How to play rising interest rates

Paul-Rickard-headshot2
Co-founder of the Switzer Super Report
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It is no certainty that interest rates are going to go up that soon, or that fast, but if Wednesday’s consumer price index comes out higher than expected, it may allow the RBA to think about acting sooner.

Last week’s employment data, which showed that 20,000 jobs were added in September – the 12th consecutive monthly increase – and took the unemployment rate to a four year low of 5.5%, suggests that the labour market is tightening and the economy is reasonably robust. Over the last 12 months, the Australian economy has added 370,000 positions, of which 315,000 or 85% have been full-time. To put this rate of growth into perspective, it would be something like the US non-farm payrolls growing by an average of 350,000 positions per month!

The RBA’s hand may be “forced” by the US Federal Reserve acting more decisively than expected. At the moment, the market is geared for the next increase by the Fed in December, and two to three further increases in 2018. However, the appointment of a more hawkish Chair (to replace Janet Yellen) or an uptick in US wage/price inflation could see rates rise more quickly. In this scenario, a surging US dollar would see the Aussie dollar fall, removing the major impediment for the RBA to act.

And this is where the bond markets come in, because they are the best guide to what the market expects. Rising bond yields will signal that the market expects interest rates to increase higher and more quickly. In the short term at least, the equity markets will follow the bond markets.

After dipping below 1.5% in mid 2016, US Treasury 10-year bond yields surged following the election of President Trump to over 2.5% on talk of increased spending on defence and infrastructure, a stronger economy and cuts to company taxes. They retreated a little in the first half of 2017, but in recent months, have started to climb back above 2.3%.

US Treasury 10 Year Bond Yield – Oct 2012 to Oct 2017

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Source: Bloomberg

And as the following chart shows, where the US bond market goes, the Australian bond market follows.

Australia Government 10 Year Bond Yield – Oct 2012 to Oct 2017

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Source: Bloomberg

Switzer Super Report subscribers may recall that the rout of the bond market late last year led to a big sell off in interest rate defensive stocks like Sydney Airport and property trusts. While this presented some great buying opportunities, a sustained movement in bond yields (and interest rates) might not be accompanied again by such a quick reversal in the fortune of these stocks.

With the possibility of higher interest rates around the corner, the obvious question remains – how do I position my portfolio in an environment of higher rates?

Winners

There won’t be many winners on the stock market as interest rates move higher. One group of companies that will win in the short term are the banks because they will increase their net interest margin.

If interest rates go up, banks can readily pass on a higher charge to their borrowers. But because banks have billions of dollars in 0% or near 0% deposits (cheque accounts, transaction savings accounts etc) where the deposit rate never changes, they only have to pass on a higher deposit rate to a proportion of their deposit base. In this way, their overall net interest margin improves.

But in the long run, higher interest rates cause stress for borrowers and are bad for bank profits. Defaults by borrowers increase, leading to an increase in provisions for bad and doubtful debts.

Losers

In the long run, the stockmarket and most companies will be losers because higher interest rates are bad for stocks. Earnings will reduce because more money is spent paying the interest bill, while revenue will be harder to earn because higher interest rates will act to curb consumer and business demand. Stocks will look less attractive on a yield basis compared to other asset classes such as fixed interest securities, with the likely outcome that equilibrium will be achieved by stocks selling off and becoming cheaper.

Immediate losers will include the following:

  • Companies with high leverage, both in an aggregate sense and also compared to their peers. If the market gets spooked, it will use relative leverage to favour one stock over another;
  • Companies with cash flow challenges. While the cost of borrowing shouldn’t impact he supply of funds, it is a fact that finance is harder to obtain when interest rates are rising;
  • Interest rate defensive stocks/sectors, such as:
    • Property trusts;
    • Utilities; and
    • Bond proxies (stocks such as Sydney Airport and potentially even Telstra). While Telstra is not highly leveraged, its yield will be relatively less attractive if interest rates rise; and
  • Sectors or companies more exposed to consumer spending/sentiment. Discretionary retailers, leasing companies

How to play

Firstly, avoid stocks with high leverage or gearing ratios, and purchase stocks with strong balance sheets. Consider reducing your exposure to the interest rate defensive sectors (property trusts, utilities etc), and also to sectors exposed to the whims of the consumer.

If playing in the speculative parts of the market, scrutinise quarterly cash flow reports. Known as an Appendix 4C and published as an ASX company announcement, mining and oil and gas exploration companies, as well as many recent IPOs, are required to lodge a quarterly cash flow report every quarter within one month after the end of each quarter. In tough times, cash is king.

And of course, higher interest rates make cash/term deposits and fixed interest securities more attractive on a relative basis. Strategically, you might shift some of your funds out of shares and into bonds. Importantly, keep the duration (term) of any bonds or fixed interest securities short while rates are rising, and look to increase duration when rates peak and start to trend down.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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