bankruptcies that we started to see were really in February and not even before Silicon Valley Bank was happening. And it is very much tied to what's happening in the VC community in terms of saying, hey, we want our businesses to be profitable. You know, for me as a small and mid-cap investor, we really try to focus on businesses that have zero debt and it's for exactly this reason. And you need to have the level of cushion that allows your business to kind of power through any kind of recession. So I think having businesses that have good, durable earnings are great.

5:42But a pristine balance sheet, there's no price to pay for that. How long is there like a typical period where you're starting to see sort of the canary in the coal mine and then it goes to full blown sort of this is what it is? Yeah, it tends to be about six to 12 months. So you're in a range now where, you know, in the back half of this year into the first half of next year, you should start to see more and more stress. This year, this cycle is going to be a little bit different because so much of the lower quality debt out there was financed through the loan market, and the loan market has floating rate debt.

6:15And so companies had a choice many years ago. Do I want to lock in very low interest rates for a long time, or do I want to issue floating rate debt? And what do they choose to do? And this is what led to the private credit boom. It was to issue floating rate debt. And now they're paying a lot more for that. So, Michael, are there anything that we should look in the private equity market? Are there like funds that are set up to kind of take advantage of this environment? And again, are there things that like investors should be looking for, you know, like certain activity, like whether they be funding, whether they be, you know, like again, you know, we haven't seen a lot of huge down rounds in the private tech market.

6:48But are there things that may be in small cap land that we might see in the public markets with private equity companies? Well, I mean, listen, I think looking at the publicly traded private equity firms out there can be a kind of tip a little bit. So you probably want to pay attention to those, especially the ones that have big private credit and private re-exposure. All right. Let's get to retail now. Turn to Target. The retailer wrapping the day more than 2 percent higher, despite warning consumers are getting cautious on spending. They also raised quite a few eyebrows when they said that theft related to organized crime totaled more than three quarters of a billion dollars in the last year.

7:21Walmart reports tomorrow morning. So are we going to see a similar message here, Karen? I mean, it was pretty good considering we were thinking that it wasn't going to be a great quarter for them because of all the discretionary items and the lack of groceries that they have. Right. All things being considered, it wasn't terrible. They have had this persistent problem. They were sort of the first one last year to really have it kind of on a bigger scale. And then we saw it from a number of other retailers, although they seem to have the worst problem. And I can't help but think they haven't quite fixed it, so maybe they'll continue to have the worst problem of the group.

7:54But I thought it was decent. You know, they didn't. The guidance was a little softer than I would have liked, although it wasn't terrible. But they were talking about March was difficult, which we expected, given what happened with the banking situation. April was a little better, OK, sort of. And May, they didn't give us a great feel on May. So I'm long target. I'm kind of surprised it held in as well as it did. When you piece together what we've heard so far from the retailers, I mean, you really get the picture of sort of a trade down going on amongst the consumers. Paring back projects for Home Depot, TGX saw increased store traffic.

8:28So maybe higher end consumers trading down looking for bargains, Dan. Yeah, no, I know you guys were talking about on Monday's show. You know, we see the consumer savings data and it's not going the right direction relative to consumer credit right now. And so, again, you know, we have unemployment at a 70 year low. That's the one piece of the puzzle that hasn't come in line with what the Fed would like to have happen with this economy. And if it starts to tick up, I have to think that you're going to see that in the retailers. Some of the stuff that we've heard over the last couple of quarters, even though they've gotten their inventories in line, we're going to start hearing more and more of that.

8:59And I think that could be like a little bit of the canary in the coal mine. I know we're going to be talking about in a recession, not in a recession. We're in a profits recession, no doubt about that right now. And I suspect as soon as we see unemployment start to tick up, it's going to be reflected in these retailers. And sometimes it's just perception, Julie, right? I mean, the consumers hearing all this talk about recession, they're going to pull in. They're going to be, you know, battening down the hatches in case of a recession, regardless of whether or not there is one officially declared or not.

