Wednesday, September 11, 2013

As S&P 500 Earnings Double from Five Years Ago, Rising Interest Rates Spell Disaster

By Sasha Cekerevac

As I’ve been stating for most of the past year, interest rates will rise, and this will have a significant impact on the markets. But the real question you have to ask yourself is why are interest rates rising?

If these rates were rising due to a much stronger economy, this would actually be bullish, as corporate earnings would also be increasing. But interest rates, I believe, are increasing as the market is now adjusting to a more “normal” environment and pricing in the exit of the Federal Reserve.

This will have an impact on corporate earnings, as firms have benefited from the extremely low interest levels. According to Bloomberg, the costs of borrowing for S&P 500 companies was only 1.4% of sales over the past year, a record-low during the 11 years that these data have been kept. (Source: Bloomberg, September 2, 2013.)

Not only is the expense of higher interest rates going to reduce corporate earnings, but many companies have borrowed to fund share buybacks and dividends. This will also begin to decrease as interest rates rise.

Since revenue is not accelerating and costs associated with higher interest rates are beginning to rise, this squeeze can only mean a lower level of corporate earnings growth.

This is not something to be taken lightly. Historically, a huge part of total returns results directly from cash being returned to shareholders in the form of dividends and buybacks. With increasing costs from higher interest rates, shareholders will get less money back, and the higher costs will result in lower levels of corporate earnings.

This is a significant paradigm shift that we have to take into account over the next decade. Much as investors have been used to 20 years of ever-lower interest rates, this new shift to higher interest rates will create an environment that is quite different than what we’ve experienced in the past.

Traditionally, companies that issue dividends and buyback shares outperform the market. If interest rates rise and begin to curtail these activities, we then have to look at purely increasing revenues to generate higher levels of corporate earnings.

In this economic environment, that is easier said than done. While margins have increased tremendously over the past few years, these, too, are in question. Can the pace of margin expansion continue over the next decade?

Clearly, companies are in an extremely strong position, with very strong balance sheets. Corporate earnings growth for the S&P 500 is expected to exceed $110.00 next year, as compared to only $60.00 in 2008.

This level of corporate earnings growth has partially stemmed from cost-cutting, as well as the low levels of interest rates obtained on corporate debt. Both of these factors appear to have run their course, and at this point, I would focus on stocks that have the ability to increase revenues going forward.

It is the companies that are essentially a commodity, unable to differentiate their products, that will be at the mercy of both increased competition and higher interest rates; thus, they will be unable to increase their revenues and face higher costs associated with increased rates.

Firms that are able to differentiate their products should be able to maintain strong margins, generating corporate earnings growth, on a relative basis, even if interest rates continue rising. These are essentially Warren Buffett-style companies—ones with giant economic moats that create a business edge and, ultimately, create shareholder value.

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