The much-anticipated Consumer Price Index for August was released this week, and the results disappointed many investors. The index, used as a measure of inflation, ticked up in August by 0.1%, and its 8.3% year-over-year increase was worse than expected.
With no sustained downward movement in inflation, investors got further confirmation that the Federal Reserve Board will continue its aggressive move to raise interest rates in an ongoing effort to slow down the economy and reduce inflation. For growth stocks, in particular, this is not welcome news. Higher interest rates are generally bad for them, as it means the economy will slow down, and it will cost more to borrow money.
But some growth stocks actually benefit from higher interest rates. One of them is CME Group (CME -0.24%). Here is why CME Group has market-beating potential right now.
CME Group surges on higher interest rate derivative volume
CME Group runs the largest derivatives exchange in the world. It is the parent company of the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange, among others.
The company's stock price is down about 15.6% year to date, but a good chunk of that came during Tuesday's sell-off when the Dow Jones Industrial Average dropped 1,276 points -- the worst day on the market in more than two years. Over the past month, as of Sept. 14, the stock is up nearly 2%, and it should move higher during this period of market uncertainty for one primary reason. CME Group is the largest derivatives exchange and the dominant player in interest rate derivatives.
When interest rates dropped to near 0% during the pandemic, interest rate derivative trading was way down. But since the Federal Reserve Board started raising interest rates earlier this year to reduce inflation, trading has picked up. In August, the exchange's average daily volume (ADV) was 21.2 million contracts -- up 22% year over year. The most volume by far was interest rate derivatives, which had an ADV of 10.6 million -- or roughly half. In the second quarter, ADV was up 25% year over year, with the third-highest quarterly volume ever.
CME Group makes most of its income from clearing and transaction fees, so the more volume on its exchange, the more income it will generate. In the most recent quarter, it posted revenue of $1.12 billion -- up 5% year over year; operating income of $750 million, up 11% over the previous year's second quarter, and net income of $662 million, up 29% year over year.
Navigating the bear market
With interest rates expected to continue to rise until inflation comes down to historical levels, CME Group should continue to see increases in ADV, led by interest rate derivatives, as the higher rates will drive more trading activity. That, in turn, should drive revenue higher. And the expectation is for the Fed to continue to raise rates well into 2023.
CME Group maintains very high margins, as it has very low overhead and has reduced expenses by 3.5% year over year. Outside of technology and compensation, there aren't a lot of big line items. It has an operating margin of 58% and a profit margin of 60%. As the market leader, with an established brand, in a market with few competitors and a high bar to entry, it enjoys strong competitive advantages. The stock has a forward price-to-earnings ratio of 24, which is not unreasonable, given its earnings power and overall strength in the industry.
Overall, CME Group is well positioned to not just navigate this rocky stretch but benefit from it until equity markets bounce back.