Weekly Market Perspectives: When will Fed rate hikes pressure credit?
Published: July 28, 2023
The Federal Reserve delivered another well communicated interest rate hike last week bringing the target Fed Funds rate to 5.25%-5.50%. The eleventh increase since early 2022 sets the Fed Funds rate to the highest level since 2001. Federal Reserve Chair Powell continues to suggest a soft landing is the base case with economic growth proving to be resilient and inflation trending lower (although core inflation remains sticky). Corroborating Powell’s position, the Q2 gross domestic product (GDP) release on Thursday showed the economy picked up steam (+2.4% annualized) with key consumption inputs rising and then, on Friday, the Fed’s preferred measure of inflation (PCE) showed more signs of cooling. Moving forward, any additional rate change will be data dependent, but Powell suggested there could be more rate hikes needed to curb core inflation stating, “We intend to keep policy restrictive until we’re confident inflation is coming down sustainably to our 2% target, and we’re prepared to further tighten if that’s appropriate.” The market is somewhat on board… giving the probability of another rate hike less than a coin flip at time of writing. The market reaction to the hike and subsequent press conference was largely subdued as earnings were the dominant driver of markets this week – S&P 500 finishing +1.0% and bond markets ending -0.4%. The tug of war for investor expectations continues to be front-and-center – will the market achieve a soft landing? Or will there be a recession? The market seems to be pricing in the former for now.
One area that seems to be somewhat under-the-radar but has been flashing signs of distress is in credit. While broad high yield spreads are tight relative to recent history, rising interest costs and rising input prices (commodities, wages, etc.) are beginning to weigh on fundamentals. The combination of rising costs will pressure corporate margins, particularly when these companies cannot pass increased prices onto their customers. The pressures are growing more quickly for small cap or private companies that grew reliant on floating rate debt in the ZIRP (zero interest rate policy) era. So far, companies have been able to manage through higher costs, but any slowdown in their business will risk a technical default. The credit rating agencies have taken notice… rating downgrades have been rising since the start of the Fed rate hike campaign. The good news is that economic activity continues to be robust, and the US consumer is showing few signs of slowing.
The following chart shows the industries with the most amount of debt trading at distressed levels (or those trading at a 20% discount or more). The real estate debt market is very large, but it is also showing the most amount of debt trading at distressed levels. Other industries with a large amount of distressed debt include health care, retail, telecom, and software (SaaS).
Private equity sponsors account for a significant portion of distressed issues. As private equity sponsors used cheap floating rate debt in the ZIRP era to help finance buyouts and M&A, they left companies vulnerable to rising rates. Loans with a LIBOR or SOFR base rate have seen steady increases throughout the Fed rate hike campaign which is putting pressure on fundamentals. With the credit crunch that emanated from the regional banking crisis, non-bank lenders have been taking a larger share of the market; however, the market share grab has largely come in riskier areas of the market (naturally, where banks do NOT want to extend credit). This will be a space to watch if economic activity slows.
A quick update on earnings season… nearly 40% of the S&P 500 measured by market cap reported earnings last week and the general tone has been positive. Companies are maintaining margins and posting solid earnings beats; although, many companies have been communicating mediocre guidance for the next several quarters. Next week is an equally large week for companies reporting, but the signs have been good so far. More to follow…