How Higher Interest Rates Will Impact Us

Friday’s strong job report has increased the odds that the Federal Reserve will finally raise interest rates on December 16th.  There has definitely been improvement in the labor market but I believe it would be tough to define the U.S. economy as strong.  The ISM manufacturing index has dropped to contraction levels and inflation is still non-existent.  Almost all commodities are at record lows, highlighting the slowing and changing dynamics of the Chinese growth story.  Labor participation rates are the lowest since the 1970s.  The other big issue is that the strengthening of the U.S. dollar has our industrial sector in an industry-specific recession, as foreign companies can beat us on price, bolstered by the weaker currency.  With all that said, the Fed has kept rates low for a very long time and it believes that the strong job growth will continue, leading to increased wages.  I’m not smart enough to know if they will be right or wrong in this endeavor, as I’d put the odds at 50/50.

Higher interest rates is actually a welcome sight for our portfolios.  The biggest beneficiaries of higher interest rates are financial companies.  The banks benefit from higher net interest margins, as the rates at which they lend raises faster than the rate at which they pay depositors.  Higher short-term rates will help but long-term rates need to rise as well for this to be a very meaningful benefit to profits.  Banks like Bank of America, Wells Fargo, Citigroup and J.P. Morgan would likely see a combined $10-$15 billion more in net income if rates were 1% higher in both the short and long-term.  Insurance companies such as AIG would also benefit as the their massive investment portfolios would be able to generate higher amounts of income from their investment programs.  AGO also has been waiting for higher interest rates to come for quite some time.  Municipal bond insurance becomes more and more attractive as spreads widen and higher interest rates makes that happen.  More insurance volume allows AGO to take in premiums that results in increasing operating and investment income.

Higher interest rates is negative for companies with excessive leverage.  We don’t have much exposure to highly leveraged companies thankfully, but the junk bond market is showing serious signs of distress.  If the economy stays resilient that might be an opportunity, but many of these companies that have double-digit yields are in the battered energy sector.  If higher interest rates leads to continued strengthening of the U.S. dollar than commodity prices will likely continue to struggle.  Wheat for example has already been hurt be excess supplies, but in the United States our market share is the lowest in many decades due to our wheat being far more expensive for other countries to buy due to the strong dollar.  Farm incomes have plummeted across the country, which hurts agricultural-related industries of course.  The retail industry also gets hurt especially on the high end because tourists are more reluctant to travel to the U.S. and spend lavishly as they have in the past when our dollar was weaker.

While it does indeed look like we will see the first rate hike, the trajectory and speed at which further rates move will be most important.  Does the U.S. economy see continued improvement in the jobs market, leading to increased wages and ultimately inflation?  Does the U.S. economy turn over and send us into a mild recession, as the industrial and energy sectors continue to struggle?  How will housing react to higher rates?  I believe that it is very important that China and Europe continue to see improvement for the U.S. to be able to keep raising rates.  Europe seems to be getting better, but China is the bigger wildcard.  Brazil, which was once one of the most promising growth stories in the global economy is in an extremely steep recession.  The U.S. is capable of leading the global economy out of this economic malaise, but there will inevitably be some hiccups along the way.  Fortunately, we have been prepared for higher interest rates and I believe that ultimately we should see solid portfolio growth in a higher rate environment.  I’ll keep you updated as always with new developments.  Thank you very much!