Every time anyone at the Federal Reserve says something about interest rates, the market seems to panic. Investors and traders across the board dump equities in the belief higher interest rates will lead to an economic slowdown, which will hurt earnings and justify lower valuations.
This is a pretty simplistic view.
Yes, higher interest rates will hurt economic growth, but it seems unlikely that every single company on the market will be equally impacted. It does not make sense to sell every single investment just because a handful are going to suffer in an economic slowdown.
The challenge investors face
This is the challenge investors face today.
Trying to distinguish between companies that will be able to survive and prosper over the next 24 months also is not an easy task. Still, there are plenty of pockets of value in the market where investors can hide to ride out the storm and potentially even generate a profit simultaneously.
Rather than start by trying to outline the sectors that I believe will perform the best, I am going to take a look at the sectors that I believe are most exposed to higher interest rates.
The single most-exposed part of the market is high-growth speculative tech stocks. The companies that are not making any money have been relying on investor handouts to stay alive.
Actually, this is not just limited to the technology sector. Plenty of companies have binged on cheap credit and taken advantage of easy financial conditions over the past couple of years to throw good money after bad.
This will stop as interest rates increase. Investors have been willing to fund loss-making businesses because there has been no alternative.
However, with interest rates rising and alternatives appearing, the chances that investors will select loss-making businesses in hopes that one day they will turn a profit over other safer investments and a guaranteed return are declining by the day.
Companies with lots of debt will also face pressure. Businesses with near-term debt maturities and floating rate debt are the most exposed.
How to navigate the storm
Considering these factors, I think it is sensible to suggest that investors should look for profitable companies with strong balance sheets to survive the coming storm.
It may also be sensible to seek refuge in groups with large profit margins.
Large profit margins can indicate a competitive advantage. A competitive advantage can take many forms, but size or a unique product are the most common.
Companies with large profit margins can absorb higher costs without the higher costs impacting the ability to service debt or meet other obligations. And if they do have a unique product consumers are willing to pay more for, they should be able to increase prices to offset higher costs.
The perfect example is the luxury goods industry. Luxury goods tend to have substantial profit margins. Moreover, companies usually have robust balance sheets stuffed with cash, and their target customers tend to be more affluent individuals who will not worry about higher interest rates or energy costs. Individuals shopping for luxury goods are less likely to be exposed to the economic cycle than others.
In addition to the above factors, I think it is also worth considering the major economic themes that are currently evolving. Even before the global crisis, the world invested more in renewable energy.
This trend will only accelerate, and so will the train to preserve and secure water resources worldwide. Europe and Asia have been hit by some of the worst droughts in recent memory this year.
So on that basis, perhaps the best trade for today is to find companies that produce exclusive and patent protected products or products supplying the renewable energy or water industries with strong balance sheets.
