With Inflation At A Forty Year High, All Eyes Are On The Federal Reserve

All market participants’ eyes are on the Federal Reserve as the Federal Open Market meets today and tomorrow. With inflation at a forty year high, investors are right in being passionate Fed Watchers for the next two days and possibly beyond this week. Despite the Federal Reserve’s best efforts, inflation has continued to rise. Presently, the consumer price index is at 8.2%, a level last seen in January of 1982. Ongoing pressure from supply chain disruptions, the Russian invasion of Ukraine, and U.S. consumer borrowing and spending practically at record highs, have all made it very difficult for the Federal Reserve to contain inflation. I expect the Federal Reserve to raise rates by fifty to seventy-five basis points during this November meeting. These continued rate hikes will cause significant market gyrations.

Importantly, inflation is even more challenging for the Federal Reserve, because inflation is global; key central banks like the Bank of England, the European Central Bank, and the Bank of Canada have also been raising rates, almost to no avail. Inflation in the UK and the Euro area is over 10% while in Canada it is almost at 7%.

While analysts at Morningstar and JPMorgan have announced that they expect inflationary pressure to decrease in 2023, investors should remain vigilant on how inflation will continue to hit their investments. The reason that inflation is likely to decrease next year is because in many countries a recession is around the corner. Current inflation will cause both consumers and companies to reduce their spending, which unfortunately, will lead to a decrease in Gross Domestic Product (GDP). If a significant recession arises, that too will push company stock prices down.

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Inflationary pressure is not only hurting consumers, but also continues to push companies’ cost of borrowing up. Faced with higher costs of borrowing, companies then continue to raise prices for consumers. Additionally, I anticipate that companies will start to reduce the dividends that they pay investors. For the foreseeable future, unfortunately, this is a bad spiral, and I expect significant periods of stock market volatility.

As long as the Federal Reserve cannot control inflation, I expect that investors will continue to sell stocks periodically and will rush to U.S. treasuries and investment grade bonds as safe havens. The stocks that will be particularly hurt are those of companies that are very leveraged, what bank regulators typically describe as having levels of debt six time more than their Earnings Before Interest Tax and Depreciation (EBITDA). As long as the Fed cannot control inflation, leveraged companies will find it harder and harder to pay their existing debt, and if they can get lenders to underwrite them more loans, the rate which companies will have to pay will be higher.

No matter where I look, there are plenty of data and market signals that the leveraged loan and high yield (below investment grade bond) markets are increasingly in trouble. Fitch Ratings monthly ‘U.S. Leveraged Loan Default Insight’ published last week shows that the dollar volume total leveraged loans of highest market concern rose 13% to $228.0 billion from $201.3 billion in September; this is the largest one-month increase since the pandemic struck. Fitch Ratings’ Other Market-At-Risk Issuer list shows “an overwhelming majority of the new additions, driven by technology with 41% of new additions, healthcare/pharmaceutical at 23%, building/materials at 17% and banking/finance at 9%. Citrix Systems CTXS Inc., Quest Software Inc., and Ivanti Software represent sizeable technology issuers added to the Other Market At-Risk list. The Market Concern total is up 39% since end-1Q22 and is the highest amount since YE 2020.

”According to Eric Rosenthal, Senior Director of Leveraged Finance at Fitch Ratings, “The more worrisome Top Market Concern total jumped to $34.0 billion from $29.6 billion in September. Bausch Health Companies BHC Inc., which completed a distressed debt exchange for just 48% of its unsecured notes, is a new Top list addition because a 2023 filing remains a possibility. Nearly 30% of the Top list issuers have a term loan, 19% by volume, coming due before YE 2023, led by Serta Simmons Bedding LLC. ColourOz MidCo’s and infoGROUP Inc. moved up in October from Tier 2 due to their looming maturities.” The significant majority of leveraged loans and high yield bonds are in the BB and B range. The anticipation that more companies will be downgraded or worst yet default on their obligations will keep investors ready to sell bonds and stocks at a moment’s notice.

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