After Friday's blockbuster payrolls report, interest rates are almost certainly going higher. And that means it's time to start betting on companies that won't feel the pinch from higher borrowing costs.
Consider: The Federal Reserve has been raising rates this year, which is just another way of saying that it's increasing the cost of borrowing. The Fed has hiked rates to a range of 2% to 2.25%, and while no change is expected at the coming week's meeting of the Federal Open Markets Committee, another boost in December wouldn't be a surprise. In fact, after the payrolls report—the U.S. added 250,000 jobs—the odds of a December hike hit 75% Friday.
As a result, companies will have to pay more interest on new or refinanced debt. That's not a problem yet—rates are still low, and profits remain strong—but 25% of outstanding debt will come due in the next three years, according to Sanford C. Bernstein data. And higher rates will make servicing large debt loads more expensive.
Many companies have already reached that conclusion, and started taking action. On Alliance Data Systems ' (ADS) earnings call, management told analysts that "cash flow will continue to be used to continue to support share repurchases and our quarterly dividend, but will also be used to reduce our corporate leverage ratio to 2.2 times or lower by year-end." Likewise, United Technologies (UTX) said it "will be focused on deleveraging for the next two, three years and does not anticipate any significant share buyback in 2019."
With more money going to service or pay down debt, companies will have less to spend on things like dividends and buybacks. Extreme examples include Anheuser-Busch InBev (BUD), which recently cut its dividend in half, and General Electric (GE), which slashed its payout to just a penny. But even smaller shifts could act as a head wind on individual stocks.
Those kinds of problems are likely to grow in importance for investors, argues Bernstein strategist Inigo Fraser-Jenkins. "As we consider the near-term outlook for global equities over the next couple of years and the medium-term horizon beyond that, we think that the dynamics of rolling over debt will form an increasingly important part of the investment outlook," Fraser-Jenkins explains. "At the very least. we suggest that one should tactically avoid highly levered companies."
The flip side is that stocks with smaller debt loads—a group that includes retailers such as Gap (GPS) and Costco Wholesale (COST), industrials including Southwest Airlines (LUV), and tech stocks such as Micron Technology (MU) and Alphabet (GOOGL)—should be able to sidestep those same problems, making them safer plays than overly-indebted peers in the same sectors. This group of stocks—found via a screen for low leverage by sector—is also trading at low valuations, relative to the overall market, Fraser-Jenkins says. "There has been no anticipation of the interest rate or credit spread cycle in the valuation of these companies," he explains.
Maybe there should be.
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