How asset classes could fare as rates rise and yield curves move up

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Around the world, monetary parameters are tightening. Central bank balance sheets are shrinking and interest rates are starting to rise. The culprit is of course inflation, and it is the next period of high inflation and rising interest rates that will play a key role in the direction of investment markets.

Interest rates are being adjusted from a very low base and some investors are trying to rationalize that this is not a bad thing because economies have improved and even after several hikes rates would still be low relative to the story. While a ‘glass half full’ is great for sentiment, aggressive rate hikes would undoubtedly wreak havoc on financial markets, like in 1994. It was a tough time for stocks and totally diabolical for bonds. .

In all likelihood (despite the material impacts of the Russian-Ukrainian war), inflation will finally slow in the second half of this year and that should be enough for the RBA to lift its foot off the interest rate accelerator – especially if wage growth remains modest.

But there are fears that the RBA is looking to quickly restore credibility on the inflation-fighting front and not raise rates too much, dampening the economy and with it the outlook for businesses. This would hurt both equity and debt markets, with high-yield credit bearing the brunt of the impact in the case of the latter.

Some investors are already worried about this happening, especially in overseas markets, where credit spreads have widened sharply, leading to steep losses. Equity risk premiums – a measure of the rate of return required to invest in stocks – in developed and emerging markets have also risen in recent months.

While value appears to be emerging in the bond markets, longer duration bonds remain out of favor as risk-free rates continue to rise. At the time of writing, the yield on a 10-year US Treasury had jumped to nearly 3.2%, while the yield on 10-year Australian government bonds had risen above 3.6%. Both are more than double their implied yield from just six months ago. These moves help explain the sell-off in tech stocks and long-lived growth stocks more generally.

Rising rates in the money markets are also leading to a strengthening US dollar, which is seeing strong exits from emerging market equities. At a time when food and energy prices are rising, weak local currencies make imports even more expensive. This hampers the post-pandemic recovery of these economies and puts pressure on their interest rates to maintain differentials. Thus, the outcome is generally negative for most emerging market stocks by reducing demand, but also increasing the risk of credit default, thereby destabilizing emerging market debt.

But it’s not all bad news in emerging markets, as some countries, like Brazil and Nigeria, are heavily exposed to energy, resources and agriculture. Meanwhile, countries like India and Sri Lanka, which rely heavily on imported energy, are going through tough times. Sri Lanka is already in crisis, although much of this appears to be of its own political fabrication, while India appears to be positioning itself for cheaper Russian oil.

In 2022, commodities were the best performing asset class. This is due to the post-COVID cyclical rebound, but also to its real asset qualities, which investors tend to favor as a partial hedge against inflation. This leads us to expect domestic equities to outperform their global peers in 2022, in an environment of heightened volatility. Big Australian banks should also be direct beneficiaries of the RBA’s tightening cycle thanks to an improved ability to expand interest margins. History shows that banks tend to do well when real yields rise.

But, a good overall performance will only happen as long as the RBA does not plunge Australia into a deep recession.

Other asset classes with real asset properties, such as infrastructure and listed real estate, have done reasonably well this year in local currency terms, but real estate trusts are just starting to capitulate. As sentiment deteriorates, cap rates look unlikely to tighten and funding costs have already risen.

Finally, we come to cash. As investors in this space lock in a negative real return, it’s a small price to pay to hedge against volatility and preserve capital for redeployment when the time comes. And it will arise. This is always the case, especially for the patient investor. Because over the long term, financial markets tend to go up more than they go down.

Angela Ashton, Founder and CEO, Evergreen Consultants

How asset classes could fare as rates rise and yield curves move up

When the Reserve Bank of Australia (RBA) recently raised rates for the first time since 2010, many investors and analysts were surprised not by the move, but rather by the quantum. The strong inflation reading for the March quarter saw the consensus advance its expectation of a hike from June to May, but for it to be only 15 basis points, or 0.15%. When the RBA announced a 0.25% move, it rattled investors.




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Last update: May 17, 2022

Posted: May 17, 2022

Neil Griffiths

Neil Griffiths

Neil is the Associate Editor for Wealth Headlines including ifa and InvestorDaily.

Neil is also the host of the ifa show podcast.

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