9:23I think that's very much what the Fed has in mind in terms of thinking about not just inflation that's actually happening, but the inflation that's being embedded into customers' behavior. And you see that at Target, right? You see people choosing nondiscretionary items because they're concerned about higher prices going forward. You have a report out today that says 38 percent of people out there are struggling to pay their regular bills. It's starting to really hit them. What I think is interesting is I do think there are pockets within retail that are investable even in a recession. TJ is a great example of that.

9:54If you go to a TJ Maxx, you'll actually notice that customers aren't just shopping on need. They're shopping as entertainment. And I think that holds true. You get a trade down customer and great traffic is the lifeblood of any retailer. So I think that's an interesting business to look at right now. All right. For more on retail, let's bring in Terry Lundgren. He is the former CEO of Macy's and even Marcus currently is the founder and CEO of TJL Advisors. Terry, welcome to the Nasdaq Market Site. Welcome to the show. Happy to be here. Thanks, Melissa. How do you think the consumer is going to spend on some level to some degree during even tough times?

10:27So as we enter this sort of period of sort of unknowns, how do you think the consumer spends? How should we be thinking about the retail landscape? Yeah, you've got to look at it by income level. So much of this conversation has been right on track as far as I'm concerned. And that is the lower household income consumer is buying needs. And that's basically all that the paycheck is allowing at this point. So they're rotating out of discretionary. That middle household income consumer, that consumer is trading down. And so we're starting to see the benefits that will, I think, occur here in the months ahead and the quarters ahead for the off price.

11:03Even even though some of the mid tier department stores may benefit from the trade down for them, it may be possible some of these going out of business, these bankruptcies may benefit those. And then the high end consumer there, they still have they still have money. They're less affected, but they're trading into experiences. And so the airlines are full. The airports are full. The car rentals are sold out and, you know, the concerts are sold out. So so, you know, all of this is going to is going to impact goods. And, you know, we had a really nice uptick during during the COVID period where the consumer started buying goods again.

11:40And I think that's that's shifting back to to services. And so I think it's going to be a challenging period here for many retailers in many categories over the next couple of quarters. You've been in retail your entire career, correct? Correct. You graduated from Arizona way back when. That's right. Don't even mention it. Just a few years ago. Yeah. So you've navigated various periods. In your experience, when we're going through a period where there is a credit tightening period to come, we're in a period of tightening rates, we're in a period of maybe a recession, maybe not. How do the consumers react?

12:12What have you found? Yeah, what I find is that the consumer takes in all this news, and almost all the news that gets reported is bad news. You know, we talked about earlier, I was listening to the program, we're talking about store closings. And, you know, no one talks about store openings. But for the last several years, there's been more stores opened than closed. Now, the big stores are closing, smaller stores are opening, but net-net, there's 800 more stores open this year than closed in 2023. So what they're reading isn't that. They're reading all the bad news. And so that affects consumer confidence.

12:45And when consumers are feeling like there could be a recession around the corner, I might lose my job. My company might not perform well. They might start laying off. When they start thinking like that, they pull in their spending. So, Terry, you talked for a minute in the green room about the e-commerce evolution at Macy's. But do you think that the sort of the push that the pandemic made on the e-commerce growth has that plateaued? And what do you think is the long term sort of what's the right stable amount of sales that will be the e-commerce sales? It's a good question. We've been tracking this and it was something that we thought might happen and in fact is playing out this way.

13:25But prior to COVID, 16, 17, 18, 19, the online penetration as a percent to sales was growing between 100 and 150 basis points in penetration to total sales each year. And that was consistent. And then all of a sudden, COVID hits. And we go from 11.5 percent online purchases to the total to 20, you know, because because a stores were closed by the government. and because that's no one was leaving home. So so it's spike. This last report was now that it's back to 14.7 percent. And if you do the math, it's basically back to where we were. It's back to the mean. So I forecast that it'll be 16 percent a year from now and then it'll be 17 or 17 and a half percent.

