Will credit risk spoil the party?

Will credit risk spoil the party?

If you wanted to spin a story of why stocks are up 18 per cent from recent lows, here are some facts you might cite:

• Inflation is falling.

• Perhaps more importantly, inflation expectations are falling. The New York Fed’s one-year and three-year inflation expectations measures both fell hard in July. Market-based gauges are falling too. Two-year inflation break-evens, the market’s best guess of inflation’s near-term path, were at 4.4 per cent in mid-June and now sit closer to 2.7.

• Even as inflation turns down, the jobs market is still growing. The 528,000 jobs added in July lowered the unemployment rate to 3.5 per cent, and some forecasters are expecting another 400,000 in August.

• Consumer sentiment is finally perking up. June notched a record low of 50 in the University of Michigan’s consumer sentiment survey, but it bounced to 55 in August.

• Sales are growing. Yesterday Walmart and Home Depot reported 8 and 6.5 per cent year-on-year sales growth, respectively, in the second quarter. That number is 15 per cent for S&P 500 companies (ex-financials) that have reported earnings.

It’s easy enough to poke holes here. Headline inflation at 8.5 per cent is better than 9, but nowhere close to what the Fed wants. The hot jobs market may keep inflation uncomfortably high. Sales look worse adjusted for inflation; half of S&P 500 companies have negative real sales growth, according to Bank of America.

That’s all to say: how much you believe this market rally depends on where you believe growth and inflation are heading.

But there’s another threat markets may be ignoring: credit risk. Interest rates are still rising and growth, while not collapsing, is softening. That puts borrowers in a pinch, squishing revenue just as financing costs rise. Paul Britton of Capstone Investment Advisors made this case in an FT interview over the weekend:

While sharply falling equity prices in the first half of the year reflected concerns about future earnings due to inflation, investors have not yet reckoned with the effects of higher interest rates on overly indebted companies, [said] Britton . . .

“We are getting close to the end of phase 1, a repricing of growth. Phase 2 is more interesting to me. It is more of a credit cycle,” Britton said. “People are upset that they’ve lost money, but there is no fear.”

“The headlines in Q4 and Q1 are going to be of people having trouble refinancing, and nervous investors will start selling,” he said. “By Q4 or Q1 it will switch to fear.” . . .

Refinancing woes will have an outsized effect on market sentiment, he said, because investors have become too complacent that central bankers will ride to their rescue with lower rates. This time, he predicted, Fed governors will stick to their inflation-busting mantra and maintain higher rates.

Investor flows in recent weeks suggest many believe issues in credit won’t prove disastrous. The upturn in stocks has been led by growth, with meme stocks and thematic ETFs showing some bull market euphoria. Junk bonds, too, have staged a remarkable comeback, as the FT’s Ian Johnston and Eric Platt report:

A renewed sense of optimism about the economic outlook has sent traders back into debt markets. Money has been pumped into investment grade, high yield and emerging market debt funds in recent weeks, after sustained outflows since January, according to flows tracked by EPFR.

The drop in high-yield credit spreads over Treasuries is astonishing. These are not investors scared of credit risk:

This makes sense if you assume — as it seems markets are — that the Fed will pivot to cutting interest rates in the first half of 2023. Under this (questionable) premise, a surge in defaults looks rather less likely.

Normally it takes time for higher rates to hit borrowers, some of which will have fixed-rate debt maturing over months or years. This is doubly true after the coronavirus pandemic, when companies used ultra-loose credit conditions to lock in low rates with long maturities.

And as Viktor Hjort of BNP Paribas points out, there hasn’t been enough time since the 2020 recession for the usual credit-cycle vulnerabilities — think rising leverage and worsening asset quality — to accumulate. The fraction of high-yield bonds rated CCC or below is just 12 per cent, a lower share than before any of the last three recessions. Such balance-sheet buffers could delay widespread refinancing problems.

Short of refinancing or default, tighter financial conditions can weigh on firms in other ways, Marty Fridson of Lehmann Livian Fridson Advisors explained to me. Extending generous credit terms to customers becomes too expensive. Financing inventory management gets harder. But these matter more as drags on sales than as threats to creditworthiness.

The point is not that you should discard credit risk, but that its urgency depends on how high the Fed raises interest rates to damp inflation. The longer that rates stay high, the more that balance-sheet buffers will wither away. If a Fed pivot is coming soon, however, that worry seems distant.

That’s why the Fed/inflation narrative has been so all-consuming. It is drowning out everything else is because it affects just about everything else.