As S&P 500 Earnings Double from Five Years Ago, Rising Interest Rates Spell Disaster

earnings: As I’ve been stating for most of the past year, interest rates will rise, and this will have a significant impact on the markets. But the real question you have to ask yourself is why are interest rates rising?

If these rates were rising due to a much stronger economy, this would actually be bullish, as corporate earnings would also be increasing. But interest rates, I believe, are increasing as the market is now adjusting to a more “normal” environment and pricing in the exit of the Federal Reserve.

This will have an impact on corporate earnings, as firms have benefited from the extremely low interest levels. According to Bloomberg, the costs of borrowing for S&P 500 companies was only 1.4% of sales over the past year, a record-low during the 11 years that these data have been kept. (Source: Bloomberg, September 2, 2013.)

Not only is the expense of higher interest rates going to reduce corporate earnings, but many companies have borrowed to fund share buybacks and dividends. This will also begin to decrease as interest rates rise.

Since revenue is not accelerating and costs associated with higher interest rates are beginning to rise, this squeeze can only mean a lower level of corporate earnings growth.

This is not something to be taken lightly. Historically, a huge part of total returns results directly from cash being returned to shareholders in the form of dividends and buybacks. With increasing costs from higher interest rates, shareholders will get less money back, and the higher costs will result in lower levels of corporate earnings.

This is a significant paradigm shift that we have to take into account over the next decade. Much as investors have been used to 20 years of ever-lower interest rates, this new shift to higher interest rates will create an environment that is quite different than what we’ve experienced in the past.

Traditionally, companies that issue dividends and buyback shares outperform the market. If interest rates rise and begin to curtail these activities, we then have to look at purely increasing revenues to generate higher levels of corporate earnings.

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