Expensive stocks. Rising rates. What does this mean for Russell Investments' managed portfolios?

It’s been a relatively volatile start to the year for financial markets (but not too surprising nor out of line with history) with changing and rising expectations of interest rate hikes. U.S. Inflation has been rising, especially in the U.S. The U.S. Federal Reserve is expected to raise rates in March 2022 for the first time since the pandemic started. It’s been nearly two years of ultra-accommodative ‘crisis time’ monetary policy. Some central banks such as the Bank of England and Reserve Bank of New Zealand have already started raising rates. We see these initial rate hikes as a natural progression resulting from the transition towards reopening from previous harsh lockdown conditions. Domestic economies have mostly normalised (Growth Domestic Product – a measure of output - for most major economies are back to pre-covid levels) but inflation is higher due to supply-side bottlenecks. We see interest rate hikes as a way of kickstarting this re-adjustment.

How the portfolios faired in 2022?

The portfolios have outperformed their benchmarks during 2022 as expensive high growth technology stocks have pulled back. The plan is to wait patiently for slightly deeper selloffs to add back into shares, after previously reducing equity exposure mid-2021 head of this anticipated volatility. We have also been reminding clients that 10-15% equity market reversals have occurred frequently (once every year or two) and the start of rate hikes is a common catalyst for these reversals. This market reversal has been off the back of an extraordinary rally in shares, and investors have benefited.

Our view is central banks are unlikely to abandon their general desire to help sustainable economic growth by maximising employment. In other words, central banks are conscious that some developed countries are emerging from COVID-19 induced lockdowns, whilst some remain lockdown. Interest rates may rise but it will be considered in context of the challenges when trying to fully reopen the global economy, which includes international travel, logistics and free movement of labour.

Why do equities and other growth assets tend to face near-term headwinds when interest rates rise more than expected?

Most investment analysts model and calculate corporate valuations by factoring in financing costs. Furthermore, they compare the attractiveness of shares relative to cash. If interest rates are higher, then the cost of financing is higher, and the company could be worth less. Also, cash and bonds may look more attractive relative to equities, if cash and bond yields are higher.

So, the question we should answer is whether shares look significantly more expensive if interest rates rise, and if the potential alternatives (cash and bonds) are worthy replacements? We must also consider this in the context of the economic cycle, which we see as positive, as the economy transitions from recovery to expansion.

Our answer? We are still positive on share markets relative to cash and bonds due to the expansionary view on the economic cycle. However, there are specific areas of the share market that will continue to struggle if interest rates rise faster than expected. These areas are very expensive and tend to rely on high growth expectations to support these high valuations. These stocks have also benefited from the pandemic. Examples of these type of stocks include Zoom (video conferencing), Peloton (exercise equipment), Afterpay (buy now pay later) and Redbubble (ecommerce).

Our portfolios are positioned to hold lower allocations to these parts of the market. We do not see these shares rallying in unison as higher interest rates and inflation dampens the enthusiasm for paying for future earnings. There will be winners and losers amongst these companies. Some of them are brilliantly innovating with strong structural trends supporting them. But the key message is that this strength will not be uniform, and earnings reports will be scrutinised. We continue to prefer shares that have lower valuations and are more cyclical in nature to benefit from the expanding economy. This has been the right place to be positioned in for more than a year and the portfolios continue to benefit from these exposures.

The bottom line

We prefer to be patient before redeploying more capital into share markets. This interest rate cycle narrative is going to take some time to digest as higher inflation could continue to persist over coming months. We still have to navigate through the first-rate hike by the U.S. central bank (expected in mid-March 2022) and the messaging accompanying the rate hike will be crucial too. Whilst equity markets have reversed, it’s been in specific areas, and this has so far been in line with expectations. More short-term volatility is possible, but further upside strength in share markets over the medium-term is likely. This volatility is part of the transition from crisis to recovery to expansion. This is why a dynamic asset allocation, and a patient approach is vital, to take advantage of market opportunities whilst minimising risks.

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