With the potential of more cuts on RBA’s cash rate, investors are once again forced to ask, what strategies perform best in this strange, and largely unprecedented environment?
To understand this, we must attempt to understand the flow on effect of rate cuts. The most obvious – cash is no longer a viable means to generate income. Nominal rates are poor at 1.75%, but when adjusted for inflation, the real cash rate is close to zero, offering insufficient yield to support investors.
Figure 1. Australian cash rate (nominal versus real)
Sources: ABS, RBA
How about bonds? For fixed interest (debt) securities, falling interest rates creates lower costs of debts and again lower yields. Again, investors must look elsewhere.
This leaves two major asset classes: property and equities (shares).
For property and equities, the incredibly low cost of debt that is crippling bond yields is an incentive for growth. Businesses and households alike can finance investment at lower rates, thereby increasing their future earnings potential. This is meant to stimulate economic growth and is one of the primary reasons for cutting interest rates. It encourages borrowing and most benefits the most highly leveraged investments. This is an important point, which we will come back to later.
A secondary effect of falling rates is the tailwind it provides to asset pricing. When attempting to price or value an investment, there is typically some consideration of a required rate of return (e.g. weighted costs of capital [WACC]) by which to discount future values in order to present them in terms of today’s value. In most cases, this includes a risk free rate, the proxy for which is typically based on government bond yields. Therefore, when central banks reduce rates, they are in effect, increasing asset values. This is why stock markets often rally following a rate cut.
What this all means, in theory, is that investors should have access to more capital and be willing to pay higher prices for the same assets. This should translate to capital inflows into the stock market resulting in widespread price rises. However, anyone invested in the Aussie market can tell you returns over the last 12 months have been anything but spectacular. This is because the capital that is being injected into the equities market is concentrated around those stocks that most similarly embody the risk/return profile of fixed income and cash securities. At the same time, investors are pulling money out of distressed cyclical sectors such as mining and agriculture. These two opposing effects have contributed to the short-term volatility in the market, and may be one of the reasons the market is at the same level as it was 3 years ago.
Positioning your portfolio to take advantage of interest rate cuts has a lot to do with understanding the psychology of investors who need to allocate more capital into equities. These investors are looking to replicate the characteristics of fixed income.
To do so, they target ‘defensive’ stocks with high yields. The sectors most commonly characterised as defensive are property, infrastructure, healthcare, containers/packaging, and consumer staples. These sectors are typically characterised by large, entrenched companies with earnings that are less or unaffected by changes in economic conditions. They typically offer lower but more predictable growth, and have higher payout ratios and dividend yields. In some cases, such as with infrastructure, earnings have a regulated component which offers further transparency and stability.
With the exception of consumer staples, which have been hampered by the poor performance of Woolworths, defensives have outperformed the market by a wide margin. One very important point to emphasise at this juncture is that not all blue chips are defensive stocks. The banks are the most glaring example given their high leverage to economic cycles and credit conditions.
Figure 2. Total return of selected indices, versus RBA cash rate
Sources: Thomson Reuters Datastream, RBA
Two points stand out in this chart. Firstly, in the years following the GFC, as interest rates declined, defensive stocks outperformed the broader index. When rates declined again in 2015, defensives once again outperformed. Secondly, there is an observable negative relationship between interest rate movements and all of the above index returns. This would seem to suggest that cutting interest rates does indeed herd more capital into the market, and particularly into defensive sectors.
This is an important principal of portfolio positioning under falling interest rates. Investors forced out of less risky asset classes into equities tend to favour sectors with more defensive properties.
Another principal is that companies with higher levels of debt (gearing) are more sensitive to changes in interest rates. Interest rates directly influence the cost of debt in the market as discussed previously, so it is simple maths that the most geared companies stand to gain the most from falling rates. Take two examples from the infrastructure sector, Sydney Airport (SYD.AX) and Transurban (TCL.AX). Both are high quality defensives that have had high but serviceable levels of debt throughout their listed lives. Through recurring refinancing, over the last five years SYD’s cost of debt has fallen from to 5.5% while TCL’s cost of debt has fallen to <3%. This has greatly reduced repayment costs, not only freeing cash to increase the dividend but increasing balance sheet capacity for new debt to fund new projects, expansions and acquisitions. Of course, interest rate risk works both ways. If rates were to rebound, the cost of debt would follow, raising repayment costs and hence reducing available capital for distributions and reinvestment.
