Since the US election, the ASX has rallied +4%, but strong gains in financials, energy and materials have been offset by losses in the “bond proxy” sectors of listed property, utilities and telecoms. The biggest question facing equity investors now isn’t so much rising bond yields, but rather the trajectory of this rise. We do not see a 1994-style bond yield spike, such as what occurred after the US Federal Reserve raised rates from 3% to 6% in a 12-month period starting February 1994. That move saw Australian 10-year bond yields rise from 6.4% to 10.7%, and the ASX falling -8%. Rather we see Australian equities avoiding significant falls and weathering a slow grind up in bond yields, as corporate earnings improve through 2017. In this wire we look at three types of companies that should perform in this scenario, and provide an overview of one company that we think will be the biggest beneficiary from rising bond yields on the ASX.
The companies that will perform well in a rising interest rate environment fall into the following categories:
1) Companies that hold significant cash balances due to the nature of their business such as insurers QBE and cash handlers like Computershare and Flight Centre. Computershare on average holds US$15 billion in client balances generally from dividends yet to be paid to investors, but on average since 2011 has only earned 1.5% per annum on this amount.
2) Major trading banks should see a benefit from rising rates due to a fast-growing spread between the short-term interest rates that they pay depositors and the rates at which they can lend money.
3) Fund managers such as BT could see increasing inflows into higher margin equity funds, as investors aggressively sell out of bond funds as their unit prices fall in response to rising yields.
QBE Insurance will be one of the biggest beneficiaries on the ASX from rising bond yields. As an insurer, the company holds US$23 billion in cash and short dated debt as a “ float” (this occurs as premiums collected before claims are paid out). Whilst QBE has managed this float well, it has nevertheless generated meagre returns in this period of low rates. A mere 0.5% increase in interest rates will add over US$100 million to 2017 net profits or boost reported profits by 11%. Additionally Australian investors will see a translation benefit from the company’s USD-denominated earnings if rising bond yields continue to weaken the AUD.