The Daily Spark

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.

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.

The Fed is not going to pivot anytime soon because if the Fed pivots to dovish with inflation at 8%, it will push up inflation even more. The FOMC wants to lower inflation from 8% to 2%, and it has to happen through a tightening of financial conditions via higher rates, wider credit spreads, and lower equities. Our latest credit market outlook is attached.

During the pandemic, more people earned income doing TikToks, selling things online, and, more recently, driving Uber, and the growth of the gig economy over the past decade has been very significant. 

Data from the Fed shows that 27% of US adults earned some money from gigs, and 8% were regular gig workers, in that they spent 20 or more hours in the prior month on gigs. The Fed survey also shows that gig work frequently supplements earnings from a traditional job, nearly half of gig workers also have full-time jobs, while 22% have part-time jobs.

This gradual shift towards more and more gig workers is complicating the Fed’s efforts at cooling down the economy. The more flexibility workers have with alternative work arrangements, the harder it is for the Fed to slow down aggregate demand because having a job is no longer a binary decision, which is a problem when the FOMC is trying to quickly slow down growth and income in the economy.

Tourism in Singapore is starting to come back to normal, see chart below.