By now, it’s a familiar refrain: Interest costs (or at least interest payments) for the largest US corporates have diverged entirely from the trajectory of rates.

The story goes something like this. Companies opportunistically tapped capital markets in 2020 and 2021, terming out their debt and locking in low rates. Enormous cash piles were deployed to fund operations in 2022 shielding firms from rising borrowing costs. Whatever wasn’t spent earned 5%, effectively turning cash-rich corporates into beneficiaries of higher rates.

That dynamic, the narrative goes, helps explain resilient corporate profits and also the delayed onset of recession.

One of the big questions looking ahead is this: When will higher rates begin to bite corporates? The answer is it depends. On firm size, for one thing. Cash-rich big-caps are insulated for longer, while small-caps are more vulnerable. That’s yet another example of the “haves versus have-nots” nature of American capitalism.

Of course, the longer rates stay high, the more firms will be exposed. Everybody has a maturity wall, it’s just a matter of how far out it is. And, as it turns out, higher rates are already having an impact — even on large companies.

“Although the long-maturity, fixed-rate debt structures of S&P 500 companies generally insulate them from higher rates, borrow costs have ticked up on a YoY basis by the largest amount in nearly two decades,” Goldman’s David Kostin remarked, in his latest.

Note that the implications of higher-for-longer rates are multiplicative. As Kostin wrote, “If rates continue to rise or stay higher for longer, increased borrow costs would disincentivize companies to take on greater amounts of leverage.”

That’s problematic for profits. Over the past half-century, the combination (there’s the multiplicative part) of falling interest expense and greater leverage contributed quite a lot to the overall increase in S&P 500 return on equity.

Although still high, S&P 500 ex-fin trailing four-quarter ROE was 23.4% at the end of Q2, down nearly 70bps this year and 175bps versus Q2 of 2022.

As an amusing aside, the sharp inflection higher for the financials series shown above in grey is basically just Berkshire’s investment income.

Out of the 70bps ROE contraction mentioned above, nearly half was attributable to higher interest expense, Kostin said. Obviously, the situation varies by sector.

He went on to cite a recent Fed paper in noting that “lower interest expenses and corporate tax rates explain more than 40% of the real growth in corporate profits from 1989 to 2019” while Goldman’s estimates suggest falling COGS drove “the remainder of the profit margin increases not driven by taxes or rates.”

The punchline is fairly obvious: Lower interest costs, lower tax rates and falling COGS explain corporate profit growth, and we’re now in a world of higher rates, higher taxes and higher input costs for everything from raw materials to labor.

“Smokey, my friend, you are entering a world of pain.”