As the concept of “higher-for-longer” interest rates sink in, there are three areas of concern:
consumers, businesses, and the stock market. Each segment responds differently. Consumers are
expected to, in time, curtail spending in favor of saving now that interest rates are higher than the inflation
rate.
The outlook for businesses and the stock market is more nuanced. For businesses, higher interest
rates tend to dampen consumer demand, which can slow revenues and obviate the need for additional
capital investment. At the same time, depending on how leveraged the company may be, higher interest
rates can eat into profitability. This is especially true of small and private businesses that rely on bank
financing for capital.
Larger companies can issue debt securities that are more contractual in terms of interest rates for
the life of the instrument. However, the low interest rates of 2009-2022 lulled a number of firms to
depend on short-term financing because it was so cheap and did not require the cost of issuance or
covenant constraints associated with debt obligations. A general rule of thumb is to treat debt of up to
24 months as obligations of the company, while debt with a maturity of more than 24 months is treated
more as patient capital. Accounting convention requires debts due in 12 months to be treated as short-term,
but that is considered arbitrary to finance professionals, who prefer to look further ahead.
In the nomenclature of finance, equity is considered owner capital, while debt is owed capital.
Like many accounting concepts, equity has undergone revisions as many firms that deal in intellectual
property cannot value such as equity due to the accounting concept of conservatism. For example, the
returns on capital of Coca-Cola are high because there is no value placed on the formula for Coke.
Without the formula there would be no Coke. Owed capital is considered more easily valued due to it
being the product of an arm’s length transaction.
While companies are impacted differently by rising interest rates depending on the amount of and
maturity of their debts, the impact of rising rates on stock prices is somewhat more uniform. In general,
stocks trend lower in valuation as interest rates rise due to the competition from short-term interest rates.
However, stocks that pay dividends can stand up to interest rates better than those who do not, so long
as they still have growth prospects. Stocks that pay little or no dividends tend to be more volatile in a
rising interest rate environment as, lacking an income component, such investments have to continue to
advance to create a return for the holders. For this same reason, stocks with high valuations come under
more pressure from higher interest rates than lower price/earnings multiples.
Two groups of investors that have been under some pressure are the hedge funds and private
equity firms. Having spent years with interest rates lower than the inflation rate, some such companies
made leveraged acquisitions with the intent to sell at even higher prices down the road. Higher interest
rates have, in some cases, forced a re-evaluation of the investments. Look for a number of public
offerings of the same companies as firms try to get out from underneath a deal that looked attractive at
lower interest rates but less so now.
While higher interest rates may not kill off a stock market in itself, it can be combined with other
factors such as the rise of packaged financial products and untested hedging strategies to make a decline
more severe than would otherwise be the case. While such a decline may be cause for concern, it will
also be a wonderful time to buy assets for future gains.
In truth, the level of interest rates is one of perspective. Those who have invested over longer
periods of time have seen these rates before. More recent market participants have assumed low interest
rates to be the norm.
Historically, interest rates have fluctuated, usually around the inflation rate. If interest rates are
above the inflation rate, they act as a lid on inflation. If interest rates minus inflation are positive, savers
are rewarded as borrowing has an after-inflation cost. If inflation is above interest rates, it encourages
purchases of assets that can appreciate with borrowed funds in order to preserve the purchasing power
of one’s capital.
In sum, rising interest rates above the inflation rate encourage saving over spending. The effect
on stocks depends on their valuation and capital structure. The higher the valuation and greater the
leverage, the more adverse the impact. Those who invest understand this; hose who speculate or gamble
do not.
The Economy
As interest rates increase, consumers are more enticed to save instead of spend. This can lead to
a more subdued economy.
The lack of movement in housing is having a ripple effect on businesses that cater to redesign
and renovation. It will be interesting to see how the homebuilding industry responds to this challenge.
One option will be to create smaller and more affordable homes. This requires in many cases a
change in zoning to permit denser development in an effort to make the land cost per house smaller.
Smaller homes are often anathema to existing homeowners who believe they will depreciate the value of
existing residences.
Inflation
Inflation is reviving, thanks to higher oil prices. Decisions on the part of Saudi Arabia and Russia
have caused supply to shrink and prices to climb. Expect this to last until January if not longer.
The response to higher prices is complicated by the desire to discourage energy investment by
western governments in favor of renewable energy. The problem is that there is not the infrastructure to
accommodate large-scale conversion to renewables. This makes the existing energy providers more
valuable, as banks and other lenders are pressured to not make additional investments in fossil fuels.
Interest Rates
The idea of interest rates being higher for longer, and perhaps not coming down anytime soon,
seems to be slowly sinking in. Financial markets tended to believe the idea of an interest rate reduction
as it suited their situation with so many assets supported by variable rate debt. The appetite of the Federal
Government for additional debt to cover a $2 Trillion deficit this year would seem to ensure that rates
will stay up.
The Stock Market
For most of this year, stocks have in general appreciated not due to rising earnings so much as
expanded valuations. The Standard & Poors 500 Index is flat on a trailing basis, but projected
price/earnings valuations are up 14% from a year ago. This implies that investors are paying more for
future estimated earnings. Estimates can change, especially with interest expenses rising.
Historically higher yielding stocks were considered a port in this storm, with electric utilities
being the chosen proxy for the same. With slowing electricity growth due to increased usage efficiency,
the ability of utilities to increase their dividends has been called into question. Other sectors of the
market would seem to offer a better combination of current income and increasing dividend potential.
Warren M. Barnett, CFA
September 18, 2023
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