Adventures In The Knowledge Economy
The Credit Strategist - August 2023
The economy and financial markets are sending confusing signals and behaving contrary to many people’s expectations. Despite historic interest rate hikes by the Fed, the economy keeps growing and stocks are rallying and threatening to hit new all-time highs. The economy grew by 2.4% in 2Q23 when many expected it to start slowing. While the inverted yield curve traditionally portends an economic slowdown, stocks are sending a contrary message. By mid-July, the S&P 500 was up +20% from its October 2022 low after rallying strongly since May after investors convinced themselves that the Fed was done raising rates. Not that it mattered, but that conclusion proved premature when the Fed raised them another 25 basis points in July and signaled it will raise them again if necessary. Core PCE, the Fed’s favored inflation gauge, is dropping steadily but remains well above its 2% target (it rose +4.1% year-over-year in June). That was its lowest reading since March 2021 and its reading over the next two months before the Fed meets again in September will determine whether more tightening is needed before year end. With inflation fading quickly, investors are starting to anticipate rate cuts early in 2024 though the Fed will likely move cautiously.
Whispers of a soft landing are growing louder but it should not be overlooked that non-organic factors are likely responsible for the economy’s strength. One of these factors is continuing fiscal stimulus from the ludicrously titled Inflation Reduction Act which is directing huge amounts of capital into certain sectors. This stimulus is helping support the labor market and manufacturing activity. The economy is also benefitting from steps taken by corporations during the pandemic to extend debt maturities at very low rates that are delaying the impact of higher interest rates on their heavy debt loads. A closer look at the internal dynamics of the economy and markets suggests why this may be happening.
When it is said that monetary policy works with lagged effects, we need to take that adage very seriously. There really is a delay between when rates are increased and when they hit the economy because debt is governed by contractual arrangements that take time to adjust. Many borrowers protected themselves from the possibility/probability that interest rates would rise in the future and their precautions are having the desired effects. There was a burst of borrowing during the pandemic at extremely low rates that is now delaying the impact of higher interest rates on corporate credit. Rolling 12-month issuance of U.S. junk bonds exceeded $500 billion in early 2021 according to LCD (and thanks to Grant’s Interest Rate Observer for pointing this out), nearly three times the level of two years earlier, allowing many low-rated borrowers to lock in low rates for an extended period of time. As a result, only 11% of corporate bond coupons have adjusted upward since the Fed began raising rates in March 2022. That means, of course, that more trouble lies ahead than behind the credit markets as the vast majority of corporate borrowers face higher costs in the future. (In contrast, the real estate sector is suffering a much more rapid adjustment process as more of its debt is floating rate and subject to more immediate interest rate increases than the corporate sphere.) At the moment, U.S. non-financial corporate net interest costs as a percentage of post-tax profits sit at their lowest level in sixty years, down about 25% from mid-2022 (thanks to Albert Edwards and Grant’s for this data). These low interest costs are sheltering companies from the negative consequences of higher rates – for now.
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