Keep an eye on real interest rates in portfolio construction
The potential for central banks to cease raising interest rates is likely a cause for celebration in some quarters. But the likely timing of future rate cuts has perhaps a bigger impact on portfolio construction than many people realise.
One of the emerging risks for investors is that rate decreases could be delayed from the early part of 2024 until later in the year. Such a delay could trigger a period of positive real interest rates which would, in turn, influence stock selection.
“We’re effectively done with interest rate hikes from here – both locally and in the United States. We’re getting very close in Europe too,” says John Lockton, Head of Investment Strategy at Sandstone Insights.
The story is going to change from “how many rate rises” to “how long do high rates stay where they are,” Lockton says.
Real interest rates – or headline inflation less core inflation – are a proxy for the real cost of capital. Companies with high leverage, for example, typically don't do as well in an environment of positive real rates, as they do in a period of negative real rates.
Likewise, positive real rates can be a handbrake to the multiples applied to very high growth stocks. Companies with no revenue can also find it difficult to raise money.
Lockton explains that over the past 60-70 years it was not unusual to experience a decade in which real interest rates were positive at 2-2.5%, even if more recently negative real rates appeared to be the norm.
“Where real rates go will be an increasing focus of the markets in the remaining months of this year but, more importantly as we go through 2024,” he says.
“Part of the reason we predict a period of positive real rates is the trajectory of US forward earnings. They peaked about 12 months ago before ebbing – but have accelerated again over the last three-to-four months.
“This persistence of recent high level of earnings and a positive earning trajectory is one of the reasons the US equity market is outperforming other major regional markets at the moment.”
Australia could ultimately experience positive real rates too, simply if inflation falls and official interest rates remain stable at current levels.
The local market has experienced earnings downgrades for most of the calendar year but that dynamic has the potential to reverse over the next 12 months.
“At the moment, we’re seeing downgrades for the aggregate level of earnings for the index at least in the short term, predominantly led by resources. But we’re also seeing compression in bank earnings and in some industrials as well,” Lockton says.
“There is potential for earnings to start to begin to improve as we go through the remaining months of this year and into 2024.”
The upshot is that earnings resilience is going to be a key focus of the markets over the next six to 12 months – and that advisers need to watch more than headline interest rates when constructing portfolios.