Market Implications of Higher Interest Rates
Production is the engine that powers an economy and enables wealth-building. Capital is the fuel on which the engine of production runs, which we’ll call dollars. Interest rates represent the cost of dollars, meaning, the “rent-rate” to place dollars in the hands of producers to keep businesses producing. It is financially beneficial for businesses to borrow dollars only when the borrowed dollars are invested productively (after expenses, taxes, and inflation). In a “cash-only” society, interest rates wouldn’t matter so much, but in a highly indebted society, such as America and the world today, they are the most influential factor. That’s why the rate on the 10 Year Treasury bond is widely regarded as the barometer of the global financial system.
The artificially easy borrowing conditions and artificially low interest rates fueled by ‘Fed’ manipulations over the past two decades, culminating in 5,000 year low rates of 0% from 2020-2022,¹ resulted in the biggest debt load America has ever carried, both nominally and proportionately in certain respects. Joel Litman, founder of “Altimetry”, and a respected forensic accountant on Wall Street, recently revealed deep concerns for the U.S. economy and stock market for the next 24-36 months due to the following converging factors:
$4 trillion in U.S. corporate debt, the majority of which must be refinanced, will mature in the next 36 months.
A significant portion of this debt is of low credit quality.
Lending institutions are struggling to make a profit in the present interest rate environment and are tightening lending standards.
The majority of this debt will roll to a significantly higher interest rate than the rate at which it was last financed.²
The implications of this unique credit market challenge include:
Small companies are at a disadvantage due to difficulty or inability to issue their own bonds, and must go to the general credit market, often at higher rates, to obtain financing.
Many corporations, both large and small, with questionable balance sheets, may fail to obtain financing and be forced into bankruptcy.
Profitability for companies renewing debt at a higher rate will likely be reduced. It’s unlikely Wall Street’s earnings estimates have fully priced-in this issue.
Higher ‘risk free’ interest on savings attracts investment dollars away from stocks, which can be volatile and at times unpredictable, to safer securities, like Treasuries, CD’s, and Money Funds.
Prudent considerations regarding this credit market challenge are:
Evidence of a crisis has not materialized, many credible investors remain bullish on stocks, and this is not a cause to panic-sell stocks.
Focus on big companies with strong balance sheets that have pricing power.
Maintain stop-losses on a meaningful portion of your equity exposure in an effort to mitigate risk.
Get a competitive interest rate on all cash savings. Do not accept less than the going rate.
If present market volatility is keeping you up at night, trim equity exposure to your comfort zone. Make sure your portfolio has sufficient cash to meet 36 months of planned distributions.
Maintain a long-term perspective on your ownership of great businesses, and if you are able, reinvest all dividends.
I liken the decision to trust a collection of bankers with such incredible powers to hiring a very expensive, very bad mountain guide to lead a very dangerous climb. On the other hand, with the dollar lacking any immediate viable threat to its global dominance, America will survive this credit market challenge, and will likely emerge in a relatively short period to an environment that is quite favorable to business and investing.
Think about it, and may God bless your financial decision-making, Shaun.
“Honor the Lord from your wealth and from the first of all your produce; so your barns will be filled with plenty and your vats will overflow with new wine.” ~Proverbs 3:9-10
1 FRED, Economic Data, St. Louis Fed, October 20, 2023
https://fred.stlouisfed.org/series/FEDFUNDS
2 Joel Litman Webex Presentation by private invitation, October, 2023
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial.
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