Why rising rates impact corporate earnings too

Why rising rates impact corporate earnings too

If you had to pick one topic which has overwhelmed investors in 2022, it is inflation. Inflation is where all roads in 2022 have led – it has forced a shift in central bank policy, impacted both wealth and standards of living and dominated headlines in both financial markets and mainstream media alike.

Even the war in Ukraine and Russia has added fuel to the inflationary fire, as a renewed focus on energy and food security has countries underpinning the bid in these commodities.

Put bluntly, inflation has been the “real world” check and balance to central bank and government largesse in terms of money printing – a world of finite resources versus infinite numbers on a screen.

With inflation running well ahead of comfort zones, this has steeled the U.S. Federal Reserve to act aggressively to cool the economy. The Reserve Bank of Australia (RBA) did its part on Tuesday, raising the overnight cash rate by 50 basis points to 0.85 per cent and triggering concerns over consumer spending.

While rising rates have understandably stoked concern over household balance sheets, there has been little focus of rising rates on corporate balance sheets. That is because balance sheets are the odd one out in terms of Investment Fundamentals – they rank a distant third in terms of investor priority after the Profit and Loss / Cash Flow statements. Balance sheets really only matter during times of earnings stress and / or rising rates. Arguably a scenario facing investors today.

For most ASX 300 companies, balance sheets are in acceptable shape as the lessons of the GFC are (not yet) too far removed for both corporates and investors alike. However, for some companies selling “widgets” (including fashion retailers), there has been a build-up of inventory to manage supply chain unpredictability. The sudden change in consumer sentiment and spending will mean higher inventory positions may need careful management, posing potential challenges to gross margins.

In addition, while financial health appears manageable based on trailing and projected earnings, it is also important to remember the impact of rising interest costs on corporate profits. Companies with floating instruments can expect to see an approximate 50 per cent increase in net interest expense over the next 12 months, assuming their interest expense line moves from around 2 per cent all-in, to 3 per cent all-in.

While interest (and tax) lines are often ignored, it’s important to remember that they too, are variable in nature.