The Reserve Bank of Australia’s decision to lift interest rates by 75 basis points since May, and the likelihood of more hikes, has exacerbated equity market volatility and unnerved some investors who have not previously experienced rate rises. AFIC Portfolio Manager, David Grace, comments on this change and the positioning of AFIC’s portfolio of high-quality company investments in this environment.

What’s causing interest rates to rise?

Australia has experienced strong economic growth following the COVID-related weakness of 2020, which has contributed to higher inflation against the background of COVID-related disruption to supply chains, the war in Ukraine, and higher wages which are all leading to upward pressure on prices for resources, food, and other commodities.

Inflation typically makes it harder for companies to grow earnings because inputs and labour are more expensive, and consumers’ tend to experience a decline in real wages producing a fall in demand.

Consumer prices in Australia are currently rising at an annual rate of 5.1 per cent, and in the US at an annual rate of 8.3 per cent. Consequently, central banks such as the RBA and the US Fed are now increasing rates under their mandate to dampen inflation.

In May this year, the RBA lifted the cash rate to 0.35 per cent. In June, the RBA lifted the cash rate further to 0.85 per cent. Before May, the last hike in the cash rate was in March 2008 when it rose to 7.25 per cent. These levels are still a long way from the cash rates in January 1990 when it was 17.5 per cent. In this context, we’ve had several decades of declining interest rates, and remain very low despite the recent lift.

Uncertainty over future interest rate levels is creating market volatility

Australia’s higher-than-expected inflation rate implies that interest rates may increase at a faster rate than the market initially expected. At question is the level of interest rates needed to control inflation within the RBA’s target band of two to three per cent.

The market is weighing up whether we’re seeing a temporary lift in inflation that’s related to supply chain challenges or a broader, prolonged period of sustained inflation. There are different views around this and the final level of interest rates that are appropriate to quell inflation, which is why there is so much volatility in the current market.

What do higher interest rates mean for AFIC’s portfolio?

In general, it is the quality of a company that often determines which stocks do better amid rising interest rates—stocks that have a strong balance sheet, a good competitive position, the capacity to pass on cost increases to customers, and the ability to deploy capital and generate continued cashflow over the long term are better placed than those who do not have this profile. These companies are well positioned to grow earnings over the full economic cycle and are less dependent on prevailing conditions to grow earnings. In this context we believe AFIC’s portfolio is well positioned with rising interest rates in mind.

Transurban, together with healthcare companies Resmed and CSL are examples of portfolio holdings displaying these quality attributes. We expect all these companies to continue delivering meaningful cash flow growth in spite of the headwinds that a rising inflation environment presents. All these companies have a strong industry position, are putting through price increases and maintaining investment into future growth projects.

While valuations may remain volatile in the near term, often times of market volatility present opportunity to invest in quality companies at attractive prices. We are actively adding to our preferred companies where we deem valuations to be attractive in light of a company’s long term prospects.

Conclusion

A rise in interest rates is a part of a typical economic cycle, it has just been a prolonged period since we last saw interest rates rise. When there’s a pivot or change in strategy from the central banks, it is the initial shock and uncertainty that tends to disrupt equity markets.

At such a time rather than trying to predict where interest rates are heading, we focus on the quality of the companies that we’re invested in and the levers they possess to navigate the tougher operating environment.

When the market is going up consistently like it did for some years, everything looks like quality. But an environment of inflation and rising interest rates reinforces the attributes that define true “quality” companies, particularly a strong balance sheet. Such quality stocks are at the core of our portfolio.