The most important event for equity investors in 2016 was the reversal in bond yields (interest rates) off highly abnormal lows in mid-2016, accelerated by Trump’s surprise US election victory and promises of improved growth (expected to lift inflation). Until then, investors had enjoyed several years of outperformance in high yield and defensive stocks benefiting from their relative appeal versus falling risk free rates and robust earnings.
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Based on our preliminary analysis, Trump’s economic plan would add 0.4 per cent to US growth, both in 2018 and 2019 (from 2.4pc), which is clearly positive for corporate earnings and share prices. However, we think the market’s relative moves since the election are overdone, given risks attached to the legislative passage, financing, execution and impact of Trump’s plan, and the fact that its full effect would not be felt until 2018-19.
On the surface, the transmission mechanism for higher global interest rates will result in an increase in the cost of capital and therefore lower asset valuations. However, the prospects for improving growth and inflation should flow through to better earnings, with cyclically sensitive stocks the key beneficiaries.
Positioning for a cyclical recovery
The ongoing recovery of cyclical industrials in line with a reflationary economy is a theme that we expect to continue to play out in coming years. However, progress is likely to be slow and interspersed with periods where the markets may lose or gain confidence in the timing of its trajectory, not to mention likely macro shocks that we simply cannot predict.
Similarly, we expect interest rate settings to remain at historically low levels over the short term providing investors opportunities to accumulate high yielders that are oversold in market over-reactions.
We have consistently flagged that path to the normalisation of global monetary policy is going to be slow and bumpy. It is paramount that investors appreciate the economic and interest rate environment has now begun its shift. Therefore, equity strategies that performed best in the last five years are unlikely to be those that deliver outperformance in the years ahead.
That said, we are not overhauling our current investment strategy but simply advocating a gradual shift in exposure, allocating slightly less capital to defensive equities and slightly more to the cyclicals. Our focus on quality and conviction also aims to recommend stocks that can thrive independently of the interest rate environment (ideally) and/or regardless of political machinations elsewhere. Investors must continually adapt to new realities.
Financials – the key beneficiary
The financials sector is arguably the space most likely to benefit from rising interest rates across the equity market. Most financials stocks (banks, insurers, registry maintenance companies) benefit in some way from rising interest rates:
- Banks benefit as a lift in the yield curve allows them to charge higher interest rates on customer loans; meanwhile, the cost of some bank deposit funding does not really alter with an upward move in the yield curve, e.g. transaction deposits which offer little to no interest. Banks also hold excess shareholder capital, as required by the regulator, which they invest in fixed interest/liquid securities providing additional leverage to rising yields.
- Insurance companies take upfront premium payments (known as a ‘free float’) and invest them in bonds while waiting to see what payments they must make for insured claims over the year. Similar to banks, insurers also invest excess regulatory capital in bonds. Higher interest rates thus benefit their earnings.
- Registry maintenance companies (e.g.. Computershare) accumulate float balances through a variety of activities like processing and payment of dividends, trust activity, which sees them hold a portfolio of short-dated fixed interest securities as part of their regular operations
Conclusion
We believe that with the probability of higher long term interest rates investors should consider how to position their portfolios. We believe that the rise in interest rates will be gradual allowing time for any portfolio changes to be made.
- Boh Burima Financial Adviser | Authorised Representative: 000341081. Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410
