How to think about equities in a ‘higher-for-longer’ world (and two stocks that fit the bill)

High government spending, union-friendly industrial relations laws and rocketing immigration are putting unrelenting pressure on inflation – which means investors must adjust to higher-for-longer interest rates. The economic shift means investors will need to pay close attention to company valuations and avoid business models built on the previous era’s assumption of low interest rates and minimal inflation.

Higher rates will also mean shorter and more volatile market cycles, meaning investors should seek out profitable companies with strong balance sheets and competent management.

In this wire, we'll look at the implications of the new "higher for longer" mantra on investing and provide two stock ideas which fit the bill.

Higher real rates for longer

We’re going to have persistent system inflation for a while and because of that, we’re going to have higher real rates for a lot longer.

If you look at history, we’re equating this to the 70s where there were quite a few similarities – an oil crisis, higher labour rates, and more chances of strikes because of new legislation.

Consider the Labor government’s new industrial relations laws - which in our view, represent a significant threat to investors by reducing the flexibility of the Australian workforce.

Wage levels tend to ratchet higher over time because the rates set in any Enterprise Bargaining Agreement tend to form the base line for future negotiations. Recent changes also mean regulators can set pay rates across an entire industry if just one company comes to an agreement.

This is pretty aggressive given we are in cost-of-living crisis. We’re expecting that wages will grow well more than 3 or 4% – perhaps even 5 to 6% – and that’s material.

The migration factor

At the same time as pressure on wage costs, more than 400,000 people a year are migrating to Australia since the borders opened post-COVID, putting further pressure on inflation as they compete for limited housing stock.

When immigration goes from zero to 400,000 people, and you’ve been under-building to accommodate for that, there’s only one thing that changes – inflation. These problems are here to stay.

What you need is real supply-side reform – that means land release and that’s getting into a sticky situation dealing with local governments. The only way you get rid of these problems is by having a pretty material recession. I don’t think the RBA wants that and nor does the government. So, at the moment, while they can afford to service the government bonds, they will keep things going.

Fiscal policy impact

We think the government’s expansionary fiscal policy is exacerbating inflation and putting upwards pressure on interest rates.

We have a high inflationary environment with still expansionary fiscal policy for most governments. It adds fuel to the fire – not as big as it was a few years ago, but still not allowing the economy to readjust.

Global pressures are also fuelling higher prices.

The US government’s flagship Inflation Reduction Act will see spending of close to US$1 trillion to encourage investment in renewable energy and energy efficiency.

Typically, when a politician gives a name to a program of spending, it means the complete opposite. The ‘Inflation Reduction Act’ has done the reverse. It’s effectively a war for global capital. Whenever there’s a tax incentive, you’ll find a company trying to find it so global capital is now charging towards the United States and that is quite inflationary.

Meanwhile, tight oil supply from the Middle East is lifting energy prices while America’s shale oil reserves are starting to get exhausted.

Saudi Arabia needs about US$90 a barrel of oil to balance their budget right now – so they’re not adding any more supply. It sounds dire, but it feels a bit like the 1970's.

The consequences of all this is likely to be a per-capita recession.

It’s very hard to have large recessions when you have that much immigration growth – but everyone’s ability to spend more will be lowered. It will feel like a recession.

What it means for investors

We argue that investors should avoid the types of investments that have worked for the past decade including fast-growing technology firms and highly indebted utilities. With higher real rates, it typically will favour having a bit more balance in the portfolio.

You want companies that will generate cash flow today – because they can pay you dividends out of cash today, and they don’t have to borrow.

This process sounds straightforward enough, but how does it work in practice? To help illustrate how the team thinks, we discuss two contrasting holdings: Goodman Group and A2 Milk.

Goodman Group (ASX: GMG) 

Goodman Group is a developer, owner, and manager of logistics real estate around the world, with a presence in key growth cities globally.

It is the largest listed property fund manager in Australia with $76 billion of external assets under management and a strong portfolio of assets near big cities.

Key to its attraction is leverage to long-term global trends like the growth of e-commerce, near- and on-shoring, and continued urbanisation. Early last year, concerns arose that interest rates were putting pressure on property companies’ valuations, balance sheets, and also distributions.

We saw this as an attractive opportunity to build a position in Goodman and believe that the market was underestimating the strengths inherent to Goodman’s model.

This was based on multiple factors — the macroeconomic strength of the logistics warehousing space and Goodman’s development-driven growth model, strong balance sheet and excellent management team, she says.

Our desire for next day or same day delivery pushes warehouses into the cities. For a logistics company, your cost of delivering a product is much bigger than your rent. So, you can pay more rent to be closer to your end customers.

At the same time, warehouse automation has resulted in older warehouses being not fit for purpose — facilities need higher ceilings and bigger bays. This has pushed occupancy to record highs. 

Goodman’s portfolio is especially leveraged to these trends because management has consciously pruned and recycled its portfolio to placing its assets near big cities. Today, Goodman’s property portfolios are 99% occupied and saw like-for-like net property income growth of 4.7% in 2023. Find me an office manager that’s done that!

More recently, Goodman has started repurposing logistics buildings as data centres and returns here are even more attractive than traditional logistics.

A2 Milk (ASX: A2M)

A2 Milk markets and sells premium-branded dairy nutritional products across Australia, New Zealand, China, and the US.

The A2 milk protein is marketed as easier to digest than other types of milk, which resonates particularly well with Chinese consumers.

Over time, infant formula sales to Chinese consumers have become a significant share of A2 Milk’s sales and profits.

A2’s Chinese infant formula is available in close to 26,000 mother and baby stores in China. That’s a big turnaround from its pre-COVID model of selling infant formula in Australian stores to Chinese buyers who would then re-sell to family and friends back home.

We see the growth of the Chinese label sold on the ground in China and the pivot to controlled sales of the Australian product on their own website as the creation of a much higher quality business model where A2 has control over its inventories, its marketing and also its price in China.

This has been demonstrated throughout this year as A2 gained market share in China while maintaining solid pricing and avoiding inventory build-ups in a very challenging overall market environment where a lot of the competitors cut price and saw inventories increase.

While the weak Chinese birth rate remains a headwind for growth, we think A2 has the potential to leverage its brand recognition by adding more products.

A2 has over $800 million in net cash at the end of fiscal year 2023 and an operating cash conversion of 114%, meaning that every year they’re building that cash pile further, so you have plenty of ability to invest in growth.

This piece features insights from Vince Pezzullo, Perpetual’s head of equities and portfolio manager of Perpetual Equity Investment Company, and Louise Sandberg, Perpetual's senior equities analyst.

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The Perpetual Equity Investment Company Limited (ASX: PIC) is a listed investment company that provides a simple and transparent way to invest in a diversified portfolio of high quality Australian and global listed securities. 

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