Fed Policy is the Key Driver to Valuations

The sustained elevated pace of inflation is the focus of the global capital markets.  Inflation, measured by the CPI, is running at a 7.7% annual rate in November which is lower than the 9.1% in June. The response from the Fed has been to increase short term interest rates by over 300 bps so far this year. The increase in short term interest rates has raised the borrowing costs and slowed demand. Given the persistent strength of global inflation, we now expect the Fed to push rates high enough to choke economic growth.

Higher interest rates are flowing through the capital markets and impacting corporate earnings, mortgage loans, and existing adjustable rate leveraged loans. Corporate earnings are negatively impacted by rising wages and increased interest expense. Companies are being forced to rationalize paying rent on office space that is still not fully utilized following the pandemic. In the face of slowing revenue growth, in order to preserve profit margins, companies will begin to reduce leverage, headcount, and rent expense.

The labor market remains very strong. According to the Bureau of Labor Statistics, the November unemployment rate was 3.7%, which is near a 50-year low level of unemployment. While there are currently 6.1 million unemployed people, there are over 10 million job openings. The key to the sustainable economic growth is the health of the labor market. In November, 263,000 jobs were added to the market, and the labor force participation rate didn’t change much at 62.2%.

The Fed has increased short term rates by 300 bps this year. However, we expect the Fed to begin to slow the pace of rate increases. In the absence of a dramatic decline in the rate of inflation, at the current pace of inflation, we expect the Fed will have to push short term rates up to 4.5%.

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