The impending interest rate hike has been at the forefront of many investors’ minds over the last year or so. Every six weeks, marketplace participants await comments from the Federal Open Markets Committee (FOMC) meeting with bated breath. Language from those meetings is meticulously analyzed, and any strong wording regarding the progress of the U.S. economy usually is met with a downtick in stocks. Good news around economic indicators — such as employment — has almost become bad news, taken as a sign that rate tightening is in the not- too-distant future. The July FOMC meeting came and went with no change in interest rates as many were speculating at the beginning of the year. This caused a sigh of relief for the markets, with expectations for a hike pushed out to the September meeting (this publication goes to print before the Sept. 17 FOMC meeting) or beyond, with the Estimize community anticipating no rate increase on that date.
Despite fears surrounding tightening, markets should be able to absorb a rate increase easily, especially as Federal Reserve Chair Janet Yellen has indicated that normalization will follow a gentle and gradual trajectory. While markets may suffer from an initial sting of a rate increase, what will this change mean for corporations? Companies will feel modest discomfort. Higher rates will increase the cost of borrowing, thereby eating into profits and slowing down growth. The current environment has encouraged increased mergers and acquisitions activity, especially among the healthcare names, but interest rate pressure potentially could make acquisitions less appealing as buyers’ financial flexibility is reduced. The bright side is that increased economic growth should offset the impact of a hike and there are certain sectors whose fundamentals are expected to withstand — and even benefit — from tightening.
Anyone that follows quarterly results for U.S. banks has no doubt heard them whine about persistently low interest revenues. This sector is one of the most receptive to normalizing because of their capacity to lend and insure assets. Banks are able to capitalize from the perfect storm that is created when a rising rate environment is brought about by strong underlying economic growth. This results in expanding interest margins from the rate hike, and increasing economic activity usually translates to increased loan demand (see “Diminishing returns”). Insurance companies also are poised to benefit, thereby earning higher returns on the income they collect from policyholders.
This one is two-sided. The current economic landscape has been good for consumers: Improving employment, paired with lower fuel prices all mean consumers have more discretionary income in their pockets and make them more likely to spend, and not just on low-ticket items, but high cost items as well, such as appliances and cars. The one caveat may be homes. Housing analysts currently are heavily debating whether or not the housing market can sustain higher rates. For the most part, the consensus is yes. However, rising rates will reduce inventory as moving becomes less attractive and pushes marginal homebuyers out of the market. Homebuilders will feel this pinch, especially as the cost of financing land purchases increases, and they will have to be more selective about which projects they take on and which properties they choose to develop.
This is a turning point for the United States as it’s been a while since we’ve been in a sustained rising interest rate environment, therefore making it difficult to predict exactly what will happen. Prepare for stock market volatility initially, although the pace of rate hikes should be minimal and modest to start, making that volatility temporary. The key is to diversify and focus on those industries that will have a favorable reaction to tightening such as banks, insurers and retailers.