The rapid escalation of interest rates marks a ‘turning point’ for markets, and one that investors need to consider when choosing how - and where - to invest.

The Reserve Bank of Australia on Tuesday raised the cash rate by 25 basis points to 3.6%, the 10th consecutive increase, and flagged more hikes were on the way.

International Women's Day Panel

Katie Hudson, Elizabeth Kumaru and Laura Ryan spoke with Morningstar's Annika Bradley ahead of International Women's Day. Picture: Morningstar

“The board expects that further tightening of monetary policy will be needed to ensure that inflation returns to target and that this period of high inflation is only temporary,” RBA governor Philip Lowe said in a statement following the rate decision.

But Lowe warns the path to a soft landing is narrow, with the full effect of the rate rises yet to flow through to consumers.

For insights into the implications for investors, Morningstar sat down with the women who head up the investment strategies for three top-rated funds during a panel event ahead of International Women's Day.

The turning point for markets


The current environment marks a turning point for equity markets after more than a decade of falling interest rates, according to Katie Hudson, a portfolio manager and director at Yarra Capital Management with a focus on small and midcap Australian stocks.

Hudson says ultra-low interest rates had caused multiple re-ratings in markets – meaning shares were trading at more expensive levels relative to their earnings.

But in a higher interest rate environment she says cashflow is king, and the winners will be companies that can grow their earnings and generate real cashflow.

“When you've got these big turning points in markets, you really have to start thinking very differently about what the environment is going to be like going forward,” Hudson said.

“Great businesses are not necessarily great investments because valuations matter.”

Hudson manages the gold-rated UBS Australian Small Companies fund, which aims to identify undervalued small cap ASX stocks.

Reflecting on the lessons of the dot com bubble, Hudson says it’s worth remembering that missteps can present opportunities for quality names caught up in a broader market selloff.

“The early 2000s was a really challenging time for me. I was young analyst, I'd been following a number of growth companies, like CSL (CSL) like Cochlear (COH), and in the early 2000s there was a tech wreck and there was a big selloff in growth companies,” she said.

“But those opportunities for great companies when they do have missteps can be really good opportunities to step in. If you had have bought those at that time, they will have gone up more than 10x now.”

The buying opportunities she’s seeing are among the small cap growth names that were hit hard last year during, particularly in areas like technology and some financials.  

“Certainly that's an application that we apply in running small cap money at Yarra Capital. We definitely take advantage of those and I think we're in a really interesting environment where some of that's happening.”

As of the 31 January, Morningstar data shows some of the top holdings in Hudson’s fund include 4-star Pinnacle Investment Management (PNI) – which is trading at a 18% discount to Morningstar’s fair value estimate – as well as Nanosonics (NAN) and AUB Group (AUB).

On the back of reporting season, Hudson says some investors have been caught off guard by the ‘margin crunch’ which has caused earnings expectations to be downgraded for companies unable to beat inflation.

Around half of the companies that missed expectations did so around margins, she says.

“Companies reported very strong revenue growth through reporting season, mainly due to price, not volume,” she said.

“The impact of that price growth resulted in volume impacts, and consumers starting to trade down, values starting to be evident.

“And as a consequence, we've seen earnings expectations downgraded which is what we thought would happen but it’s probably surprised people as far as how quickly that's happened.”

Investor subscribers can read more about UBS Australian Small Companies fund here.

Private assets


The high inflation and interest rate environment is presenting both challenges and opportunities in private corporate assets, as they have an ‘enormous impact’ on the valuation of assets.

Elizabeth Kumaru runs the private corporate assets division at Australian Retirement Trust, a bronze rated superannuation fund that manages over $200 billion in retirement savings for more than 2 million members.

“So that does mean that there will be some good opportunities and entry points in in private markets, but it is quite different depending on the private market,” Kumaru said during the panel discussion.

“That is a very large definition, there is significant depth and breadth of types of assets and industries within that.”

Private credit is seeing some of the best opportunities in 10 years, she notes, as rising interest rates drive up yields. Infrastructure assets are fairly well insulated to the effects of inflation, so she expects infrastructure assets to be relatively resilient in this environment.

But real estate assets will see much more of a dispersion, depending on the sector and region.

“They're going through a bit of a valuation readjustment in light of the changing tenant demands and increasing financing costs.”

She points to the scarring effects of the Covid pandemic on parts of the sector, like office buildings, which still haven’t fully recovered from the work-from-home shift.

“There will be changes that will never turn around. I mean, we're sitting in an office building today, but office buildings are very empty around cities. So once upon a time, when you had an incredibly valuable asset with a with a very stable income, today, we’re really rethinking the valuations of these assets.”

The biggest lesson learned, she says, is really around diversification.

“It is critically important when you have a portfolio to make sure you've got diversification because you can't manage everything.”

Large institutions have access to real estate and infrastructure assets that individuals don't, so investors can turn to large Super funds to have a piece of their portfolio invested in these private assets.

And as Morningstar’s Mark LaMonica explains in a recent article, there are also ways to get similar exposure using listed companies.

Fixed income


The message around the role bonds play in a diversified portfolio has been misunderstood says Laura Ryan, Ardea Investment Management’s head of research.

Rather than providing a negative correlation – or inverse relationship – to equities, Ryan says the role of bonds is to reduce overall volatility.

“We often get questions about the role of government bonds in an equity heavy portfolio, and I think over the last few years, there's been a bit of a myth about the role of government bonds in in a multi asset portfolio,” Ryan says.

“One is that whenever your equities are down, your bonds should be up. But historically, that's not happened very much.”

What investors should expect from government bonds is reduced volatility at the total portfolio level, she says.

“The maths is such that if the volatility on your bond portfolio is less than the volatility of your equity portfolio, when you combine them, it doesn't matter what the correlation is between them, even if it's 100%, those bonds will still reduce the volatility in your portfolio.

“I think that message has really been lost over the last few years.”

Bronze-rated Ardea Real Outcomes primarily invests in fixed-income markets, and aims to deliver investors a stable return in excess of inflation over the medium term.