A recent report from Goldman Sachs Portfolio Research suggests that the expected boost in interest rates over the next few quarters is likely to have a material impact on profits at many S&P 500 firms. The problem is that margins are at record highs, and are therefore more likely to fall back than continue to move up.
Recent economic data confirm this, as margins are already starting to slip in a number of sectors. Moreover, as Goldman Sachs analyst David J. Kostin and colleagues note, profits and stock prices are highly correlated. “The historical relationship between Return on Equity and price/book ratio shows that investors typically reward superior profitability with higher valuation. ROE tends to lead valuation.”
It’s all about margins
The GS report notes that S&P 500 return on equity was down 43 bp to 15.8% in the fourth quarter of 2014, largely because lower EBIT margins kept a lid on returns. Of note, margins were lower in six of ten sectors. The telecom sector was off by nearly 10% because of pension-related charges at AT&T and Verizon. Ex-financials, ROE was down by 48 bp to 18.6% largely due to lower margins and higher taxes. The analysts also point out that lower leverage continues to hold back ROE for the financials, which ticked down modestly to 10.2% in the fourth quarter.
Kostin et al. emphasize the importance of margins: “Our economists expect the Fed will first hike rates in September. S&P 500 borrow costs, which are historically low, increased by an average of 10 bp in the year following prior initial rate hikes but firms lifted margins which actually raised ROE by an average of 57 bp. Margins now stand near record highs which means future increases in borrow costs may reduce ROE.”
Increasing interest rates / borrow costs will negatively impact profits
Not surprisingly, when the cost of operating capital goes up, profits go down. The report highlights that the borrow cost for the S&P 500 was up by an average of 10 basis points during the year following each of the three most recent rate hikes. Moreover, borrow costs moved up by an average of 20 basis points in the two years after hikes in interest rates.
The GS team explain the relationship between borrow costs and profits. “Rising interest costs negatively impact ROE. All else equal, a 10 bp rise in borrow cost would result in a 30 basis point decline in ROE.”