Navigating the share market in a new paradigm

Rising inflation and interest rates can spell danger for share investors, but there will always be pockets of value to be found if you know where to look, say experts. 

Last week’s rate hike from the Reserve Bank of Australia has added fuel to media speculation about runaway inflation and soaring mortgage rates, but the local share market was largely unperturbed – initially at least.

The reaction is a sign that investors had long factored in the imminent end of two decades of easy money. The question now is just how tightly the central bank will turn the monetary taps with further rate rises.

The re-emergence of inflation after a prolonged absence will pose a challenge to stock pickers who have grown rich in the era of cheap funding. Higher interest rates will increase the cost of corporate borrowing, eating into profit margins, while increasing the returns investors can achieve elsewhere, such as risk-free term deposits and government bonds.

Rising inflation also subdues consumers’ willingness – and desire – to spend on discretionary items, while companies which are unable to lift prices find their margins squeezed as the cost of inputs such as energy soars.

The best performing firms will be those that can maintain or increase their pricing or capture new markets, says Westpac senior economist Justin Smirk. 

“For those who can’t, there will be pressure on their share price because they will need to lift revenues to match the yields offered elsewhere.”

Banks traditionally do well in higher rate environments because it boosts their interest margins. Of course, the risk is that the benefit is negated if mortgage stress results in an uptick in home loan delinquencies.

According to Martin Currie portfolio manager Ashton Reid, ‘real assets’ such as infrastructure are also well placed because they have rent or toll income linked to inflation.

One example in the Martin Currie portfolio is the Australian and US toll road operator Transurban. 

Shopping centre owners are insulated because rents are usually linked to tenants’ turnover, which will increase as prices rise. Most mall leases are struck on a CPI-linked increase plus an additional annual increment.

“It’s a challenging landscape, but we believe real assets provide a compelling inflation-protected investment opportunity, as well as meaningful income upside potential,” Reid says. 

While the mall owner might be OK, conditions may not be so rosy for their retail tenants, especially the ones that rely on discretionary spending. Office REITs (real estate investment trusts) are also vulnerable to increased vacancy rates as the economy slows. 

The new paradigm has put tech stocks in the firing line because they tend to be highly dependent on funding,and need to service that debt while often taking several years to turn a profit after starting up.  

While the Dow Jones index has lost about one-tenth of its value over the last six months and our market is around 5 per cent lower, the technology-heavy Nasdaq has lost around one-quarter of its value.

For the rest of the stock market, much will depend on the impact the RBA’s tightening moves have on the broader economy. A gentle cooling should support asset prices, while a more severe downturn akin to Paul Keating’s famed 1990s “recession we had to have”, would likely see investors run for cover. 

Zenith Investment Partners head of asset allocation and strategy Damien Hennessy says history suggests that when central banks move to “normalised” monetary settings, a downturn is likely 12 to 18 months later.

Put another way, of the last nine Federal Reserve tightening cycles of 180 points or more, seven have resulted in a recession.

“The outliers were in 1984 and 1994 when balance sheets were in good condition. Banks kept lending and the economy escaped recession,” he says.

“From an asset allocation perspective, it’s about understanding what’s priced in and assessing the probability of a recession.”

Hennessy said he would rather be in Australian shares than elsewhere, given the resources sector accounts for about half of the market. Commodities producers have been a bright spot for the bourse this year as supply bottlenecks, exacerbated by the war in Ukraine, sent prices skywards. 

UBS strategist Richard Schellbach believes Australian shares can continue to deliver solid earnings growth given the record low unemployment, “elevated household and business deposits, the re-opened domestic economy and tight commodity markets.”

He notes that among the nations that moved on rates earlier than Australia, the resources-heavy British and Canadian exchanges have held up well.

“This illustrates how the trajectory of mining and energy stocks can remain detached from domestic rate cycles in a late cycle economic environment of high inflation and decelerating growth,” he writes.

Fortunately, the collective debt position of Australian companies looks sound, with leverage in line with the long-term trend.

Unpredictable geopolitical factors aside, the market’s ongoing resilience hinges not so much on Tuesday’s quarter percentage point rise in the cash, but the quantum of further expected increase.

Westpac expects the cash rate to peak at 2.25 per cent in the first half of 2023, with headline inflation maxing out at 5.6 per cent at the end of 2022 and abating to 2.6 per cent within a year.

‘Core’ or ‘trimmed’ inflation – which ignores the 15 per cent of items that have moved most extremely – is tipped to peak at 4.5 per cent. It’s then expected to decline to 3 per cent – the top of the RBA’s targeted band – by the end of 2023.

“I get nervous when people talk about stagflation because it brings up references to the 1970s and 80s,” Smirk says.

He notes companies back then were focused on growth, whereas modern corporate mantra is on cost controls and constrained wages growth.

“We are in a different place,” Smirk says. “Growth might be slower but true stagflation is rampant double digit inflation and zero growth.”

_{The views expressed are those of the author and do not necessarily reflect those of the Westpac Group. This article is general commentary and it is not intended as financial or tax advice and should not be relied upon as such.}