By Mark Bern, CFA
Rising interest rates will have both short-term and long
term impacts as well as positive and negative.
Some industries benefit from rising interest rates while others
suffer. Even within industries there are
potential winners and losers.
Losers
Those companies with heavy debt burdens will receive a
double whammy. First, the new tax law
limits how much interest can be deducted for tax purposes. Those paying interest expenses in excess of
that threshold will no longer have the tax benefit they once enjoyed meaning
that the tax cut savings will be far less and, in some cases, companies could
end up with a higher effective tax rate than before tax reform.
Second, companies in industries that generally pay a
relatively high dividend will begin to lose the appeal with investors looking
for yield. They will be affected in two
ways: as bond yield rise some investors will switch from riskier stocks for the
more traditional yield of bonds; as rates rise many of these companies, such as
REITs, Utilities, MLPs and BDCs will act like fixed income securities in that
as yield rise the price will drop. This
second phenomenon is because many companies in these industries tend to borrow
heavily and the expectation will be for the cost of capital to rise with
interest rates which, in turn, should decrease profit margins.
So, companies in industries that are reliant on debt to fuel
growth will find a reduced tax benefit and rising expenses due to higher
borrowing costs. Even though some
industries, like REITs, have had tough sledding for a while now, the worst may
not be over yet.
Eventually, higher interest rates could dampen demand for
new construction because of higher mortgage rates. But, for the time being, the slow pace of
rising rates will probably tend to help increase demand in the short to
intermediate term as would be buyers decide to purchase a home sooner before
rate rise too high. At some point,
though, demand should begin to fall off because prices continue to move higher
and, along with higher mortgage rates, will make home ownership unaffordable
for too many average families. We are
not quite there yet, but it may not be long (another year or so) before demand
could start to slacken. Then, home
builders, mortgage issuers and many other construction-related businesses will
not be where we want our money.
Subprime borrowers will get hit harder than the rest of us
as higher rates will directly impact what and how much they can buy on
credit. It will make more durable items
such as cars and light trucks too expensive.
Default rates on subprime auto loans have already begun to tick higher,
so most issuers of such debt will see narrowing margins due to loss reserve
increases. The only company in this
industry that I like remains Credit Acceptance Corp. (CACC) which off loads
most of the risk onto the dealers in its network in return for lower rates
(which, in turn, usually translates to higher sales volumes). I am staying away from the rest until after
the auto sales cycle runs its course.
Other forms of credit will rise as the Fed hikes rates. Credit cards, home equity loans and
adjustable mortgages will become more expensive. Issuers should fare okay as they adjust rates
higher that are tied to the prime rate or other such rates that are dependent
upon the Fed’s interbank rate and discount rate. Those who pay minimum payments on credit
cards will experience rising monthly payments and balances which could
constrict consumption somewhat.
Winners
Banks should gain the most as the spread between rates paid
on deposits and rates charged on loans will increase leading to higher
earnings. I think regional banks stand
to fare better than most in the industry but the benefits should be widespread.
Those borrowers with fixed rate loans will be unaffected;
fixed mortgages, student loans, existing auto loans. And savers will finally be able to get some
return on their hard-earned cash in CDs (certificates of deposit) from small
banks and some online banks which generally offer higher rates than the mega
banks do. Nerd
Wallet tends to be a good resource to find the best rates available. Bankrate.com
is also a decent source. The only
problem with many such online sources is that they tend to sell space to the
highest bidders (usually the big financial firms and banks) so it is good to
also look locally and check credit unions which tend to not advertise
nationally but often have even better rates.
Pension funds will benefit from higher interest rates making
their, heretofore, projected earnings rates unreasonably high somewhat more
attainable. Several states and cities
will remain in bad shape, though, and will likely become stressed during the
next recession (Illinois, Chicago, Connecticut and New Jersey come to mind but
there are others).
Companies that have been able to keep or reduce debt to well
below the average for their respective industries while accumulating cash will
be well-positioned to make acquisitions when the next recession comes as
competitors who have been poorly managed will become distressed and will need
to sell assets to survive. The buyers
may be able to pick up assets at bargain prices while consolidating their
positions and increasing market share.
Finally, those corporations with tons of cash will benefit
because they will earn more for their idle cash while waiting for a better way
to deploy excess cash for a higher rate of return. As long as our economy, especially industrial
companies, operate well below capacity there is no reason to expand production
or build new facilities. So, holding
onto cash is like holding a call option on the future if one expects better
opportunities to emerge. Or, at least,
that is how Warren Buffett likes to consider his cash hoard.
Respectfully,
Mark Bern, CFA
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