Should you adjust your asset allocation for higher rates?

“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man,” – Ronald Regan.

With that scary warning from the former US president ringing in investors’ ears, should asset allocation be adjusted to handle a world of higher inflation and interest rates?

Rising food, electricity and housing costs have pushed US inflation to 40-year highs, peaking at 7.9% in February 2022. Since then, Russia's invasion of Ukraine has seen average gas prices surge 22% to record highs of US$4.43 a gallon, putting upward pressure on inflation. 

Analysts are now pointing to as many as seven or eight rate hikes by the US Federal Reserve in 2022, raising the official rate from 0.25% today to 2%. The first hike could come as early as the Fed’s March 16 policy meeting.

In Australia, a “shock” inflation spike saw headline inflation reach 3.5% by the end of 2021, with “underlying” inflation at 2.6%.

Retiree budgets have been hit hard. The Association of Superannuation Funds of Australia (ASFA) says that higher fuel and healthcare costs have driven “the largest annual rises in retiree budgets since 2010”.

Accelerating inflation and declining economic growth have even raised the prospect of “stagflation”, an economy that experiences a simultaneous increase in inflation and stagnation of economic output, last seen following the 1970’s oil price shocks.

In this environment, output falters but prices remain elevated – “the worst of both worlds,” says Morningstar’s head of equities research, Peter Warnes.

From previously signalling no change in policy until 2024, the Reserve Bank of Australia (RBA) faces increasing pressure to tighten policy. The market now expects rate hikes to begin in the second half of 2022.

“The RBA cannot afford to keep kicking the rate-rise can down the road,” Warnes says.

“I expect there to be at least two rate hikes to a total of 50 basis points [0.5%] this year. The RBA could go very quickly after the federal election, say in June.”

Portfolio impacts

Rising inflation reduces real (post-inflation) returns and the value of savings, while increasing the value of real assets such as real estate and infrastructure. With central banks around the world hiking interest rates to combat inflation, consumer spending is expected to contract, weighing on corporate earnings and stock prices.

Defensive portfolios with a larger weighting towards cash, term deposits and bonds are more exposed to inflation compared to those holding growth assets such as stocks and property.

In fixed income, inflation-linked and floating-rate bonds offer more protection, together with real estate investment trusts (REITs) whose rents are linked to inflation.

Gold and other commodities are often considered a hedge against inflation, with the precious metal also a “safe haven” investment. Gold prices hit a 13-month high of US$1,976 on February 24 amid Russia’s invasion of Ukraine as investors sought protection against market volatility.

While cryptocurrencies have been promoted as a potential inflation hedge, recent evidence shows a similar correlation to equities, as noted by the International Monetary Fund.

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“We are anticipating an era of higher inflation that only seasoned investors may be familiar with,” says Morgan Johnson, senior financial planner at Solomons Wealth Management.

“As such, we’ve had to become more resourceful with our portfolio construction and look beyond the traditional asset classes of equities, property trusts and long term bonds. 

“We are implementing thematics focussing on tech and rare metals, for example, into growth portfolios and seeking out exposures to shorter dated bond and income focused property and securities to provide downside protection for our defensive clients.”

Winners and losers

Higher interest rates are traditionally “bad news for highly indebted sectors, including REITs, utilities and infrastructure,” Warnes says.

“Growth stocks with no earnings will get belted – the valuations and discount rates for these companies will come under pressure, and rightly so,” he adds.

Already, the technology-heavy US Nasdaq index has officially entered “correction” territory in 2022 – having fallen more than 10 per cent from its most recent peak – as investors downgrade valuations.

“Historically, value companies have outperformed when inflation and interest rates increase as they are less sensitive to changes in macroeconomic conditions,” VanEck’s Russel Chesler told the Australian Financial Review.

“This [current] environment is supportive of value companies, and we expect cyclicals to do well in this market.”

Energy, materials and “post-Covid” beneficiaries such as airlines and travel companies are seen by fund manager Ausbil as the cyclical winners, together with companies that can pass on the impact of higher inflation, such as healthcare businesses.

Time to act?

Amid rising inflation and interest rates and geopolitical tensions, is it time for investors to adjust asset allocation?

Morningstar’s Warnes says younger investors with time on their side have less to fear than older investors who need sustainable and regular income.

“Retirees need to understand that life expectancy is rising – they need to plan to live to around 85, so you need at least 20 years of sustainable, regular income,” he says.

“A lot of your funds have to be skewed towards high quality, income producing stocks. In an inflationary environment the companies with pricing power offer a degree of protection, including those providing necessities such as supermarkets.”

Warnes nominates infrastructure stocks APA Group [ASX:APA] and Qube Holdings [ASX:QUB] as two companies offering the potential benefit of income plus potential takeover premiums, as seen with Sydney Airport.

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He also suggests investors build higher cash levels than usual.

“I would use recent dividend payouts to build some cash, as well as pulling out of DRPs [dividend reinvestment plans] where it suits. You should have a reasonable allocation to cash as it increases options in the event of a market downturn,” he says.

Warnes is also cautious about investing in government bonds, given the prospect of rising rates causing capital losses.

After the super-sized gains of 2021, Warnes says investors should expect lower returns in 2022.

“The last 18 months has seen all the gains from capital growth and not much income. This is going to switch – you’re going to get single digit gains and it will be from income, not capital,” he says.

“If you get 6% to 7% you would be happy – and that’s despite higher inflation.

“However, stick to your plan – in the long term equity markets go up.”

Charts provided by Lauren Solberg, data journalist at Morningstar, and Preston Caldwel, equity analyst for Morningstar.