Ahead of next week’s webinar, where I will be joined by two Economists from EY and Macquarie, I am taking the opportunity to zone in on interest rates in this week’s blog. Let’s start by pinpointing a few key reasons why rising interest rates present a threat to the stocks and the sharemarket:

1. Risk versus reward – During periods of lower interest rates, investors struggle to generate cash flow returns from fixed interest investments, such as bonds and term deposits. They then head higher up the risk curve, opting for dividend-paying stocks to provide the income returns they need. At the same time, introducing greater volatility into their portfolios. When rates begin to rise again, some investors will retreat to lower-risk investments given they can once again satisfy their cash flow needs.
2. Cheap money – Low-interest rates can result in borrowing rates becoming very attractive. Companies can borrow money to invest heavily in their future growth and with lower interest costs, arguably they can take greater risks to fund growth. When rates begin to rise again companies are forced to review their strategy, and investors begin to question whether their investment is worth the risk they are taking on the growth stock.
3. Quantitative easing – In addition to lower interest rates, Governments can perform quantitative easing (QE). This involves the printing of new money, which is used by central banks to purchase government bonds. This flushes the new money into the financial system, benefiting companies to continue operating and growing. As we emerge from the pandemic economic risks begin diminishing, therefore; QE is wound back.  This makes investors nervous. It forces them to question how much of a company’s performance is based on near ‘free money’, versus sound independent management.

Typically rising interest rates are used to slow inflation. While this point can point to a rapidly growing economy, typically a good thing for sharemarket growth, investors begin to question just how much they may slow economic growth.

So why would the share market still rise during periods of rising inflation and interest rate periods?

When inflation poses an issue for the Government, their job is to introduce strategies, such as interest rate increases, to slow inflation. Some companies will benefit and some will suffer. Here is why:

1. Markets are made up of a variety of companies all doing very different things, hence, it is like comparing apples with oranges. ‘Growth’ stocks use cheap money to invest for the future while forgoing near-term profitability. These companies have outperformed during the low-interest-rate period, but have already come under extreme pressure in 2022 with the prospect of rising rates. On the other hand, mature age ‘value’ stocks, such as Banks, Insurers, and Resource companies may in fact benefit from rising rates for various reasons.
2. Not all investors will exit the sharemarket, particularly long-term investors. Let’s not forget, rising rates tend to be in response to a fast-growing economy. It may slow growth somewhat, but it does not mean that companies will cease operating successfully if they are ‘fundamentally’ strong.
3. We saw in January 2022, the mere prediction of rate rises later this year saw the Australian share market fall around 15%. This is an ‘emotional’ reaction from many ‘short-term’ investors, which creates an opportunity for ‘long-term’ investors looking to buy quality companies at discounted prices.

History shows us that during the last eight interest rate rise periods, shares have performed at or above their long-term average. So, what is the lesson here?

• Often macro-economic trends are misunderstood by the market, with investors making decisions with their hearts, not their heads.
• History is not always a good guide for the future, so a diversified approach is in order.
• Do not try to times markets. As part of your diversified approach, focus on companies that present long-term value.
• I am not suggesting there isn’t a place in portfolios for high-growth companies, if your circumstances suit, however; like any investment that may do very well, never be afraid to take a profit.

To learn more about what lies ahead for the Australian and Global economies in 2022 I urge you to register for next week’s webinar HERE. I have no doubt it’s going to be a very informative hour, where you will have the opportunity to listen to and ask questions of two leading economists.