Debt Burdens, Elevated Rates to Test Equity Investors

Equity markets have become more volatile of late, as investors fret about economic slowing ahead of likely Federal Reserve rate cuts. But beyond the obvious macro-level implications of what had been a higher-for-longer rate environment, we believe investors should consider how high rates affect corporate profits—an issue that is too often overlooked.

Higher Rates Have Increased Financing Costs

Higher interest rates have dampened aggregate demand, which has helped contain inflation, although pockets of wage inflation persist. Less noticeable to some investors is the impact of higher rates on corporate and household balance sheets. That’s because the effects of changing rates—both up and down—tend to build as time passes, particularly for infrequently purchased items with higher price points.

For example, installment loans, such as home mortgages and auto loans, are typically measured in years rather than months. Regardless of market conditions, a relatively small number of consumers purchase these big-ticket items in any given month. As a result, it may take a long time for borrowers to feel the adverse effects of higher rates.

Consider what would happen if interest rates spiked for six months but then fell sharply. Given the tight time frame, few consumers of high-cost goods would be exposed to elevated financing costs. But what happens when rates stay high for a long time? That’s the scenario we’ve been experiencing, with consumers and businesses feeling the pinch.

High Financing Costs Reduce Economic Activity and Flow Through to Bottom Line

The housing market is a case study. Trailing 12-month existing-home sales hit a 14-year high of 6.2 million in August 2021, driven by rock-bottom fixed mortgage rates (Display). Since then, 30-year fixed mortgage rates have climbed more than 400 basis points to a 20-year high of roughly 7%. The result? Trailing 12-month home sales fell to four million units by the end of May 2024.

elevated rates