RCM Managed Asset Portfolio - A Filter for Higher Interest Rates Ahead

RCM Managed Asset Portfolio 

By Christopher Chiu, CFA

June 2025

A Filter for Higher Interest Rates Ahead

We are probably headed for higher cyclical interest rates over the next decade.

Many signs point to this. On the one hand, the world is trending toward less globalization, which will mean future challenges to available supply. On the other hand, the resulting upward pressure on inflation will force central banks to raise interest rates with every interest rate cycle. This is a distinct change from what happened during the last forty years when the world economy became more integrated and supply became more abundant, which put downward pressure on inflation and helped create conditions for lower interest rates. For example, from 1982 to 2015 interest rates had been grinding downward with each interest rate cycle, as seen below.

But since 2015 one can argue that rates have been headed higher with each interest rate cycle. If, in the next interest rate cycle, interest rates are not cut to zero, but some level higher, then we can confidently say a new interest rate trend has formed, one where central banks raise and lower interest rates at levels higher than the previous cycle.

I. Given this, it is reasonable to ask what kinds of equity investments will not do as well in a cyclically higher interest rate environment.

First, we would eliminate the kinds of companies that have emerged lately with near zero interest rates. With near-zero interest rates and an abundance of capital, many companies came to the public markets in the last ten years with no profitability, relying on rounds of equity financing and paying expenses through stock compensation. With higher interest rates and more capital constraints, companies on the margin will likely need to be profitable before they IPO and be more capable of financing their own needs.

Second, with higher interest rates companies that heavily rely on debt financing will become less profitable. These are companies to shy away from if they are unstable and cannot grow because heavy debt burdens create the conditions that result in loss of value and eventually result in insolvency. We will likely see more bankruptcies if interest rates remain higher for longer. During this latest interest rates cycle most companies took advantage of low rates to raise cash and bolster their balance sheets, so I would expect the number of bankruptcies to be relatively mild for any upcoming recession. But this will not be the case in further interest rate cycles if higher interest rates persist.

Finally, with higher interest rates we should have lower expectations of positive exits of privately and publicly owned businesses. Higher interest rates will mean that buyout deals will be harder to come by on the margin, since the risks for the new owners with more expensive debt would be higher and the financing would be scarcer. The number of buyouts is likely to be less prolific than they were when base borrowing rates were much lower.

II. So now we should consider what would work if interest rates were higher.

Companies that can benefit from higher interest rates are the kind of companies that do not depend on outside financing, generate cash, benefit from holding that cash, and can pass on inflation to their customers. There are a number of companies that meet these criteria.  But here we will try to focus on one kind. One of the kinds of companies that fit this description is insurance companies.

As we know insurance companies collect premiums on policies they write to cover the risk of the policyholders. That cash that they receive from the time the policy is written until the time when they must pay a liability is called insurance float. Insurance companies are valued on how they handle this risk (if they pay out less than what they receive from premiums) but also the investment returns they receive on the insurance float.

Higher interest rates benefit insurance companies in the following ways. By (1) providing higher investment income from the insurance float they have invested. When interest rates rise, the yield on new investments increases, boosting their overall investment income. (2) Higher interest rates provide reduced reinvestment risk for this insurance float. Higher rates reduce the risk of reinvesting premiums at lower yields, ensuring better returns on their long-term investments. (3) Finally, as we said earlier, higher interest rates occur in higher inflationary environments, and higher inflationary environments can create higher profit margins for insurers. This is because insurance companies are generally able to pass on inflation to their customers. We noticed this with the most recent bout of inflation, as auto insurance was among the highest inflationary items contributing to the Consumer Price Index (CPI). Nevertheless, higher prices do not diminish the demand for insurance. By law, car owners need to continue to buy auto insurance. Similarly, businesses that buy property and casualty insurance are compelled to buy insurance because their operational risks do not go away so long as their businesses continue to operate.