It may be that we are not used to it and that is why the rate hikes that are coming are being a jug of cold water for investment. There have been many years of strong rises –with the stoppage of the Covid on the stock markets in 2020– both in equities and in bonds doped for decades by the hand of central banks. Very high inflation, the invasion of the Ukraine and now the fear of lower economic growth or a recession have set off alarm bells and pessimism. But it would not hurt to remember that the now punished Nasdaq technology index – it falls almost 30% this year – is around 11,400 points but was only five years ago fooling around with the 6,000 level.
The negative sign is imposed on stock market indices and bonds. In the case of stocks in this 2022 of harsh adjustment, only the MSCI World Energy is saved, with a rise of more than 35%, and the MSCI EM Latam, which rises more than 5%. Even defensive or gaining sectors with higher interest rates, such as consumer discretionary or banks, are posting losses on their global metrics this year.
Víctor Alvargonzález, director of strategy and founder of Nextep Finance, recalls that “the difference between the Nasdaq and the indices that perform best in an inflation environment has been more than 20%. Therefore, the difference in profitability will also be double digits if the inflation/asset equation, sector or country chosen to invest is correct. If inflation turns out to be lower than expected, a great opportunity to enter the market will be lost”, he concludes.
Bonds also pick up those losses. European government debt has fallen by an average of 8%, and the losses generated by corporate bonds, both in their investment grade and high yield versions, are at the same level. Some movements that affect US fixed income and that have put an end to the gain of the last three years in these assets.
Only the energy and Latin American stock market indices achieve gains in the year
On the opposite side, raw materials stand out, whose general index shows a rise of 30% so far in 2022, supported above all by oil and its revaluation of 43.42%. Mar Barrero, director of analysis at Arquia Profim Banca Privada, highlights the good performance of investment funds in raw materials. Specifically, those of the Spanish manager Azvalor, which exceeded a profit of 30% in the year, and JP Morgan Global Natural Resources, which has rented 27% in these almost five months.
The volatile outlook will in any case continue for markets until central banks are able to send more dovish messages about their willingness to raise interest rates. It will be a sign that inflation is bowing.
Assessment
Higher interest rates negatively affect equities for several reasons. From the outset, companies find financing more expensive and, therefore, earn less by dedicating part of their profits to these higher costs of debt. Also the very competition between products: with a bond at 3% or 4%, for example, many investors do not bother to assume the greater risk of the shares.
The other aspect has to do with the valuations of the companies themselves, and very especially of the technological ones (growth values), in which the cash flow system is used. IG Markets analysts explain this phenomenon: a cash flow of 100 euros a year from now, with a discount rate of 5%, is equivalent to a present value of 95.24 euros. The higher the discount rate, the lower the present value. The present value of a cash flow of 100 euros five years from now, at 5%, is around 78.35 euros (the later in the future the flow is located, the lower the present value)”, they explain. .
The question of determining the correct discount rate is of paramount importance and this is where inflation comes into play. “If the inflation rate is used as input to determine the discount rate, then a higher inflation rate will cause a higher discount rate,” they conclude from IG Markets. This explains why technology companies fall sharply when updating their value with higher interest rates.
This form of valuation would also be applicable to dividends. Thus, higher inflation lowers the present value of each expected future dividend. This, in turn, lowers the current share price.
However, investing in high-dividend securities has had success stories such as the DWS Top Dividend fund, which accumulated a revaluation of 4.7% in the year, “very interesting when compared to the average loss of around 5% of variable income funds, which rise to 20% for those specialized in technology”, explains Mar Barrero.
sectors
In addition to energy stocks, for Roberto Ruiz-Scholtes, director of strategy at UBS in Spain, “only the financial sector (banks and insurance companies) benefits from the rise in interest rates, since the valuation of the rest of the sectors is pressured downward by the increase in the cost of capital. Banks will increase their interest margin and also trade as if delinquencies were going to skyrocket in a recession that we continue to see as unlikely.
The bank continues to be a favorite with rising rates, but also suffers from the fear of recession
The UBS expert points out that cyclical securities are not doing well since, unlike other crises, this rate hike does not indicate economic recovery. “The correct approach now is to go to the causes of these rate hikes (inflation due to the crisis in raw materials), and that is why we recommend investing in the oil sector and in integrated electricity companies,” explains Scholtes. And he adds: “Now, the economic downturn is already involved in the price and if we do not enter a recession, it will be precisely the stocks and cyclical sectors that would lead the rebound: banks, industrials, construction, steel and cars,” he concludes. There are already industrial funds with a good track record, although they are few. In Arquia Profim Banca Privada they point to Fidelity Global Industrials, which accumulated a rise of 4.67% in the year.
Without a doubt, active management is making a difference in the returns of the different investment funds. Sean Markowicz, head of strategy, studies and analysis at Schroders, explains in a study his preference for the energy sector (oil and gas) that exceed inflation 71% of the time and offer a real annual return of 9.0% of half. “Revenues from energy stocks are naturally tied to energy prices, a key component of inflation rates,” he says.
However, Markowicz is less sure that inflation and rate hikes are in the utilities’ favor, as they have a somewhat disappointing 50% success rate. “As natural monopolies, they should be able to pass on cost increases to consumers to maintain profit margins. In practice, regulation often prevents them from fully doing so.” In addition, their usual comparison with bonds – with which they compete for the regularity of their income – does not favor them either. Marta Díaz-Bajo, director of investment solutions at Atl Capital, recommends mixed funds with short-term fixed income and with shares focused on solid companies that can transfer the rise in inflation to their prices without damaging their margins. In this sense, she bets on the Spinosa Partners Inversiones fund, which obeys this investment philosophy and has avoided falls with a revaluation of 1.25% in the year.
real estate
Another more exotic alternative to provide protection against rate hikes are listed real estate companies (REITs and socimis) – they acquire real estate for subsequent rental – or those that invest directly in listed real estate companies. For example, the Spanish fund GVC Gaesco Oportunidad Real Estate Companies has accumulated a return of 20% this year and leads the ranking of the European sector, according to Morningstar data. From Schroders they explain that these funds have exceeded inflation 67% of the time and obtain an average real return of 4.7%.
REITs own real estate assets and provide a partial hedge against inflation through the pass-through of price increases in rental agreements and property prices. By contrast, mortgage REITs, which invest in mortgages, are among the worst performing sectors. Like bonds, their coupon payments lose value as inflation rises, causing their yields to rise and prices to fall to compensate.
The key to this difficult year will be in the policy of the central banks and their communication to the markets. For now, the rate hike is still on the calendar, always looking out of the corner of the eye at the effect it produces on the evolution of the economies, which will mark its intensity and duration.
Is there still life in the bonds?
The movement of types. Given the current uncertain economic situation, experts do not expect large movements in the long terms of the interest rate curve. The German at 1%, the American close to 3% or the Spanish at 2% seem acceptable levels if the economies are not doing well. Another thing is the expected rise in intervention rates. From A&G Private Banking they point out that “although we believe that the great movement of upward rates has already been done, we still do not see the duration risk sufficiently remunerated (and less so in Europe). We expect a very slow recovery when inflation expectations begin to adjust”, they explain.
Monetary. In this same month of May, the profitability of some money market funds (they invest in short-term fixed income) has returned because these assets have once again offered positive returns after many negative months. A profit that, as Mar Barrero indicates, is due above all to private fixed income in very low commission products that, at the moment, are only open to large assets.
#Opportunities #havoc #investment #expensive #price #money