Penn Capital Management Company, LLC
The elephant in the room
Lest we get comfortable with their message, the Federal Reserve (Fed) once again reminded the markets that it remains the boss and is not easily predicted. First, Jerome “Jay” Powell told us that the Fed had not even started “talking about” tightening monetary policy, but then we learned quite the opposite, that they had, leading them to actually start talking “out loud” about it. Then came the FOMC meeting when the dots moved forward and some hawkish comments were made. Next came news that Jay Powell and others tried to walk back some of the hawkishness. Oh, and somewhere in between, the Fed announced it would sell (gasp) its remaining corporate bonds from the SMCCP (Secondary Market Corporate Credit Facility).
The SMCCP is a facility that expired in December 2020 (from buying, that is). Why is it surprising that the Fed would want to clean this facility up, especially after it didn’t buy much other than bonds from Apple and from foreign car makers like Toyota, Volkswagen and BMW? Recall our note from last summer that highlighted it was really just the Fed’s words, not actions, that helped provide stability to the markets. Was it a sign that tapering could be on the table after they exited these bonds? Yes, but at all time low yields and nearing all-time spread lows, we don’t have to worry about the technical impact that actually selling these bonds will have on the market.
Take a breath
So how do you invest in a market that is obsessed with crypto currencies and that hangs on every word spoken by a Fed official? They are dovish, they are hawkish, no they are dovish, no they are hawkish. And should the Fed’s new more hawkish messaging be concerning? To that we would say: a) remember that the Fed is reacting to positive near-term and expected fundamentals, b) the Fed might actually be more patient than is implied by the dots, and c) once the Fed starts tapering and hiking, follow-on tapers and hikes don’t have to be done with the same haste as in 2016-2018.
Most importantly, keep focused on the ball of fundamentals. Whereas it is wise to begin preparing for a new part of the rate cycle, the fact is that we have arrived here because fundamentals are good. Remember that when Fed members moved up their dots, the Fed also upped its GDP forecast for 2021 to 7% from 6.5%. It is also assuming an unemployment rate of 3.5% in 2023. Recently, J.P. Morgan lowered their default rate forecast on both high yield bonds and leveraged loans to 0.65% in 2021 and 1.25% in 2022; both lows since 2011, including energy! Believe it or not, at these default rates, spreads actually have room to compress. Corporate debt refinancing has reached its fastest pace in 20 years, which helps to create long runways for corporate balance sheets at low rates. Consumers have done a great job paying down their credit card debt, household net worth is at a record (in part due to housing) and job availability (using JOLTS [Job Openings and Labor Turnover Survey] as a measure) has reached the highest ever.
Act as I do, not as I say
The fact remains that the Fed will continue to be data-driven. Even if Jay Powell is replaced in 2022 (a risk not many people are talking about), his successor is unlikely to be more hawkish on monetary policy, albeit perhaps more hawkish on regulations. If we get to 2022 and 2023 and the facts on the ground do not support tightening policy, we believe that the Fed will be patient. They have tried desperately for years (perhaps decades) to spark inflation (against structural headwinds which still exist) and will look past a one-year pop in prices versus low global pandemic comps. Forget about the dots, we think it would be a mistake to think that the Fed will act aggressively and prematurely in the future. By virtue of how the market recently reacted to the Fed’s hawkish trial balloons (rates and break-evens down), they probably think that they can let inflation run hot and then act quickly if things get out of control; rather that than the other way around of not having enough inflation.
Fresh in the Fed’s mind has to be the span of rate hikes from 2016-2018. Look at the beautiful staircase they created with repeated hikes without hardly taking a breath. That was a mistake they probably don’t want to repeat, so don’t assume that shape repeats itself. Even if the Fed does start tightening in response to positive fundamentals, they can do it in a more gradual way. The safest way to slow down after coming off the highway isn’t an abrupt stop, but rather a long off-ramp.
At this point of the rate cycle, we continue to like leveraged loans and short duration credit as a way to hedge against the potential of rising short and long-term rates, although the cycle could take a while to play out. Jackson Hole at the end of August. Get your popcorn ready and be prepared to buy the dip.
The views expressed are those of Spouting Rock Asset Management as of July 1, 2021 and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.
