Favourable conditions have a way of making investors overconfident, like jogging with a tailwind, it can make you feel more capable than you are. Overconfidence can see a runner take on more than they can handle and before they know it, they’re looking for an Uber to get home. Similarly with investing, overconfident investors can take on bigger and more concentrated positions which can see them left stranded as their investment fitness is challenged when tailwinds turn into a headwind.
Until relatively recently, the investor tailwind has been a multi-decade trend of falling interest rates. However, the rise of inflation and expectations it could remain stubbornly entrenched following June’s CPI shocker and July’s only modest easing has all but killed hopes of a breeze returning to investors backs in the near term, with expectations for interest rate cuts unlikely before 2025.
This means gains for asset price will need to increasingly rely on their capability for earnings growth rather than the being pushed along by interest rate cuts.
Why do higher rates impede expected returns?
There are several reasons interest rates impact returns, one being valuations. Assets are often valued by forecasting future earnings and then discounting (dividing) these by the risk-free interest rate – so as interest rates rise, the value of future cash flows falls, justifying a lower valuation.
Relative returns offer another reason. As interest rates rise, so did the returns on cash and deposits, encouraging yield-hungry investors to hold more cash rather than chasing more risky growth assets. This reduces the flow of cash into the market, reducing demand and price support.
Higher interest rates also reduces the volumes of cheap debt chasing asset values higher something many have witness at frenzied property auctions.
Essentially, stocks, bonds and real estate should eventually trade at lower prices when interest rates are rising all other things being equal.
Navigating the new terrain
In the current climate, it’s good to remember that interest rates are closer to the long-term average now than they have been across the past decade.
Although investors may yet see interest-rate cuts in 2025, these are likely be a short-term normalisation, rather than a multi-decade trend as previously experienced.
So, what should investors be watching for in the coming months to level some of the playing field?
Well, if falling interest rates are the tailwind on a jog, then earning growth assets (for example higher rents or company earnings) represents running downhill. Although higher interest rates impede valuation measures, the growth in asset earnings can offset some or all of the valuation pressure.
The earnings fitness of the Australian share market will come under the spotlight as the main reporting season for the ASX approaches. Australian company earnings earlier this year were largely in line with estimates, but markets were buoyed by the expectations of coming interest rate cuts.
With these appearing off the table anytime soon, market are likely to be far less forgiving this earnings season.
Active vs passive investing
So how can investors manage portfolios to respond to this environment? Is now the time to take a more active or passive stance?
That depends on your long-term goals.
Passive or index funds require fewer resources, making them significantly cheaper than their active peers. And with an emphasis on cost, passive funds have experienced phenomenal growth in funds under management. This growth has also accelerated by the fact that many actively-managed funds have struggled to beat their respective benchmarks in the mutli-decade trend of falling interest rates.
While there is a role for passive investments in a portfolio, the trade-off is often responsiveness and a more selective investment approach which is something that may become more valuable in a lower growth, higher inflation environment.
Accepting reality
While a change of strategy may improve investment returns, higher interest rates are likely to hold back returns when compared to history.
Simply wishing and waiting for the re-emergence of a long-term interest rate tailwind won’t deliver results. Picking a path to limit the headwinds will be crucial to navigating this challenging investment landscape.
