Interest rates are back on the rise. On Sept. 16, the Federal Reserve voted unanimously to hike the federal funds rate by 0.25%. Markets fell the day the rate hike was announced.
“In a set of quarterly projections, the Fed also signaled that its rate-setting committee expects to further raise rates later this year,” CBS reports. For now, however, no rate changes are expected in 2027.
In many ways, the rate increase is not surprising. “For more than five years, inflation has been running above target,” Fed Chairman Kevin Warsh stressed. “So our predominant focus is on the price stability side of our mandate. The plain fact is that inflation is too high, and has been for too long.”
Higher borrowing costs are already impacting various markets, including the mortgage market, which saw rates hit multi-month highs. The average 30-year mortgage interest is now close to 7%.
AI investors should also be cautious about higher rates. McKinsey & Co. projects $7 trillion in spending on data center infrastructure by 2030. If borrowing costs rise, the scale and pace of that spending could ultimately underwhelm.
Higher borrowing costs could, however, help some AI businesses. And there’s one factor that can help investors predict who the winners will be.
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These AI stocks could benefit from higher interest rates
In anticipation of September’s rate hike, Morgan Stanley (MS +0.54%) released a report detailing how AI stocks will be impacted. The bank’s guidance couldn’t be more clear.
“Higher rates and sharper scrutiny of AI investments are raising the bar for companies and rewarding discerning investors,” Morgan Stanley stresses. “In this environment, selectivity matters.”
How exactly does Morgan Stanley suggest investors discern which AI stocks will benefit and which will face challenges in a higher rate environment? It all comes down to profitability and cash flows.
Morgan Stanley specifically advises investors to focus on companies that “generate steady cash flows and have clearer ways to benefit from AI, such as select hyperscalers and companies using AI to boost productivity.” The bank warns investors to “stay cautious on unprofitable tech companies and smaller businesses.”
Image source: The Motley Fool
Morgan Stanley’s advice makes a lot of sense when you consider the AI industry’s growth constraints. To grow, AI companies need more compute power. That necessitates building more data centers — a very capital-intensive endeavor.
Higher borrowing costs decrease the industry’s access to capital. Companies with high existing cash flows and profits will have an easier time funding their growth capex commitments. Unprofitable businesses, meanwhile, will need to continue tapping capital markets for more funds, this time at higher interest rates.
Consider Alphabet (GOOGL +1.30%)(GOOG +1.27%), the parent company of Google. The company expects to spend roughly $200 billion on capital expenditures this year, most of which is focused on scaling AI infrastructure. Alphabet generated a whopping $73 billion in free cash flow last year, with net profit reaching $132 billion.
C3.ai, Inc. (AI +2.08%), meanwhile, posted a net loss of $288 million last year, with negative free cash flows.
Which company will have an easier time scaling capital expenditures now that interest rates have risen? The obvious answer in Alphabet.
In fact, hyperscalers such as Alphabet could ultimately win as borrowing rates rise. That’s because smaller, less profitable competitors will likely be forced to reel back spending, while bigger, more profitable firms like Alphabet can continue aggressive spending largely unabated.