27 Aug 2024
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Article written by the PSK Investment & Research team
This month, we look at the possible implications to equities if interest rates stay higher for longer.
Inflation reached its highest peak for thirty-plus years in late 2022, causing central banks globally to raise interest rates to their highest levels in two decades as they sought to tame the inflation beast. Consumers remained relatively resilient for much longer than most expected given full employment, healthy wage increases, and the buffer in a significant accumulation of covid-era savings. However, over the last six to twelve months, it became more evident that some consumers and households were feeling the strain of higher rates and higher costs of living. The subsequent reduction in demand, increases in supply, as covid bottlenecks cleared, and falling energy prices saw a period of disinflation. Disinflation, that is, the slowing pace of still increasing prices, was seen as the first step towards a possible interest rate cut.
As 2024 progresses, inflation has continued to remain at elevated levels (i.e. above central bank targets) and in some parts of the economy has even increased. The U.S. headline consumer price index (CPI) rebounded in Q1 driven by the rising cost of transportation, services such as medical care and continued housing inflation that did not ease as rapidly as expected whilst in Australia, inflation increased from 3.60% to 3.80%, also in Q1. Whilst we expect some central bank rate cuts in the period ahead, stubbornly higher inflation may be here to stay, particularly if structural elements remain. This may force central banks to keep interest rates well above their covid, and even pre-covid levels, for an extended period. Which poses the question - how will higher interest rates impact equity portfolios going forward?
All groups CPI, Australia, quarterly and annual movement (%)
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Why could interest rates stay higher for longer?
Central Banks determine the direction of interest rates to control the rise and fall of inflation. Inflation is driven by supply and demand and therefore spending, which in turn is driven by wages. For example, wage growth has fallen in the U.S. but getting it further down to an acceptable level remains a big challenge. In Australia, overall wage growth had actually increased in Q1 and although it did moderate slightly in Q2, also remains at uncomfortable levels. This indicates that job markets remain tight and reducing inflation may be challenging in the foreseeable future. Moreover, the recent easing in inflation has partly reflected the “rolling off” of large one-off price increases such as rising energy costs due to Russia’s invasion of Ukraine and covid-related supply chain bottlenecks which impacted the price of goods purchased. These impacts have largely dropped out of the annual inflation rate data which means the easy wins in the inflation battle have been had.
Over the longer-term, most expect current inflationary pressures to linger due to a changed environment revolving around weaker global productivity growth, deglobalisation, unhinged government spending (large deficits), an aging population and the cost of the energy transition. The “neutral” interest rate (i.e. where inflationary forces are in equilibrium) that central banks spend plenty of time trying to calculate and estimate, might be higher as a result of these changes and will certainly impact their decision in the future.
What does higher for longer mean for equities?
With higher rates potentially here to stay, investors may need to recalibrate equity selection, positioning, and sizing. This might sound daunting for some; however, it could provide tremendous opportunity.
Broadly speaking, higher interest rates are generally not great for share market investing. Companies’ earnings are directly impacted by higher rates as their borrowing costs increase, or indirectly if it results in new investment being postponed or rejected. This all affects cash flow, arguably, the main building block and ongoing health of all companies.
Higher interest rates put upward pressure on longer-term bond yields, which drive up equity discount rates that analysts use to value companies into the future. Higher discount rates lead to lower asset values which lead to lower expected returns. In saying this, higher interest rates do not affect all stocks and sectors the same way. Some will benefit from higher interest rates.
Poorer quality companies, that is, those that are highly leveraged/high debt levels, face bigger challenges as high borrowing costs lessen their capacity to pay interest payments on their debt without adequate cash flow. Their ability to grow is also stifled as higher rates suppress consumer spending, therefore limiting companies’ ability to pass through higher prices which of course reduces the companies’ overall cash flow.
Better/higher quality companies, those with stronger balance sheets and superior business models, can fare much better. Companies that can more robustly generate free cash flow throughout varying economic cycles can not only cover their interest rate costs when rates are high but also finance expansion to continue their growth plans without the need to borrow from third a party or existing shareholders. A strong position to be in, in times of market duress or uncertain and volatile markets.
As noted above, some sectors behave differently in a higher interest rate environment (see table below). There will be winners and losers. Beneficial sectors can include financials (banks, insurance companies) - higher rates can lead to wider net interest margins and higher premiums, boosting profits; and utilities and healthcare - provide essential services, making their revenues less tied to economic cycles (defensive qualities). More vulnerable sectors include those that are more and highly sensitive to movement in interest rates such as consumer discretionary, industrials, and materials. Higher interest rates can dampen consumer spending, as noted above, affecting companies in the consumer discretionary sector. Industrials and materials sectors, which are reliant on economic expansion, might see reduced profits as borrowing becomes more expensive and economic growth potentially slows.
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Sources: WisdomTree, FactSet. For the period 3/31/1998-3/29/2018. Past performance is not indicative of future results. You cannot invest directly in an index.
So, it is not all doom and gloom in an environment of higher rates. As rates also stabilise and volatility recedes, companies can prepare and build their strategies to ensure optimum output and return.
What now for investors?
It is clear from the above that equity market winners will change depending on the interest rate regime we experience ahead. What worked well in the past ten years is unlikely to work well over the next ten years as no two periods are identical. We actively try to avoid binary outcomes where portfolios are too reliant on a narrow set or single backdrop. As always, a well-balanced and well-diversified portfolio to mitigate any unintended concentration in investment styles and sectors in the equity part of a portfolio can ensure investors are well-prepared for most market conditions. It may be a good time to review equity settings in portfolios to ensure they’re not hinged or dependent on a low interest rate regime.
The Investment & Research team at PSK are always monitoring market conditions and data points to ensure portfolios align with our overall long-term objectives. If you’d like to discuss any of the points raised, please contact your Adviser or call us on (02) 8365 8300.
General Advice Warning - Any advice included in this article has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs.
