The Stock Market Cannot Ignore the Impact of Rates on Earnings This Season

Stock markets that have remained resilient in the face of the highest yields since 2007 are now facing a fresh challenge. The upcoming third-quarter results will reveal the extent to which these elevated interest rates are impacting corporate profits and how they might affect the lofty valuations of equities.

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As earnings season gets underway, corporate leaders are likely to face inquiries regarding the sustainability of their balance sheets in the face of rising interest rates. Prolonged periods of high rates could make debt refinancing increasingly burdensome. Moreover, companies may reconsider new projects, potentially curbing corporate investments in growth.

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Approximately $820 billion worth of non-financial corporate bonds in the United States and Europe are set to mature in the next 12 months, constituting around 7% of the overall market, according to Bloomberg data. While most companies are not expected to encounter a maturity crunch until 2025 or later, heavily indebted firms are already grappling with the consequences of higher rates.

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Patrick Armstrong, Chief Investment Officer at Plurimi Wealth, remarked, "The sword of Damocles has been hanging over highly indebted companies for a number of quarters, 3Q earnings may see this sword drop."

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Goldman Sachs Group Inc. strategists, led by David Kostin, recently cautioned that borrowing costs for S&P 500 companies have already increased by the largest margin in nearly two decades on a year-on-year basis. They noted that nearly half of the 69 basis points of contraction in return on equity (ROE) during the first half of the year resulted from higher interest expenses.

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Since the global financial crisis, declining interest expenses and increased leverage have contributed to almost one-fifth of the overall 8.8 percentage point increase in the ROE of S&P 500 firms. The risk of interest rates remaining elevated for an extended period could deter companies from taking on more debt, thereby impacting long-term profitability.

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However, Kostin's base-case scenario suggests that margins will reach their lowest point this year, with moderate expansion anticipated in 2024 and 2025. He stated, "We forecast margins for the aggregate S&P 500 index and most sectors will remain near their 10-year highs." Nevertheless, significant margin expansion is unlikely due to persistent wage growth, higher interest rates, and taxes.

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Marija Veitmane, Senior Multi-Asset Strategist at State Street Global Markets, suggests that large-cap stocks with robust balance sheets are a safer choice, particularly compared to industries tied to economic cycles and growth. She anticipates a substantial economic slowdown in the coming year, which may lead to conservative guidance from management teams.

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Even megacap stocks are not immune to rate risk. Growth-focused shares, such as Nvidia Inc. and other tech giants, derive much of their elevated valuations from future profit expectations. When these profits are discounted at higher rates, they may appear less appealing to investors.

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For instance, Nasdaq 100 equities trade at 23 times forward earnings, a 25% premium to the S&P 500, whose valuation is also influenced by these tech megacaps. When assessed based on sales, the Nasdaq commands a multiple of nearly four, almost double the broader market's valuation.

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Societe Generale SA strategists led by Manish Kabra pointed out that over 70% of S&P 500 valuations are contingent on long-term growth outlooks, making U.S. equities highly sensitive to fluctuations in bond yields.

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In this environment of rising rates, valuations become increasingly significant, which may prompt investors to shift away from stocks, as indicated by the shrinking equity risk premium – the difference between expected returns from stocks and bonds.

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Emmanuel Cau, a strategist at Barclays Plc, emphasized, "In a higher rates regime, valuations matter more."

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