Investors concerned about the impact of rising interest rates on their portfolios should consider allocating to quality shares, according to strategists at BetaShares.
Higher interest rates were usually seen as being damaging to stock valuations as they led to an increase in the discount rate used to assess future cash flows. Effectively, higher rates today meant companies’ future profits were worth less to investors in the here and now.
BetaShares’ portfolio analyst, Benjamin Smith, said: “With the US Federal Reserve indicating a period of rising rates to assist in curbing inflation, investors may fear a period of muted equity market performance. There are even fears of a ‘lost decade’ where, as rates rise and the Fed shrinks its balance sheet (scaling back quantitative easing), equity prices stagnate.”
However, it was worth remembering that not all companies had the same sensitivity to movements in interest rates.
Consumer staples stocks, for example, tended to grow earnings with inflation, which reduces the impact of rising rates; on the other hand, growth companies such as technology stocks were often bought with an eye for stronger future earnings, which made them more sensitive to changes in the equity risk premium than others.
Smith pointed to recent research from Goldman Sachs, which argued that companies with ‘quality’ attributes, high margins and moderate valuations were some of the most attractive assets to hold in a rising rate environment.
This was because quality attributes such as high returns on equity and strong balance sheets created a level of underlying business stability, which meant companies struggled less when corporate debt became more expensive to service and more difficult to raise.
In addition, high and stable margins were indicative of high pricing power, which was beneficial in times of inflation, while moderate valuations suggest stocks had not become over-valued relative to fundamentals.
“Taken together, these factors represent quality, high margin businesses at a reasonable price,” Smith said.
He also pointed to the index tracked by the BetaShares Global Quality Leaders ETF, which comprised 150 global companies (ex-Australia) ranked by highest quality score. This index outperformed during the one period in the past 20 years when the Fed has lifted interest rates.
“Beginning in Dec 2015 (and for the first time in seven years), the Fed started to hike interest rates as unemployment rates declined and wage growth improved. Rate hikes were finally halted by the US-China trade war causing economic growth to slow in December 2018,” he explained.
“Over this period, the quality index outperformed the MSCI World index by 14.7%. Additionally, the fund also outperformed other factors (namely value and growth).”
Investors seeking exposure to quality stocks had several options including the BetaShares Global Quality Leaders ETF as well as SPDR MSCI World Quality Mix ETF and VanEck MSCI World ex Australia Quality ETF.
Active strategies included WCM Quality Global Growth (Managed), GMO Quality Trust, Insync Global Quality Equity and Morgan Stanley Global Quality.
