High rates start to bite?
High rates start
to bite?
Whilst the rest of the world has struggled to generate upbeat economic data in 2023, the US economy has grown by more than expected. This positive outcome has not resulted in higher inflation.
However, interest rates have also risen by more than expected as the Federal Reserve wants to bring the rate of economic growth down to dampen the potential for inflationary pressure in 2024.
Higher interest rates and increased borrowing from the US government, which has run a larger than expected budget deficit in 2023, have combined to push bond yields up to multi-decade highs.
Higher bond yields will curtail the economy especially when borrowers must refinance their current debt, which will be the case over the coming years.
The trend of lower interest rates over the past 40 years has been a contributor to the higher profit margins enjoyed by companies and equity investors alike. This is likely to reverse as interest rates may be higher for longer. This increased cost burden is not yet reflected in forecasts for companies’ profits in 2024.
US economic growth surprise
US economic growth has turned out to be stronger in 2023 than forecast. The resilience has been striking given the increase in interest rates and the headwinds of weak economic growth in Europe and China.
Economic growth has been stronger in the US than economists had expected.
Source: Bloomberg, Artorius
One of the consequences of the better than expected US economic data, is that interest rates have increased by more than either the market and even the Federal Reserve had suggested at the beginning of the year. Markets had priced in a peak in interest rates in the middle of the year and some rate cuts by now but instead there are questions over whether interest rates may go even higher.
The US Central Bank, the Federal Reserve, produces an interest rate ‘dot-plot’ which provides the outside world with a guide to where the Federal Reserve believes interest rates will be in the future. Investors believed that the Federal Reserve would continue to raise interest rates in the first few months of 2023 but then proceed to cut them by now. The Federal Reserve policy projection was that interest rates would end up staying above 5% long into 2024, but not increase by as far as they have done. This is striking because inflation has turned out more or less in line with the start of the year forecast.
In 2023, interest rates have risen by more than the market had discounted and further than the Federal Reserve themselves had forecast at the start of the year.
Source: Bloomberg, Artorius
Deficit and growth
With interest rates rising by more than expected through 2023, the bond market has suffered significant losses.
The US bond market is also dealing with a government deficit that is also higher than expected, even though economic growth has been faster than originally forecast. We would suggest that one of the reasons that economic growth has been stronger than expected is due to the willingness of the US government under President Biden to engage in proactive and expansionary fiscal policy.
The budget deficit in the US is expected to come in at around 7% of GDP (Gross Domestic Product), up from 5% in 2022. The rise in the budget deficit is striking given the resilience of the US economy, and with unemployment running at below 4%. In the past when unemployment has been so low, one could expect the US government to run a very small deficit or even a surplus.
But the larger than expected budget deficit is a double-edged sword. On the one hand it is likely to have contributed to the better economic outcome than would have been the case in 2023, but the downside is that more bonds have needed to be sold by the US Treasury to fund the deficit.
At the same time, the Federal Reserve has been selling bonds bought under the Quantitative Easing policy since 2008. The consequence of the reduction in the Federal Reserve’s balance sheet and the need to finance the elevated budget deficit is that investors will be asked to buy $2,730 billion of Treasury bonds, net, over the coming year; about 10% of GDP and 50% higher than in the past year.
It’s a similar story in the UK as a £140 billion budget deficit combined with a £100 billion Quantitative Tightening programme will increase the supply of gilts to about 8% of GDP.
Increased supply of bonds naturally forces prices down (and yields up) until the yield rises enough so that investors are enticed to buy the assets.
The fiscal stimulus in the US economy (which resulted in the increased deficit) is unlikely to be repeated in 2024, as the Republican controlled House of Representatives will be targeting a much smaller budget for the next 12 months.
Interest rates and who pays…inequality
Higher interest rates are seen as a negative for the economy, but there are winners. Some companies and consumers are in great shape, enjoying large incoming interest payments on their cash stockpiles. Savers receive a higher level of income. This also applies in the corporate sector. US companies sit with $3 trillion of cash on their balance sheets. Focusing on the largest 3000 companies in the US, 40% of the cash is held by 20 companies. And 36% of free cash flow (that is operating cash flow less capital expenditures) is generated by only 20 companies.
Over one-third of the largest 3000 companies in the US were loss making, in terms of free cash flow, and with interest rates increasing this is unlikely to improve in the near term.
Margins and interest rates
One of the striking features of the past 20-30 years has been the relentless climb of company profit margins.
Whilst profit margins of US companies have moved up and down in sympathy with the economic cycle, the long term trend has been up over the past 20 years.
Source: Bloomberg, Artorius
Wage rates are moderating but remain more elevated than the Federal Reserve’s implicit comfort level given their inflation target. How quickly wage rates slow in the face of weakening labour demand could be the determinant of the path and pace of change in policymaking of the Federal Reserve.
Since the mid-2000s, interest and tax expenses have steadily declined relative to earnings for S&P 500 non-financial firms. Indeed, prior to the Global Financial Crisis, the ratio of interest and tax expenses to earnings before interest and taxes (EBIT) was fairly high, hovering around 45%. As of 2022, this measure had fallen to 26%. This was a consequence of the effect of interest rates paid by companies falling from 5% to 3% between 2004 and the end of 2022. In other words, a smaller share of corporate profits is now being paid out to debtholders and tax authorities—thus leaving more available to shareholders.
With interest rates rising equity investors may have to get used to a smaller share of the earnings pie.
Interest rates and taxes have taken a lower share of profits since the 1980s as companies have benefitted from lower interest rates and taxes.
Source: Bloomberg, Artorius
We note that the analyst community anticipate profit margins recovering over the next few years. If that does not transpire then the expectations for earnings growth may be too high.
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Higher rates start to bite?
Whilst the rest of the world has struggled to generate upbeat economic data in 2023, the US economy has grown by more than expected. This positive outcome has not resulted in higher inflation.
However, interest rates have also risen by more than expected, as the Federal Reserve wants to bring the rate of economic growth down to dampen the potential for inflationary pressure for 2024.
Higher interest rates and increased borrowing from the US government, which has run a larger than expected budget deficit in 2023, have combined to push bond yields up to multi-decade highs.
Higher bond yields will curtail the economy especially when borrowers must refinance their current debt, which will be the case over the coming years.
The trend of lower interest rates over the past 40 years has been a contributor to the higher profit margins enjoyed by companies and equity investors alike. This is likely to reverse as interest rates may be higher for longer. This increased cost burden is not yet reflected in forecasts for companies’ profits in 2024.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 20th October 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
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