The Impact Of Inflation And The Fed On Indices And Corporate Bonds

CalibratedConfidence's picture

Everyone's talking about the Federal Reserve's exit strategy and whether rates will increase before or after it contracts its balance sheet. A major topic is inflation, and specifically the most recent increases in the Consumer Price Index (CPI) on a year over year basis.

When listening to the chatter, remember that these increases are nothing in the context of history. Actually, the recent CPI increases benefit the S&P 500 and is very bullish for certain sectors.

Since 1948, inflation has averaged a growth rate of 3.6 percent. According to the April data, inflation currently floats around two percent.

Some Twitter and TV stars have pointed to the rapid jump in inflation recently as a sign of trouble and a signal for lower economic growth, implying the Fed will stay around or at least alter its "exit strategy". What these commentators are missing is the fact that the economy has enjoyed a very steady and low-level of inflation over the past 25 years.

Market Fears

The new fear in the markets is how high and how quickly inflation will grow.

So long as inflation stays under four percent, it's a bullish factor. In such environments, the S&P 500 (since 1948, according to S&P's Capital IQ) increases on average 70 basis points per month. The increase reflects investors' desire for exposure to a growing economy alongside accepting exposure to higher inflation.

If inflation increases past a certain point, the correlation reverses, with higher inflation indicating a decreasing S&P 500. Historically the line in the sand for this analysis comes at four percent Annual CPI Change. After four percent, the S&P 500 returns have become negative on a monthly basis.

Sam Stovall, Capital IQ's US Equity Strategist for Global markets Intelligence, writes in his most recent release that, "during periods of rising inflation....the Energy, Info Tech, and Materials sectors held up best, while Consumer Discretionary, Financials, and Telecom Services were hit hardest".

As Benzinga CEO Jason Raznick hinted in a recent article, the reallocation of capital from traditional markets to other asset classes poses a risk to investment, especially as capital runs into the Leveraged Loan market, and avoids the corporate bond market.

In this period of low rates, corporate bond activity has increased for certain speculative-grade debt.

When the Fed finally does move away from its Zero Interest Rate Policy (ZIRP), there may be a pause in corporate debt issuance resulting in higher issuance costs which could be detrimental to credit markets.

Stovall also noted that the increase in companies with negative outlooks or CreditWatch negative ratings compared to those with positive outlooks or CreditWatch positive ratings will be the reason for downgrades becoming more common than upgrades in the coming quarters.  This will drive up interest payments which are already hovering around 11-13 percent of EBITDA profits as default rates fall toward 2008 lows.

The current environment is still beneficial on a monthly basis. To the long-term investor it would appear, though past performance is not a guarantee of future performance, one could formulate a plan for the coming few months.  The pump fakes will come from the Fed as they prep the market to digest the Fed's desire to increase rates and shrink its balance sheet.