Which asset class is best for higher interest rates?
The Reserve Bank of Australia’s decision to increase the cash rate by 25 basis points in early May and a further 50 basis points at its June meeting has prompted many economists and financial market analysts to pencil in several official interest rate rises between now and the end of the year.
Both moves came in well above market expectations and signalled the RBA was serious about trying to bring burgeoning inflation under control.
Inflation has surged in the past year, with the latest Consumer Price Index (CPI) standing at 5.1% annually and 2.1% for the first quarter of 2022, according to the Australian Bureau of Statistics.
Many newer investors have never experienced an era of rising interest rates, and it has become unfamiliar territory for even the most seasoned of market players, so it is prudent to explore how various asset classes are affected in this environment.
Interest rate rises are designed to slow the flow of cash in the economy and for financial markets, this is often a time when investors will sell off stocks and book profits.
This can drive share prices down, however, rate rises do not tend to affect all market sectors equally.
Financial stocks will usually benefit because higher interest rates mean greater margins on the money that is being borrowed. By contrast, technology shares and stocks in sectors where start-ups are common, usually suffer as investors seek out more stable companies.
Investors holding global shares can experience a deterioration in their returns, because of the appreciating Australian dollar (AUD). During periods of higher interest rates, the Australian dollar generally strengthens against other currencies because overseas investors are attracted to a higher yield, driving up demand for AUD.
Historically, stocks have generally managed positive returns during tightening cycles, however, these returns were much more modest than those in the periods preceding the cycle.
One of the most obvious beneficiaries of higher interest rates is cash, with deposits attracting stronger returns.
However, while a rate rise matching or even exceeding the Reserve Bank’s official movement is all but guaranteed for customers with bank loans, financial institutions will not always apply that same principle to deposit accounts. It can therefore be a slow process to accumulate noteworthy returns on savings.
This tightening cycle also comes at a time when interest rates have languished at historically low levels for a prolonged period. Cash savings have been rewarded with anaemic interest for much of the past decade and even a relatively aggressive tightening cycle means those conditions will not be rectified quickly.
Investors seeking simplicity and security may start casting around for competitive term deposit rates, however, it is likely to be a long while before higher interest rates have any meaningful impact on savings.
Interest rate fluctuations impact bonds more than any other factor.
When interest rates rise, more valuable bonds will likely be issued and investors may seek those higher yield products.
For example, an existing ten-year $1,000 bond which pays a 3% coupon will still pay 3%, even if market interest rates rise to 4% in one year. However, for an investor holding this bond, they may wish to sell to fund the purchase of a more attractive 4% bond. The 3% bond’s price, however, may drop to $925, because new bonds issued with a 4% coupon make the original 3% bond less attractive, unless it can be bought at a discount.
This is an example of interest rate risk, whereby interest rates rising result in an investor holding a bond yielding below market rates. The longer the time to maturity, the greater the interest rate risk an investor takes on, as it is harder to predict market fluctuations over a longer timeframe.
Residential Real Estate
Although demand for housing can initially decline as mortgage interest rates rise and debt becomes more expensive, this asset class has proven to withstand the impact of tightening cycles in the long term.
Generally, when inflationary pressures start to mount, property prices appreciate, keeping pace with the overall rate of inflation. At the same time, rising labour, building materials and equipment costs can lead to a slowdown in property development, putting a strain on the supply pipeline and further stimulating existing property values. Globally, the construction industry is already dealing with higher prices because of COVID-19-related supply chain disruptions, and there are daily headlines about projects in peril and developers on the verge of collapse.
Rental prices are usually one of the first of many living costs to go up during periods of growing inflation. A lack of housing supply can create fierce competition among tenants, driving up rental prices and generating higher revenues for landlords. The Australian Bureau of Statistics’ Consumer Price Index for the March quarter of this year revealed strong rises across all capital cities (apart from Sydney and Melbourne, which also recorded growth, albeit slower than elsewhere), reflecting historically low vacancy rates in most major metropolitan centres.
Commercial real estate
Interest rate rises have varying implications across commercial real estate sectors.
Demand for quality office stock has increased, as employees return to offices in droves from home-based work, post-pandemic. The strain on construction of new stock is driving a boom in the redevelopment or retrofitting of existing properties. Employers know they need to create a desirable, welcoming space for their teams and are investing in value-add strategies.
A further boon for commercial property investment is the fact that leases in this sector can include fixed annual rental increases. This effectively boosts investors’ income and offsets the impact of higher inflation, and interest rates. These annual rent increases are often set above the long-term inflationary outlook, or even sometimes specifically tied to increases in inflation.
Right now, heightened demand and a lack of stock coming to market means that commercial property landlords are in a strong position to command higher rent for buildings in sought after areas.
Overall, incremental rate rises are not expected to significantly dampen heightened investor interest in commercial property, and any moderation in growth would be coming off strong levels of demand.
One property sector where rising interest rates usually present a challenge is retail, which is currently still recovering from the fallout from the pandemic lockdowns and supply chain issues. Higher interest rates also generally weigh on discretionary spending, which can further hinder demand for retail space.
However, the hangover in this sector from the pandemic means retail asset pricing is currently competitive, particularly in regional areas.
Furthermore, Colliers reported 2021 as a record year for national retail investment activity, with a total of $12.7 billion transacted, suggesting fundamental resilience in this sector1.
It is also the case that pent-up demand has been outstripping supply in certain retail sectors, especially clothing and hospitality. That is leading to higher prices for goods and more robust balance sheets, meaning occupiers are well-placed to manage more expensive mortgages and rents.
Traditionally, industrial real estate can come under similar pressure to retail properties when rates rise, as companies run down inventories and vacate warehouse space.
In the current environment, the industrial property market is booming thanks to widespread ‘Just In Case’ inventory strategies.
Many companies were caught off guard by the resurgent consumer demand and supply chain disruptions that dominated over the past year. Businesses are wary of falling short or selling out of goods, so large stockpiles are being maintained to satisfy demand.
As investor competition for logistics and industrial assets has intensified in Australia, prices have risen significantly across the eastern states. And the shortage of industrial properties in the market could see prices continue to rise, with landlords potentially seeing increases to rental income2.
However, an increasing demand for warehouse automation puts older-style buildings at risk, causing some uncertainty in the sector3.
Historically, rising interest rates have driven a flight from liquidity among investors, with sectors like commercial real estate performing well, because it comprises real assets. In the current environment, this area is a beacon for sustained growth.
Stocks tend to tread water, often stabilising after initial selloffs, while bonds under-perform. As this tightening cycle begins, there are questions over how quickly and aggressively interest rates will climb in the battle to fight inflation.
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Peta is a Financial Services professional with over 25 years’ experience and a passion for helping Australian consumers make sense of investment markets and opportunities. As a top performing institutional portfolio manager and investment...
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