“Strap In”: Looming Credit Crunch Means Junk Bond Defaults Will “Surge Higher”
Submitted by QTR’s Fringe Finance
Friend of Fringe Finance and well known financial news contributor – as well as 38 year veteran of markets – Kenny Polcari has been kind enough to share his most recent thoughts on the market with our readers.
I’ve been lucky enough to be friendly with Kenny for about a decade now, and he was the first guy to ever take me on what I can only describe as an unauthorized tour of the NYSE trading floor, where I got to personally tell several confused specialists and market makers that the Chinese names they were trading were frauds that didn’t even exist.
The tour didn’t last as long as I would have liked, to say the least. But I’ve always appreciated Kenny’s willingness to welcome people into his busy world for nothing in exchange, and his decades of experience, which gives you a pulse on markets that only time can help you recognize.
For those who aren’t familiar with Kenny or don’t recognize him from TV, he is Managing Partner of Kace Capital Advisors and Chief Market Strategist at SlateStone Wealth. He started his career on the floor of the New York Stock Exchange (NYSE) as an institutional broker back in the early eighties when the march of electronic trading was already taking its first steps, and the great bull was first learning to run.
I’m happy to offer up Kenny’s latest thoughts on the week’s trading so far. The post has been lightly edited for punctuation and grammar.
Kenny’s Thoughts From Mid-Week
Economic data showed us that the US Services PMI either rose or fell – depending on which data point you choose to look at – the S&P Global US Services PMI plunging even more than expected coming in at 43.7 – deep into contractionary territory – while the ISM survey reported that Services PMI surged to 56.9 – which would put us well into expansionary territory – so which is it?
My guess is Door #1, the S&P Global metric.
And then we had all of the drama on Monday in Europe and the Middle East over oil and natural gas: OPEC+ cutting production while Russia halted natural gas to Europe after the West imposed sanctions on Russian oil over Putin’s invasion of Ukraine.
And now that winter is coming, Europe is the one that is about to suffer, because leaders there got into bed with Putin, leaving themselves vulnerable to his desires and, right now, he is not desiring Europe.
The dollar index surged on Tuesday and is trading at 110.30 – that’s up 5.5% from mid-August and up 15.5% YTD. [QTR’s Note: The index is at 109.50 as of this writing].
That sent treasuries spiraling lower, which sends yields higher – and the curve remains inverted: the 2’s yielding 3.5%, the 5’s yielding 3.45%, the 10’s yielding 3.34% and that helped turn one of the street’s most fervent bears into an even more fervent bear. Mikey Wilson – Morgan Stanley’s market strategist has now cut his expectations for earnings growth for the balance of this year and next year.
He is now calling for profits to fall by 3% in 2023 and has a 3200 target on the S&P and that’s without a recession – imagine what he is gonna do if we ‘really’ have a recession
Many on the street are now calling for new bear market lows, which means you can kiss 3636 goodbye. “Guesses” now range from S&P 3000 to 3450ish before this is over. If that is true, that’s another leg that could take us down another 12% – 23% from here. Recall, the S&P is already down 18% year to date.
History tells us that a bear market usually suffers a 32% drawdown (on average) from the high and, if that’s true, then the bottom should be somewhere around 3265ish.
And the financial pain is spreading into the junk bond market – which many on the street are now calling the ‘canary in the coal mine’. As rising junk bond ‘defaults’ are suggesting that interest rate increases are strangling the debt laden companies and that is suggesting a looming credit crunch. Defaults on leveraged loans hit $6 billion in August – $6 billion – and that is the highest monthly total since October 2020 – when the world was dark. And while some will say $6 billion is nothing but a pimple on my a** considering the total market size is more than $1.5 trillion, I would say – strap in – because that figure is about to surge higher.
From The Wall Street Journal:
One sign of concern—a flurry of reports published by investment banks after Fed Chairman Jerome Powell signaled on Aug. 26 his intent to keep rates high to suppress inflation. Wall Street firms sounding the alarm included Bank of America Corp., UBS Group AG and Morgan Stanley, which called the loans a “canary in the credit coal mine.”
“Borrowers are particularly vulnerable to the double whammy of weaker earnings and rising interest rates,” Morgan Stanley strategist Srikanth Sankaran said. That will trigger a wave of credit-rating downgrades and push average loan prices—currently 95 cents on the dollar—below 85 cents, a level breached only during the 2008 financial crisis and the depth of the Covid-19 pandemic, he said.
It’s just a math problem – right?
