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4 Likely Consequences of the Fed’s Interest Rate Hike

Posted On June 22, 2017 9:23 pm
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the front of the Federal Reserve building

The Federal Reserve’s decision to raise interest rates and pare back its balance sheet was perhaps more emphatic on the latter point. However, that still doesn’t change the larger economic picture.

The overall level of personal and corporate borrowing — compared to earnings — remains reasonable. Existing Treasury bonds won’t be affected by the Fed’s increase, as long as the Reserve reinvests at a slower rate rather than selling off assets. They can increase short-term interest rates without inverting the yield curve for Treasuries.

Bottom line, bonds will likely disappoint for the near future, but the stock market should remain stable enough.

Certain Corporations Will Be More Indebted

There’s seemingly going to be more cause for concern for individual firms that have excessively borrowed in relation to their earnings. They will have a harder time servicing their debt in the near future. With the Fed decision raising the costs of taking on additional debt, it’s important to take a close look and see which companies may find themselves over-leveraged.

Because of the financial crisis demands, companies have been able to borrow, at a low rate, for years. This has resulted in a glut of corporate debt in certain areas. Breaking the issue down sector by sector, it’s apparent that utilities, materials companies, and energy companies are borrowing the fastest relative to earnings.

However, it seems to be worst in the utilities industry, where companies like Dominion Resources and Duke Energy have taken on seven times more debt than earnings in the last two years.

CNBC analyzed the issue, and showed the distortionary effects of these industries’ borrowing on the overall outlook for the S&P 500:

A 10-year debt collection chart on energies, utilities, and material stocks, courtesy of NBC

Some of this information is old news already: the fragility of energy companies like Vanguard Natural Resources or Pacific Drilling SA have been quite apparent since 2015 — when oil prices fell and cut into their revenues, forcing hundreds of firms into bankruptcy.

However, there are other companies outside these three sectors that have added to their debt burden as well, like Caterpillar and McDonald’s.

The debt-to-income ratio is one consideration when judging which companies might be facing losses in a market correction. Another question is which companies will have their bonds reach maturity in the near future. This metric also spells some trouble for the energy sector, with $117 billion in investment-grade debt maturing from 2017 to 2021.

Among sectors with speculative-grade debt, there’s more trouble for telecommunications companies with $81 billion in maturing debt, but that’s less of a concern given the sector’s positive outlook overall.

High Debt Can Lead to Inefficiency

So, what does the future hold if a small but potentially significant subset of firms are squeezed financially by rising interest rates? An MIT study from late 2015 analyzed the role of firms in the 2008 financial crisis, and found that overleveraged firms were far more likely to lay off workers. Those firms at the high end of their leverage distribution showing triple the elasticity of employment relative to housing prices.

Because overleveraged firms are more constrained financially in the run-up to a crisis, they’re less able to engage in the practice of labor hoarding, which seeks to reduce the additional expenses involved in firing, hiring, and training workers.

Without the ability to retain more of their workforce like a less indebted firm could, highly-leveraged firms are more likely to respond to a downturn by laying off larger numbers of their workers and paring down the workforce closer to what’s minimally required to maintain operations.

“Consequently,” the authors argue, “firms with little financial slack face a genuine tradeoff between long-run optimization-saving on the costs of firing, hiring, and (re)-training workers-and short run liquidity needs.

Our results suggest that firms with weaker balance sheets cut more jobs in response to a decline in consumer demand than they (optimally) would have in the absence of financial constraints.” From an investment standpoint, this means that highly- leveraged firms can be expected to suffer in the medium term after a downturn. This is due to the inefficiencies involved in rehiring and retraining a workforce.

What This Means for the Market

With all of this in mind, some dangers are apparent overall — a market correction still can’t be ruled out in the near future. Although we still believe that any such contraction is likely to be manageable, it would be remiss not to consider a more pessimistic scenario. The country certainly seems overdue for a market correction, and some observers, including OppenheimerFunds CIO Krishna Memani as well as Larry Summers worry that rising interest rates may exacerbate the problem.

Both argue that the Reserve is overestimating the likely rate of inflation in justifying their rate increases and balance sheet reduction. Summers goes further and argues that the Fed’s usual target of two percent inflation is a less expansionary target than in the past, citing his own prior work on secular stagnation, and suggests that, “[I]f the Fed errs and tips the economy into recession , the consequences will be very serious given that the zero (and perhaps slightly negative) lower bound on interest rates will not allow the normal countercyclical response.”

In other words, courting recession by increasing interest rates too quickly poses additional danger since they can’t be lowered any further than current levels.

Possibly the most bearish assessment out there of the possible fallout from the current rate increases comes from the International Monetary Fund, who calculate that about a fifth of American corporations, with a combined 4 trillion in assets, will have a hard time servicing their debt once interest rates increase:

If true, then the IMF’s worst-case scenario would portend a major crisis brewing as large numbers of firms started going under. Investors still shouldn’t expect a contraction of this scope, but the possibility explains why some investors are more concerned about the potential dangers from rising interest rates. The reason the Fed and its supporters expect less severe consequences than this comes down to their confidence in the overall health of American firms at the moment, as well as the moderation and caution involved in the Reserve’s reduction of its balance sheet.

Smart Responses for Investors

With these concerns addressed, one last question to consider asking is how investors could take advantage of the Federal Reserve’s changes?

To recap, bonds are still likely to yield disappointing returns for the time being. Meanwhile, the utilities, energy, and materials industries are likely to underperform in the next few years due to overleveraging. The most obvious upside to the increased interest rates are more lucrative savings than they have been in years, when depositors couldn’t expect a significant appreciation from their holdings at all.

Also, the low inflation rates that the economy’s likely to see over the next several years will make imported goods cheaper than they would have been otherwise.

Indeed, although the Federal Reserves’ interest rate hikes are generally sound, they do have a record of overestimating future inflation rates. And it’s not unlikely that they are high-balling their estimates again, reinforcing this point.

Lastly, in addition to making savings more lucrative, hikes in interest rates will increase the payout from CDs and similar financial instruments. Overall, retirees are major beneficiaries of the Federal Reserve’s policies, allowing their fixed incomes to stretch farther than they have in recent years.

For other investors, Stock Market Sherpa assembled a list of eight stocks to consider with high dividends and healthy balance sheets. If you’re looking for companies with with good chances at weathering interest rate increases — without any problems — Sherpa argues that companies like Intel, Boeing, Qualcomm, VF Corp and The Gap have healthier outlooks than most other firms. In addition, Sherpa singled out the latter three as being fairly-priced options.

All in all, the Federal Reserve’s interest rate hike shouldn’t radically change the financial landscape, but there’s no reason not to hedge against the risks that might come as a result of contractionary monetary policy. It’s worth inspecting your holdings for companies that might be overleveraged and asking yourself whether their earnings will outweigh their existing obligations moving forward. Likewise, the increased profitability of deposits makes playing it safe a more viable option. It also adds some peace of mind for those out of the workforce. So long as you keep an eye on balance sheets and steer clear of overleveraged sectors. Then you’ll be able to make the most of things as American monetary policy attempts to return to normalcy.

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