As everyone bar those living under a rock will have heard, the Federal Reserve decided to increase interest rates by 25 basis points on Wednesday. The Fed’s rate hike took the federal funds rate from 0.75% to 1% – a level it has not reached since October 2008. While rates remain near historic lows, the Fed signalled its plan continue raising rates over the near- to mid-term.
While the rate hike could be seen as a signal that the economy will continue to grow, the Fed’s outlook is actually less hawkish than many anticipated – and this has not gone unnoticed. In a letter to investors, Jan Hatzius, Chief Economist at Goldman Sachs, noted that Goldman’s “Financial Conditions Index (FCI) eased by an estimated 14 basis points on the day … and is now considerably easier than in early December, despite two funds rate hikes in the meantime.”
“Our FCI has reversed most of the recent tightening” – Goldman Sachs
While Mr Hatzius remained confident that the Fed would continue to raise rates over the course of the year, this was not the result that most analysts expected prior to the decision. In fact, the FCI usually tightens following a rate hike.
Unpacking the Fed’s Rate Hike
Thursday’s reaction to the news invites the question: what’s going on? There are three possible answers, and none of them are good for middle-market companies.
First is the possibility the that Fed has been too dovish for too long in its attempts to normalise rates, which could force the central bank towards overcompensation – potentially increasing the frequency of rate increases, or some other measure that could cause a tightening. Such a situation would put pressure on middle-market companies as they seek to contain cost pressures.
Is Money Heating Up?
Second is the possibility that inflation is gaining momentum. In fact, the Fed pointed to this in their announcement, noting that “inflation will stabilise around 2% over the medium-term.” While the Fed continues its conservative stance, others are concerned that inflation is gaining pace and believe that it could accelerate to 2.5% by the end of the year.
Given that the most recent consensus report from Thompson Reuters puts US 2017 GDP growth at 2.32%, the result could be a net negative for companies large and small. The graph below shows how forecasts for this year’s overall US growth has changed over the last few months:
In fact, the same forecast expects industrial production to grow at a much slower rate than consumer spending. While this is good news for retailers and wholesalers, it could be a sign of continued headwinds for manufacturing companies – many of whom are in the middle market.
Finally, there is the very real possibility that hot money is driving the market to breaking point and that a correction could be on the way. This view is shared by a growing number of economists. In a recent article in The Atlantic, Ben Herzon, a senior economist at the St Louis-based Macroeconomic Advisers, noted that the economy is in the midst of “a really long expansion.” While this does not mean a correction is imminent, the post-election market rally is pushing asset prices towards what many believe to be unsustainable levels.
Where Does This Leave Middle-market Companies?
While the near-term impact of a 25-basis-point increase in rates is minimal, the longer trend points to the effective federal funds rate eclipsing 2% by some time in 2018. This would have a dramatic impact on the cost of capital for companies in the middle market – especially as they seek to roll over their rapidly maturing debt.
Assuming the Fed enacts two additional 25-basis-point hikes this year – a rather conservative estimate, as some economists believe three rate hikes are in store – the impact on borrowing costs would be somewhere between 1% and 1.25% for borrowers with ‘AAA’ credit ratings.
Granted, the impact of a 1% hike for a company with ‘AAA’ credit is marginal. However, a ‘BBB’ rated company could be looking at an additional 2% to 2.5% on top of current rates. To put this into, perspective a ‘BBB’ rated company with $100m in revenue seeking to borrow $10m would have to pay nearly $200,000 in additional finance costs. This would severely impact profitability.
That being said, expected rate increases are unlikely to have a “major impact on direct lending activity”, as Elvire Perrin argues. If anything, the increases might cause more money to flow into the corporate debt market.
In addition, a clear rate direction will help middle-market companies to more accurately forecast their cost of capital for the next 12 to 18 months, allowing them to make better decisions about what they need to do with their debt portfolio.
How Ford Used Debt to Survive a Tsunami
The Great Recession hit American automakers particularly hard. It forced General Motors into bankruptcy and the newly liberated Chrysler was sold to Fiat just to stay running, while the Federal Government needed to step in with a massive bailout package to stop the entire industry imploding under its own weight.
The outlier was Ford. The company neither sought protection from the bankruptcy courts or the Government. Instead, Ford’s leaders saw that a crisis was looming and decided to take out nearly $24bn in debt before the markets seized up.
While the unconventional move raised eyebrows at the time, it turned out to be the company’s salvation as it gave the automaker the ammunition they needed to survive one of the darkest moments in the history of the American auto industry.
The Lesson? Lever Up or Regret It
The era of cheap money is coming to an end. Roughly eight years into the current period of economic expansion, it is only a matter of time before the economy begins to contract. This is not to say that a recession will happen next week or next quarter. However, increasing inflationary pressure, as well as uncertainty in the markets, could prove too much.
The Fed has set a clear signal that the cost of capital will continue to increase. Middle-market executives should take heed by securing structured credit lines at rates which will be considered inexpensive on a lookback basis. Even if they avoid touching the funds, having access to these credit lines will allow for more flexibility going forward.
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