Watch Your Leverage!

When the Federal Reserve squeezes, unintended consequences follow.

The collapse of SVB Financial Group (SIVB) was last week’s biggest story for investors by far. And even if you’re not a shareholder or depositor over the FDIC insured limit, you ignore the lessons at your peril.

Simply, when the Fed pushes up interest rates, the cost of debt gets more expensive. And individuals, businesses, even governments can be caught out, unable to absorb the added expense and thereby forced to throw in the towel.

If they’re prepared, the damage can probably be contained by paying down credit lines, or in more extreme cases closing down a line of business operations and covering the loss by selling assets. But if they’re not ready and conditions become extreme enough, there may be no alternative to bankruptcy. And as history shows all too clearly and painfully, one failure frequently triggers another.

In my September 22, 2022 Substack post, I warned readers not to count on the Fed to tame what had become the highest inflation rate in nearly half a century. Unfortunately for the stock market, that forecast has proven to be on the mark. And if anything, the key factors driving it are more entrenched than ever.

The drive towards mutually destructive economic decoupling between the US and China appears to be picking up steam on both sides of the Pacific Ocean. The latest round of earnings reports and guidance calls from oil and gas companies clearly shows managements have not become any less conservative, devoting big chunks of free cash flow to dividend increases, stock buybacks and paying off debt while keeping a lid on CAPEX. The latest employment report highlights a labor market that’s still quite robust, with rising wages presaging higher consumer and producer prices to come in an emerging cycle.

Worst of all, higher interest rates coupled with a sliding stock market are crimping investment. This is demonstrated even in projected 2023 CAPEX of renewable energy companies, which did not lift off as many expected. That’s despite unprecedented government support from $1 trillion plus in targeted infrastructure spending and then $347 billion in the targeted subsidy and long-term tax breaks, headlined in the Inflation Reduction Act.

When the Fed stops raising rates, inflation will almost certainly flare up again. In fact, if the example of the 1970s holds, it will be higher than ever, provoking an even more aggressive response from the central bank. And the consequences will be even more dire for anyone who interprets easing as an all clear sign to lever up.

Such is the investment world of the 2020s. In my February 24 post “Learning to (Really) Love Inflation, I highlighted smart long-term investment choices for dividend seeking investors. But it’s equally important to guard against the current environment, as the Fed’s continued squeeze on interest rates pressures the most vulnerable.

I prescribe following an investment strategy based on four simple rules. They are:

·        Sell stocks of companies that are weakening as businesses. 

·        Build a pile of cash by unloading weakening companies as well as by taking partial profits on favorites that have run to unsustainable valuations. 

·        Build a watch list of high-quality companies to buy when they hit designated entry points that represent long-term value.  

·        Make fresh investments incrementally, rather than all at once. 

In investing, one size definitely does not fit all. And that applies even if your primary motivation is dividends.

For example, some need to harvest dividends to pay living expenses. Long term savers can put the power of compound interest to work to build wealth by reinvesting dividends. And others will seek out big gains by buying stocks paying exceptionally high yields, offering the potential for big capital gains as underlying companies overcome challenges.

Whatever your motivation, it’s critical for stocks’ underlying business to be getting stronger. Every company stumbles from time to time. But so long as management is sticking to its core strategy, earnings and share price will eventually recover. And it makes since to stick with the investment—regardless of how down on it others may be.

Conversely, if the business is really weakening, we want to be out of the stock. That’s even if it means taking a loss from holding on too long in hopes of a recovery.

The ideal time to assess prospects is with earnings and guidance updates. Calendar Q4—the batch of results just out—are still coming in, mainly because reporting requirements are so much more intense than for Q1, Q2 or Q3. But for the vast majority of companies, we do have enough information to make a judgment on the health of their underlying businesses. And we can in fact answer that key question of the day: How vulnerable are they to the Fed’s continuing squeeze on interest rates?

Market history is loaded with examples of unintended consequences hitting investors where they least expect it. The sudden implosion of Lehman Brothers back in 2008, for example, almost simultaneously threatened a first-ever break below $1 net asset value for a money market fund.

This time around, the Fed and the Biden Administration have been on high alert for broader systemic breakdown following the collapse of cryptocurrency. The aftermath of the MVB breakdown shows the authorities have been less vigilant regarding fallout from the collapse of high yield bonds.

Another budding crisis could be building from the rising cost of variable rate debt. Several otherwise well-run companies in my income stock coverage universes have warned investors their 2023 results will be negatively impacted by the need to reduce large levels of variable rate debt.

Kinder Morgan Inc (NYSE: KMI), for example, expects relatively flat results this year against 2022, with higher anticipated interest expense basically offsetting the positive impact of new pipelines entering service on time and budget despite historic inflation. Boston Properties (NYSE: BXP) is successfully transitioning its office REIT portfolio to properties that will always be in demand despite the post-pandemic movement to work from home. Yet this year strong rent growth and occupancy at the bottom line will be more than offset by higher finance costs.

These are strong companies that are already looking ahead from this stumble. And their stocks are well priced to bet on recovery. But not every company affected by higher interest rates will be able to say the same at the end of the day. That’s where the axe will fall next so watch your leverage!