CIARAN RYAN: Is a spike in inflation imminent, and what does this mean for markets, with unprecedented levels of fiscal and monetary support globally, the US Federal Reserve’s determination to suppress interest rates for longer, and a possible post-Covid-19 consumer spending boom? Market participants have enough reason to believe that a spike in inflation is imminent.
Previously we spoke to the chief investment officer of PSG Wealth, Adriaan Pask, about investment risks in the current environment. He explained that rising inflation reduces your spending power and the real value of your investment. Today, we speak to Adriaan again, this time about the impact of rising inflation on different sectors in the market. First of all, welcome Adriaan. Tell us what impacts do rising interest rates have on financial markets?
ADRIAAN PASK: Hi Ciaran, and first of all, thanks for having me. It’s great to be on the show again. I think you hit the nail on the head. The more important component here is actually the interest rate. Everybody’s talking about inflation. You don’t have to look far at the moment to read an article about inflation. But I think the real concern here is the interest-rate component. If you look at the inflation research that’s out at the moment, it’s still rather indifferent. I think it’s a little more tilted towards yes, we could quite possibly see some inflation come forward, rather than what it was maybe a few months ago where quite a few experts were still saying we think it’s under control. It feels like the momentum is heading in that direction.
But in our view, regardless of what the inflation rate is, we will see interest rates move higher. Interest rates are on ‘year zero’, and they will have to normalise, even if inflation remains relatively [steady]. We know that monetary policymakers are always inclined to have something in reserve in the event of a crisis, because if something was to happen and they can’t pull that lever, then we’ve got very little available to stimulate economies.
So that fear is almost a non-event in the sense that it will take place. Don’t waste your time worrying about whether interest rates are going to go up or not – they will go up. I think the only component that we are really debating at this point is to say, well, will interest rates go up sooner than expected, or maybe a bit later?
From a long-term investment perspective, that’s a less valuable debate to maybe have. But again, where you are right is it does impact financial markets. So in terms of managing money and looking after the client’s money in portfolios, it becomes an important dynamic to understand quite well.
If we go back to basics in terms of your original question about the impact on financial markets, I think it’s really important to understand the economic drivers here. Ultimately interest rates are there to alter the existing status or health of the economy. So, when interest rates are pushed up, normally it’s because there’s an inflation problem that’s already present, and that inflation problem is normally there because the economy is usually thriving. It’s almost after the fact, and you pay penalties for benefits that you harvested through an economy that was on the up.
Obviously on the other side of it, if you see interest rates decrease, it’s probably in response to the problem. That’s really in a nutshell what we saw last year – the way that interest rates impact, not really just different sectors in the equity sectors and sectors of the economy, but also, different asset classes can vary greatly. They don’t all respond in the same way. And I think that’s why, if you look at a lot of the communication that we’ve been putting forward over a very long time, it’s always around diversification and the increasingly important role that that’s playing in portfolio management. And I think again here it’s really very, very important.
If we look at asset losses, for example, we are quite negative on the international bond space. It’s been a space that’s been benefiting from decreasing interest rates over the last four decades or so, where interest rates have moved lower in a big way; but from here on we see a big reversal on that front. As I say, if interest rates go up, it’s actually quite good for equities because it means there’s growth around, and where there’s growth there’s earnings.
From that perspective, it’s really important to understand exactly where the impact will be in the various sectors and areas of the economy.
CIARAN RYAN: Maybe just break that down a little bit more. We do know that the markets react differently, or different segments of the market react differently to interest-rate changes. You’ve mentioned the impact on bonds, and you’ve mentioned the impact on equities, but just explain why that is and why these different asset classes will respond differently.
ADRIAAN PASK: Well, I think firstly, if you look at something like banks, for example, typically they benefit from economic activity that’s around. So, they tend to do well when interest rates rise, just because, as I said, typically the economy is in good shape. And that’s why we saw a lot of pressure on financials last year, on a global front as well as in South Africa. Typically, when there are fears that the economy will suffer, financial stocks take a big plunge. But obviously, in the short term, there’s also a broader sentiment component here that impacts asset classes. So for equities generally, it would be negative, but it has an impact on how quickly various sectors can recover out of that. So it didn’t take long for the market to realise that lower interest rates are actually very pro-growth for tech stocks, for example, for obvious reasons. You can think back to travel and leisure, for example, in lockdown.
