The Implications of Higher Rates for Longer
As the Federal Reserve continues to battle lingering inflation from COVID-related stimulus plans, the primary weapon remains interest rate hikes to slow the economy.
Despite numerous rate hikes, inflation of more than 3.7% remains sticky . The Fed has declared their stance will most likely be, “higher rates for longer.”
Given this, what are the implications to investors?
For fixed income investors, now you can get a bit of return. Earning 5% on money market funds or short-term fixed income seems like a dream compared to the previous fifteen years. It certainly helps when balancing liquidity and cash flow to a portfolio. Despite the rate hikes, fixed income investors will most likely break-even once inflation and taxes are factored in. Fixed income should not be counted on to grow your wealth.
If fixed income is, at best, a break-even proposition what is the outlook for stock market investors?
Early in my career, I was given an investment rhyme to understand investing and the economy. Simply put, “When interest rates are low, stocks will grow. When interest rates are high, stocks will die.”
This rhyme recognized that as companies borrow money to finance operations and expansion, increased rates made it harder to borrow money, pay interest and remain profitable. Hiring slows and the economy cools. Conversely, as rates fell, companies could borrow and expand with greater efficiency and profitability.
When I entered the investment industry thirty years ago, the world was a different place. Despite a growing tech sector, we were an industrial power. Cell phones were not mainstream, and a functional internet was years away. As such, e-commerce was just a nice concept.
In 1992, the economy was dominated by companies like Dow, Dupont, AT&T, General Motors and Exxon. The average profit margin on the 500 largest companies in the U.S. was less than 4%.
We are no longer an economy dedicated to borrowing huge amounts of debt to build factories worldwide. Instead, the economy is led by businesses like Microsoft, Adobe, Alphabet, Meta, Amazon and Intuit. The average profit margin for the S&P 500 is now nearly 12%.
As a broad category, companies predicated upon intellectual property and software have risen. Call them capital light. As the internet has become stable for most of the world, distribution of product costs almost nothing and is delivered in an instant. Many of these companies are not only “mission critical” to a person or business, but they are also less susceptible to the ebb and flow of the economy.
In comparison, the manufacture and distribution of cars remains virtually the same as it was 30 years ago.
Taking this a step further, many capital light businesses operate by borrowing little to no debt to fund operations. Their product or service requires thought, not factories. The result is that many of these businesses accumulate massive amounts of profits.
For these rare, valuable, capital light businesses, the impact of rising interest rates is the opposite of what it has been historically. Assume a large capital light business has accumulated $50 billion of net profit that is just sitting in bank accounts. Three years ago, that business earned virtually zero from these non-distributed net profits. Today, they are earning more than 5% per year. In this example, this translates into a $2.5 billion profit tailwind simply because some businesses derive a benefit from higher interest rates.
Given this, the impact of “higher rates for longer” may be a traditional headwind. Or, for other businesses with superior business models, the increase in rates will result in increased profitability while exerting zero additional effort.
The shift away from the industrial economy has been remarkable. The stock market will not “die” simply because rates have gone up. However, the wise investor must understand which businesses benefit from higher interest rates versus those that are hindered by them.