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Welcome to “Ask an Investment Banker,” where we ask investment bankers on Axial questions submitted by middle market CEOs.
Today, we’re examining the potential effects of the highly anticipated rising rates by the US Federal Reserve on domestic manufacturing. Here’s the question:
Aside from slightly higher borrowing costs, what would an increase in interest rates by the Federal Reserve imply for the US manufacturing industry?
Rajesh Kothari, Managing Director, Cascade Partners
We believe a rising interest rate environment will have a high impact on the relatively strong valuations seen in the market today. One of the drivers for these high valuations is the relatively low cost of capital. Debt is both inexpensive and readily available, with few alternatives to generate more meaningful return, and as a result valuations are high.
We believe rising interest rates will be the catalyst that reduces the current strong market valuation. From an operating perspective, an interesting element to consider is the black swan event if rates rise to much higher levels. For many of these executives, they have not operated in a world where interest rates are 10% or 12%. This increases the demands and costs of working capital or managing cash flow.
Pitt Means, Director, Exvere
In addition to seeing their own borrowing costs rise, a rise in interest rates (and perhaps the signaling of additional increases to come) could also impact US manufacturers indirectly – their customers and suppliers would also face higher borrowing costs, potentially leading cost increases from suppliers and/or a ratcheting back of growth initiatives or other investments (and thus purchases) from customers.
Higher borrowing rates impact the M&A market as well – PE firms and other buyers currently taking advantage of inexpensive debt to fund acquisitions will not be able to bid as aggressively going forward.
Gregory Dayko, Partner, Inlet Capital Group
In the short-term, increased interest rates will have two key impacts on US manufacturing. The first is obviously an increase in short-term borrowing costs, an effect likely to be magnified by the proliferation of floating rate debt instruments over the past several years. Manufacturers can potentially mitigate this effect by shifting to the longer end of the yield curve, which remains relatively flat.
The second effect is currency related, with an increase in U.S. interest rates likely resulting in a stronger dollar. While a stronger dollar may reduce the apparent cost of foreign-made inputs for some American manufacturers, it will also make American-manufactured goods appear more expensive in foreign markets. Thus, the effect on any single manufacturer will vary, based on its exposure to global markets for both its sourcing and its end sales.
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