Winners and losers from rising inflation and interest rates
In mid-2021, I appeared on a webinar for this Report. When Peter Switzer asked me about my top market concern, the response was “inflation”.
At the time, there was raging debate about whether signs of rising inflation were transitory due to supply-chain and labour-market bottlenecks during Covid, or whether higher inflation would be sustained because of massive fiscal and monetary stimulus.
I favoured the latter scenario. After decades of falling bond yields, thanks to low inflation, it seemed obvious that inflation would rise. That’s what happens when the world is awash with stimulus and there is too much demand for too little supply.
Although I expected higher inflation, the 7% increase in the US Consumer Price Index in December 2021 – the largest 12-month gain in almost 40 years – shocked me. Even ardent inflation hawks would have been surprised by the magnitude of growth in US inflation.
The big problem, of course, is that rising inflation expectations lead to rising interest-rate expectations. Central banks lifting rates sooner and more aggressively than the market expects is bad for equity investors. It can puncture bull markets.
My view? We’re entering a period of rising inflation and interest rates that will have a huge influence on investment returns this decade. Easy gains are over. As prices rise, and the cost of capital increases, high equity returns will be harder to deliver.
I see several implications from higher inflation and rates for investors in 2022 and beyond.
Here are three key changes. I’ll outline more in coming weeks for this report.
Trend one: underperformance of long-duration growth stocks
The sharp sell-off in technology stocks this year is a sign of things to come. Rising rates affect the future value of cash flows, which analysts use to value tech stocks. It becomes harder to buy growth companies, such as tech, on high Price Earnings (PE) multiples.
Some investors will be tempted to pounce on tech-sector weakness and buy the dip. Don’t. It’s too soon.
Granted, some of the US FAANG stocks (Facebook (Meta), Amazon, Apple, Netflix and Google (Alphabet)) look interesting after price falls. So, too, some large Chinese tech stocks, such as Alibaba Group. I wouldn’t buy yet. The market is just getting its head around higher inflation. Tech has further to fall.
Nevertheless, I have tech stocks on my portfolio radar, in anticipation of lower prices over the coming year. ETF Securities’ ETF Fang+ (FANG) is a useful tool to gain exposure to the world’s largest tech companies. The ASX-quoted Exchange Traded Fund owns 10 of the world’s largest 10 companies.
ETF Securities FANG+ ETF (FANG)
Trend two: outperformance of global banks
Banks generally benefit from higher interest rates, although it’s not as clear-cut as it seems. Their profit margins expand as rates rise. Also, higher rates usually point to a strengthening economy, which is good for credit demand and fewer loan defaults.
I became bullish on Australian banks for this report in April 2020 as the sector tanked during Covid. I described the opportunity to buy banks as the best in decades and nominated the VanEck Vectors Australian Banks ETF (MVB) as a tool to ‘buy the sector’. MVB has returned 31% over one year to end-December 2021.
VanEck Vectors Australian Banks ETF (MVB)
Although I like the prospects for Australian banks in 2022, better valuation opportunities in the sector are available overseas. Several US banks, and particularly those in Europe, trade on more attractive valuations than their Australian peers.
The BetaShares Global Banks ETF – Currency Hedged – (BNKS) is the simplest way to gain exposure to global banks stocks, for Australian investors. BNKS tracks the performance of the world’s largest banks (excluding those in Australia).
Key holdings include Bank of America Corp, JPMorgan Chase, Wells Fargo and Royal Bank of Canada. By geography, about half of the ETF is invested in US banks, with the rest in Asian and European banks.
The forward PE ratio of BNKS was 9.54 times at end-December 2021, BetaShares data shows. The ETF’s average price-to-book ratio was 1.06 times. For comparison, the Commonwealth Bank is on a forward PE of almost 20 times FY23 earnings and its price-to-book ratio is 2.24 times, using Morningstar numbers.
That highlights the valuation opportunity in global banks compared to local ones.
BetaShares Global Banks ETF – Currency Hedged (BNKS)
Trend three: outperformance of insurance sector
Economic conditions and interest rates have been headwinds for the insurance sector over the past decade. But as bond yields head higher (due to rising inflation expectations), the global insurance sector could outperform in 2022 after a long period of underperformance.
A recent survey of global insurers by the Deloitte Centre for Financial Services said: “Insurers from around the world … remain fairly bullish when it comes to their growth prospects for 2022, despite lingering concerns about the potential impact of Covid on overall business recovery and return-to-work strategies.” About a third of 424 respondents expected “significantly better” revenue this year.
This looks like an important turning point for the insurance sector. As the economy roars back to life in the post-Covid recovery, interest rates will continue to rise and insurance demand will increase. Premium growth and lower-than-expected claims (in part due to ongoing disruptions from Covid) could feature.
Faster economic growth underpins higher business formation, property turnover and auto purchases. Each major purchase usually requires some form of insurance.
Unfortunately, there is no dedicated ETF on the ASX to play the global insurance sector. For investors prepared to buy ETFs offshore, the SPDR S&P Insurance ETF KIE (NYSEMKT: KIE) is an option.
Australian investors who prefer to buy directly should have QBE Insurance (QBE) and Insurance Australia Group (IAG) on their portfolio watchlist. QBE has rallied sharply off its 52-week low as the market prices in an earnings recovery.
Insurance Australia Group is interesting. Unlike QBE, it has badly underperformed the Australian sharemarket with a negative 5% total return (including dividends) over one year. IAG has returned almost nothing over five years for its investors.
IAG reaffirmed profit guidance for FY22 for low single-digit premium growth and an insurance margin of 10-12%. Morningstar values IAG at $5.60, versus the current share price of $4.30. An expected dividend yield of almost 6% in FY23 is another attraction.
I like the look of IAG at the current price. The market has lost some interest in it after years of underperformance. With the insurance sector’s prospects improving, IAG – trading near multi-year lows – is the type of value stock that could do well in an environment of rising inflation and interest rates.
Insurance Australia Group (IAG)
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 20 January 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531).This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.