CIARAN RYAN: The impact of inflation and rising interest rates on equity portfolios has been the subject of considerable debate lately. Investors rightly fear that rising inflation will affect not only their monthly expenses, but also their portfolios.
Wendy Myers, head of securities at PSG Wealth, joins us to explore this. Hi Wendy, nice to see you again. What should investors be aware of when looking at these factors in the context of stock market returns? Of course, I’m talking about inflation and interest rates.
WENDY MYERS: Yes. Thank you, Ciaran, for having me back on the show today.
I think in theory stocks provide a buffer against inflation. Obviously, we know that a rise in prices must correspond to an increase in income, which naturally supports the price of shares. This could, however, be offset by shrinking profit margins as, of course, business input costs will also rise, driven by inflation.
But in practice, we find that the impact on incomes is varied, depending on the different economic sectors. It is the ability of these sectors to pass on rising input costs to consumers [that] really puts these sectors on the path to success, being able to cushion inflationary impacts. So really what we find, in summary, if we look at theory and practice, as long as revenues grow faster than input costs, profit margins will naturally increase and translate into higher nominal revenues.
But it is important to note that consumers will be under pressure in the event of price inflation and [that] could lead consumers to buy fewer products or, at the very least, to reduce some of their expenses. This would obviously lead to lower profits for these companies.
CIARAN RYAN: I think people would be very keen to hear if there are certain sectors that are more resilient in times like this [and] are an inflation hedge? What sectors should we look at, or asset classes?
WENDY MYERS: The [are] a few sectors that we have seen, certainly in the past, that have performed well in the inflationary environment. The energy sector is an example; remember that the energy sectors comprised of oil and oil companies have typically beaten inflation 71% of the time – which is quite an impressive statistic – and delivered real annual returns. Thus, after taking into account an inflation of 9% per year on average, the revenues of these types of companies are generally linked to energy prices, which is a key factor in inflationary indices. That’s why this sector in particular is doing well.
I also think another area to consider is Real Estate Investment Trusts, or “Reits”. Thus, they have generally outperformed inflation 67% of the time. They posted an average real return of, okay, only 4.7%, but that’s at least a positive real return. To explain what a REIT is, we all know it is real estate. It provides a partial hedge against inflation; it acts as a pass-through of price increases, as these price increases in leases and properties are passed on to the tenant, and this is how this sector is able to account for these increases.
Another sector to consider is information technology. [IT] side. These stocks are likely to suffer even more, as their promised future earnings growth is likely to be far less valuable in today’s monetary terms. The bulk of their cash flow is expected to arrive in the distant future, and inflation is clearly corroding those returns.
[As for] financials, I think banks, on the other hand, have performed better than the IT sector, as their cash flows tend to be more concentrated in the short term.
So I think if we sum up the different sectors, where there are inflationary pressures – and we’re starting to see that the inflationary rise continues – stock prices will remain fundamentally volatile. But some sectors will be able to absorb the impact much better than others, so I think it’s extremely important to be very careful and deliberate about where you put your money in this environment.
CIARAN RYAN: OK. Thus, the energy sector, [and you] certainly want to consider real estate investment trusts, another. Information Technology – not so good of an inflation hedge, apparently.
Is that a good enough summary of the sectors – the good ones and the bad ones?
WENDY MYERS: Yes, I think that’s a perfect summary, Ciaran. Thank you.
CIARAN RYAN: OK. So we talked about inflation. Let’s talk about interest rates and how that’s going to impact equity portfolios, because globally we’re really at the beginning of an interest rate…
WENDY MYERS: … ascending cycle.
CIARAN RYAN: Yes, the ascending cycle. What impact will this have on portfolios?
WENDY MYERS: I think we all know that a rise in interest rates has a negative impact on stock prices as businesses and consumers reduce spending. This causes earnings to fall and, naturally, stock prices to fall.
So when we consider both inflation and interest and their impact on equity returns in 2022, you can see why portfolios are going to be extremely volatile.
I think it’s important to note that the 2021 investment debate was all about inflation; what we’re seeing now is that interest rates are definitely the topic of conversation, more so in global markets, where inflation has been benign for some time. As a result, stock prices ahead of 2022 have been extremely robust and investors have enjoyed strong returns in this market.
Now, with rising interest rates, we expect these equity returns to contract and thus volatility to rise, so investors should be extremely careful when deciding where to put their money.
But in summary, it’s important to discuss your portfolio construction, as we’ve discovered the different sectors that can be positive from an investment perspective in an inflationary economy, and those where your returns could be at risk. It’s important to discuss portfolio construction with your financial advisor, who is in the best position to help you truly build a diversified portfolio that accounts for volatility and better prepares you for success in the future.
And then I think in closing, Ciaran, it’s important to have a long-term view when investing. This is certainly how we perceive the investment landscape at PSG.
CIARAN RYAN: Exactly. We are inundated with stories of people in the Covid crash of March 2020 selling their wallets, which of course rebounded in two weeks. It simply shows you the mistakes that can be made by cutting and modifying your portfolio due to events that seem dramatic at the time, but in retrospect are not. Is it correct?
WENDY MYERS: Yes. In fact, we often say that investors should be careful when trying to chase performance. I certainly think as much as they panic on the low, [they] then fight over when to enter and they believe that a stock’s past performance reflects where it will be in the future – which is not necessarily the case.
CIARAN RYAN: OK. Wendy Myers is Head of Securities at PSG Wealth. We will leave it there. Thank you very much, Wendy, for coming.
WENDY MYERS: Thank you so much for having me on your show today, Ciaran.
Presented by PSG Wealth.
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