|By Marco The Editor|
November 17, 2016
For some time now interest rates around the world have been ultra-low. In fact, in some of the world major economies, interest rates are negative. For instance, in Japan, the 10-year yield is sitting at negative 0.03% with a low of minus 0.42%. In other economic areas, such as Switzerland and The European Union, the story is the same. And, in the United Kingdom, the rumor is that the Bank of England will also push interest rates into negative territory. However, in the United States, the landscape is changing. Currently, the 10-year yield is quoting 2.228% and that rate is moving higher. The Federal Reserve is proactively moving interest rates higher bringing short-term rates from the near-zero levels they have been sitting for almost a decade. This bears to ask two questions. First, is this a good thing or bad thing, and, what will happen after the fact?
Interest Rates Around The World Continue to Stay at Ultra Low
Consider the Financial Sector and Higher Interest Rates. Since the financial crisis of 2008, the banking sector has diligently and fervently worked to earn profits in with the very smallest of margins. One of the biggest profit centers of a bank is the spread of interest rates that an institution can charge for a loan and pay out for savings deposits.
Savings rates were at a paltry 0.1% for the past many years. For an individual to deposit funds, perhaps $1,000.00 into a savings account, that would be a mere $1.00 interest paid over the course of a year. At eh same time, the bank would be able to lend those same funds out to a borrower at a rate of about 2.25%. The difference, or the spread, between what is paid to a savings account and what is taken in via a loan interest rate is the profit a bank earns.
Since the financial crises, and the eventual debasing of interest rates to near zero, banks have been forced to take whatever means necessary to become profitable with such a small and tight spread. These financial institutions have had to work excessively hard to earn a profit under some of the most difficult of conditions.
Now, these very nimble companies are poised to increase their earnings potential from one of their most lucrative profit centers. In fact, the Dow Jones Financials Index has increased significantly over the past five years and should continue to do so over the long term. From a low of 2009 the index has increased nearly five times over.
The effects of Interest Rate Increases on the Energy Sector
But, on the other end of the spectrum is the energy sector. Historically this sector has underperformed other sectors on a comparative basis. The very root of energy starts with a commodity product, perhaps oil or coal. There is not a tremendous amount of added value from either of these commodities that a company can do to these base commodities to increase profits. A pound of coal from one mine will fire a power plant the same as a pound of coal from any other mine.
At the same time, the machinery necessary to mine coal, transport and put to use to generate electricity is highly capital-intensive. Most often, the companies that work within the industry utilize a significant amount of debt with this process. Now, the potential debt loads that these companies are going to carry are going to increase in costs as interest rates move higher.
It is important to note, however, two very key factors. First, any debt loads being carried by these companies have been lent out with during the previously mentioned ultra-low interest rate environment. There will not be any rest of debt loads. The burdens of higher interest rates will take time to work their way into these company's bottom lines. At the same time, this is not to suggest that any company within the energy sector will be unprofitable moving forward. On the contrary, as the economy of the United States continues to expand the demands on energy will continue. However, the most significant takeaway is this: The energy sector will improve just not as much as other sectors, such as the financial sector. This will be an important point to consider when you are formulating your portfolio. You will want to maximize any potential opportunity in market growth. On a relative basis, certain sectors will grow more significantly than others.