John Maynard Keynes’ famous line that markets can remain irrational longer than (investors) can remain solvent is an apt descriptor for the direction of US interest rates and asset-price distortion from radical monetary policy experiments worldwide.
Markets know US interest rates have to rise. The debate is over the timing and magnitude of rate rises. The “doves” favour continued low US inflation, low economic growth and slow rate rises from here. The “hawks” say higher US interest rates are needed to combat inflation risks.
The debate outcome will have massive ramifications for the global economy and asset classes. If the doves are right, US rates will remain low and increase only gradually for a few more years, in turn supporting asset valuations, companies with high debt and investor confidence.
If the hawks are right, a strengthening US jobs market could spark a “breakout” in US inflation, which in turn demands faster rate rises than the markets expect. Rising US rates and their effect on rates and currencies worldwide could spark the next financial crisis.
The debate is on a knife-edge. Even the US Federal Reserve seems to have growing divergence between voting and non-voting members over the timing of US rate rises.
Dr Charles Evans, President of the Federal Reserve Bank of Chicago and a current non-voting member, told the Australian Financial Review this week that a December rate hike in the US would be reasonable, but added that the US economy needs monetary stimulus for longer to ensure inflation rises.
Boston Federal Reserve President Eric Rosengren, a US Fed voting member, this month said the US economy was proving “resilient” – a hawkish comment that markets interpreted as a sign that the Fed is leaning towards more rate hikes. Equities sold off on the news.
US Fed Chair Janet Yellen said in late August that the case for rate hikes had strengthened, but was vague on timing. Markets expect a rate rise in December.
The hawks’ case for more US rate rises in the next six to nine months is building. A tightening labour market, rising service sector inflation and an acceleration in credit and money supply growth in the US suggest inflation pressures are rising.
More US workers are “quitting” their jobs – a sign they are confident they will get another one in a buoyant US labour market. Stronger labour demand in theory means rising wages pressures that feed through into higher inflation and higher interest rates.
Expect lower rates, for longer
I favour the doves’ argument that US rates will remain low for longer and was intrigued by Dr Evans’ comments that the “sustainable” rate of US unemployment, before prices pressures are stoked, might be less than markets expect because of an ageing population and lower labour market participation from older men and people aged 18 to 25.
I’d add technology, and its deflationary effect on many prices, to that list. The unfolding boom in middle class consumers in emerging markets is another factor, as western companies have greater scope to use educated, lower-cost workers in eastern countries, and drive down costs.
My point: the US unemployment rate might be able to fall further than in previous cycles before a tightening labour market drives up wage costs and leads to a breakout in US inflation, and thus US interest rates.
Powerful technological, demographic and social trends, not easily captured in economic models and theory, could be “disrupting” the concept of full employment and its effect on inflation.
Do not expect rapid rises in US interest rates, or a sharply higher Greenback and sharply lower Australian dollar in the next 12 months. I’m not convinced that a potential December US rate hike is the big inflexion point for global interest rates and the end of an era of record-low interest rates.
The global economy remains incredibly fragile, and the actions of other central banks that are trying to debase their country’s currency to stimulate economic growth are affecting the timing of US rate rises. The odds favour more of the same – low rates – for a while yet.
Caution needed on US rate strategy for investors
Buying Australian stocks that benefit from US rate rises is tricky. For one thing, faster rate rises than the market expects are bad news for global equities generally because cash flows from stocks have to be discounted by more, reducing company valuations. Valuations of highly indebted companies that have been bought for yield, such as infrastructure stocks, are vulnerable.
Focus first on quality Australian companies trading below their intrinsic, or fair value. Then look for those that benefit from rising US interest rates and a rising Greenback. Typically, that’s Australian companies with a high proportion of offshore earnings, particularly in the US.
The likes of Brambles (BXB), James Hardie Industries (JHX), Treasury Wine Estates (TWE) and Macquarie Group (MQG) are a good place to start. CSL (CSL), Cochlear (COH), Resmed (RMD) and Ramsay Healthcare (RHC) are other potential beneficiaries.
The small-cap Ardent Leisure Group (AAD), with its US family entertainment business, Main Event, is interesting at current prices. Device maker Sirtex Medical (SRX) is an impressive small-cap with a growing presence in the US.
Another strategy is using an Exchange Traded Fund (ETF) that provides leverage to a lower Australian dollar versus the Greenback, and eliminates company and equity market risk in the investment. The BetaShares US dollar ETF is a contender. If the US dollar goes up 10% against the Australian dollar (our dollar falls), the ETF is designed to go up 10%.
QBE Insurance Group (QBE)
Another approach is focusing on stocks that specifically benefit from higher US interest rates. QBE Insurance is the pick of them at current prices. The Australian insurer derives about a third of its revenue from North America. Generally, higher interest rates are good for QBE because its portfolio is stocked with bonds; higher yields improve its investment returns.
Historically, QBE’s share price has risen during periods of rising US bond yields. It hit a 10-year low in September 2016 after a weaker-than-expected profit result and as the US 10-year Treasury bond fell. QBE has since rallied from $9.25 to $10.22 as expectations of higher US interest rates firm.
QBE looks undervalued. Macquarie Equities Group in late September said QBE traded at a 10% Price Earnings (PE) discount to a weighted group of its peers – a point where the stock has traditionally rebounded from, as was the case this month.
Macquarie has a 12-month share-price target of $10.75 and Morningstar values it at $14.
QBE has plenty of work ahead to restore market confidence, but buying the insurer near a 10-year low as US 10-year bond yields trend higher – in anticipation of higher rates – appeals.
Source: Yahoo!7 Finance
Computershare (CPU)
The share registry and investor-services provider is another potential beneficiary of higher US interest rates. It makes almost half of its revenue in the US and earns higher investment returns on client cash balances (it invests these balances) when rates rises.
Computershare noted in its latest annual report that a rising interest-rate environment should drive improved yields on client balances. Lower yields and the effect on client cash balances, held via Computershare, weighed on its latest earnings result.
An eventual increase in US and United Kingdom interest rates should provide a tailwind to Computershare’s earnings. A pick-up in mergers and acquisitions, underway in Australia, is another growth driver as it leads to more share-register activity (through mail-outs to shareholders etc.).
Computershare has a great business model and offers a “sticky” product as customers tend to stick with the same share registry. However, it has less scope to grow by acquisition and is not the glamour, high-growth stock it once was.
But a forecast PE multiple of 14.6 times FY17 earnings, based on consensus analyst estimates, is undemanding for a genuinely global company of its quality.
Like QBE, Computershare has much work ahead in challenging market conditions, but the expectation that US interest rates are rising, even if just gradually, strengthens the investment case for Computershare and particularly QBE at current prices.
Both stocks suit long-term portfolio investors seeking a mix of capital growth and yield.
Source: Yahoo!7 Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at Oct 12 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
