Rising Rates Rattle Markets

Global markets fell sharply on the tail end of last week. The S&P 500 ended the week down -0.95% while the MSCI World USD Index fell -1.49%.

Another Rate Hike

The fall in the market was driven by rising interest rates. The Federal Reserve announced its third rate hike of the year (in line with expectations). The Fed removed terminology about being accommodative and stressed that the rates were still well below historical norms.

Cheap debt and shareholder buybacks have changed the capital structure in the investment landscape. As a result, many companies are more leveraged than they’ve ever been. For example, Harley Davidson (which we do not hold) is more leveraged (meaning they have more debt to overall assets) than when they required a bailout during the financial recession.

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Those companies could afford to take on more leverage because the amount of interest they had to repay on that debt was lower. As interest rates rise, companies will have to either repay some of that debt or borrow new money at a higher cost.

The Brazilian Election

Jair Bolsonaro won 46% of the vote in the Brazilian election. Without a simple 50% majority win, a run off election between Bolsonaro and Haddad (the top 2 candidates) will take place. Concerns of Bolsonaro having a hard ceiling on voters appears to be disproved as he outperformed in the initial election. This may have been related to the candidate being stabbed by a member of the opposition during a rally. While Bolsonaro is viewed as a divisive character, his law and order platform appears to resonate in a country that has been struggling with internal corruption in its political class and a spike in violence that has caused many of the elite to flee the country.

Conclusion

The US economy probably still has some legs on it. While rising interest rates and historically high debt levels are a concern in the US markets, the effects are unlikely to be felt immediately. Most company debt revolves over a 2-year time horizon so it will take time for companies to start feeling the drag of a more normal interest rate burden. Despite this, companies got a reprieve in the form of corporate tax cuts this year. From a profitability perspective, a dollar going to taxes or debt after tax should not impact the bottom line. The losers are likely to be companies with higher overall debt and high turnover in the next few years. The winners will likely be companies with low debt and higher tax rates (prior to the cuts). Other winners may include companies that are lower barriers to trade and freer flow of immigration.

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