Tuesday, June 21, 2022

Interest Rates Are Rising... But It's Not Time to Panic

By Joel Litman (View Archive)

Editor's note: Over the past week here at Empire Financial Daily, we've been sharing insights from our friend and colleague Joel Litman over at our corporate affiliate Altimetry...

As longtime readers know, Joel's "Uniform Accounting" methodology analyzes companies' financial statements – making more than 130 adjustments to uncover their real earnings and financial health. (Until midnight tonight, you can claim six free months of his Uniform Accounting research – get the details right here.)

In today's essay, Joel explains how his Uniform Accounting analysis reveals insights into the high-yield credit market... and what the picture for the debt environment looks like now.


If you're looking to buy a new house, you've likely felt the pressure of rising interest rates...

As the U.S. Federal Reserve has increased the benchmark interest rate, the repercussions have trickled down the line. In fact, last week, the Fed hiked rates 75 basis points... the largest increase since 1994.

Average rates for 30-year mortgages climbed from 3.37% in February to above 6% in response.

Even a two-percentage-point jump can make homes much less affordable...

A customer paying back a standard $500,000 mortgage at 3.37% would pay $295,000 in total interest. It works out to a monthly payment of $2,200. Meanwhile, a homebuyer paying a 6.28% rate would fork over $3,088 per month and pay a total of $611,805 in interest.

In other words... the higher mortgage rate really means you'll pay 114% more interest.

This shift in housing affordability is hurting homebuyers. And of course, this situation isn't isolated to the housing industry... From credit cards to corporate debt, higher rates slow spending – and they can stop the flow of financing entirely.

Higher-risk companies don't have a choice but to turn to the high-yield debt market. And even in that space, lending is slowing down. Similar to homebuyers who can't afford houses at 6%-plus, higher rates are forcing cash-strapped companies to tighten their belts.

Corporate credit issuance is one of the key drivers of the economy. It can kick-start spending that flows out and drives employment, home construction, and more.

That's why it's critical to look at the recent slowdown in the high-yield credit market. If the riskiest businesses can't secure financing, who's next? And worse... could it start a panic?

By aggregating the market's debt, we can measure the risk of a panic...

First, let me be clear...

Slowing high-yield debt activity is not the spark that lights the powder keg of a recession. As long as businesses still have cash on hand, an inability to access credit doesn't change anything.

However, problems arise when companies run out of cash and then can't get it. Then, widespread defaults ensue... and the entire economy crashes.

To understand where we are today, we need to see what's going on in the credit markets.

Long-term interest rates, driven by the Fed's rate hikes, are currently at the high end of their 2018 levels. However, interest rates aren't yet at Great Recession levels, when the cost to borrow for high-yield companies was higher than 10%. That's why the market froze and mass defaults rocked the economy.

Today, companies are slowing their borrowing habits. They're figuring out if they really need the money. And that's where things get interesting...

Using our Credit Cash Flow Prime ('CCFP') analysis, we can look at aggregate corporate credit risk...

Our CCFP analysis allows us to visualize a company's cash flows versus its annual obligations – debt, capital expenditures, dividends, and more.

From there, we can combine the CCFPs of the entire S&P 1000 Index. That provides us with a good proxy of corporate America's credit health.

In the charts below, the stacked bars represent corporate America's total obligations each year through 2028. Then, we compare these obligations to aggregate cash flows (blue line), as well as the cash on hand at the beginning of each period (blue dots).

As of this month, all S&P 1000 companies have reported their 2021 earnings. As a result, we have a comprehensive view of their 2021 fiscal data and 2022 forecasts.

And importantly, the picture for the debt environment has actually improved...

Back in April, the aggregate CCFP showed a jump in debt-maturity headwalls in 2024 – to the point where cash flows alone couldn't service all obligations. That's partially why we've often talked about how 2024 or 2025 could be when the economy boils into a crisis. Take a look...

But over the past month, companies have reported healthier financials.

Now, the S&P 1000's aggregate cash flows cover obligations through 2024. That paints a much better picture of economic health and lowers the risk of a crash...

The reason why we're not seeing debt issuances right now is simple...

No one needs the money.

Instead, they're waiting. And they'll only borrow if growth really makes sense.

Without serious risk of default, it's clear that the market is holding off on further debt issuances for now. And like everyone else, it's waiting to see where rates go next.

Regards,

Joel Litman
June 21, 2022

Editor's note: While the financial media panics over rising rates, Joel recently issued his latest warning about a completely different situation – one that could turn out to be a massive financial "heist" you've likely never considered before. However, he says the opportunity hidden within is far greater than anything you could make on gold, ordinary stocks, bonds, or even cryptos. Until midnight tonight, you can get the full story – including the details on how to claim six free months of his Uniform Accounting research – right here.

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