14:14And that that will continue to to grow, but not the pace that we saw during COVID. So to answer your question, I think it's it's peaked to where to back to the mean. So we'll continue to see growth. And what that means is that it will affect physical stores. And so getting that balance right of physical stores is really important. A lot of that has happened, even though there are new stores opening. They're mostly smaller formats or they're off price or they're, you know, individual specialty stores, not the big, big box format stores. Last question. What is in the Terry Lundgren portfolio when it comes to retail stocks?

14:53Well, I happen to like first of all, I think Target did a good did a good job. And you all you all mentioned that. And you you suggested that they they did a pretty good job. I think the most important thing was they got their inventory in line. Their inventory was out of line the last couple of quarters. They got their inventory. Now I give them credit for that. When you're doing that, however, it's hard to grow sales. So I think they put themselves in a good position. And I and I actually like Walmart very much. You're going to hear from them tomorrow. I don't actually know what the numbers are, But I wouldn't be surprised if they if they surprise a little bit on the positives upside, because, you know, first of all, the 50, 55 percent of their business is in food, grocery.

15:28And they are the largest grocer in the in the United States. And that obviously still is benefiting from inflation. And I think they'll I think they'll perform well. Do you like Target and Walmart over Macy's in this environment? I love Macy's and I will always love Macy's. There's always the most important store in Bloomingdale's, too, and Blue Mercury. That's also part of the portfolio. Terry, good to see you. Thank you so much. My pleasure. Terry Lundgren. How about you? Do I like Macy's? Yeah. Well, so something, you know, we often talk about is how smart the equity investors are versus the bond investors, rather, versus the equity investors.

16:06And that's a good tell to look at it. Here, this is an unusual one. I looked at the Macy's debt and looked at the Macy's equity and the Macy's debt is doing just fine. It's just fine. They're telling you there's not a problem here. And the Macy's equity is telling you, oh, my God, there's a huge problem. I think the disconnect is actually on the equity side. Some of these multiples price to EBITDA, I mean, four and a half price to sales, you know, point four. I mean, these are some crazy low numbers and the debt is telling you we're OK. Well, I obviously like, Karen, your comment about the debt side being right.

16:44You know, listen, at the end of the day, I think there's a little bit of a disconnect oftentimes between how bond markets trade and equity markets trade. Because equity markets, to Dan's point earlier, are going to trade based on earnings. And we're in an earnings recession. And so I think maybe there's some uncertainty around how earnings are going to play out in the retailers and across really all sectors, right? But for someone like Macy's or other companies out there whose balance sheet is reasonably strong, You know, you sort of have limited maybe default risk, even if you have an earnings decline.

17:12And so I think that sometimes is part of the reason why you get these divergences. But clearly, I always think that that's the debt's right. And smarter. And smarter. Coming up, we're watching some after hours movers. Shares of Take Two and Cisco on the move after reporting. The details from the quarters next. Plus, keep an eye on building. Homebuilders continuing to rally as demand doesn't seem to wane. But can the climb continue as rates keep rising and the U.S. heads towards a potential recession? More on that ahead. Don't go anywhere. More Fast Money in two.

17:47Welcome back to Fast Money. A pair of movers after ours. Take two interactive surging following a revenue beat and upbeat guidance while Cisco dropping despite a top and bottom line beat. Both calls underway. Let's get to Steve Kovach with the latest on take two. Steve. Yeah, Mel, and those Take-Two shares were up as much as 11 % earlier. But revenue beat and bullish commentary about the coming pipeline of games next year is what's driving the stock. Revenue was a beat,$1.39 billion versus$1.34 billion adjusted. And the outlook for the fiscal year was a little light of expectations. That's just starting this quarter, up to$5.5 billion anticipated versus the$6 billion expected.

18:27But look, here's the really unusual move, Mel, that's setting the stock higher. Very bullish commentaring in this earnings release about next year, the company's fiscal 2025. CEO Strauss Zelnick giving Outlook for 2025 on the earnings call, saying the releases next year will see a jump in growth after what he called several groundbreaking titles. Also predicting those new games will bring in over$8 billion in net bookings. Now, if you'll allow me to put on my nerd cap for a little bit, This screams to me the next Grand Theft Auto game. That is the biggest entertainment property ever. It did a billion dollars in sales when it came out about a decade ago and still continues to generate more and more sales for Take-Two.

