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Selling defensives to buy growth

This artice first appeared in the ARF's Smart Money section:

The waters in the upper reaches of Sydney’s Middle Harbour are generally quietest at the turn of the tide. Between the inrush of the rising tide and the draining gurgle of the outgoing water is a period of calm. This stillness can lull into a forgetfulness of the force of the tide to come. Global interest rate markets are at this turning point.

Whether borrowing to buy a house, to expand the balance sheet or to fund a budget deficit, interest rates touch all our lives. This includes the fact that the benchmark for investments usually leans on the relevant term interest rate in some way. Yet thirty-five years of declining bond yields means many investors have never dealt with a rising interest rate environment.

Moves by the US Federal Reserve almost guarantee this era is coming to an end. The tide has already turned in the US. Three rate hikes since December 2015 and the Fed forecast for two more this year have spurred major changes in interest rate structures around the world. In August 2016 US ten year bonds hit 1.318% - the lowest yield in more than fifty years. They have now doubled to around 2.60%. The situation is similar in Australia. Ten year bonds are now closer to 3.00% than the low at 1.818%.

Australian Ten Year Bond Yields

This steepening interest rate curve means higher costs for Australian banks. Despite the apparent belief of at least one former Australian treasurer, banks do not fund their lending books purely at the overnight cash rate. Risk management demands they spread their borrowings over the interest rate term structure.

The cost of funds is therefore a blend of short and longer term rates. This is the reason we are already seeing banks increase borrowing rates. As we move further into the rising rate era borrowers should expect more “out of cycle” rate rises from the banks, independent of RBA moves.

Further, banks play an important role in the capital importation required to maintain Australian living standards. Around 40% of major bank funding is sourced internationally. Even without a steepening local yield curve, the rise in US and European rates means higher costs for Australian banks.

Borrowers will pay more, but investors will receive more on their term deposits. Swings and roundabouts. The impact on investment markets is harder to judge.

Most stock valuation methods involve discounting cash flows. It’s a given that a higher discount interest rate gives lower valuations. Additionally, many corporates are leveraged in some way, and their cost of funds is now likely to rise substantially over time. Score two for the bears.

However rates are rising because the economy is improving. Studies show that share markets generally rise for the first two years of a tightening cycle as a growing economy adds to the corporate bottom line.

This partly explains the initial positive reaction to the hike by US investors. The other factor is the fact the Fed did not revise up its estimates of growth and inflation, leaving its forward interest rate guidance unchanged. This leaves US share markets in a curious position. The market lift since last November’s elections reflects optimism the incoming administration will stimulate the economy. Yet the Fed declined to join the party. Investors may have panicked at this refusal, but instead bought on the basis that the Fed will be forced to lift its projections at a later date. This is a doubly optimistic reading. In the coming weeks and months US share investors could face a market that corrects to the Fed view, rather than a Fed that shifts to the market view.

The turning of the interest rate tide has profound implications for Australian investors. At the asset allocation level there is likely rising discomfort at disproportionate exposures to property and bonds. Only the most aggressive investors would abandon these asset classes altogether, but reductions may be in order. Leveraged property investors could benefit from reducing borrowings, or shifting to fixed rate loans. Bond investors will almost certainly look to reduce the duration (roughly the average maturity) of their holdings.

Share investors may have more work to do. The first point to consider is that the most reliable measure of the market over the last five years could turn treacherous. Dividend yields are much less relevant in a rising interest rate environment. The high-quality dividend yield stocks are very crowded, and any spark could start a panic. Telstra is already under share price pressure, and the big four banks remain very popular with individual investors.

Secondly, in broad terms growth exposures (energy, mining, consumer discretionary) are likely to outperform defensive stocks (healthcare, property, utilities, infrastructure). At this stage there is little evidence to show individual investors have begun the portfolio rotation towards growth. If the global economy continues to improve in line with recent trends this may prove a very costly procrastination.

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