Interest payments on junk bonds ‘float’, which means they are not ‘fixed’ (think revolving credit vs. a mortgage) so the higher the Fed pushes rates, the tighter the squeeze on the companies that borrowed billions at 0% becomes. Because suddenly, the rate isn’t 0% anymore – it’s 2%, 3% and going higher. So do the math: $6 billion at 0% vs. $6 billion at say 3%. Think adjustable-rate mortgages that were at the core of the GFC (Great Financial Crisis): it’s all good until it isn’t.
Remember – corporate borrowers are at risk of the double whammy: weaker earnings and rising interest rates. That will cause the credit agencies to issue a wave of downgrades, making it harder for these companies to borrow even more money to fund growth or to repay current debt which will cause defaults to rise. So that idea of a ‘soft landing’ – yeah…get it out of your head. I have been saying SOFT and LANDING should not be used in the same sentence ever again.
Now the same thinking goes for home loans of which there are already 5 million in default. If a weakening economy and rising inflation causes the Fed to push rates higher and higher (which it is) it will cause unemployment to surge as the economy slows, leaving many unemployed and unable to pay their mortgages. This pushes mortgage defaults higher as housing prices retreat. Remember – it’s just a math problem.
Which makes me want to ask – what were any of the ‘ivy league’ bankers at the Fed thinking? Were they thinking? What did they think was going to happen as they kept policy loose, kept interest rates at 0% all while stimulating the bond market when the data clearly was screaming STOP!
What was the conversation behind the curtain when inflation spiked and kept spiking all while the current administration kept spending money like a drunken sailor? What are they teaching at business school? And now [President Biden] wants us to pay for their educations? Is it me?
In the end stocks around the world continue to come under pressure as worries about a looming global recession build. Forget a soft landing, forget the idea that the ‘Fed’ has it under control, forget the idea that it is all transitory. Remember – I have been saying it for months now: we and every other major central banks have been stimulating the global economy since March 2009 by slashing global interest rates and supporting the bond markets – for 13 years.
Now, the chickens have come home to roost, so anyone who thinks this is ‘under control’ needs to see a shrink. This is not going to be over anytime soon – not next month, not next year.
And this is exactly why we have been talking about taking new money and building a more defensive portfolio as the weeks go by: overweighting healthcare, energy, consumer staples and utilities – or what I like to call stuff that people need.
You need companies that pay hefty dividends and have good solid cash flow and you need to know what you own and why you own it. Because in the end – you don’t need HOOD, PTON, COIN or ROKU to name a few. I think you do need names like UNH, CL, XOM and AEP to name a few. [QTR’s Note: This is not financial advice and not a recommendation by me to buy or sell any securities.]
Tuesday was a perfect example. While 8 sectors were lower, 4 ended higher. And what were they? Utilities, Healthcare, Industrials and Real Estate (good dividend payers with strong cash flow).
Gold continues to thrash around, falling $10 Tuesday to end the day at $1712. It remains in the $1700/$1760 range with the surging dollar putting pressure on commodities – and gold is a commodity, just like silver, platinum, corn, soybeans, lumber, coffee, sugar, lean hogs, cattle. On Tuesday the BCOM (Bloomberg Commodity Index) fell by 1.4% on the back of the stronger dollar.
Oil is also a commodity – and that also came under some pressure due to the surging dollar as well as the continued Chinese lockdowns (which is chipping away at demand) and talk of a global recession. By Wednesday morning oil was trading at $87.20/barrel – below the trendline but holding onto the recent lows. If it fails to hold right here – the chart suggests that $80 is the next level of support – but then you have to ask – what will OPEC do?
Will they sit back and watch prices fall or will they announce new cuts to production as they try to defend the price of oil? It’s a tangled web we weave….
European stocks were lower mid-week with Putin blaming Europe for the current energy crisis – suggesting that demand for Russian oil and natural gas is at all-time highs but that sanctions and price caps are unfair forcing him to take control and stop the flow of energy through the Nord Stream pipelines….(not the Nordstrom pipelines, as Press Secretary Karine Jean-Pierre called it).
She has oil & natural gas pipelines confused with the famous US clothing store. You can’t make this up!
In addition markets are lower as recession fears build and the ECB is about to raise rates again today (referred to a ‘jumbo rate hike’ of 75 bps) as Eurozone inflation hits a high of 9.7% and is forecasted to go even higher in the months ahead.
In any event –September and October are full of angst and volatility – I suspect this year won’t be any different. Stay focused – put money into your account and keep it in cash if you must – but be prepared to put it to work at some point. I always say it is better to remain in the game than sit it out, but that’s me. You do you. Remember – in an environment like this – big boring names are beautiful and offer some shelter from the storm.
If you own good, solid US mega cap names that are decent dividend payers then sit tight and take advantage of weaker prices that will bring down your average cost.
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Fri, 09/09/2022 – 11:30