September 13, 2023
By Acuity Trading
Much to the relief of businesses and investors, the Federal Reserve took a breather and kept interest rates unchanged at its September meeting. Faced with inflation at 40-year highs, the US central bank really had no choice but to keeping hiking rates, taking the range from nearly 0% to 5.25%-5.50% over just two years. Rising interest rates dampen demand for goods and services and curtail rising prices. Companies then face a double whammy, that of higher borrowing costs and pressure on their ASPs (average selling prices) due to low demand. Both impact corporate margin dynamics and investor sentiment for certain companies and sectors. Here’s a look at the most rate sensitive sectors.
Real Estate
Real estate is among the most capital-intensive sectors and borrows heavily to complete projects. Higher selling prices to offload rising borrowing costs severely tempers demand. One might think the trade-off is really business as usual for this sector. But builders are caught between a rock and a hard place. Construction coming to a halt during the pandemic and rising demand for better accommodation sent home prices skyrocketing from 2020 through the first half of 2022, while higher interest rates have taken the 30-year mortgage rate above 7% for the first time in over two decades. Against this backdrop, mortgage applications to finance new home purchases declined by 30% year-on-year in August 2023, leaving builders little wiggle room to pass on higher costs to homebuyers.
REITs, which are considered a hedge against inflation, underperformed the stock market due to the challenging interest rate environment. Both the S&P Developed REIT and S&P US REIT indices have lost around 8% each over the past year.
Shares of some of the largest real estate companies have plummeted in 2023. American Tower Corp has lost 17% year to date, while Realty Income Corp is down 14% and Simon Property Group by 2%.
Manufacturing
This is another economic activity that relies heavily on capital infusion. Manufacturers of heavy machinery or equipment and automakers face a similar dilemma as builders. Some manufacturers lease machinery for construction projects and are directly impacted by the plight of the real estate industry.
Automakers also suffered as consumers jammed the brakes on new vehicle purchases due to rising car financing costs with interest rate hikes. The Also, interest rate rises prompt a shift from spending to saving. While the shares of Ford and General Motors have remained subdued year to date, Tesla’s stock has jumped more than 130%, although the EV maker has slashed prices multiple times to spur demand.
Technology
Although the tech sector includes some of the world’s largest companies, it experienced a brutal year in 2022. This is because these companies invest billions of dollars in innovation, which spells colossal borrowing costs when interest rates are high. On the other hand, many of the tech giants are hugely cash generative and have a higher ability to curtail costs. With technological advancements and disruptive powers, shares of Microsoft jumped more than 30% year to date, Apple by over 40% and Google by more than 50%. Yet, investor sentiment remains bullish, as reflected by Acuity’s AssetIQ widget.
The net profit margins for S&P 500 companies declined on a sequential basis for seven straight quarters in Q1 of 2023. Many industries, especially consumer discretionary, consumer staples and industrials, are facing challenges navigating interest rate pressures. Their profit margins have contracted and could continue to be eroded this year.
What’s the Bottom-Line?
Higher rates sent jitters in the stock markets. But the Fed’s rate hikes will unlikely be a nail in the coffin for US businesses. Firstly, they were not the sole perpetrators. Corporate margins were shaved off by global supply challenges translating to higher shipping costs and the Russia-Ukraine war, which led to elevated oil prices. This means companies may begin reporting margin expansion with the easing of supply chain bottlenecks and oil-led inflationary pressures.
Yes, high interest rates are detrimental to margins. Then again, that is not the complete picture. Rates were hiked to rein in inflation, which skyrocketed in part due to soaring corporate profits. Thanks to the government’s decision to dole out money to households during the pandemic, coupled with rock bottom interest rates, businesses recorded fat margins and raked in huge profits for almost two years. From 1979 to 2019, growth in US corporate profits averaged a little over 11%. Between Q2 of 2020 to Q4 of 2021, corporate profits grew by a jaw-droppingly 54%. And corporate profit margins hit a 100-year high. US companies exited 2021 with profits after tax of a whopping $2.8 trillion, versus $2 trillion pre-pandemic.
While there’s no slam dunk with elevated interest rates, most sectors will experience margin expansion as inflation recedes, provided the Fed doesn’t go overboard and drive the US economy into recession.
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