The pursuit of yield
As previously mentioned, the yields being generated from bonds and cash have been so meagre that many investors are being herded into riskier assets. They are not necessarily seeking any significant capital return but seeking strong yield. The appetite for yield in the market has been so voracious that it has been a dominating investment theme since the GFC. In an environment when yield benchmarks in debt and cash are lower, it would seem logical that investors would be willing to take lower yields from equities by paying higher prices. However, this has not been the case. In fact, since 2010, the average yield in the market has actually increased from around 4% to nearly 5%. The reason is that many listed firms have responded to the demand for yield by raising their payout ratios. In fact, the market average payout ratio has increased from around 63% to 75% over the same five-year period.
Figure 3. ASX 200 weighted average dividend yield, payout ratio
Source: Thomson Reuters Datastream
With borrowing costs so low, firms can pay out more of their profits to investors, with any ensuing reinvestment capital shortfall being covered by debt. Alternatively, as is the case in the U.S., companies can debt fund share buybacks in lieu of dividends, consequently enabling them to retain high levels of cash and artificially inflate earnings per share. Investors want yield, and companies are finding creative ways to leverage low debt costs to accelerate yield growth. High yielding defensives have been noticeably rewarded over the last five years, and among such stocks, there is an observable positive relationship between expected yield and valuation multiples. In other words, investors forced into defensive equities tend to pay more for those with higher yields.
Figure 4. Forecast dividend yield versus forward EV/EBITDA
Sources: Clime estimates, Thomson Reuters Datastream
Building your portfolio
The preceding observations and lessons paint a picture of the companies that stand to benefit the most from further declines in interest rates.
Large, liquid, high yielding defensive stocks with high levels of debt are most likely to benefit from interest rate declines. You may think this description is obvious or at least intuitive and perhaps it is. But how many portfolios are still dominated by blue chip cyclicals like the big four banks, BHP and Rio, or any number of stocks mistakenly identified as defensive? Such stocks may be high quality and even have some defensive characteristics, but ultimately, earnings (and hence yields) are leveraged to the performance of the economy. As a result, they are not the closest substitute for fixed income or cash in the equities market. That honour belongs to the true defensives in property, healthcare, infrastructure, consumer staples and packaging, as well as a host of individual standouts across many major sectors. Of course, it is impossible to say whether these stocks will continue to outperform the broader market, but there is ample evidence thus far to suggest that they are among the greatest beneficiaries of falling interest rates.
With that in mind, below are ten stocks which fit the bill and are trading below or near value. Their sensitivity to market movements (volatility) is measured by average beta, with 1 being equal to market. Gearing is measured by net debt to equity and offers a proxy for interest rate sensitivity. Value is measured by 12-month forward value which is more heavily skewed to the FY17 value at this point in the year. This is by no means an exhaustive list but should provide a good starting point for investors looking to reposition their portfolios to take advantage of any further interest rate cuts.
But one final caveat, naturally the same stocks that stand to benefit most from falling interest rates are among those which stand to lose the most should interest rates begin rising.
|Company||Sector||Market cap||ND/Equity||Fwd. yield||Avg. Beta||Fwd. Value|
|Sydney Airport (SYD.AX)||Infrastructure||$16.0bn||592%||4.2%||0.60||$6.55|
|APA Group (APA.AX)||Infrastructure||$9.6bn||229%||4.7%||0.58||$7.42|
|Scentre Group (SCG.AX)||Property||$24.7bn||67%||4.6%||0.67||$3.83|
|Ramsay Healthcare (RHC.AX)||Healthcare||$14.4bn||190%||1.7%||0.76||$68.13|
|Pact Group (PGH.AX)||Packaging||$1.6bn||165%||3.8%||0.67||$5.84|
Figure 5. Ten stocks which stand to benefit from interest rate cuts
Source: Clime estimates
Written by Associate Analyst, Damen Kloeckner.
Disclosure: Clime Asset Management owns shares in several of the stocks mentioned in this article.