Higher Rates Are a Clear and Present Danger to Economy

Share:

Consumers have carried the U.S. economy on their backs for a long time, but lately they are showing signs of fatigue. Consumers' response to higher food prices shows how frail they really are.

Higher Rates Are a Clear and Present Danger to Economy
Consumers have carried the U.S. economy on their backs for a long time, but lately they are showing signs of fatigue. Consumers’ response to higher food prices shows how frail they really are. Food distributor Sysco (SYY), which reported 5.9% food inflation in the latest quarter, has passed commodity price increases on to restaurants. But when restaurants tried to pass higher prices on to their patrons, they witness a decline in traffic and volumes. From listening to other consumer companies’ earnings calls, I have gathered that every time companies raise prices, in an effort to pass commodity inflation on to the consumer, demand drops off. This was the case with Sara Lee (SLE) as well.
 
This is not the behavior of a strong consumer. The current quarter inflation experienced by Sysco is lower than the 8% it experienced last quarter, and it is unlikely that high food inflation will stay high for a very long time. A deceleration in the rate of growth in the current quarter is a good initial indication of that. Also, supply and demand imbalances in food commodities that are pushing prices up tend to correct themselves more quickly than in other industries (i.e. in natural resources). It is very likely that any improvement in the economy will be followed by rising rates.
 
Even in the absence of economic improvement, high inflation in commodity prices is likely to push rates higher, since inflation will be eroding the already very small real return in bonds. Rising rates are a serious concern. Low interest rates have drugged and steroided consumers, sending them on a three-year-long shopping spree for bigger and greater must-haves. Ironically, rising rates from an ultra-low to a long-term average level are a lot more painful to the consumer and to the economy as opposed to an environment in which rates just remain at the long-term average. A low interest rate environment brings a significant benefit since it helps consumers refinance their balance sheets, lowering the cost of financing and, in theory, increasing discretionary income. In reality, the negatives that cheap money brings to the consumer may outweigh the positives.
 
Consumers got used to home equity lines of credit that only cost what risk-free rates used to cost in the pre-cheaper-than-dirtiest-dirt time, thus leading consumers to use debt financing as if they discovered that Croesus had put them in his will. Though discretionary income (gross income minus taxes) has grown consistently over the last several years, consumer debt as percentage of discretionary income has reached an all-time high over the same time period. Consumers’ appetite for debt has outgrown their income consistently over last decade. Total Consumer Debt as % of Discretionary Income (Send me email for the chart) The problem with the “consumer debt as percentage of discretionary income” measure (the above chart) is that it ignores the true cost of debt since higher debt levels in a low-interest-rate environment may not result in a high debt service burden (interest and principal payments) on the consumer.
 

However, despite low interest rates, debt service burden as a percent of discretionary income is one iota away from being at an all-time high. Consumers have benefited from all-time low interest rates, but they have taken so much debt that monthly expenses associated with paying interest and principal payments in relation to their discretionary income have actually increased despite the low interest rate environment and growth in discretionary income. In other words, this is where “theory” went out the door. Total Debt Service Burden as % of Discretionary Income (Send me email for the chart) Rising interest rates will escalate problems that stem from consumer indebtedness.

Though many consumers refinanced and locked their mortgages at ultra-low rates for 30 years, over a third of total consumer debt is floating and will be readjusted upwards once interest rates rise. The impact of rising interest rates will be delayed since it takes time for higher rates to trickle through. For adjustable rate mortgages, it takes as much as a year for payment to reflect higher interest rates. Rising interest rates will have significant consequences on an already-overleveraged and over-extended consumer. Rising interest will be a stagflation-like headwind to future economic growth. It is hard to measure the magnitude of the impact that higher interest rates will have on the consumer and the economy, but it is clear higher interest rates will temper economic growth. In addition, significantly higher rates would have a tremendous impact on the housing market, driving down housing prices and reducing or wiping out any equity left in houses, pushing homeowners to be upside down on their house (not in a literal sense).

For example, according to the Financial Times, U.K. housing prices have declined in October by the highest amount in four years due to higher mortgage rates. I imagine we will be seeing similar headlines hitting U.S. newsstands in the not-too-distant future. Higher interest rates will not impact homeowners that either are not selling their house or don’t have a second mortgage on it. Actually, it will probably benefit them by reducing their property tax value thus resulting in lower property taxes, though personally I don’t know anybody who has a house and doesn’t have a home equity loan. It seems mental accounting (irrational behavior described in behavioral economics) is impacting consumers spending behavior.

Money that came from borrowing against home equity is spent on discretionary and products more durable in nature . Since consumers feel that they did not have to “work for” these funds, they are placed in a separate “mental account,” which has less value placed on it. Thus, money is spent with relative ease. This explains a very impressive performance by the home remodeling market and all-time high consumer indebtedness. “Hard-earned” money consumers use to pay for staples, food, and restaurants is placed into a different mental account that carries a higher value to consumers. Thus, consumers are more frugal about spending those funds, resulting in higher elasticity of demand. It is very likely in absence of the cheap money stemming from home equity loans, consumer behavior will reverse. We are gradually recalibrating our portfolios to mitigate the risk of a weakened consumer, and though we don’t expect the consumer to weaken overnight, we’d rather be early to the party than late. Here are the adjustments we are making to our portfolios.

  1. We are shying away from companies whose products and services are highly discretionary and constitute a large portion of consumer budgets. Reduced home equity and higher interest rates will have a significant impact on these businesses. Names that come to mind to avoid are Home Depot (HD), Lowe’s (LOW), Best Buy (BBY), Circuit City (CC), and Fortune Brands (FO), among others.
  2. We are shifting our focus to industries that have very little exposure to a weakening in consumer discretionary spending. There are plenty of names that fit the bill starting with healthcare, consumer staples (with unique and strong brands), defense, and many other industries.
  3. We are identifying beneficiaries from a higher interest rate environment and consumer weakness. There are fewer names in this category. Though banks in general should benefit from higher interest rates, they will likely suffer from higher loan defaults caused by a weakened consumer. Collection agencies sound like a logical alternative, but they actually perform worse in such an environment. The only company I’ve found so far is that fits the bill is Jefferson-Pilot (JP). It should benefit from higher interest rates, and demand for its products is unlikely to decline in a weaker consumer environment.
 

Please read the following important disclosure here.

Related Articles

Q&A Series: Money Habits for Kids and the Power of Writing

Q&A Series: Money Habits for Kids and the Power of Writing

In this Q&A excerpt, we'll explore teaching money habits to young people and how writing has improved my investment approach.
The Impact of Higher Interest Rates on the Economy - AI Edition

The Impact of Higher Interest Rates on the Economy – AI Edition

I asked AI to educate and entertain my readers with a radio show-style dialogue based on my essay - The Impact of Higher Interest Rates on the Economy.
Navigating Market Cycles From Bulls to Nvidia – AI Edition

Navigating Market Cycles: From Bulls to Nvidia – AI Edition

I asked AI to transform my essays into a radio show-style conversation. In this episode, topic is stock market math, sideways markets, the role of P/E in market cycles, impact of interest rates on P/E, economic analysis, Magnificent Seven stocks, NVIDIA, and a lot more.
Managing a Million What Would I Do Differently

Managing a Million: What Would I Do Differently?

Warren Buffett has stated multiple times that if he could manage a very small amount of money today, he would be able to return more than 50% per year to shareholders. If you managed a million dollars of only your own money, would you do it differently? 

Leave a Comment