Low interest rates have been a stock market support factor, but now they are rising sharply as central banks try to catch up with inflation that has resulted from record levels of pandemic stimulus and the war in Ukraine.
So how is the Australian stock market prepared for what’s to come? Given that the index is dominated by commodity producers who traditionally do well in an inflationary environment, this could leave the market well positioned.
The index is also very cyclical, however, and if there is a slowdown in global growth, the Australian equity market will surely suffer. The fall of the Australian dollar certainly reflects this reality.
Australia is often described as a hole-and-house economy.
So what about houses? Governor Lowe was asked about the impact of rising rates on the housing market, and he again reiterated his view on the relative strength of households and the banks that lend to them.
This seems to suggest that the economy may face an inevitably weaker housing market that will result from the rate hikes needed to bring inflation under control.
So while asset prices could be ultra-sensitive to higher interest rates, we may be underestimating the sustainability of the economy as a whole. MST Marquee market strategist Hasan Tevfik certainly embraced this view.
He says corporate and household balance sheets in the United States and Australia are in good shape. He thinks non-housing consumption could hold up better than expected as rates rise, cushioning the effects of a global recession.
Based on this position of relative strength, he says the inflation-adjusted US 10-year bond rate may rise to 1% before the drag on growth worsens. This implies a nominal 10-year bond rate of 3.5%, which almost happened.
A few years ago Tevfik coined the term “bondcano” to describe the pervasive strength of long-term bond rates in the equity market.
Now that force is surging through the market and will not slow until inflation moderates or central banks calm the pace of tightening. We’re not there yet, but as dramatic as they are, double or triple barrel rate hikes could get us there sooner.
Until then, investors should exercise caution. Tevfik remains gloomy on banks as he believes the property market will weaken. But the problem won’t necessarily be a surge in non-performing loans that compress margins.
Rather, he believes it will result in slower lending volumes, which in turn will weaken earnings.
Tevfik is also cautious on high-growth stocks which he believes simply haven’t been downgraded enough to provide a level of comfort. The top quintile of stocks, as measured by price-earnings ratios, is at 27.5 times, or 30% above the average. History, he says, suggests that growth stocks will underperform until there is a spike in bond yields.
Also, watch out for bargain hunting. Former market darlings like Xero and REA Group may have strong balance sheets but, he says, they still look expensive. Other discontinued favorites, including Magellan, Domino’s and Sonic, are expensive or show weak profit momentum.
So, where to seek solace from the bondcano? Tevfik says some out-of-favour Materials, Energy and Industrials companies are trading on attractive double-digit free cash yields, which should make them relatively immune to further interest rate hikes. .
Among them are miners and energy companies such as BHP, Santos, Ampol and Viva.
These seemingly attractive free cash flow yields are either a sign of stocks that have been overlooked or oversold, or the market is anticipating a drop in free cash flow as the global economy slows.
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