Investing amid a “Fedflation” fixation

• Another big Fed hike is expected this week.?All eyes are on the U.S. Federal Reserve’s meeting this Wednesday, the first since the Fed’s August symposium in Jackson Hole, Wyoming. Chair Jerome Powell and his colleagues have been steadfast in their resolve to bring inflation to heel through tighter monetary policy — even if doing so may, in Powell’s words, “bring some pain to households and businesses.” (Not to mention investors … which he, in fact, did not mention.)
• How many basis points are in the offing??Expectations have shifted dramatically in the past few weeks. As of 9 September, markets were pricing in a 90% chance of a 75 bps hike and 10% odds of a 50 bps bump. Now, the prospect of 50 bps is off the table, replaced by the possibility of a 100 bps increase, or one full percentage point. Perhaps more significantly, the hikes expected at future meetings have increased and the terminal policy rate expected to be reached in 2023 has jumped from about 4% to nearly 4.5%.
• Inflation remains the hot button.?In August, core U.S. CPI inflation (which excludes volatile food and energy prices) spiked month-over-month (+0.6%) and year-over-year (+6.3%), topping forecasts and dashing hopes that a more benign inflation climate might hasten a Fed pivot toward looser monetary policy. And while the producer price index (PPI), which measures wholesale inflation, subsequently came in cooler (-0.1%) for August and year-over-year (slowing to 8.7% from 9.8%) — this was not enough to assuage market anxiety.?

Portfolio considerations:

The market reacted violently, with the S&P 500 Index posting its worst one-day loss (-4.3%) in more than two years. Such?inflation-induced volatility has been a key driver of our continued preference for higher quality within equities and makes us reluctant to call the bottom of the bear market.

While many?equity and fixed income markets have continued to struggle in this “Fedflation” environment,?those seeking temporary refuge might find solace in money market funds yielding 3% for the first time since 2008. But knowing exactly when to cash out and when to cash back in can present its own challenges, as the history of market timing has shown. Instead, holding assets with historically favorable risk/return behavior might be a more effective strategy for managing risk, especially when such assets offer an attractive entry point.

There are still opportunities for investors to find value.?Rather than over-relying on cash, Nuveen’s leveraged finance team prefers less volatile complements to equities that may benefit from higher short-term rates, such as floating-rate loans. The coupons on such loans are set as a spread over the Secured Overnight Financing Rate (SOFR) and likely to increase alongside Fed rate hikes in the next 12 months (Figure 1).

Of course, higher interest expenses will put pressure on these levered borrowers, already facing headwinds from cost inflation and margin pressure — which is why index level yields today are just shy of 10% (Figure 2).?Overall, though, borrower fundamentals remain solid, with aggregate net leverage back to pre-pandemic levels.?Larger, higher-quality borrowers should be better positioned to withstand higher rates via a combination of inflation rate hedging, stronger balance sheets and less cyclical business models versus lower-quality segments of the market.

Middle market direct loans are a similar option.?They involve smaller loan sizes to smaller firms in the private market, where lenders may receive better collateral and covenants than with broadly syndicated floating rate loans. Cumulative default rates have historically been lower (4.2%) for middle market loans versus their broadly syndicated counterparts (5.9%), with recovery rates higher, at 73.8% versus 67.3%. These loan term advantages may increase as the Fed continues to pull liquidity from the system. While the yield advantage for middle market loans has been temporarily eclipsed by broadly syndicated loans, the lower default risk makes them worthy of consideration.

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