As Fed Decision Looms, Credit Fears Flash In Stocks' Underbelly

There is a sense of calm returning to Wall Street just a few days after policymakers contributed to restoring confidence in the global banking industry.

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The underbelly of the stock market is teeming with companies that are most vulnerable to rising borrowing costs as a result of the coming decision by the Federal Reserve on interest rates.

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An index constructed by Trade Algo that focuses on highly leveraged stocks and shorts those with limited debt at the same time, was able to post its worst week since April 2020 because traders are grappling with a tightening credit environment. Based on the baskets of Goldman Sachs Group, the story is similar. Since 2018, a Societe Generale SA index that buys stocks with strong balance sheets and sells those with weak balance sheets has risen for 10 consecutive days among US small-cap shares. 

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Following the crisis that hit Credit Suisse Group AG and regional US banks last week, the market rout last week was exceptional, but lenders are likely to become more cautious going forward. Thus, Citigroup Inc. strategists believe a credit crunch is now inevitable - putting the weakest links in Corporate America at risk of recession. 

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A Citi team led by Dirk Willer wrote that the severity of the situation depends on how quickly and how much additional support is provided by US authorities. "We expect downside for risky assets with equities barely reacting to the turmoil following a strong rally from last year's lows."

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March has been a month of bank drama, which caused investors to flee to safety and Treasury yields to plunge. In spite of this, corporate bond issuers are planning to pay their highest monthly premium since June. 

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According to a poll by Bank of America Corp. this month, systemic credit events are the biggest tail risks for investors. In the meantime, JPMorgan Chase & Co.'s head of research warns of the potential for a "Minsky" moment, where assets collapse suddenly and dramatically. 

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To a certain extent, that may be a bit of hyperbole, but for the time being the market is being supported by fading stress in the financial sector. Through Tuesday, the S&P 500 was still up nearly 1% this month through an increase in technology giants that are benefiting from an easing in Treasury yields that are pushing them higher. 

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The spreads on corporate bonds and credit default swaps are widening across the board, while strategists elsewhere are taking their cues from those spreads. It is under the leadership of Andrew Lapthorne, a Quantitative Analyst at Societe Generale, who slices and dices stocks by a variety of factors that determine their performance. In the past week, one of the Russell 2000 stock tracking systems, which excludes financials, has posted the biggest moves out of the 20 stocks it tracks based on its probability of default assessment based on a Merton model - so far this month. 

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A tightening of credit is most likely to affect smaller firms, according to Lapthorne. Compared with the 150 largest US stocks, Russell 2000 earnings before interests and taxes were just about three times their interest costs at the end of 2022.

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Research by SocGen shows these smaller firms will also experience declining profits more rapidly and grow more indebted until a peak in 2026. 

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According to Lapthorne, the risk on balance sheets keeps building and building until something breaks. Balance sheets are really impacted by declining profits and declining cash flows, and we're not yet there."