Corporate Profits Under Pressure from Higher Interest Rates

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Corporate profits are starting to feel the pinch of higher interest rates, but so far their stocks are holding up. Companies will need to grow those earnings, however, if they don’t want their shares to feel the pain.

Earnings Impacted by Elevated Interest Rates

Elevated interest rates have already cut into earnings. With most of the second-quarter results now in, per-share earnings for the S&P 500 are down just over 4% from the year-ago period, according to Credit Suisse.

Challenges of Revenue Growth and Higher Interest Expenses

It isn’t just that revenue growth has been paltry as the Federal Reserve has aimed to cool inflation with interest-rate hikes. Companies are also grappling with higher interest expenses on their debt. Firms refinancing any debt have to borrow at significantly higher rates compared with just last year.

Rising Interest Coverage Ratios and Its Impact

Firms have seen rising interest coverage ratios, the ratio of operating profit to interest expense. This metric shows how well a company’s profit can cover its debt. Now, for every dollar of interest expense on the S&P 500, there’s $7.60 of operating profit, down from a post-pandemic peak of just over $10, according to Ned Davis Research.

That, in theory, should hit companies’ bonds and ultimately their stocks. Higher borrowing costs make it harder for firms to pay their debts, which should hit the price of their bonds and in turn lift the interest rate they can borrow at even further. That would pressure their equity valuations. (Corporate bonds and stocks generally move in the same direction because favorable conditions for companies both improve profits and make it easier for them to repay their debts.)

Limited Impact on Corporate Bonds and Equities

Surprisingly, neither corporate bonds nor equities have felt much pain this year. The share price of the Shares iBoxx $ Investment Grade Corporate Bond Exchange-Traded Fund (ticker: LQD) is up about 0.6%, indicating that investment grade bond yields have slightly decreased for 2023. Bond yields and prices move inversely.

The Confidence in the Stock Market Continues

2023 has been a promising year for the stock market, with the S&P 500 witnessing an impressive 18% climb so far. Despite this record-breaking performance, the market is still trading at a rich valuation. FactSet reports that the current stock market valuation is just over 19 times the analysts’ expectations for per-share earnings over the next 12 months, a figure that has remained largely unchanged since March 2022 when the Federal Reserve began raising interest rates.

The market’s high valuations can be attributed to the unwavering confidence in companies’ earnings. Investors are hopeful that as the Fed’s interest rate hikes come to a halt and the economy finds stability, sales and profits will experience substantial growth in the coming year. This anticipated growth in operating profits could potentially outpace companies’ interest expenses. Analysts are forecasting an aggregate operating profit growth of approximately 10% for S&P 500 companies next year. Such positive prospects would strengthen companies’ ability to manage their debt and encourage investors to continue investing in corporate bonds and stocks.

However, it is crucial to acknowledge the inherent risk involved. Federal Reserve Chairman, Jerome Powell, expressed at the Jackson Hole Symposium in late August that there is a possibility of the central bank keeping rates elevated for an extended period. The adverse effects of higher interest rates on the economy usually emerge with a delay, and many professionals in Wall Street anticipate further declines in economic growth, which could impede profit growth. In the event that companies fail to meet profit expectations and still carry significant debt burdens, their stocks and bonds are likely to face consequences.

Ultimately, it all boils down to earnings – a determining factor for companies to continue their upward trajectory. The stakes are higher than ever as companies must deliver strong profits to keep their stocks thriving.

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