Price Taker/Price Maker: 3Q21 Inflation Playbook

CreditSights Research
Winnie Cisar
CreditSights Staff

EXECUTIVE SUMMARY
  • With recent inflation data showing more persistent, rather than transitory, characteristics, corporate credit investors must navigate high levels of portfolio sensitivity to duration-driven return losses and, at the same time, identify inflation-related fundamental headwinds for specific sectors and issuers.
  • IG and HY may also see technical pressure from inflation as the Fed moves away from accommodation through a taper announcement and the market pulls forward expectations for a Fed Funds rate hike. These factors could ultimately drive investors out of low yielding fixed income and into inflation-linked markets, including TIPs, leveraged loans and equities.
  • Heading into Q321 earnings season, our US analyst team identifies the price makers and the price takers across the IG and HY markets, assessing the potential impact of inflation on near-term cash flows. In IG and HY, inflation poses a high risk to cash flows in only two sectors: Autos and Consumer Goods; however, a number of sectors are likely to face acute headwinds from commodity prices, labor costs and supply chain/transportation challenges that will flow through to earnings.
PERSISTENTLY TRANSITORY

Most market participants view the Fed as ‘in play’ to make a taper announcement at its November 2-3 meeting, and the October 29 release of September PCE deflator data may prove a key focus for investors leading into the meeting. The Fed uses core PCE as its preferred measure in its policy of ‘average inflation targeting’ and, in the April 2021 reading, core PCE jumped to 3.1% (YoY % change). In the subsequent months, core PCE has climbed above 3.5% and consensus estimates point to another heady gain of 3.7% (YoY) for the September data. Looking further out, many, including the Fed, believe inflation will moderate as core PCE is expected to end 2021 at 3.2% before declining further in 2022 and 2023 (to 2.8% and 2.2%, respectively). With other central banks implementing rate hikes and inflation proving stickier than expected, market participants have pulled forward expectations of one (or more) Fed Funds rate hike(s) into late 2022. The Fed Funds futures market currently shows a 40% chance of a hike at the September 2022 FOMC meeting and an almost 60% chance of a December rate hike, a significant change in expectations from just a few months ago. At the end of June, the futures market was pricing in a 24% chance of a September 2022 hike and 32% of a December hike.

STRATEGY
Price Taker/Price Maker: 3Q21 Inflation Playbook

CreditSights Analysts:
Winnie Cisar
CreditSights Staff

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