Wednesday, 15 June 2022 08:02

The Domino effects of rising interest rates

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While it is easy to get caught up in the headlines of the largest interest rate rise since 2000, investors should be focussed on the domino effects of rising interest rates and their destination.

The financial markets have well and truly priced in further interest rate increases with current pricing anticipating the cash rate peaks at 3.85% in around 12 months time, up from 0.85% today.

 

Source:  PIMCO using IR strip, Bloomberg – as at 7 June 2022

Based on their analysis of household debt levels, Bill Evans, the Chief Economist at Westpac is forecasting the cash rate peaks at around 2.35% in early 2023, which is considerably less than what the market has factored in.

Hugh Dive, the Chief Investment Officer at Atlas Funds Management believes that the RBA will be wary of raising rates too fast as Australian households have higher debt levels than in previous rate rise cycles.  The average loan size for owner occupiers in Australia as of April 2022 was $611,000, almost double in size since the last time rates rose in November 2010.

Dive says that historically rising interest rates have diverted household expenditure from non-discretionary areas such as restaurants, travel and purchases of consumer goods, to servicing mortgages.  Companies that could be negatively impacted from this behaviour include Myer, Flight Centre and Wesfarmers (owner of Bunnings).

46% of mortgages in 2021 were on fixed rates with an average term of 2 years.  This compares to the usual volume of fixed rate mortgages of around 15% and means that some of the impact of rising rates could be deferred until 2023.

Dan Moore a portfolio manager from Investors Mutual says that while Australian companies have not yet reported profits since rates started to rise, he points to the recent poor profit result in the US from clothing retailer GAP to highlight how the consumer is reacting to rising interest rates.  Moore says that not all retailers will be impacted equally, as those retailers who deal with more affluent customers or retirees who stand to benefit from rising term deposit rates, are less likely to be effected.

Moore asserts that rising interest rates haven’t always led to falling property prices as it depends on where you are in the interest rate cycle.  Typically in the earlier stages of the rate cycle, both rates and property prices can rise as they did in 2004 – 2007, but towards the later stage of the cycle higher rates start to bite, impacting the consumers ability to fund their borrowings. Moore adds that the current cycle is different as property prices have started to fall in the early stages of the rate cycle, probably because prices are extremely elevated and consumers are highly leveraged.

Moore expects Australian property prices to fall, citing falling auction clearance rates as an early warning signal.  He also relates New Zealand’s experience where interest rates have already risen by 1.75%, resulting in Auckland house prices falling by 14%.

Moore is wary of companies who are leveraged to new housing starts due to his concern about the property market such as property developers and building material companies.

Dive suggests investors be wary of companies with higher levels of gearing with debt expiring in the near term.  

There are not too many companies that do well in a rising interest rate environment, as usually rising rates are a headwind for the economy, but Moore nominates Computershare as a beneficiary who will earn higher margin income from their share registry business as interest rates rise.

Dive says that insurance companies should also benefit from rising rates.  QBE holds an insurance float of US $29bn from premiums that are paid up front.  This float is invested in high quality government bonds, corporate debt and the short term money market.  Every 1% rise in rates should result in additional earnings for QBE of around US $290m.

He is also of the view that food retailers could be a beneficiary from consumers choosing to eat at home more often.

Bank margins are likely to benefit from rising rates in the short term, but could face higher bad debt charges as a result of increased mortgage stress.

Investors have not seen interest rate rises for over a decade and will need to adjust their playbook.

 

This article was written by Mark Draper and featured in the Australian Financial Review on Wednesday 15th June 2022.

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