Fractures in fracking growth

Stocks jumped yesterday on better-than-expected earnings from heavyweight Bank of America and Morgan Stanley. Tech stocks got a boost from Microsoft, who will begin charging business customers for its AI offerings.

Stressed over distress. It is hard to fathom these days, but interest rates used to be around… 0%. Go on, take a second to think about it. Now you remember. Interest rates were super-low around much of the globe for a long period of time with some countries even sporting negative interest. That’s a story for another day, but for now, let’s just reflect on the fact that Fed Funds is now at 5.25% and will likely be raised to 5.5% next week. Do you want to know the last time Fed Funds were that high? How about 2001? More than 2 decades ago! Remember The Global Financial Crisis? Fed Funds were exactly where they are today just before the global financial system nearly imploded on itself. In the wake of the GFC, the Fed adopted ZIRP (Zero Interest Rate Policy) for the first time.

Once the smoke cleared, the Fed attempted to slowly ratchet rates back up to “normal” levels but were foiled in 2018 when an “earnings recession” spread through the corporate complex. An earnings recession is exactly as its name implies, a significant contraction in earnings growth. You may remember that dark end to 2018 when stocks were set to deliver the worst December since The Great Depression (with a “D”), only to get a lifeline from Fed Chairman Jerome Powell who made a dovish pivot right around Christmas. Whether it was the Yule spirit or the fact that the economy was on tenterhooks at the time, that shift ensured that Fed Funds would never exceed 2.5%. Ultimately rates would drop back to near zero in the pandemic. So, let’s just say that rates were low from August 2007 through March of last year’s first hike. That is some 175 months of little or no worry about interest rates getting the better of you.

The first thing that we think of when we talk about the low interest rate environment was low mortgage rates, which persisted throughout that period. That was good and it allowed many folks to buy more real estate with less money providing a boon for an industry that was reduced to a pile of rubble in 2008. But there is a much broader impact of low interest rates that goes beyond residential real estate.

Corporations rely heavily on debt to keep their businesses moving smoothly, and low interest rates provided cheap cash for that extended period of time. Unfortunately, that cheap money flew out the door last year with the Fed’s blisteringly rapid rate hikes last year. Companies with adjustable-rate debt are just starting to feel the pain as rates adjust. Others who opted for short-term debt will find their costs rise significantly when it comes time to refinance. That is something that cannot be ignored when it is looking more likely that rates will remain higher for longer. That burden will certainly have an impact on many companies. Healthier companies will struggle to maintain margins with debt service rising. Weaker companies may not even be able to afford the rise in costs and find themselves in default possibly opting for bankruptcy.

This is something that cannot be ignored by investors. In fact, the trouble has already begun. According to a Bloomberg study, there is nearly $600 billion in distressed debt outstanding. Much of that will be part of the $758 billion in debt coming due within the next few years. To be clear, not all that distressed debt will lead to default, but some certainly will. According to Moody’s, the global default rate will rise next year to 5.1% from 3.8% with its most pessimistic scenario reaching as high as 13.7%. The following chart from Bloomberg shows where that distressed debt exists. On first glance, it is clear that the Real Estate sector is in the direst situation of the lot, which should not be a surprise to you. However, the real takeaway is that the challenge goes beyond the obvious sectors. That simply means that investors must be diligent in their selection process. You don’t own corporate bonds? That doesn’t mean that a default won’t affect your stock holdings… it surely will. Does your portfolio contain stocks in Real Estate, Healthcare/Pharma, Telecom, or Software? Of course, it does! Now, I did not write this note to send you into a panic, but rather to remind you that picking stocks is never easy, but it is about to get more difficult. Be diligent, be vigilant, and please, please, please, do your homework!

STOCKS TO WATCH BEFORE THE OPENING BELL

Omnicom Group Inc (OMC) shares are lower by -7.67% in the premarket after the company announced that it missed revenue targets by -1.27%. The marketing/advertising company has risen by some +21% year to date. Dividend yield: 2.85%. Potential average analyst target upside: +1.8%.

Halliburton Co (HAL) shares are off by -2.52% in the premarket despite announcing a +3.02% earnings beat for Q2. The announcement revealed that its revenue growth slowed as US shale drilling has slowed. Though the company expects a recovery going forward, the “brake pumping” by large drillers has taken its toll on revenues. Dividend yield: 1.67%. Potential average analyst target upside: +23.2%.

ALSO, THIS MORNING: Elevance Health, M&T Bank, Carvana, Baker Hughes, US Bancorp, and Nasdaq beat on EPS and Revenues, while Citizens Financial, First Horizon, Ally Financial, and Goldman Sachs came up short.

YESTERDAY’S MARKETS

Stocks rallied yesterday on solid earnings announcements and more AI happiness sparked by a Microsoft announcement. The S&P500 gained +0.71%, the Dow Jones Industrial Average climbed by +1.06%, the Nasdaq Composite Index traded higher by +0.76%, and the Russell 2000 Index jumped by +1.27%. Bonds rose and 10-year Treasury Note yields gave up -2 basis points to 3.78%. Cryptos lost -0.70% and Bitcoin gave up -0.49%. The S&P ESG Index added +0.89%.

NEXT UP

• Housing Starts (June) may have slipped by -9.3% after jumping by +21.7% in the prior month.
• Building Permits (June) are expected to have risen by +0.2% after a +5.6% revised gain in May.
• After the closing bell earnings: Netflix, IBM, SL Green, Steel Dynamics, United Airlines, Alcoa, Tesla, Las Vegas Sands, and Zions Bancorp.