The U.S. Federal Reserve is widely expected to start edging short-term interest rates upward later this year. According to Fitch Ratings, that won’t necessarily be bad news for U.S. companies, even though they have issued record debt at historically low interest rates.
A gradual hike in interest rates would increase the cost of borrowing, likely resulting in lower profits and slower growth, the ratings service said in a report Thursday, but the corporate discomfort would only be “modest.”
The impact of a rate hike would be offset, Fitch predicted, by U.S. economic growth and the aggressive refinancing by most corporates over the last few years, which has resulted in maturities being pushed out with low-coupon, long-dated debt.
However, if the Fed were to depart from its plan to raise rates slowly, the outlook could be less favorable for corporates. “Under our stress-case scenario, rapid interest-rate increases by the Federal Reserve would put additional pressure on credit metrics and could prompt more rating changes,” Fitch said.
“Against a backdrop of increased M&A activity, interest-rate pressure could also impair the financial flexibility of buyers as acquisitions become more expensive to finance,” it added.
Fitch’s stress test indicated that economic sectors with cost recovery mechanisms, such as utilities and master limited partnerships, or industries with strong pricing power (aerospace and defense, engineering and construction) were generally among those best able to deal with faster rising inflation and interest rates. On the other hand, sectors with limited pricing power (such as homebuilders) may encounter more issues.
“The secondary effects of a stress scenario are also important, as rising rates in a stagnant economic environment are likely to dampen equity values,” Fitch noted.
Fitch’s stress scenario assumed that the economy cannot grow above its long-run potential rate, which the Fed estimates at 2.1% to 2.3%, without putting upward pressure on inflation, and that U.S. inflation will start to rise above the Fed’s 2% target, peaking in 2016 at 4.5%.
Under its base case, inflation remains close to the Fed’s target and the central bank starts to gradually tighten monetary policy over the next 12 months as GDP grows above trend and employment increases.