Juggling Dynamite

The June US Consumer Price Index (CPI) came in at a 3% annualized rate, down from the pandemic-inflamed peak of 9.1% a year ago. FOMC chair Powell has said that ‘super-core’ services ex-shelter (which excludes food, energy, rent and used car prices) is his preferred inflation gauge, and (as shown below) it came in at 1.4% annualized versus 4% in January, down sharply from 3.1% in May and below the 2.5% average over the two years pre-pandemic (2018 and 2019). Shelter costs make up more than a third of the CPI index, and year-over-shelter CPI moved lower for a third consecutive month to 7.8% in June from 8.2% in March (the highest since 1982). To reach the 2% CPI target, housing is the bogey that must be deflated, and that means holding the credit hand brake with the good, bad and ugly.

Focused on that task, the Bank of Canada (BOC) announced another 25bps of monetary tightening, taking its overnight rate to 5% for the first time since April 2001 (!) In addition, the BOC is shrinking its balance sheet (QT) as large amounts of bonds mature and roll off monthly.

Floating rates are immediately affected. That’s good news for savers: the interest rates on investment savings accounts are moving above 5%–a ten-fold increase in 16 months.

For debtors, tough times are getting tougher. Prime borrowing rates offered by commercial banks in Canada are moving to 7.2%, variable rate mortgages around 6% and home equity lines of credit (HELOCs) around 7.7%. Those looking to qualify for new mortgages need to do so in the 8 percent range. That math is stark: a household earning $200k a year with zero other debts can qualify to borrow a maximum of $621k (play with the numbers here) and be saddled with a mortgage payment over $4,600 a month (plus taxes, utilities and maintenance). Many existing owners will need to sell as mortgage terms come up for renewal.

The next stress accelerant will be lost income. Policy tightening is intended to reduce employment (“wage pressures”), and it will. The BOC sees Canadian GDP slowing to a 1% annualized rate in the second half of 2023 and early 2024, with GDP growth of just 1.2% in 2024.

On the upside, shelter prices are already heading lower in many areas, and that’s likely to spread and improve affordability over the next several quarters. Housing downcycles historically have taken four to six years before prices bottom.

The US Fed is expected to hike another 25 bps at its July 26th meeting. But recessionary odds are mounting that this will be the final hike from central banks in Canada and America. Financial markets are celebrating that thought and the hope that rate cuts will soon come to the rescue.

But here’s the thing: the impact of tighter credit conditions will slow the economy over the next year to 24 months, even if no further hikes take place from here.

Not only that, in past cycles, the average Fed pause between the last hike and the first cut was eight months. As shown in the table below, in every case, the stock market did not bottom until 13 to 33 months after the last hike (see S&P low dates).

Unlike government bonds that typically rise while stock prices fathom bear market lows, higher-risk corporate bonds tend to fall with risk appetite and equity prices. That trend has held over the past 15 months as most corporate securities have lost value.

As US junk bond prices have tumbled, their yields have risen to around 8.75% from sub-4% in 2021, when desperate and undisciplined funds were eschewing risk management for “there is no alternative” madness.

The rapid doubling in yields is an encouraging trend for value-conscious investors. But it’s early days yet. A ton of low-rate debt is not yet up for renewal. A growing default, reorganization and bankruptcy wave suggest that firesale prices (and hence higher yields) are yet to come. See, The corporate bankruptcy wave will get even uglier:

Business bankruptcies are surging around the world, in some countries reaching volumes not seen since the aftermath of the 2008 financial crisis. It’s likely just the start of a wave of corporate defaults: A decade of cheap money instilled a false sense of invincibility in business executives and private equity managers who forgot that bust normally follows boom. Now, a combination of weakening demand, surging inflation, over-indebted balance sheets and much higher borrowing costs will prove too much for weaker borrowers.

US bankruptcies in the first six months of 2023 were the highest since 2010 among the companies covered by S&P Global Market Intelligence. In England and Wales, corporate insolvencies are near a 14-year high. Swedish bankruptcies are the highest in a decade, while in Germany bankruptcies jumped almost 50% year-on-year in June to the highest level since 2016. In Japan, bankruptcies are at their the highest in five years.

US business failures in the first half of 2023 were already the highest since 2010 (blue bar below). Insolvency pressures are set to intensify in the second half.

Rapid Ratings CEO James Gellert reviews corporate refinance troubles for upcoming debt maturities. Here is a direct video link.

The Visual Capitalist chart below shows the pace (in months) and percentage points of Fed hiking cycles since 1988 and confirms that the 2022-23 cycle (in yellow) has, by far, been the sharpest in at least 35 years.
In the process, interest-sensitive assets–commodities, bonds, equities and real estate–have all sold off.

In the last week, the US 10-year Treasury yield tested 4% for the eighth time in 15 years. Is 4% the 10-year peak this cycle? As shown below, since 1998, courtesy of my partner Cory Venable, prior yield spikes of lesser magnitude have been followed by financial shock, economic weakness and falling treasury yields/rising government bond prices for many months afterwards (green bars).
Stocks (S&P 500 below in blue since 2005) have traditionally tumbled when the price of the US 20-year Treasury bond (in green) rises (yields falling), and the gap between stock and treasury prices today is the largest we have seen in at least 20 years. This suggests that when treasury bonds next rebound, their upside and downside for equities are larger than average.
Even worse than the 2000 top (S&P 500 top chart below since 1996 ), stock market risk has been magnified this cycle by a whopping 31% concentration in the ten most expensive companies–mainly in the tech space. These ten have driven the bulk of index rebounds since last October, even as their earnings contribution has tumbled (lower chart). #irrationalexuberance. Most other companies and sectors remain flat and negative year-t0-date. Like other cycle tops, the worst market losses typically unfold as the last leaders finally stumble. The extremely suppressed equity market volatility (VIX) versus high Treasury rate volatility (MOVE index) below since 1997, courtesy of the Daily Shot, is screaming for mean reversion. The beachball of equity volatility is never held down indefinitely. We can never know when equity markets will recover cycle highs. They don’t come with due dates, and most individual companies ultimately fail, taking shareholder and lender capital with them. History warns that after manic valuation peaks, even the companies that endure typically spend years before reclaiming their prior highs. This is why buying corporate securities at low valuations is so critical when their risk/reward prospects are most favourable. Ben Graham called this margin of safety.

Government bonds have been a rough ride since 2021. Still, unlike the rest, they have the lowest odds of default, prescribed interest rates, return of capital dates and appreciate as bear markets drive risk-fleeing capital toward them.

Today’s setup for the highest quality bonds (yield plus capital gain prospects) is the most favourable in decades.