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Interest rates: Fed hikes set to hit smaller companies harder

US interest rates are at their highest level since the financial crisis. In recent months, the inflation-fighting Federal Reserve has hiked the cost of money as much as it did in a span of a few years. The hawkish tone of the central bank at the Jackson Hole meeting is taking steam out of a premature rally in US stocks.

Higher rates would hurt most for companies whose balance sheets ballooned during the long period of low rates. High energy prices and supply chain disruption will compound the problem.

A stagflationary scenario of rising prices, higher interest rates and slowing growth represents the worst of all possible outcomes in the worst of all possible worlds. The resilience of one-fifth of non-financial S&P 500 companies would be tested, according to a Lex data screening. Companies hardest hit during the pandemic such as cruise operator Carnival, American Airlines and casino group Caesars Entertainment are all in the danger zone again.

Lex chart showing Interest cover in stagflationary scenarios S&P 500 vs S&P 400

The findings mirror a screening of European companies. Here, interest cover for one-fifth of big listed companies would fall below two times operating profits. We assumed interest costs would rise by half and earnings fall a quarter from current forecasts.

Free money handed out during the pandemic — with the enthusiastic assistance of Wall Street — would cushion balance sheets, however. American Airlines might not be able to cover its interest payments from earnings. But $12bn of cash and equivalents represents five years of interest cover, even after adjusting for higher rates.

Carnival is in a similar boat. The cruise line has enough cash to meet interest payments for more than four years at past rates. Its rival Royal Caribbean meanwhile can only cover last year’s interest charge 1.5 times with cash on hand.

Smaller businesses are at greatest risk. A stress testing of S&P 400 mid-caps found a quarter would fall below two times interest cover in our severe scenario. Available liquidity was also lower as a share of current assets. The little guys always end up carrying the depreciating buck.

The Lex team is interested in hearing more from readers. Please tell us how dangerous you think higher rates are to leveraged companies in the comments section below.

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