Equities Blog

Debt Burdens, Elevated Rates to Test Equity Investors

26 August 2024

4 min read

An extended period of elevated interest rates may have long-term implications for both consumers and businesses—affecting how investors value company shares.

Equity markets have become more volatile of late, as investors fret about economic slowing ahead of likely Federal Reserve rate cuts. But beyond the obvious macro-level implications of what had been a higher-for-longer rate environment, we believe investors should consider how high rates affect corporate profits—an issue that is too often overlooked.

Higher Rates Have Increased Financing Costs

Higher interest rates have dampened aggregate demand, which has helped contain inflation, although pockets of wage inflation persist. Less noticeable to some investors is the impact of higher rates on corporate and household balance sheets. That’s because the effects of changing rates—both up and down—tend to build as time passes, particularly for infrequently purchased items with higher price points.

For example, installment loans, such as home mortgages and auto loans, are typically measured in years rather than months. Regardless of market conditions, a relatively small number of consumers purchase these big-ticket items in any given month. As a result, it may take a long time for borrowers to feel the adverse effects of higher rates.

Consider what would happen if interest rates spiked for six months but then fell sharply. Given the tight time frame, few consumers of high-cost goods would be exposed to elevated financing costs. But what happens when rates stay high for a long time? That’s the scenario we’ve been experiencing, with consumers and businesses feeling the pinch.

High Financing Costs Reduce Economic Activity and Flow Through to Bottom Line

The housing market is a case study. Trailing 12-month existing-home sales hit a 14-year high of 6.2 million in August 2021, driven by rock-bottom fixed mortgage rates (Display). Since then, 30-year fixed mortgage rates have climbed more than 400 basis points to a 20-year high of roughly 7%. The result? Trailing 12-month home sales fell to four million units by the end of May 2024.

Elevated Rates Have Depressed Existing US Home Sales

Lines showing US existing-home sales generally moving inversely to 30-year fixed mortgage rates since 2005

Historical analysis does not guarantee future results.
As of May 31, 2024
Source: FactSet and AllianceBernstein (AB)

Since May 2022, over 9 million existing-home sales closed with rates above 5%. Trailing 12-month new-home sales are also down from the nearly 900,000 May 2021 peak.

The effect of higher interest rates on borrowing costs is easy to see. But less visible is the greater amount of consumer cash flows going toward debt servicing—and the inevitable crowding out of other spending that ensues.

For businesses, the effects of an elevated-rate environment are also significant. Lower demand—and lower prices—eventually erode corporate operating profits. Companies selling lower-priced items have seen declining sales volume in recent months. But companies heavily weighted toward high-end product lines still face risks, as they may not have medium- or lower-end products to offset changing consumer preferences.

A Return to Survival of the Fittest?

In this environment, investors must carefully consider corporate debt loads, which are significantly higher than the 20-year average (Display).

Corporate Debt Loads Have Risen Significantly

Total Debt as a Percentage of Net Cash Flow, S&P 500

Lines showing total debt as a percentage of net cash flow for S&P 500 companies increasing since 2004

Historical analysis does not guarantee future results.
Data reflect median figures over trailing 12 months.
Through July 31, 2024
Source: FactSet and AB

Healthy companies in rational markets typically generate excess cash after appropriate reinvestment and don’t need to rely on debt to fund operations. When demand falls, earnings may come down, but not necessarily enough to raise concerns about a company’s financial stability.

On the other hand, profitable companies with heavy debt loads may take on risks overlooked by investors—especially if those companies operate in cyclical markets. This can make them particularly vulnerable to sales and earnings weakness. Deteriorating financial results, coupled with high financial leverage, can even lead to solvency risk. For this reason, investors must make sure that a company under pressure is investing enough to support future earnings growth.

Cautionary Tales Abound

When financial conditions are tight for an extended period, the weakest players are often the most vulnerable.

While we don’t anticipate anything that extreme happening this time around, today’s high-rate environment still has the potential to create significant strain on consumers and businesses. Even companies with strong free cash flow to support high debt loads can be adversely affected. Higher interest expenses and the need to pay off debt as it matures can threaten a company’s operations, competitive positioning and profitability. Ultimately, this can affect how investors value its stock.

Investment strategies that don’t sufficiently consider the potential damage of heavy debt and volatile cash flows are risky propositions. Identifying companies with quality businesses, manageable debt levels and healthy balance sheets can reduce risk and ultimately boost long-term return potential.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

This website is only directed at persons residing in Singapore. Persons resident in territories other than Singapore should not access this website. This website is not directed to any person in any jurisdiction where (by reason of that person's nationality, residence or otherwise) the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction. By accessing this website, you are representing and warranting that the applicable laws and regulations of your jurisdiction allow you to access the website, and that you have agreed to the terms of use.

This content is provided on an "AS IS" basis. No representation or warranty, whether express or implied, is made with respect to the accuracy, validity or completeness of this content, and any liability for errors or omissions in such content is expressly disclaimed. This content may contain projections and other statements regarding future events or the future financial performance of countries, regions or markets. These statements will necessarily only be predictions, and actual events or results may differ. You should make your own assessment of the relevance, accuracy and adequacy of the information provided and make such independent investigations as you may consider necessary or appropriate. Any opinion or views offered are made on a general basis and are not to be relied on as advice. The views expressed here may change at any time after the date of this publication. Accordingly, neither AB nor any of its affiliates, associates, directors, connected parties and/or employees accept any liability whatsoever for any loss, whether direct or indirect, that may arise from the use of the information or opinions provided.

AllianceBernstein (Luxembourg) S.à.r.l. is the management company of the Portfolios and has appointed AllianceBernstein (Singapore) Ltd. (Company Registration No. 199703364C) as its agent for service of process and as its Singapore representative. AllianceBernstein (Singapore) Ltd. is regulated by the Monetary Authority of Singapore. This advertisment has not been reviewed by the Monetary Authority of Singapore.

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice.

AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates.

The contents of this site are general in nature, for general information only and prepared without consideration given to the specific investment objective, financial situation and particular needs of any specific person. This site contains the views and opinions of particular individuals and may not necessarily represent views expressed or reflected in other AB communications, strategies or funds. Reliance should not be placed on these views and information when making individual investment and/or strategic decisions.

Past performance, historical and current analyses, and expectations do not guarantee future results.

Investment involves risk. The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernsteinL.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.