Rates may be on pause but higher ‘neutral rate’ could impact SMSFs
SMSF investors should be mindful of rising neutral rates of interest and how they may impact their share portfolio, said an investment specialist.
Tim Richardson, investment specialist at Pengana Capital Group, told SMSF Adviser a higher neutral rate implies that longer-term bond yields and financing costs to businesses will be higher over the course of the economic cycle.
“This will impact corporate earnings and market valuation levels,” he said.
“Such an environment may favour companies that demonstrate strong balance sheets with limited borrowings, positive cash flows, which can support new investment opportunities, and sustainable earnings which can grow at higher rates over the long term.”
Mr Richardson explained that a neutral rate is the rate of interest on which the supply of savings and investment is on balance.
“It means that economic growth is reasonably consistent,” he said.
“It is something that cannot be observed and pointed to directly like inflation and is inferred from a range of data.
“The neutral rate of interest appears to be rising as households spend more and save less, while business investment levels rise. This will impact borrowing costs, affecting industries and companies in different ways.”
Mr Richardson said that if inflation is rising and unemployment is falling, then chances are the prevailing interest rate may well be below the neutral rate – and vice versa.
“Interest rates were lowered to levels well below neutral across developed markets when economic activity slowed at the start of the COVID-19 pandemic,” he said.
“This had the desired effect of encouraging households to maintain spending. When this began to push inflation higher in late 2021, major central banks (eventually) increased rates to levels back above the neutral level as spending proved more resilient than had been expected.
“This has now slowed economic activity as households cut back on discretionary spending and businesses delay their investment plans.”
He said a lot of economists are now stating that the neutral rate of interest is not static and that it varies over the long term.
Mr Richardson said the implications are that if there is a high demand for investment, it will drive neutral rates.
“This means a few things for equity investors. The longer-term bond yield is going to be high and have an effect on corporate earnings and market value of stocks,” he said.
“It will have some effect on all equity classes, but all are not treated equally. In an environment with a high neutral rate of interest, those companies that have strong balance sheets and limited levels of borrowings so they can refinance their debt on favourable terms will be more attractive.
“For SMSF investors, they should be looking for companies with positive cash flows, not just those that deliver paper profits but those with positive cash flows.
“They should also be looking for companies with a path of sustainable earnings growth not just over the next few quarters but over the long term.
“Look for those companies that are in the growing areas of the economy, such as innovation and technology, or those exposed to the ageing population and pharmaceuticals.
“They give businesses an opportunity to grow outside of the consumer spending cycle.”
