2 November 2024
Over the past few years, central banks worldwide have responded to rising inflation by increasing interest rates. From 2008 to 2021, rates remained low, but in 2022, the Federal Reserve and other central banks began raising rates significantly, with some reaching over 5%. This was done to control inflation by making borrowing more expensive and slowing down economic activity. By 2023, rates began to stabilize, and as we moved into 2024, there were signs of reductions, marking the end of the aggressive rate hikes.
Rising interest rates impact businesses and consumers alike. Borrowing becomes more expensive, leading companies to reduce investments, cut back on research and development, and sometimes even lay off employees. As a result, the economy can slow down, and safe investments like bonds become more attractive than riskier options such as stocks.
While central banks can adjust short-term interest rates and have already implemented cuts in 2024, long-term rates are influenced by various external factors. Factors such as the U.S. deficit, global conflicts, military spending, and investments in green energy may contribute to sustained inflationary pressures.
Inflation and Interest Rate Hikes: Challenges for Businesses
Inflation reduces the purchasing power of money, making it harder for companies to maintain their pricing strategies. In response, central banks often raise interest rates to slow down the economy. However, this approach presents challenges, especially for companies with substantial debt, such as Bed Bath & Beyond, which struggled with increased interest payments leading to bankruptcy. Businesses with high fixed costs, like labor and manufacturing facilities, also face significant pressure.
The automotive industry exemplifies this impact. Automakers incur substantial fixed costs from labor and production plants, and they contend with intense competition. To maintain sales, many have resorted to price reductions and promotions, which, while attracting customers, have increased costs and reduced earnings. For instance, Volkswagen has announced plans to close three plants and lay off thousands of employees to cut costs amid declining earnings and increased competition in the electric vehicle market.
Similarly, Boeing has faced significant challenges due to its debt load. The company required approximately $20 billion in additional capital to sustain operations and had to lay off over 17,000 employees. Supply chain disruptions from COVID-19, coupled with high debt and management issues, created substantial uncertainty. Boeing's bond rating was at risk of being downgraded to junk status, with revenues declining while interest expenses increased. Recently, Boeing raised $21.1 billion through the largest equity sale by a U.S. company in history to avoid a downgrade of its credit rating to junk status.
These examples highlight the complex challenges businesses face in managing debt and fixed costs amid inflation and rising interest rates.
Technology and Banking
During periods of high inflation and rising interest rates, the tech industry faced significant challenges. In 2023, over 262,000 employees were laid off from tech companies worldwide, with more than two-thirds of these layoffs occurring in the United States. Many companies also reduced research and development budgets, and some even filed for bankruptcy.
However, major tech companies like Microsoft, Amazon Web Services (AWS), Alphabet, and Oracle demonstrated resilience during these challenging times. Their revenue growth was largely driven by advancements in cloud computing and artificial intelligence (AI). Collectively, these tech giants invested close to $200 billion in areas such as data centers, AI model training, GPUs, and software development. This substantial investment transformed them into more capital-intensive companies, heavily reliant on large-scale fixed assets. Although the long-term returns on their AI investments remain to be seen, their ability to thrive in a high-interest-rate environment underscores their strategic foresight and adaptability.
Well-managed banks also benefited from the high-interest-rate environment. For instance, JPMorgan Chase successfully grew its assets and earnings and kept investors happy, despite some challenges in investment banking. In contrast, banks like Silicon Valley Bank and Signature Bank faced significant difficulties. Both institutions were closed by the Federal Deposit Insurance Corporation (FDIC) in March 2023 due to financial instability. This underscores the critical importance of strong management during challenging economic times. Additionally, the banking industry saw increased consolidation, but not all mergers were successful. For example, New York Community Bancorp encountered difficulties and required an additional $1 billion in capital, significantly diminishing shareholder value. These were indeed tough times.
As the Federal Reserve can control short-term rates, long-term rates are decided by supply and demand, and it looks like inflation will persist based on what we have seen.
What Makes a Company Resilient in Tough Times?
Not all businesses are equally impacted by rising interest rates and inflation. Some companies have certain characteristics that help them weather these challenges better than others. Here are a few key traits of resilient companies:
Low or No Debt: Companies with little or no debt are better positioned to handle rising interest rates because they don't face the increasing costs of borrowing. In contrast, heavily indebted companies see their profits erode as they struggle to manage higher interest expenses.
Essential Products or Services: Companies that provide essential goods or services—like healthcare, energy, and utilities—tend to remain stable even when the economy slows down. People continue to need these products regardless of economic conditions, which keeps demand relatively constant.
Strong Brand Loyalty: Companies with loyal customers can often raise prices without losing sales. Brands like Apple, for example, maintain a strong customer base that is willing to pay more for their products, which helps them weather tough times.
High Gross Margins: Companies with high gross margins are more efficient at absorbing rising costs. They can maintain profitability even when inflation increases the price of inputs, like raw materials or labor.
Operating Leverage: Companies that can grow their profits without dramatically increasing their costs benefit from operating leverage. This is often seen in industries like software, where the cost of producing an additional unit is low once the infrastructure is in place.
Pricing Power: Companies that can raise prices without losing customers have a significant advantage. This ability to pass on rising costs to consumers is especially valuable during periods of high inflation.
No one can predict the future, especially with so many factors at play—such as the U.S. deficit, global conflicts, military spending, and investments in the green economy. These elements are all inflationary. The best way to hedge against this uncertainty is by investing in companies that are well-positioned to weather these challenges. Focus on businesses with strong fundamentals, pricing power, and a strong balance sheet. That said, U.S. stocks are currently trading around 29.4 times P/E, which seems to be pricing in perfect outcomes.