How Will Higher Interest Rates Impact Investors? Income Can Fall Meaningfully



  • Higher rates should drive markets lower, and our view is that the market is pricing rates at half of what they should be.
  • Earnings could become affected by substantially higher interest expense, and companies with large investment burdens might be less attractive in the coming years.
  • Disposable income could be hurt as mortgage and other loans growth leak into the rest of the economy, so sellers of essential products might be of priority.
  • Overall, we see trouble on the horizon and think that a substantially higher rate than expected should be a risk factor equity holders need to prepare for.
  • Looking for a helping hand in the market? Members of The Value Lab get exclusive ideas and guidance to navigate any climate. Learn More »

3d arrows and percent sign on a background of a building under construction and US banknotes. Concept of growth of financial and mortgage rates, profits in construction industry.

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How Will Higher Interest Rates Impact Investors?

Interest rates are of critical importance to investors. Since investment is about optimising for return on risk, when rates rise non-equity products like bonds offer better risk-reward, making equities less desirable and driving down levels of the stock market. Even previous bondholders get hurt by rising rates as older bonds become worse on a risk-reward basis when coupons from lower rate periods don't stack up to the growing standard. For equity investors, there is the additional issue that with years of monetary accommodation, leverage has grown and rising rates can damage net margins with increased interest expense. So when there is reason to believe that rates will rise, which there is now as the Fed has made its hawkish intentions clear, equity investors need to think carefully.

Is The Fed Raising Interest Rates?

The Fed is definitely on a path to raising rates, but by how much they will actually do it depends on how much is necessary. Rate increases were expected at a faster rate prior to the Ukraine war, but with pressure on the aggregate supply side of western economies, central banks including the Fed are feeling the need to hold off on raising rates at a time when the economy is being acutely pinched by inflation. A certain level of inflation prior to the Ukraine war was the reason why the Fed began adopting a hawkish tone, as the economy appeared to be in the process of overheating due to structural changes introduced by the pandemic, putting pressure on logistics and a host of manufacturing industries like semiconductors where underinvestment in supply meant capacity could not keep up with demand.

Currently, the expectation priced in by markets is that the Fed will raise rates to about 2.75% by the end of the year, 1% away from current rates as the hawkish push takes a pause. Some companies like Nomura (NMR) are thinking a more justified rate will be 3.5% to effectively tackle the heating inflation in the economy. We think that due to the structural issues presented to the economy by COVID-19, the range of outcomes quite easily includes rates as high as 6% or even higher. Below we explain our reasoning.

By how much will the Fed Raise Rates?

We're using the US as a microcosm. The money supply grew by about 40% until recent tapering activity. All else equal, prices and wages would all increase by 40% and equilibrium would be maintained. Of course, the 40% increase in money supply was a consequence of COVID, so all else is not equal. COVID decimated aggregate demand initially as services, around 60% of the global GDP, containing highly exposed channels like tourism (10% of GDP) which declined by 50%, took its toll on the economy creating a deflationary effect. Money printing has obviously offset this, but there are other effects.

Services were exchanged for goods in the typical basket. This meant that various premiums in services disappeared from consumption, and underutilised capacity was made use of more efficiently as goods and industrial activities starting to pick up in the aftermath. Some goods fell meaningfully in demand like fuel as people stopped commuting and traveling. Bills fell. Moreover, productivity grew in the economy, increasing aggregate supply, as WFH and digitalisation made companies more efficient. These are all deflationary effects with a mix of demand and supply side offsets to the money printing while the economy recovered.

The problem is credit begets more credit, as part of the exaggerating effect that debt has on the credit cycle, so spending grew and goods started to run into shortages. With shortages persisting and getting worse with Ukraine, prices have continued to rise and create inflation. Companies started building out more capacity, increasing capacity by 20-40% in various important industries to meet demand.

goods service pandemic

Goods-Service Split (VTS and other sources)

This would have made inflation transitory, the problem is also inflation begets more inflation due to expectations and the wage-price vicious cycle. This is where we are now.

Rates will need to rise. But by how much to stop the wall of demand hitting the limits of supply? Inflation could have been a lot higher were it not for the interacting effects that offset it. More money sloshing around in the tank, but the tank did get a bit bigger for sure. So maybe massive increases aren't necessary?

If the shortfall in supply for goods is between 10-15%, let's just say that a 10% decrease in consumption on goods should do the trick to get inflation under control. So rates must increase such that disposable income falls enough to eliminate that level of consumption. Assuming that interest leaves spending cycle for long enough for capacity expansions to help out the situation, rates might need to rise to 6% from the 2.8% they are priced at currently.

disposable income rate hikes

Disposable Income Effects (VTS and other sources)

Bottom Line

That's our house view now. It's more than a doubling in variable interest expense for companies, and a reason to worry about the need for debt loads to grow into the future. So perhaps self-financing companies with low capital intensities deserve a premium right now, since they won't be growing their liabilities in an increasingly expensive capital market? We thought about Telcos the other day, specifically Proximus (OTCPK:BGAOF), due to their stable cash flows and recurring revenues as well as margin of safety multiples. But maybe 5G auctions and fiber rollouts mean that the time isn't right for that investment after all, since they may need to grow debt to meet those objectives. So companies with great cash generation appear more attractive than ever, as do companies with debt loads that are primarily fixed. Gilead Sciences (GILD) comes to mind here, where they have $0 in variable rate debt, all fixed at quite low rates. With products that can also manage against a shrinking pocketbook due to their essentiality, they appear an excellent pick.

There is also the possibility that things don't get nearly as bad as we believe they can, and the main reason for this in our view would be the service economy. Tourism is picking up with signs that mobility is recovering, even against demand destruction caused by rising commodity prices. With tourism being so important in service GDP, it bodes well for the strain being put on goods capacity right now. This would relieve some of the inflation pressure and hopefully stop rates from needing to grow as much as they potentially might. Nonetheless, preparing for the worst with stable companies offering necessities, and ideally with fixed rate debt, is a wise move.

While we don't often do macroeconomic commentary, we do occasionally on our marketplace service here on Seeking Alpha, The Value Lab. We focus on long-only value strategies, where we try to find international mispriced equities and target a portfolio yield of about 4%. We've done really well for ourselves over the last 5 years, but it took getting our hands dirty in international markets. If you are a value-investor, serious about protecting your wealth, our group of buy-side and sell-side experienced analysts will have lots to talk about. Give our no-strings-attached free trial a try to see if it's for you.

This article was written by

Author of The Value Lab
A long-only voice with eclipsing growth through 2020 and 2022 bear markets.

Valkyrie Trading Society seeks to provide a consistent and honest voice through this blog and our Marketplace Service, the Value Lab, with a focus on high conviction and obscure developed market ideas.

DISCLOSURE: All of our articles and communications, including on the Value Lab, are only opinions and should not be treated as investment advice. We are not investment advisors. Consult an investment professional and take care to do your own due diligence.

DISCLOSURE: Some of Valkyrie's former and/or current members also have contributed individually or through shared accounts on Seeking Alpha. Currently: Guney Kaya contributes on his own now, and members have contributed on Mare Evidence Lab.

Disclosure: I/we have a beneficial long position in the shares of GILD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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