I guess you can also say, although you would look at historic data and see that there, you can always use that and try and identify areas that would consistently do well or not. But at the same time, no two crises are ever alike, and you’ve got to look at what’s happening in the market. And that’s why we are such big supporters of active management. If you look at what’s happening in the environment at the moment, for example, it seems like there’s a lot of pent-up growth. We think there’s a big underpin for commodity and material stocks in the semiconductor space, for example, there are very interesting things happening there, given that there’s obviously a very high demand for those type of goods; goods that use semiconductors. But at the same time, there’s also been a bit of a supply-side choke that’s also stoking up inflation, and that creates opportunity.
So I think you can say that there are certain sectors that probably will do less well than others in an interest-rate environment that’s moving up. If we look at consumer staples, for example, the value that it brings to a portfolio tends to be a little bit more stable and resilient than in an environment where the economy is under pressure because, even if businesses go bankrupt, you still need to brush your teeth and clothe yourself every day. So those goods remain in demand.
But leisure, for example, was something that surprised with this crisis because everybody expected it to be less than demand, given that they are typically a little bit more sensitive. But if you look at what actually happened, businesses like LVMH – those are doing quite well. It’s just because the wealthier areas of the market, higher LSM groups, actually coped quite well.
Bringing that all together in a more coherent answer, I would say it’s really important to understand the prevailing conditions and also to understand the dynamics that drive the specific crisis that you’re dealing with, to gauge where the opportunities and risks lie.
CIARAN RYAN: Adriaan, what about capital-intensive businesses, those that have got high levels of debt on their balance sheet? And real-estate companies, how are they impacted by this expected increase in interest rates?
ADRIAAN PASK: That’s a good question. For leveraged businesses that carry a high level of debt, obviously, if interest rates go up, the cost of funding goes up and that’s negative for operating margins and creates a drag on earnings. So that’s also something that we need to keep in mind. But these days with the crisis that we are seeing, debt is more common than [in] just specific sectors as well. So we do often find businesses that operate in sectors that aren’t maybe as capital-intensive – businesses do run high levels of debt – but capital-intensive businesses are a good starting point. But we’ll have to look at debt levels across the board, regardless of sectors actually.
CIARAN RYAN: Previous interest-rate decreases were generally in response to economic and market shocks, but they did not have as quick an effect as the current cycle of interest-rate decreases had. Now the current phase appears to be at odds with previous cycles. Why is that?
ADRIAAN PASK: Well, I think for two reasons. I think typically when you look at bear markets, you get different kinds. You get things that are more systemic in nature. So, if you cast your mind back to the 2008 crash – which had more to do with systemic risk and disguised risks at the time – it would require regulation intervention on the one end and also support. But you would remember there was sort of a bad aftertaste; banks act irresponsibly and then you have to bail them out. It’s not that easy. You don’t just want to create an environment where there’s a moral hazard, where you will always be bailed out no matter what you do.
In this crisis, there weren’t any of those components. It’s more in line with what we call an event-driven type of shock. And it was quite easy for the regulators to stay out of it, and for policymakers to jump in and stimulate the economy.
There weren’t any complicated things like we saw in 2008, but we did see complexity and scale. So, where 2008 was more, like I said, a systemic thing where the global economy feared that there would be contagion risk into other financial markets – that creates a change of sentiment, et cetera.
But the pandemic was a truly global problem. That’s also why we saw policymakers step up in a really big way, whether it was in monetary policy or in fiscal policy. It was the first time that you would have seen on a global scale all policymakers cut rates and stimulate as far as possible from a fiscal side in a very short amount of time. This is a unique crisis and recovery that we’ve seen. We’ll reflect back on this for many, many years to come.
CIARAN RYAN: All right, thank you. We’ll leave it at that. That was the chief investment officer of PSG Wealth, Adriaan Pask, talking about the impact of rising interest rates on individual sectors in the market.
Brought to you by PSG Wealth.
Moneyweb does not endorse any product or service being advertised in sponsored articles on our platform.