Three ways rising rates reach the share market

When interest rates climb, the market’s instinct is to treat every economically sensitive stock with the same caution.

Jack Briggs, portfolio manager of the Ellerston Australian Emerging Leaders Strategy, believes that broad brush can hide some of the more interesting opportunities for advisers building small cap exposure at the smaller end of the ASX.

He starts with a simple map of how higher rates do their work. “Rate rises have three main vectors of impact for stocks we look at,” he explains.

Three channels

According to Briggs, the most visible effect of higher rates shows up in the real economy, where they dampen spending and activity. He points to construction and discretionary sectors such as retail as the areas that tend to feel it first. Households facing larger mortgage repayments often put off renovations and big purchases, and builders and retailers soon see the effect in their order books.

Higher rates also raise the cost of money for companies themselves. Businesses carrying debt face larger interest bills as their loans reprice. That leaves less profit for shareholders and less capital to reinvest in the business.

The third effect works on valuations rather than earnings, because rising rates lift the discount rate investors apply to future cash flows. Briggs notes this weighs most heavily on long duration growth assets such as technology, and on bond proxies such as REITs and utilities.

A technology company whose profits lie many years ahead loses more present value when the discount rate rises than a business already generating steady cash.

Bond proxies come under pressure for a different reason, since their appeal rests on reliable income. That income looks less compelling once government bonds and term deposits start paying more.

Separating the three channels helps explain why two companies in the same sector can respond very differently to the same rate move. A business with little debt and a healthy order pipeline may feel only mild pressure from the first two, even if the market prices it alongside more exposed peers.

Looking past the label

Briggs targets this territory, searching for companies the market may have grouped too broadly. “We are looking for opportunities in businesses the market perceives to be exposed to broader economic activity and which in our view can outperform,” he says.

The word perceives carries much of the weight in that sentence. Markets often sell down whole sectors when rates rise, grouping companies by industry label rather than by the specific drivers of their earnings.

Where a company’s revenue depends on spending that higher rates are unlikely to slow, that grouping can leave its share price out of step with its prospects.

A Queensland example

Briggs points to building materials group Wagners as one illustration. He argues that strong infrastructure spending in Queensland is underpinning volume growth in the company’s local building materials division.

Public infrastructure investment tends to follow government budgets and long-term project pipelines rather than household sentiment. That gives it some insulation from the spending slowdown that usually hits construction first.

Briggs also sees a second growth engine in the company’s expanding capacity in composite fibre electrical distribution poles, which he believes “should drive strong earnings growth”.

Composite poles offer electricity networks an alternative to traditional timber and concrete, and demand for them tends to follow the steady work of maintaining and upgrading those networks.

The emerging companies universe

The Ellerston Australian Emerging Leaders Strategy invests in Australia’s emerging companies, one of the more direct routes to small cap exposure on the ASX. That universe spans about 757 listed businesses with market capitalisations between $50 million and $2.5 billion.

“This segment is both the broadest and least researched part of the ASX, with many companies carrying little or no broker coverage.”

Thin research coverage can work in both directions for investors. With fewer analysts watching, mispricing can persist for longer, which creates room for managers willing to do their own groundwork. It also means investors have less independent information available when they want to test a company’s story for themselves.

Testing the thesis

There is of course a counter argument to that logic. Infrastructure spending responds less to rate moves than household spending does, though it still responds.

Governments facing higher borrowing costs and rising construction prices have at times deferred, rescoped or re-sequenced major projects. A delay in a state pipeline can flow quickly through to a regional supplier’s volumes, so the timing of public works deserves as much attention as their size.

For advisers building small cap exposure for clients, the rate cycle invites a closer look at what drives each company’s earnings. The businesses that hold up best as rates rise may well be the ones the market was too quick to label.