Higher Rates Are a Clear and Present Danger to Economy

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.