SHARES

Prepare for higher inflation and interest rates – how robust is your portfolio?

The only asset class that benefits from higher interest rates is cash.

After many years of low- to no interest rates and inflation across the developed world and some emerging markets, the tide has turned and turned aggressively….

Inflation has hit a multi-decade high in the United States, the world’s largest economy. At a rate of 7% as of the end of December, inflation is three times higher than the average inflation rate of the US. The US government has also changed its view that inflation in the country is transitory; it now admits that inflation will be long term.

This does not bode well for interest rates, seeing that interest rates are used to curb and control consumerism which ultimately drives inflation. Higher prices lead to less demand which in turn impedes economic growth. We may for some time experience stagflation in the US with stagnant demand and persistent high inflation….

Expect the US Federal Reserve to start raising interest rates soon, with the European Central Bank to follow.

Local expectations

In South Africa things are not quite as bad as in the US. As a small country with a high level of imports our inflation is very dependent on external factors – such as the oil price which has been bouncing all over the place and started trending higher again of late. Increasing costs in food, labour and electricity all contribute to our inflation rate which is edging to the upper end of the inflation target band of between 3% and 6%. The latest rate is 5.9%. As with all countries our Reserve Bank (Sarb) uses interest rates to control inflation.

Expect Sarb to enter a phase of regular interest rate increases. Expectations are that the interest rate may be increased by 0.25% per quarter for the duration of 2022 and 2023. That means 2% increases are on the cards over the next two years.

I must also make a statement to say that irrespective of higher global inflation, interest rates have broadly been way too low for too long. Negative real yields do not bode well for pensioners and income funds who rely on interest rates. An upward adjustment of interest rates is necessary to bring the financial system back into equilibrium. The ‘free cash’ via loans has increased debt levels globally and the effect of debt incurred to finance assets such as property and vehicles will have to be monitored very carefully and interest rate increases will have to take place moderately. A strategy of too aggressive interest rate adjustments may just trigger the next financial crisis such as that we experienced in 2008. I am sure that the authorities learnt a valuable lesson during the GFC (global financial crisis) and that those mistakes will not be repeated….

Ironically, the country that over the past year imposed strict regulations on some sectors, which caused havoc on the share prices of many companies including our own Naspers, is going against the trend. China recently reduced its interest rates in an attempt to counter the slowdown of its economy over the past year. The Hang Seng is the worst-performing index over the past year, with a return of (-) 16.7%. For investors that is not a bad thing.

Quite, frankly I see this as a huge investment opportunity which does not come along too often…

Your investments

So, how does higher inflation resulting in higher interest rates impact your investments?

The only asset class that benefits from higher interest rates is cash. All other asset classes are negatively affected by higher interest rates.

Let me explain.

Bonds

Bond yields react inversely to interest rates. Since the coupon rate on a bond is fixed the real return compared with cash varies according to the interest rate changes. If interest rates increase, the demand for the bond will reduce thereby reducing the value of the bond and vice versa.

The above means that if interest rates increase, bond values will reduce, leading to an increase in bond yields. New issued bonds will take this into consideration and be issued with higher coupon rates.

The one caveat is inflation-linked bonds. With inflation-linked bonds the coupon is fixed at a rate above inflation. Although the rate is fixed, the overall return will follow inflation + the fixed coupon rate. For example, if the linker is inflation + 3% the return will be 7% if inflation is 4%; it’ll move up to 9% if inflation increases to 6%.

We can expect income fund managers to increase their exposure to linkers during this time of expected interest rate increases.

South African bonds still offer one of the best yields in the world.

With interest rates rising globally, global bonds will become even less attractive (many of them already provide negative real yields) and demand from foreign buyers for SA bonds may just increase.

Property

Property tends to act in a very similar way to long-dated bonds. In SA the property sector has been through turmoil for various reasons and some misrepresentation. Covid also played its part in the destruction of value within the sector. The tendency will however still be that demand will determine the price.

Properties that are highly geared will be impacted more than those that are less geared, since the financing cost of bonds/loans will increase as interest rates move higher.

It will therefore be important to understand what properties are included in a portfolio; how much gearing is applied; and if the leases are linked to interest rate increases and/or inflation.

Equities

Different sectors will be impacted differently and gearing, as in property, will be the determining factor of how company prices will be affected. Those with higher gearing will be more adversely affected than those companies that are cash flush (fortunately there are many cash-flush companies in SA). Dividends of companies with high gearing will also be affected since the companies will use the gearing to fund the dividends resulting in a lower dividend. This may in turn reduce the demand for such companies which will ultimately lead to lower share prices of such companies. Lower consumer demand due to a higher interest burden on consumers will ultimately also impact profits and valuations on some companies.

From a valuations perspective, investors value a company by using a discount rate to calculate the present value of its future cash flow, also referred to as the discounted cash flow method.

When applying this valuation methodology, increases to the interest rate result in a higher discount rate, which essentially reduces the present value of that company’s future earnings, and consequently, the price that investors are willing to pay for that stock.

Stock picking will become more important during a rising interest rate environment.

So, where to from here?

Higher inflation and rising interest rates are not new. Unfortunately we have become accustomed to low inflation and unrealistically low interest rates of late.

There is no reason to panic and move portfolios to cash.

We rely on the ability of the fund managers we use to select the appropriate stocks and investment instruments to still provide meaningful returns over the long term.

With every uncertainty an opportunity is created. Just like we see with China at the moment. SA stocks are cheap and we can clearly see prominent fund managers adjusting their portfolios over the past 12 months to include more SA stocks than five years ago. This is not because they are bullish about South Africa or the South African economy – quite the contrary. Their decisions and strategies are based on fundamentals and pricing.

Perhaps, just perhaps, stock selection and value investing will prove to be a better option than index investing. Year to date the JSE returned 3.4% as of today. The S&P 500 is (-) 5.9% and the NASDAQ (-) 9.5%. There are however companies within those markets with much better returns than the indices. I am going to follow this story with interest….

Rising interest rates are often the equaliser in a market where sanity has gone astray. Stay invested and stay calm. We are for once entering a normal investment environment.

Was this article by Marius helpful?
1  

ADVISOR PROFILE

Marius Fenwick

WealthUp (Pty) Ltd

COMMENTS   0

You must be signed in and an Insider Gold subscriber to comment.

SUBSCRIBE NOW SIGN IN

LATEST CURRENCIES  

USD / ZAR
GBP / ZAR
EUR / ZAR
BTC / USD

Instrument Details  

You do not have any portfolios, please create one here.
You do not have an alert portfolio, please create one here.
INSIDER SUBSCRIPTION APP VIDEOS RADIO / LISTEN LIVE SHOP OFFERS WEBINARS NEWSLETTERS TRENDING

Follow us:

Search Articles:
Click a Company: