Rising Interest Rates and Corporate Profits: The Unconventional Strategies Defining U.S. Business Success in 2023

Ever wondered why, in a year of aggressive Fed rate hikes, US corporate earnings are flourishing like never before? It's a riddle that's left many scratching their heads. Dive in with me as we unravel the secret moves that corporations are making behind the curtain. From playing a high-stakes game with inverted yield curves to a strategic shift in borrowing habits, this article will shed light on how modern corporations have turned the tables on rising interest rates.

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The article provides a comprehensive look at the relationship between rising interest rates and the performance of U.S. corporations, challenging the conventional wisdom that higher interest rates are a negative force for corporate profitability. Here's my analysis of the situation, breaking down key points:

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Adaptability of the Corporate Sector

Shift in Debt Structure: One of the most noteworthy observations is the change in corporate borrowing habits. Companies have shifted from relying on short-term borrowings like commercial paper and bank loans to longer-term debt with fixed terms. This has lengthened the time it takes for interest rate hikes to significantly affect debt-servicing costs.

Example: Imagine a corporation, let's call it "TechCo," that once borrowed primarily through 1-year commercial paper. After the financial crisis, they shifted to issuing 10-year corporate bonds. The short-term debts would have been immediately impacted by rising interest rates, making borrowing expensive quickly. But with the 10-year bonds, the interest rates are locked in for a longer period, mitigating the immediate impact of any rate hikes by the Fed.

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Fixed-rate borrowing: The market composition has seen commercial paper shrink and investment-grade debt grow substantially, with most of the debt being fixed-rate. This offers a natural hedge against rising interest rates.

Example: Consider a manufacturer, "ManuCorp," which borrows $100 million at a fixed rate of 2% for 10 years. Even if the Fed hikes rates to 4%, ManuCorp's debt service costs remain the same, unlike if they had variable-rate debts.

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Inverted Yield Curve Play: Companies with high cash reserves are taking advantage of the inverted yield curve by earning higher interest on short-dated notes while locking in lower interest rates on their long-term debt. This has led to falling net interest costs across many sectors, making the corporate environment more resilient to Fed tightening.

Example: "CashRich Inc." has $50 million in excess cash. Due to the inverted yield curve, short-term interest rates are 3%, and long-term rates are 2%. CashRich Inc. can invest its excess cash in short-term assets earning 3% while its long-term debt costs are locked in at 2%, thereby earning more on its cash than it pays on its debt

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Macro-Economic Factors

Household Debt and Consumer Spending: Household indebtedness as a share of GDP has decreased, and credit standards have tightened. Alongside strong labor markets and fiscal stimulus, this has led to consumer resilience, which indirectly benefits corporations.

Example: Since the 2008 crisis, households have been careful with mortgage debt, opting for 30-year fixed-rate mortgages. So when the Fed raises short-term rates, these households aren't immediately affected, which sustains consumer spending and indirectly helps businesses like "RetailCo" maintain revenue.

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Labor Market Dynamics: The sustained profitability has enabled companies to continue hiring, adding a positive feedback loop to the economy through increased employment and consumer demand.

A strong labor market has led to more consumer spending on dining out. "FoodPlaza," a chain of restaurants, continues to hire and expand, in turn spending more on suppliers, contributing to a virtuous cycle of economic growth.

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Risks and Sustainability

Debt Rollover: At some point, companies will need to refinance their debt. If interest rates remain high when that happens, the protective shield will diminish. However, the shift towards longer maturities may give corporations more time before this becomes an issue.

"LongTerm Inc." has issued bonds that are maturing in 2030. If the interest rates are high when these bonds mature, the company will have to issue new bonds at a higher interest rate, increasing their cost of capital and possibly impacting profitability.

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Sector Variability: Not all sectors have adapted in the same way. The healthcare sector, for example, has not made a similar shift in debt maturity, making it more vulnerable to interest rate increases.

"HealthCorp" still relies on short-term borrowings and has not shifted to long-term debt like other companies. If interest rates go up, they would feel the pinch more than companies that have locked in lower, long-term rates.

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Investment Implications

Recession Forecasts: The unique changes in private sector indebtedness suggest that historic norms may not be reliable indicators for forecasting recessions.

An investor who always pulled out of the market when interest rates rose based on past trends may find that they've missed out on gains this time, as companies like TechCo and ManuCorp have adapted to higher rates more effectively.

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Refinancing Opportunity: If rates fall, as is likely if inflation recedes, companies may refinance on more favorable terms.

If rates dip, a company like "RefiCo" could pay off its old 5% interest bonds and issue new ones at a lower rate of 3%, reducing its long-term debt-servicing costs.

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Credit Risk: The change in debt composition and economic resilience reduces the likelihood of widespread defaults, though idiosyncratic risks remain.

An investor who understands that companies like TechCo have locked in low-interest rates for a long period might consider them a safer investment compared to companies like HealthCorp with a higher exposure to short-term interest rate hikes.

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The resilience of U.S. corporate earnings despite rising interest rates is a function of adaptive behavior, strategic financial management, and macro-economic conditions. While the sustainability of this resilience is uncertain, especially when companies need to refinance their debt, the current landscape suggests a more nuanced relationship between interest rates and corporate performance than traditionally understood. For investors, the new dynamics call for a cautious yet optimistic approach, where traditional indicators might need to be reconsidered.

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