19:07So reading in between the lines, Melissa, between this bullish outlook for fiscal year 2025 and the fact that some of that footage from the game leaked last year, it sounds like that GTA game is actually going to come pretty soon. This is just speculation. They wouldn't say on the call. But based on those revenue outlook numbers, that's what it says to me. Your eyes lit up. I know, right. Talking about the new release. Steve Kovach, thank you. Thanks. Interesting. The company gave guidance. It typically does not give guidance that far out, Julie, which speaks to me of the confidence that maybe the company does have about this pipeline.

19:43I see it a lot with businesses where they know they're going to have some hard sledding in the year ahead. And so they give you two and three year forecast to get you excited. And, you know, for longer term investors like us, that makes sense. But I think in the near term, you're really having to look across a chasm that's that's pretty wide. But their pipeline looks to be very strong. I think it's, you know, 87 plus titles that they're talking about. And that's meaningful to their earnings growth. You know, I think what's going to be kind of critical to understand is how the cash flow progresses in this business and how they're able to manage through 2024.

20:16But it sounds like they're doing a very good job on their messaging from the stock reaction. I agree with Julie about the messaging. And I also think, you know, you said they don't normally do this. And I think of Strauss Zelnik as a CEO that under promises and over delivers. And so he must feel very confident. And I would expect that he's going to over deliver. Except that this quarter was really bad. I mean, the earnings were not that great. No, the earnings were bad. The guidance for 2024 are bad. The operating margins were bad. The gross margins they missed by like 4%. I mean, like this is not a good quarter.

20:49And then you put that together with this. Here's a quote. Our forecast reflects a challenging consumer backdrop as well. An extension of the development timelines for several high profile. I mean, they're really pushing out all of the things that it trades at this well above market multiple, you know, into 2025. I mean, that's not the thing that I would be paying up 10 % in the aftermarket for. All right. Let's get to Cisco here. Bertha Coombs here to take us through the numbers. Bertha. Hey, Melissa, Cisco crediting higher pricing that the action that they took last year now starting to kick in, providing a beat on both the top and the bottom line with revenues up 14 percent year over year and stronger margins for secure and agile networks division.

21:32Now, the company says due to improving supply constraints, they were able to cut down their backlog, though they'll end the year with double the normal levels. On the call, Chuck Robbins says lead times have now come down about 40 percent over the last two quarters in terms of orders. End user demand, he says, is driving growth. Web scale customers, he says, are now implementing some of their prior tech investments now that they've gotten it. And he says they see growth opportunity as they enable hardware and software. And he said that they already see early design wins in AI infrastructure and predicts that they'll see some market share gains there.

22:08Still, Robbins said, though they expect modest revenue growth in fiscal 2024, they will grow earnings at a higher rate for both the current quarter and fiscal 2024. Improving gross margins, he says, and strong expense management are the reason for that. But he also admits that they'll continue stock buybacks at higher levels. That often helps on the bottom line as well, Melissa. All right. Bertha, thanks. Bertha Coombs. he mentioned AI and the stock is down, Dan. What is going on? You know, it's interesting. You know, this stock sold off really hard, if you guys remember last month, and sympathy with a couple of those disappointing results by some of their competitors here.

22:49And so the fact that it's not up, I mean, they beat on the operating margin, they beat on the gross margin. I mean, it looked like a pretty decent quarter, especially with low expectations. Here's a stock. And, you know, like I was going to say this in the retail conversation, there's a lot of stocks that look really cheap, right? Even if you kind of can discount a tough slog over the next couple of quarters. This is kind of one of them. They said some of the things in a good way or cheap in a bad way. No, well, I mean, they could be value traps, right? If we were to kind of find ourselves in a recession, we know that a lot of these companies are already expected to have earnings declines year over year for a couple of quarters.