We may not be used to this, and so the upcoming rate hikes are a pitcher of cold water for investment. Both stocks and bonds, which have been doped by central banks for decades, have seen many years of sharp rises – with the Covid halting stock markets in 2020. The very high inflation, the invasion of Ukraine and now the fear of one Lower economic growth or a recession have sounded alarm bells and pessimism. But it wouldn’t hurt to recall that the now-penalized Nasdaq tech index — falling almost 30% this year — is around 11,400 points but was still toying around the 6,000 mark five years ago.
The negative sign is imposed on stock market indices and bonds. As for the stocks in this year 2022 of hard adjustment, only MSCI World Energy is saved with an increase of more than 35% and MSCI EM Latam with an increase of more than 5%. Even defensive or emerging sectors with higher yields, such as B. 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 inflationary environment is more than 20%. Therefore, if the inflation/asset equation, sector or country chosen for the investment is correct, the difference in profitability will also be double digits. If inflation ends up being lower than expected, a great opportunity to enter the market will be wasted,” he concludes.
Bonds also absorb these losses. European government debt has fallen by an average of 8% and corporate bond losses, both investment grade and high yield, are at the same level. Some moves affecting US fixed income securities that have put an end to gains on these assets over the past three years.
Only the energy and Latin American stock indices made price gains over the course of the year
On the other hand, commodities stand out, with the overall index showing a 30% increase year to date in 2022, mainly driven by oil, which appreciated by 43.42%. Mar Barrero, Director of Analysis at Arquia Profim Banca Privada, highlights the good performance of investment funds in commodities. In particular, those of Spanish manager Azvalor, which topped a 30% gain for the year, and JP Morgan Global Natural Resources, which has leased 27% in those nearly five months.
In any case, the volatile outlook for markets will continue until central banks are able to send more dovish messages about their willingness to hike rates. It will be a sign that inflation is easing.
valuation
Higher interest rates are negative for stocks for a number of reasons. Businesses find financing more expensive to begin with, and therefore make less by devoting some of their profits to these higher borrowing costs. Also the product competition among themselves: With a bond of 3% or 4%, for example, many investors shy away from taking the greater risk of the share.
The other aspect concerns the valuations of the companies themselves and more particularly the technological ones (growth stocks) in which the cash flow system is used. The analysts of IG Markets explain this phenomenon: A cash flow of 100 euros per year at a discount rate of 5% corresponds to a cash value of 95.24 euros. The higher the discount rate, the lower the present value. The NPV of a $100 cash flow five years from now is 5% at about $78.35 (the later in the future the flow is, the lower the NPV),” they explain.
The question of determining the correct discount rate is paramount, and this is where inflation comes into play. “When the inflation rate is used as an input to determine the discount rate, a higher inflation rate leads to a higher discount rate,” they conclude from IG Markets. This explains why tech companies fall sharply as they update their value with higher interest rates.
This form of valuation would also apply to dividends. Thus, higher inflation lowers the present value of any expected future dividend. This in turn lowers the current share price.
However, investing in dividend-yielding securities has success stories such as the DWS Top Dividend Fund, which accumulates a revaluation of 4.7% per year, “very interesting compared to the average losses of around 5% for variable-income funds, which rise to 20 % for those specializing in technology,” explains Mar Barrero.
sectors
In addition to energy stocks, Roberto Ruiz-Scholtes, Director of Strategy at UBS in Spain, said “only the financial sector (banking and insurance) is benefiting from the rise in interest rates, as the valuation of the other sectors is under downward pressure from the rise in the cost of capital. Banks will widen interest rate spreads and act as if defaults will skyrocket in a recession that we continue to view as unlikely.
The bank is still the favorite when interest rates rise, but is also suffering from fears of a recession
The UBS expert points out that cyclical stocks are not doing well because, unlike other crises, this rate hike does not portend an economic recovery. “The right approach now is to get to the bottom of the root causes of these rate hikes (inflation due to the commodity crisis) and that’s why we recommend investing in the oil sector and integrated power companies,” explains Scholtes. And he adds: “Now the economic downturn is already priced in and if we don’t enter a recession it will be the very stocks and cyclical sectors that would lead the rebound: banks, industrials, construction, steel and autos. ‘ he concludes. There are already industry funds with good track records, albeit few. At Arquia Profim Banca Privada, they point to Fidelity Global Industrials, which recorded a 4.67% increase over the year.
Without a doubt, active management makes a difference in the returns of different mutual funds. Sean Markowicz, Head of Strategy, Studies and Analysis at Schroders, explains in a study his preference for the energy sector (oil and gas), which outperforms inflation 71% of the time and offers a real annual return of 9.0% in half . “Revenues from energy stocks are naturally tied to energy prices, a key component of inflation rates,” he says.
However, Markowicz is less certain that inflation and rate hikes are in utilities’ favour, as they have a somewhat disappointing 50% success rate. “As natural monopolies, they should be able to pass cost increases on to consumers to maintain profit margins. In practice, regulation often prevents them from doing so to the full.” Nor does their usual comparison with bonds, with which they compete for the regularity of their earnings, sit well with them. Marta Díaz-Bajo, Director of Investment Solutions at Atl Capital, recommends mixed short-term fixed income and equity funds with a focus on solid companies that can pass the rise in inflation onto their prices without hurting their margins. With this in mind, he bets on the Spinosa Partners Inversiones fund, which follows this investment philosophy and has avoided losses with a revaluation of 1.25% over the year.
property
Another more exotic alternative for protection against interest rate hikes are listed real estate companies (REITs and Socimis) – they buy properties to rent later – or those that invest directly in listed real estate companies. For example, Spanish fund GVC Gaesco Oportunidad Real Estate Companies has returned 20% this year and tops the European sector rankings, according to Morningstar data. From Schroders they explain that these funds have outperformed inflation 67% of the time and have an average real return of 4.7%.
REITs own real estate assets and provide a partial hedge against inflation by passing on price increases in leases and real estate prices. In contrast, mortgage REITs, which invest in mortgages, are among the worst-performing sectors. As with bonds, their coupon payments fall in value as inflation rises, causing their yields to rise and prices to fall to compensate.
The key to this difficult year will lie in central bank policies and how they communicate with markets. At the moment, the rate hike is still on the calendar, always keeping a close eye on the impact it will have on the development of the economies, which will mark its intensity and duration.
Is there still life in the bonds?
The movement of the types. In view of the currently uncertain economic situation, experts do not expect any major movements in the long maturities of the yield curve. The Germans at 1%, the Americans at almost 3% or the Spanish at 2% seem to be acceptable levels when economies are not doing well. Another thing is the expected rise in intervention rates. From A&G Private Banking, they point out that “while we believe that the big hike in interest rates has already happened, we still do not see the duration risk being sufficiently compensated (and less so in Europe). We expect a very slow recovery as inflation expectations start to adjust,” they explain.
Money. In the same month of May, some money market funds returned to profitability (they invest in short-term fixed income securities) as these assets started to offer positive returns after many negative months. A win that, as Mar Barrero suggests, is largely due to private fixed income in products with very low commissions, currently only open to large fortunes.