Leave the fireworks to the experts

Stocks logged gains yesterday following Friday’s not-too-bad speech by Fed Head Jay Powell. Volume was light as traders prepared for a deluge of data, planned barbecues for the upcoming weekend, and dropped kids and grandkids off at university.

The calm before the… not-so-calm. Have the Fed policymakers lost their mojo? Have you seen those folks? They are a serious looking bunch, and believe me, they mean business. Even the most dovish of them turned carnivorous last year as the group went to battle with inflation. They ratcheted up rates and rhetoric in berserker-like fashion with vim and verve not seen for decades. Any student of economics would have surely thought, at the time, that inflation would have no chance. Moreover, the resilient US economy was sure to be a collateral victim of the Fed’s vicious assault.

Well, now that the smoke has cleared somewhat, we can have a look at the results of the great 2022 blitz. Inflation is still off target, consumers are still confident, businesses are still flourishing, unemployment is low, and the economy grew more than expected last quarter. Now, Chairman Powell is known for his ability to manipulate sentiment with his cool and calculated demeanor, but recently, even Fed watching neophytes would have noticed some cracks in his façade. Remember when you were a kid, and your cousin lit a firecracker, and you all ran and covered your ears… and… … … nothing happened. Was it a dud or was the explosion somehow delayed? You all looked at each other hoping not to be the one selected to get a closer look . Powell and other Fed members have recently admitted that the economy is stronger than they expected it to be. Despite this, members, with much debate, decided to wait and see for now pointing to famous economist Milton Friedman’s “long and variable lags” in monetary policy postulate. In other words, these things take time.

I recently wrote a few pieces which showed how simply raising interest rates would have a minimal upfront impact on consumers and companies who both, similarly, locked in low-cost, fixed financing when rates were lower. While those that did all huddle in their bunkers eating canned food, Spam, and Tang , they secretly hope that things clear up before they run out of provisions. Many consumers are choosing to forego selling their homes for fear of giving up low-rate mortgages (so-called golden handcuffs). But at some point, they simply will give up once they realize that rates won’t get back to 2021 levels any time soon. Corporations face a different challenge as bonds that mature require repayment of principal.

When a bond matures, the issuer must pay back the principal. That is usually not a problem if responsible corporate treasurers plan for it. Regardless, repayment does drain cashflow which can be a burden on a company. To avoid this strain, many companies simply refinance the debt with newly issued bonds and essentially extend the lending period. That seems like a sound strategy… UNLESS INTEREST RATES ARE +500 BASIS POINTS HIGHER than they were when you issued the original bonds! That means that debt service will be higher which will surely eat into cash flow. That strain will cause healthy companies to have to cut back, but for unhealthy companies it could mean default and bankruptcy. I saw this neat chart on the Bloomberg this morning and just had to share it with you. It details the maturities of European high yield debt. High yield is relevant because those companies must pay higher yields (due to their low credit ratings) and they are more likely to be cash strapped. If you are following my logic, you will see by the chart that most of those companies are still enjoying that canned food, but many will start to run out in 2025 and 2026. I have added my typical silly illustrations to underscore my thesis. Only $16.1 billion debt will mature next year causing those issuers to deal with refinancing or principal payments. The 2 years beyond have a rapid ramp-up to $89.2 billion and $118.7 billion! Now, this chart shows European debt, but it nicely illustrates the lag effect of tighter monetary policy which can be translated to other regions. THERE IS HOPE, however, that by 2026 rates will be a bit lower than they are today. But will they go back to where they were in 2021? Remember that rates in Europe were negative before this tightening regime!! I was always content to just call that firecracker a dud and just move on. If someone in the group insisted on getting a closer look… well, let’s just leave it at that for today.

WHAT’S SHAKIN’ THIS MORNIN’

Catalent Inc (CTLT) shares are higher by +1.01% after the company announced earnings and lowered its full-year EBITDA guidance. 38.9% of analysts that cover Catalent rate it a BUY, while 55.6% rate it a HOLD, leaving 5.6% of analysts rating it a SELL. Potential average analyst target upside: +6.0%.

Oracle Corp (ORCL) shares are higher by +2.74% in the premarket after UBS raised the company to BUY from NEUTRAL and bumped its target price up to $140 / share. The company will announce earnings on 9/12. Dividend yield: 1.36%. Potential average analyst target upside: +10.5%.

YESTERDAY’S MARKETS

NEXT UP

• FHFA House Price Index (June) is expected to have grown by +0.6% after climbing by +0.7% in May.
• JOLTS Job Openings (July) is expected to come in at 9.5 million vacancies, slightly lower than June’s 9.582 million openings.
• Conference Board Consumer Confidence (August) may have slipped to 116.0 from 117.0.