The RBA raised the cash rate for the fifth month in a row last week amid a spike in consumer spending over the June quarter. Governor Phillip Lowe announced a 50-basis point increase to combat rising inflation which is forecasted to reach 7.75% by the end of the year. In a speech last week, he reiterated that the board is committed to ensuring that inflation returns to target levels, however also acknowledged that there remain uncertainties around cash rate hikes.

“How high interest rates need to go and how quickly we get there will be guided by the incoming data and the evolving outlook for inflation and the labour market,” he said.

At a high level the relationship between higher interest rates and the share market is relatively straightforward. In general, higher interest rates lower the valuation levels of equities as they increase the discount rate used to value the expected future cash flows generated by companies. The higher discount rate is the less cash flows are worth. If the cash flows are worth less the current value of the company falls. All things being equal this will cause a drop in share prices.

While at a high level this relationship stands, the impact will vary based on the individual characteristics of the share. For instance, growth shares are often impacted more than value shares since more of their value is far out in the future which means changes in the discount rate will have a bigger impact. Many investors choose to get exposure to the share market through ETFs. In this article, we examine the impact of the climbing cash rate on ETFs with different exposures.

Australian equity exposure

For ETFs which are heavily skewed to investing in Australian equities it is important to look at which sectors the fund is exposed to. This way you can identify interest rate sensitive sectors.

An interest rate sensitive sector is a sector which reacts to changes in the cash rate in positive or negative way. Three of these sectors are, technology, consumer discretionary and financials.

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Stock prices for companies in the technology sector are often impacted more negatively by rising rates. As the cash rate rises, valuations take a hit. This is because the discounted cash flow (DCF) model used to value technology companies has cash flows far into the future which increases the risk of investing in the company.

This means that if you invest in an ETF which is heavily skewed towards the technology sector such as BetaShares S&P/ASX Australian Tech ETF (ASX:ATEC) which has 52.63% of its investments in technology companies, the price of your ETF is more sensitive to interest rates.

The same can be said for ETFs that have large amounts of assets in the consumer discretionary sector. As the cash rate rises and banks pass on higher mortgage rates adding pressure to the cost of living, consumer spending on non-necessities falls leaving discretionary companies with increased storage costs and lower profits. ETFs like Vanguard Consumer Discretionary ETF (NYSE:VCR) and iShares Global Consumer Discretionary ETF (NYSE:RXI) which have 94.10% and 91.48% of investments in the consumer cyclical sector have both underperformed the overall market in the past year.

Unlike the technology and consumer discretionary sector, the financial sector often benefits from rising rates, as they are able to pass on the higher cash rate to lenders, leading to an expansion in profit margins. Financials can suffer during rising rates if the economy slows significantly and loan defaults rise substantially.

Bond exposure

As bond prices have an inverse relationship with interest rates, a higher cash rate means lower bond prices. This is because a higher interest rate translates into higher bond yields for newly issued bonds, causing the demand for bonds issued at lower interest rates to fall and thus driving their price down.

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There is a common misconception that an investment in bonds will not results in loses as long as the issuer does not default prior to the maturity of the bond. This may be true if you buy a single bond however when you buy an ETF with bond exposure you are buying a basket of bonds. A basket of bonds never matures which means there is no event where your principal is returned.

For example, in the top ten holdings of Vanguard’s Australian Fixed Interest Index ETF (ASX:VAF) there are multiple Australian government bonds which have maturity dates ranging from April 2023 to November 2031. Investors who buy Vanguard’s ETF will not receive a payment at maturity of any of these bonds and instead will be subject to the price of the entire portfolio of bonds which will fall in a rising interest rate environment.

Since the beginning of the year the price of the ETF has fallen 8.9% and over a five-year period it has slipped 8.46%.