CEO & Managing Director of Pallas Partners, Inc.
As we look out into 2017 and back towards November 7, 2016, we see two very different paths. With the election of Donald Trump the world changed and a path towards pro-business fiscal policy, lower taxes, GDP growth, and a far less accommodative Fed all seemed to become much clearer, at least that is what the markets are telling us.
Interest rates have been kept artificially low in order to keep business moving as we have emerged from the Great Recession. In the opinion of many, rates have been low for too long and as the world has struggled to recover, in some cases, with negative interest rates America has participated with zero interest rates. All of that is now changing as in the weeks since the election the 10 year treasury is up over 75 basis points or about 40%. This bell weather treasury is a key indicator of other more common rates such as Prime. Interest rates are on the move due to both the Fed raising in December (with more to come) and the selloff in the fixed income market as the shift to equities and other risk based assets has taken place. The implications for businesses are significant. Big business- Fortune 1000 and upper middle market companies that have larger cash reserves and more resources will be less affected initially. Companies in the lower middle market and below, that are broadly reflective of the Kentuckiana market, will face a much greater struggle as banks rerate credits.
Many smaller companies operate on lines of credit that are interest only. The cost of those lines has already begun to increase. As interest rates rise companies could see the cost to carry those lines increase on a current basis by as much as 25% over the course of 2017. Many of these relatively smaller borrowers maintain balances that are 90% or greater of the available credit line.
As the renewal date approaches banks will rerate the credits and may determine, given the current balance sheet in combination with the increased carry cost, that lines may need to be reduced in order to achieve proper regulatory ratios. Companies that need these credit lines may begin to experience a constriction in working capital. The domino effect from customers who are experiencing the same constriction of working capital may begin to push out AR receipts further exacerbating the issue.
It will be critically important for smaller companies to manage their cash flow and investment decisions carefully, along with, managing operational efficiencies. This year promises to have many good initiatives in it, (lower taxes, less regulation, better technological solution sets), however it will also come with capital disruption and cost. It is imperative that companies manage their balance sheets carefully in order to be able to operate and grow. The ability to navigate through this next period and economic cycle will require skill, financial engineering, and careful stewardship and management of corporate resources. The future is bright but it also will require vision and proper financial structuring. It is not out of the scope of reality to see the 10 year hit 4% by the end of 2017. This could put line of credit borrowing in the 6% range, mortgages in the 7% neighborhood, and lower credits close to double digits.