Interest rates are rising, and particularly as inflation keeps running hot, central banks will be forced to keep hiking their respective interest rates higher and higher – which puts a large dampener on valuations in the equity market, hurts bond prices, and generally takes the wind out of economic sails.
With all these pain points across major asset classes, where do you invest? Surely there are some beneficiaries in an environment of rising rates?
Well, firstly, plain old boring cash is a beneficiary of rising interest rates, as you earn a variable interest rate in most bank and brokerage accounts. The problem is that this is pretty low and inflation will probably turn this nominal yield into a negative real one.
Next, you can invest into instruments that pay or yield linked against interest rates.
Variable rate bonds are a tricky market for the average person to access, but you could invest in preference shares that mostly pay a bi-annual dividend linked to prime.
Read: Preference for preference shares
If you want to move up the risk curve, banks and insurers are often beneficiaries of rising rates.
The former tend to benefit from wider net interest margins and have positive matching benefits (for example, fixed deposits only reprice to higher rates later while mortgages reprice immediately), while the latter get smaller present values for their insurance liability and higher effective yields on their cash and bond portfolios.
In fact, both banks and insurers are looking quite cheaply on the JSE right now.
Capitec (CPI) has just posted strong results – again – and many of the other banks are looking quite healthy and hardly expensive.
Likewise, with growing vaccination penetration and the lower mortality ratios of the last wave of the Covid-19 pandemic, many insurers are likely to see strong rebounds in their earnings and – except for Discovery (DSY) – are trading at large discounts to their embedded values.
Personally, I prefer Momentum Metropolitan Holdings (MTM), as it was the best provided going into the latest wave, has a great management team driving the turnaround / rejuvenation of the group spirit is trading at over one standard deviation below its average discount to embedded value.
Further up the risk curve, one could start accumulating investments in large, liquid and highly discounted investment holding companies (Holdcos).
Rising interest rates mean the present value of their Holdco costs (which creates their discounts) should become smaller.
Listen to Simon Brown and PSG Old Oak’s Schalk Louw discuss whether the age of the holdco is over (or read the transcript)
Simply put, higher discount rates on the same cash flows lead to a lower net present value. Remgro (REM), Reinet (RNI) and Sabvest (SBP) look particularly interesting to me.
Finally, you can dig around and find companies without debt – and large cash balances.
Higher interest rates should hurt most highly geared companies. But ungeared companies could be net beneficiaries, as they earn high interest on their cash balances spirit can deploy these cash balances into acquisitions whose valuations may become depressed at higher interest rates.
Currently, you could look to many of the commodity and resource stocks as many of them are sporting net cash balance sheets, albeit that these come with significant volatility in their share prices too.
Thus, viewing these stocks as ‘safe’ is bit misleading…
Interestingly, though, many Holdcos have lowly or entirely ungeared balance sheets. This makes sense as their ‘business’ is that of capital allocation and, thus, if they ‘run out of capital’ then they aren’t managing their business very well. Once again, Remgro (REM), Reinet (RNI) and Sabvest (SBP) all come to mind in this camp.
Thus, in conclusion, the toxic combination of rising interest rates, rising inflation and relatively high valuations across global markets is currently making investing particularly tricky. Yet even as this period plays out, at least some of the preference shares, banks, insurers and Holdcos on the JSE should offer reasonable returning sanctuary.
Keith McLachlan is investment officer at Integral Asset Management.
* McLachlan and various client portfolios may hold Remgro, Reinet, Sabvest and Momentum Metropolitan Holdings.