All eyes will be on Jackson Hole, WY, on Friday during the Federal Reserve Board’s (FRB) annual Economic Policy Symposium (held virtually) to see if Fed Chair Jerome Powell may signal that the Fed is prepared to taper bond purchases next month. I don’t expect a clear signal from the Fed just yet, and here are two reasons why:
- First, there is lingering and rising uncertainty around the Delta variant and weakness in some real-time indicators, like travel bookings. Case in point – the Jackson Hole meeting itself was switched to an all-virtual format because of health and safety considerations. Given recent downward revisions to consensus growth forecasts because of Delta, the Fed should want to maintain as much optionality as possible and wait and see how August data, to be released in September, fully shapes up.
- Second, most market participants expect a taper announcement at the September Fed meeting, and not at Jackson Hole. Since market expectations are well aligned with the Fed’s preferred timeline, there is even more reason for the Fed to err on the side of caution.
Uneven employment impedes recovery
What, then, might Fed Chair Powell talk about instead? As telegraphed,1 he should discuss the economic outlook with all its uncertainties and its unevenness, notably in unemployment. According to the U.S. Bureaus of Labor Statistics (BLS), some sectors, like financial services, are seeing very low rates of unemployment, just 3%. However, the leisure and hospitality industry still has a persistently high unemployment rate of 9%. The other challenge – leisure and hospitality, and wholesale and retail trade account for almost 40% of total private, non-farm unemployed, according to BLS data. These industries need to see an uptick in employment to make substantial progress on the headline unemployment rate, and that has become less certain due to Delta-related travel and back-to-work delays.
What does it mean for equities if Powell doesn’t signal taper?
Most sectors – gauging from options pricing – do not expect much more than average volatility coming out of Jackson Hole, but the energy sector does. Last week, the cost for an at-the-money straddle (long call and long put option with identical expiration and strike price) for an energy ETF was 5% versus 3.7%2 historically, implying a particular concern within the energy patch.
If the Fed tapers it could also cause the dollar to strengthen, on top of weaker oil demand due to Delta. That’s a double negative for oil, and this has weighed on oil and energy stocks recently. However, if the Fed taper is postponed until after Delta cases peak, this could result in a relief rally for energy stocks. Indeed, here are three other reasons why we think investors may want to buy the dip in energy after the recent pullback.
- First, Delta cases peaked in China. U.S. energy stocks pulled back -14%, primarily due to the Delta outbreak and mobility restrictions in China, as analysts lowered China oil demand by 1 million barrels/day for the third quarter. However, cases in China are rapidly declining, and we expect that curbs could soon be lifted, and activity should bounce back. Also, cases in some U.S. states, like Florida, are showing signs of subsiding.
- Second, oil and gas industry fundamentals are much improved. The sector today has low leverage, strong free cash flow yield (at $65-70 per barrel), capital discipline, above-benchmark dividend and buyback yield, and finally, an emerging focus on ESG, focusing on carbon capture utilization and storage.
- Third, energy is the cheapest sector of the S&P500. Forward P/E is 11.6x versus 21.4x for the index. And the sector is trading below its own historical averages: price-to-book is 1.7x versus 2.3x historical average.3
What does it mean for rates?
While delayed tapering amid the surging Delta will likely be a welcome sign for markets, it is still delaying the inevitable. The Fed will have to eventually reduce its asset purchase program (many market participants expect an announcement in Q4 with a December 2021 or January 22 start) that was designed to boost demand during the time of crisis. As FRB of Dallas President Robert Kaplan pointed out, QE “purchases are very well equipped to stimulate demand. But we don’t have a demand problem in the economy.”4
Provided that employment growth doesn’t stall or decline due to Delta, we still expect a taper announcement this fall. This could move rates higher, somewhat, but the bigger upwards risk to rates in our view is that consensus doesn’t expect a rate hike until Q3 2023, according to the Survey of Primary Dealers. The Fed funds futures curve looks for an earlier hike, but still not until December 2022. The risk is that this may have to be pulled forward or more rate hikes will be needed than currently priced in, and the futures curve will need to reset higher. As a result, we think the risks to rates are skewed higher at this point.
Consider private credit as rates rise
One way to position for potentially rising rates (and consensus that may be underestimating that) is in private credit/direct lending, which is typically extended by non-bank institutions to middle-market companies. Most debt in this approximately $1 trillion5 market is structured as floating rate and offers a 500-800 basis point spread over LIBOR6 depending on the size and quality of the loan (330 basis points for publicly traded leveraged loans). Yields are approximately 8.75%,7 with leverage.
Of course, this yield advantage comes with higher risk. The average implied credit quality of private credit is B, or below investment grade. Still, U.S. direct lending historically outperformed when the Institute for Supply Management Manufacturing Index was over 50 and rising, or over 50 and falling, when economic activity was in expansion mode and defaults remained low.8
Indeed, as this week’s manufacturing data should show, economic activity is still in expansion mode, and public leveraged loans default rates are at very low levels – expected to be 0.65% in 2021 and 1.25% for 2022.9 Given this strong economic backdrop, benign default environment, and potential for upside to consensus rate-hike expectations, we believe these factors present an opportunity in private credit.
(1) Fed Chair Powell is scheduled to speak on Friday, August 27th on the topic of "Macroeconomic Policy in an Uneven Economy".
(2) Source: Goldman Sachs, Weekly Options Watch, August 18, 2021. The cost of a straddle is starting 7 days ahead of day 1 of Jackson hole and expiring the subsequent Friday for most sector ETFs.
(3) Source: BAML. Historical average for the period of 1986-07/21.
(4) Source: https://www.cnbc.com/2021/08/11/fed-should-announce-bond-taper-in-september-begin-it-in-october-says-dallas-fed-president-kaplan.html
(5) Source: Pitchbook, as of Q2 2021.
(6) Source: iCapital
(7) Source: Cliffwater Direct Lending Index, as of March 31, 2021
(8) Source: J.P. Morgan Asset Management; Institute for Supply Management; Bloomberg; Barclays; Credit Suisse; Cliffwater.
(9) Source: JPMorgan Credit Strategy Weekly Update, August 13, 2021
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