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Do you know how sensitive your stocks are to interest rates? Editor's Note

Emma Rapaport  |  12 Feb 2022Text size  Decrease  Increase  |  
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Markets are entering a new phase. Not since the days of Gillard and Swan have Australian investors been forced to confront an interest rate hike. Just putting money into the market has proved a good investment as interest rates headed south, the riskier the better. But with the first-rate hike in a decade looming over the sharemarket, the bullish energy that pushed stock markets to record highs in 2021 is fading. Whether you remember the days when putting money in the bank returned 17% or your entire investing experience has never included a rate hike, we could all use a refresher on how to invest and profit when interest rates rise.

The most visible sectors savaged by the prospect of higher interest rates has been growth stocks, particularly high valuation and speculative technology names. The theory goes that higher inflation puts pressure on central banks to lift interest rates sooner than anticipated, prompting analysts to lower valuations as higher rates erodes the present value of future profits. Companies more exposed to higher rates include those losing money, those that have gorged on cheap debt through the pandemic and those with more of their earnings expected in the future.

This makes implicit sense. But is it right to say that as interest rates go up, all tech stocks will fall? Are some companies more insulated than others? And what about other sectors, how are they impacted by rising rates?

I reached out to Morningstar senior equity strategist Gareth James who gave me a great framework to think about the current environment. He said that with any company, two factors determine the direction of a stock price. On one side there is expectations of earnings increase or decreasing and on the other, there's the market multiple (P/E ratio) which represents how much the market is willing to pay for future earnings.

"On the multiples side, investors have been desperate for income in recent years, seeking out companies with fully franked stable earnings and pushing up P/E multiples," he says. "But as the cash rate increases, cash becomes more attractive on a relative basis and equities are less attractive. As such, the multiples investors are prepared to pay for falls."

Ultimately, he said it's not as clear cut as rates up, tech stocks down. While there are overarching trends, each business, and each business segment, reacts to rising rates differently, and it's important for investors to dig into the detail. To understand the impact higher rates have on a range of companies, both positive and negative, let's dig into three stocks that delivered earnings results this week: ASX, Computershare and REA Group.  

For the ASX Ltd (ASX: ASX), the lower interest rate environment has been a blessing and a curse. On the one hand, its listings business is flying as expanded equity market PE ratios encourage equity trading and new listings. Great for the company with significant pricing power that takes a cut of every trade. James says the low-rate environment has also supported the ASX's share price, seeing its own PE ratio expand from 21 to 34 in the last five years. But on the other hand, lower rates have reduced the interest the ASX earns the collateral it holds on behalf of market participants and brought out a decline in interest rate future trading, part of its markets division. These trends were evident in this week's first-half results announcement as weak futures trading activity partially offset strong cash equity trading. Looking ahead, James is concerned that higher interest rates will compress the multiples investors are willing to pay for the ASX's earnings and dampen trading and IPO activity. At current prices, he believes shares are overvalued.

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But not all businesses tied to the equity market are negatively impacted by rising rates. Stock registration and transfer company Computershare (ASX: CPU) has been hammered by falling interest rates since the global financial crisis. However, James says the company could finally be on the right side of interest rate movements. Computershare's profits are highly leveraged to interest rates because it keeps much of the interest generated by client-owned cash balances, known as margin income. When investors are paid dividends or distributions, Computershare facilitates that transaction, holding billions in cash on behalf of clients ahead of payment. The company held over US$27 billion in client-owned cash during the first half of FY22 which generated US$60 million in margin income. James now expects it to increase US$92 million in the second half due to the higher interest rates.

Let's look at one more interest rate sensitive business. REA Group (ASX: REA) delivered a strong first half update last Friday, driven by a booming real estate market also surfing low-interest rates. However, James expects increasing interest rates to be a headwind for the sector and the company share price. First, he expects P/E multiples to compress in a higher rate environment, halving from 60 in 2021 to 30. Second, he expects refinancing activity to slow, impacting REA's financial services business in the coming years. Finally, he expects the currently elevated levels of listings to fall and a reduction in residential building and sales activities "if the expectation of wealth creation via real estate diminishes".

Making the right call in a market context we haven't seen in a decade is always tricky, even for seasoned investors. Investors would do well to dig into the companies in their portfolios or any prospects on the horizon as it's clear that there are opportunities to find value past the top line impact of higher interest rates. In difficult market environments, nuance is key.

******

Earnings season kicked into gear this week with results from the Big Four banks, AGL, Suncorp, AMP and Insurance Group Australia, to name a few. Keep up to date with our reporting season calendar, and for  Premium subscribers, Morningstar analyst's take on the results as they come through.

Federal Treasurer Josh Frydenberg was dealt a blow this week as his attempt to overhaul the proxy advice sector were overturned by the Senate, just days after they came into effect. As Morningstar's Erica Hall notes, who spoke out against the reforms last month, it was the way the reforms were brought into effect that ruffled feathers, bypassing the usual legislative process and instead relying on delegated legislation, as well as the legislation itself, which tipped the balance of power to companies at shareholders' expense. In Hall's view, the canning of the laws is a win for common sense and investors

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is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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