When Rate Hikes Come, They Will Ripple Across U.S. Economy

One of the factors that fueled the recent stock market selloff that left the major indices in the red for July and erased the year-to-date gains for the Dow Jones Industrial Average was the renewed talk over the timing of interest rate hikes by the Federal Reserve. We’ve had historically-low interest rates for some time and the central bank has signaled it will keep rates low past its asset-purchase tapering efforts, which is expected to end by this October.

With more than a few signs of higher prices hitting consumers from the likes of

The Hershey Company (NYSE:HSY), Mars, Kraft Foods (NYSE:KRFT), Chipotle Mexican Grill (NASDAQ:CMG), Starbucks (NASDAQ:SBUX), J.M. Smucker (NYSE:SJM), Ford (NYSE:F), PepsiCo (NYSE:PEP), Nike (NYSE:NKE), Netflix (NASDAQ:NFLX) and more, there is little doubt those price increase will be felt in consumer wallets even if they don’t register with inflation data collected and published by the U.S. government.

Even so, higher prices are being reflected in some government data, including the sharp rise in the Employment Cost Index, which climbed 0.7% in Q2 2014, up from a 0.3% increase in the first quarter. Add to that the low-quality initial gross domestic product reading for 2Q 2014 that featured a headline figure of 4% annualized growth, and rate hike fears were stoked last week.

Granted the Goldilocks-like July jobs report – not too hot, not too cool – took some of the wind out of the rate-hike sails, but with July Institute for Supply Management manufacturing report showing another faster increase in prices, it won’t be too long before those winds are blowing again. The question is when those winds do eventually pick up, and they will, which sectors are vulnerable as borrowing costs climb at a time when consumers feel increasingly strapped? Even though interest rates on bank accounts and certificates of deposits will move higher when the Fed eventually hikes rates, so too will credit card rates and other forms of borrowing.

That means interest rate vulnerable industries, like housing and autos will be vulnerable, as will others. Housing because higher mortgage rates will make the cost of buying a home even that much more expensive given the move in housing prices over the last several quarters. This past July, the average 30-year fixed rate mortgage rate was 4.13% compared to 6.1% at the end of 2007 per data from Freddie Mac. While it may seem like only 2 percentage points, the compounded interest over 30 years on today’s home prices equates to several hundred thousand dollars in incremental costs. Much has been said over the current housing slump, but higher rates are likely to nip even the current level of activity in the bud and that could have a negative ripple effect on the economy.

While there are many estimates as to how many jobs are created with the building of a single house, another way to think about it is to consider the furnace, hot water heater, appliances, televisions, furniture, floor coverings, pipes, HVAC and numerous other items that go into building a home. Another leg down in housing would pressure not only the homebuilders like Toll Brothers (NYSE:TOL), Lennar (NYSE:LEN), Ryland Group (NYSE:RYL), D.R. Horton (NYSE:DHI) and the like, but also the appliance businesses at General Electric (NYSE:GE), Whirlpool (NYSE:WHR) and Sears (NASDAQ:SHLD), Armstrong World (NYSE:AWI), Ethan Allen Interiors (NYSE:ETH), Haverty Furniture (NYSE:HVT), Watsco and others. If we extended the ripple waves, retailers, such as Best Buy (NYSE:BBY), and hhgregg (NYSE:HGG) could see slower demand for appliances and the like.

The automotive industry has enjoyed some of its best monthly sales in years during June and July with auto loan rates as low as 2.75%. Much like mortgage rates, current auto loan rates are well below the average car loan interest rates of 4%-6% seen during the 2002-2010 period.  As with housing, an upward move in interest rates would likely to result in softer demand and pressure both consumer replacement and soon thereafter production rates. If history holds that would like be met with incentives on the part of Ford, General Motors (NYSE:GM), Honda and other automotive original equipment manufacturers, which could signal a cap in margins and earnings. Reduced production rates would also hamper demand for automotive products and components such as drive trains, automotive seat systems, electrical distribution systems, and driveline, sealing and thermal-management products, and emission reduction and safety systems from Lear (NYSE:LEA), Dana Holding (NYSE:DAN), Federal-Mogul (NASDAQ:FDML) and others.

Specific industries aside, rising rates could pressure demand for dividend-paying stocks as more alternatives become available, which in turn would be a boon to banks and other financial institutions.

The consensus view is we are several months away from an actual rate increase, but given the forward looking view of the stock market all eyes and ears will be tuned into the Fed’s Jackson Hole conference at the end of August. The growing view is at that event or at the Fed’s next policy meeting on September 16-17, Fed Chairwoman Janet Yellen could revisit her view on the timing of interest rate hikes. Hopefully, the Fed chief will choose her words carefully lest we have a repeat of when former Fed Chair Ben Bernanke attempted to describe the conditions of when the Fed might taper its stimulative efforts back in May of last year.