Federal Reserve monetary policy has been a huge tailwind for U.S. corporate profits, allowing companies to borrow cheaply, lower interest payment costs and buy back shares. With U.S. and Canadian interest rates now rising, new research suggests the trend may now be moving in reverse and rates are becoming a major hurdle for corporate profit growth.
In a recent Reuters interview, Newedge LLC strategist Robbert van Batenburg compared the effects of artificially lower interest rates on stocks to "an athlete on steroids."
Mr. van Batenburg notes that since 2009, interest expense for S&P 500 companies has declined from $4 per share (U.S.) to the current $1.50 while quarterly profits have climbed 33 per cent. Gluskin Sheff + Associates economist David Rosenberg adds that lower interest rates have increased S&P 500 earnings by $30 per share during the market recovery.
Canadian interest rates declined along with their U.S. counterparts and, up until May of 2013, undoubtedly helped domestic corporate earnings in the same way. Unfortunately, interest expense data for Canada is unavailable, but we can infer the effects of lower rates on Canadian profits by comparing earnings per share for the S&P/TSX Composite to Government of Canada five year bond yields (see chart). (Note that the bond yields are plotted in inverse order to better show the trend.)
There does appear to be a relationship between Canadian bond rates and corporate earnings. Importantly, however, there are any number of factors – both foreign and domestic – affecting earnings, so we can't take this explanation too far.
During the post-crisis recovery, earnings clearly recovered in loose accordance with the fall in interest rates. The chart also illustrates why equity investors are more skittish after the recent spike in yields – they do suggest lower profits.
Again, it's hard to pinpoint exactly how much of an effect lower rates have had on both U.S. and Canadian corporate earnings. But there is little doubt that the Federal Reserve's strategy of pushing rates lower has contributed positively to profits and conversely, the recent rise in yields is likely to be a negative influence. Investors should avoid increasing portfolio risk levels until the rate environment stabilizes.