Reflation and rising rates: adjusting to the new normal
In this video update, Alex Crooke, Head of Global Equity Income at Henderson Global Investors, explains the importance of adjusting to the ‘new normal’ and why dividend-paying equities are likely to perform well in a rising interest rate and reflationary environment.
The theme of our discussion this year is about the new normal. We are hearing a lot about interest rates, particularly about the prospect of US rates rising – the long end of the 10-year yield curve has already gone up to around 2.5% – and there is also talk of rising short-term US interest rates.
How will equity income perform in this environment?
Dividend paying stocks are more linked to inflation trends, and we are generally seeing higher levels of inflation. US wage growth is picking up, as are producer prices. We have got the highest level of consumer prices index (CPI) inflation trends for almost five years. Adding those factors to the stable growth that we are seeing around the world provides a good backdrop for equities.
When looking at the last eight rising interest rate cycles, equities have performed well and actually increased in value over seven out of those eight cycles. Therefore, interest rate rises are not bad news for equities.
Benefits of value investing
I believe it is also good news for a value investment style. Growth as a style of investing has performed very well since the global financial crisis because of the scarcity of growth stocks, which channelled investment into that segment of the market. If we have a more supportive growth environment we should see better trends for value investing. Value investing outperformed in the 1990s and the 2000s in inflationary and rising growth environments.
Key sectors to own
We believe these are going to be slightly different from recent cycles. Financials should perform well because rising interest rates help to generate higher net interest margins and the financials sector is our largest weighting within the Global Equity Income Strategy. The strategy also has a significant weighting to industrials, which should perform well in an environment of rising rates and economic growth.
We are also seeing good value in some defensive sectors, which underperformed last year. Pharmaceuticals, for example, underperformed in 2016 because of the challenges faced during the US Presidential election campaign with prospects of higher drug pricing from the Democrats. Now, a lot of these companies represent very good value and have good long-term growth trends.
The strategy’s sector underweights include bond proxies – the very high yielding sectors – which have historically underperformed in rising rate environments, notably utilities.
Our Global Equity Income Strategy is positioned for gently rising interest rates and for some more inflation. Most importantly, I think 2017 will be a good year for active investing. We are seeing that some Exchange Traded Funds (ETFs) tend to buy stocks just before dividend cuts come through and in our opinion are really not a sensible allocation in this environment. We are also seeing the correlation between sectors and stocks falling, which is good news for active investors because this provides greater potential for outperformance, and we believe that our strategy is well positioned for some cyclical growth while also holding companies in key defensive sectors.
Cyclical stocks – Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.
Defensive companies/sectors – typically less sensitive to changes in economic conditions.
Exchange traded fund (ETF) – A security that tracks an index (such as an index of equities, bonds or commodities). ETFs trade like an equity on a stock exchange and experience price changes as the underlying assets move up and down in price. ETFs typically have higher daily liquidity and lower fees than actively managed funds.
Growth investing – Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Net interest margin – the difference between the interest paid by a financial institution, such as a retail bank, to depositors (savers) compared with the interest rate it receives from those it lends to (borrowers).
Reflation – Government policies intended to stimulate an economy and promote inflation.
Value investing – Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favoured techniques is to buy companies with low price to earnings (P/E) ratios.
Yield curve – A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.