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Positioning your portfolio for rising interest rates

Anthony Fensom  |  01 Aug 2017Text size  Decrease  Increase  |  

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Official interest rates remain at a record low in Australia while other central banks have started tightening policy. With Australian Prime Minister Malcolm Turnbull adding to warnings of eventual hikes, Australian investors have been put on notice that ultra-cheap money might not last forever.

 

"The era of easy and cheap money and accommodative settings of central banks is over," argues Morningstar's head of equities research Peter Warnes.

"While the US Federal Reserve was, until recently a lone voice, the European Central Bank, the Bank of England, and the Bank of Canada have recently stepped up their tightening monetary policy rhetoric."

The Reserve Bank of Australia's (RBA) suggestion in its June board meeting minutes that 3.5 per cent is the new "neutral" cash rate, compared to the current record low of 1.5 per cent, sparked a quick reaction from markets, with bank stocks and bonds sold off and the Australian dollar surging.

Asked about the RBA's commentary, Turnbull told radio 3AW that "they are sending a signal, which is probably prudent, which is to say [that] rates are more likely to go up than go down" and borrowers should be aware.

Most economists expect the RBA will keep official rates steady this year and through most of 2018, with financial market betting suggesting only an even chance of a quarter-point hike by May 2018.

Yet former RBA board member John Edwards has suggested that eight quarter-percentage point increases over 2018-19 are "distinctly possible," while Goldman Sachs Australia's chief economist Andrew Boak has predicted a hike as early as this year's Melbourne Cup day policy meeting.

RBA Governor Philip Lowe has stated the central bank will not "move in lockstep with other central banks," amid continued low inflation. The latest data showed the consumer price index at 1.9 per cent for the year to June, down from 2.1 per cent three months earlier and outside the RBA's target band of 2 to 3 per cent.

However, with the ongoing quest by central banks to "normalise" interest rates, Australian investors have been given plenty of reasons to review asset allocation in preparation for an eventual tightening.

Bond hedge

Morningstar's senior credit analyst John Likos is not among those predicting an early move by the RBA, however.

"I don't think they're going to move this year. We might see an increase or two next year, but I think the comment about eight increases was more of a headline grabber than anything else. I think it's going to be a fairly flat to a slightly upward sloping yield curve into next year," he said.

For fixed-income investors, the prospect of rising interest rates will likely result in lower bond prices and higher yields, potentially ending the bond market's decades-long bull market.

As protection, Likos suggests floating rate notes as "a good hedge against an increasing interest rate environment". Payments on such bonds move higher in line with increased interest rates.

While the US Federal Reserve's decision to tighten policy will likely affect Australia's 10-year Treasuries, he said bond buyers should not be overly concerned.

"Treasuries have started to reprice upwards in terms of their yield and we expect that to continue, with the 10-year Treasury continuing to creep up and track the US 10-year. But we think the 20-year bull run we've had is only going to unwind slowly over the next 12 months," he said.

"Yields will start creeping up, so you won't see those significant capital gains that we've seen from bonds in the past, but they won't collapse in price."

Likos said despite the anticipated rate rises, bonds would continue to provide "capital preservation and a real rate of return--it's no less important now than it's ever been".

Stock winners and losers

"Cyclical" stocks such as energy, financials, industrials, information technology, and materials could benefit from rising interest rates, on the proviso that such increases reflect an improving economy.

In this regard, banks could be winners due to higher net interest margins, or the increased profit on the difference between the interest earned and that paid out to deposit holders.

In contrast, "defensive" stocks such as consumer staples, healthcare, real estate investment trusts (REITs), and utilities have typically been poorer performers in rising yield environments. So-called "bond proxies" such as REITs and utilities are seen as particularly exposed, since higher interest rates can hurt profits as well as their relative yields compared to bonds and bank deposits.

Higher US interest rates have also hit the price of gold, which is typically a hedge against inflation but suffers in comparison to higher-yielding investments. However, other commodities could benefit from improved global economic activity, such as copper, which is considered a bellwether for the world economy and recently hit a two-year high on improved Chinese demand.

Other options for investors include "short" funds that can capitalise on falling share markets, or alternative strategies such as market neutral with the ability to profit from both rising and falling asset prices and with low correlation to other investments.

"By combining lowly correlated investments that each produce an acceptable risk-adjusted return over time, it's possible to enhance investment performance without increasing overall risk," said Glenn Rushton, executive director of Rushton Financial Services.

Bank deposits

Higher interest rates should ultimately flow through to increased bank deposit rates, helping savers, particularly retirees. However, should inflation rise, the real return on such higher deposit rates could be quickly eroded.

According to Canstar, term deposit rates at 20 June for an investment of $25,000 ranged from an average of 1.62 per cent for 30-day deposits to 2.73 per cent for five-year terms. Historical data showed the average term deposit rate was at least 0.47 per cent higher a year earlier.

Australia's banks are under pressure due to the government's bank levy, while rising interest rates overseas will increase their funding costs. Both these factors may constrain any potential hikes in deposit rates for savers, as banks attempt to maintain margins.

Meanwhile, the property boom in Melbourne and Sydney may act as a further constraint on any official rate hikes, as argued by Morningstar's Warnes.

"The record household debt to income ratio will make it difficult for the RBA to aggressively lift official interest rates. Out-of-cycle increases driven by macroprudential measures have already increased sensitive investor and interest-only rates," he said.

"The housing price cycle is topping but the RBA is very aware of the finely balanced situation. A sharp fall in housing prices would almost certainly push an already struggling economy into contraction, and possibly recession."

Barring a massive surge in inflation, the RBA appears set for an extremely slow process of normalisation, even while its overseas counterparts move ahead. Fortunately for Australian investors, that will leave much more time to prepare for an eventual hike.

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Anthony Fensom is a Morningstar contributor. The author holds shares in healthcare, financials and materials companies listed on the ASX. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

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