A key reason inflation remains so high is that households still have significant savings left, and the market underappreciates this strong tailwind for consumer spending, see charts below. Combined with solid job and wage growth, it will take many quarters before the level of household savings is back at pre-pandemic levels.
Liquidity is getting worse in government bond markets, credit markets, and equity markets see charts below. The sources of low liquidity in financial markets are passive investment strategies, high-frequency trading, and less risk-taking by some brokers.
Tomorrow, Thursday, we get inflation data for September, and the Fed’s forecast is that headline inflation will decline from 8.3% to 8.1%, and core inflation will rise from 6.3% to 6.6%, see chart below and here.
These numbers are all significantly above the FOMC’s 2% inflation target.
For financial markets, the implication is that the FOMC will continue to raise rates until inflation starts to move meaningfully down toward 2%.
Based on the consensus inflation forecast in the chart below, the Fed will likely pause rate hikes once we get to the middle of 2023. Seen from this perspective, the equity bear market will continue for now, but we could get a sustained rally in stocks and credit starting in 2023.
The first chart below shows that the corporate debt-to-equity ratio is low.
The second chart shows that corporate debt is high as a share of GDP.
In other words, corporate debt levels are low relative to equity prices. But corporate debt levels are high as a share of GDP.
A different way of looking at this is that a decade of low interest rates and QE boosted both debt levels and equity valuations. But easy monetary policy did not boost GDP by nearly as much.
One important conclusion is that there is more financial engineering, i.e. debt and equity outstanding, in the economy than ever before. And this increase in debt and equity outstanding has not yielded a corresponding boost to GDP.
The bears see high levels of debt and equity outstanding as a future risk to financial stability, in particular in a situation where inflation is high and interest rates are rising. The bulls argue that a more developed financial system is positive for growth and risk management in the economy for households, firms, and investors.
Central banks are withdrawing liquidity, and it is having a negative impact on credit and equity markets, see chart below.
Last week’s employment report showed that the US economy created 263,000 jobs in the month of September and that the unemployment rate declined from 3.7% to 3.5%. Although the labor market remains relatively strong, one recent sign of softening is a drop in the total number of job openings. Currently, there are approximately ten million job openings in the US, the lowest level since June 2021, but still elevated from a historical perspective. In the week ahead, we will be closely tracking the release of Consumer Price Index (CPI) inflation data. The consensus expects inflation to decline to 8.1% from 8.3%. Alternatively, core inflation is expected to rise, which is not a trend the central bank would like to see after several rate hike cycles. The conclusion remains that the Fed needs to step harder on the brakes to cool the economy down. In that context, we are monitoring the impacts of ongoing interest rate hikes and whether they will result in a soft or hard landing.
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As the Fed raises rates, companies with floating rate debt have higher debt servicing costs, and companies refinancing their debt will pay higher interest rates, see charts below.
The good news is that many companies during the pandemic have termed out their debt into later years, and just 9% of fixed-rate debt is scheduled to mature by the end of 2023.
High yield debt usually is more vulnerable to rising interest rates, but high yield only makes up 19% of US corporate debt maturing by the end of 2023.
With the consensus expecting and the market pricing that Treasury yields will peak by the middle of 2023, the bottom line is that the maturity wall looks manageable for both IG and HY.
The current trading pattern seen in the S&P500 and VIX is very similar to the pattern seen in 2007-08, see charts below. Our weekly Slowdown Watch with daily and weekly economic indicators is attached.
European energy prices continue to decline, see chart below.
The idea with QE was to lower rates and create a rally in stock markets and credit markets. The idea with QT is the opposite: To push long rates higher, widen credit spreads, and lower stock prices. As QT gears up over the coming months, see chart below, investors should be positioned accordingly.
