Tighter credit may lead to defaults

Stocks staged an impressive rally on Friday after an article from a well-placed journalist suggested that the Fed would consider a smaller hike in December. Companies continue to beat estimates, but by smaller than average margins – a sign that they are feeling the pressure.

Within means. This morning the Fed is giving us the silent treatment. Don’t worry, we didn’t do anything wrong, it is policy for Fed governors to refrain from public speech ahead of its policy meeting. Yes, it is that time. The Federal Open Market Committee, the FOMC, will meet on November 1^st and 2^nd, and markets are expecting a harsh punishment to the tune of +75 basis points. Futures have priced in a 100% chance of a ¾ percentage point hike, and you are expecting it as well. What can we expect for December? As markets opened on Friday, odds were strongly in favor of another +75 basis-point hike. A Wall Street Journal report backed the expected hike for November but brought into question another big hike for December and suggested that the FOMC would be discussing how it would signal a pivot in December. “Wait, did he just say pivot,” you ask. Yes, I did, and the market was surprised a bit by it as well, and it expressed its approval with a strong rally. Futures adjusted probabilities for a bigger hike to just below even odds. Ok, so a pivot would be nice, and now that we got that out of the way let’s turn our thoughts to the effects of all this aggressive Fed behavior.

It is clear that the Fed is actively trying to kill the once-burgeoning housing market. It is, after all, one of the key drivers of this wave of inflation. It is also rather simple to accomplish given the industry’s strong reliance on credit, so raising the key lending rate will have a direct dampening effect on it, which, in fact it already has. No surprises there, just hope that housing costs will start to come down and help in easing inflation. We also know that higher interest rates affect consumer credit. Variable rate loans like those on credit cards and credit lines mean that monthly payments are higher, eating into budgets. That is supposed to cause consumers to demand less and ease inflation. One thing that we don’t often talk about is how higher interest rates affect corporations. Like consumers, companies borrow money as well. The healthy ones turn to the fixed income markets to finance projects. The not so healthy ones borrow money from the public to pay bills when revenues fall short. Now, that is not necessarily a bad thing, as long as the company can afford its debt service – that is a fancy way of saying that it can afford to make its payments. If a company planned properly and its sales remain healthy that shouldn't be a problem. But what would happen if sales slowed down? Would a company find itself in a jam? If cash flows slow, a company may look to raise more money to fill the gap. It can sell stock to raise capital, but that would only serve to weaken its stock price through dilution, and in case you haven’t noticed, now is not exactly the best time to float a stock offering. A company can also borrow from a bank, but it may face some challenges. If a company seeks to borrow money from a bank, its smaller cash flows may make it difficult to secure a loan. Even if a bank were to underwrite a commercial loan, the higher risk and higher interest rates resulting from Fed hikes are likely to make the terms undesirable. Ok, so that leaves the bond markets. A company may seek to sell bonds to the public. Unfortunately, that too would prove challenging, given that interest rates are at a multiyear high and a company that is struggling to maintain cash flows is likely going to have to pay premiums for the risk.

The low interest rate regime that emerged in the wake of The Great Recession made it easy for companies to tap into the public fixed income markets. Companies would use cheap money not only to finance growth, but also to fill their coffers with cash. Even more controversially, companies would use cheap money to finance dividend payments and stock buyback programs which would ultimately prop up stock prices. Cheap money also enabled struggling companies like the one mentioned above to continue to pay their bills. Unfortunately, all of this has come to a complete halt with the Fed’s aggressive tightening. Not only has the cost of borrowing gone up with interest rate hikes, but the markets themselves have become less receptive to new supply. What this boils down to is trouble for struggling companies which use the public fixed income markets to stay afloat. That means exactly what you think it means. The likelihood of loan defaults is expected to rise with the struggling economy, higher lending costs, and tighter credit markets. With bonds gaining in popularity due to higher interest rates, investors must choose investments wisely. If a coupon offered by a company seems too good to pass up, there is probably a good reason for it. Like all investments, bonds too require careful due diligence, especially given the current market and economic conditions. Stay focused.

WHAT’S SHAKIN’

Las Vegas Sands Corp (LVS) shares are lower by -6.07% in the premarket. The move follows a big selloff in Chinese markets resulting from weaker than expected economic numbers and Chairman Xi’s consolidation of power. LVS operates casinos in Macau and Singapore and a Chinese economic slowdown would hurt business. The company is set to deliver its earnings announcement on 11/2. Potential average analyst target upside: +21.9%.

AbbVie Inc (ABBV) shares are higher by +1.33% after it received a key FDA approval with its Rinvoq product for an additional indication. The company will deliver its Q3 earnings later this week. Dividend yield: 3,83%. Potential average analyst target upside: +7.9%.

ServiceNow Inc (NOW) shares are trading higher by +3.14% in the premarket after Guggenheim raised its rating to BUY. 92% of analysts who cover the stock rate the company a BUY or equivalent, while 5.3% give it a HOLD rating, and 2.6% rate the company a sell. The company will announce earnings later this week. Potential average analyst target upside: +49.7%.

FRIDAY’S MARKETS

Stocks rallied Friday on a Wall Street Journal report that the Fed would be considering messaging around a December pivot in its upcoming FOMC meeting. The S&P500 gained +2.37%, the Dow Jones Industrial Average rose by +2.47%, the Nasdaq Composite Index climbed by +2.31%, and the Russell 2000 Index advanced by +2.22%. Bonds gained and 10-year Treasury Note yields pulled back by -1 basis point to 4.21%. Cryptos gained +0.83% and Bitcoin added +0.80%.

NEXT UP

• Chicago Fed National Activity Index (Sept) is expected to come in at -0.10 after registering a 0.00 in August.
• S&P Global US Manufacturing PMI (October) is expected to come in at 51.0, down from last month’s 52.0 reading.
• S&P Global US Services PMI (October) may come in at 49.5 after coming in at 49.3 in September.
• Later this week: Lots more earnings along with more housing numbers, regional Fed reports, Consumer Confidence, GDP, PCE, PCE Deflator, and University of Michigan Sentiment. Check out the attached earnings and economic calendars for times and details.
• If you haven’t had enough of me: you can find my daily missives from the past several years along with my monthly newsletters here: https://www.siebert.com/blog/