Which stocks to own as rates rise (and 2 fundie favourites)

Just like Tesla's share price, helium-filled balloons, or my editor's blood pressure when I write these wires, sometimes things just rise. It's inevitable. 

Rates, on the other hand, have been on a downhill trajectory for a good 30 years. Now, it seems that they too may be on the way up. 

In fact, the RBA recently dropped its reference to rates rising "not before 2024", with economists around the country now forecasting that rates could get a hike far, far sooner (some have predicted that cash rates could rise in November 2022). 

So in this thematic episode, Livewire's Ally Selby is joined by Stuart Welch from Alphinity and Rhett Kessler from Pengana for their thoughts on the stocks you should be buying (and avoiding) in this environment. 

Plus, they also name two stocks that can benefit from inflationary tailwinds over the months and years to come. 

Note: This episode was filmed on Wednesday, 10 November 2021. You can watch, listen or read an edited transcript below.

Edited Transcript

Ally Selby: Hello, how're you doing, and welcome to Livewire's Buy Hold Sell. I'm your host Ally Selby, And in this thematic episode today, we're discussing the kryptonite of markets, inflation, which is once again dominating headlines after the RBA conceded that yes, inflation is indeed back to its target and a full two years earlier than expected. So to discuss how you should position your portfolios with this in mind, we're joined by Rhett Kessler from Pengana and Stuart Welch from Alphinity. 

First up, let's talk about buzzwords. Last year's was definitely unprecedented. This year's probably transitory. Rhett, starting with you, what's your take on inflation, and do you feel like it could be sticking around a little bit longer than we would've thought?

Rhett Kessler: So my view is it's not if inflation will kick in, it's just how much. I know big parts of it'll be transitory, but I think it's going to be quite expensive to put the inflation bug back in the box. 

Ally Selby: Stuart, over to you. Twitter founder Jack Dorsey believes that we're actually entering a hyperinflationary environment. What's the chance of that happening, and what's your view on inflation?

Stuart Welch: I agree that inflation is picking up, and I think that's what we've seen in the most recent RBA Statement of Monetary Policy. They're saying that inflation is ticking up a little bit. I'm not sure it's runaway. There are some transient components like secondhand cars and new cars, for example, which will likely subside, but there is some evidence of other elements picking up for things like rents, for example. 

We get a lot of information from talking to companies and some of the companies we talk to are saying that they're facing real input cost pressures, and they are pushing it through. And so it does feel like there is more inflation around, but I don't get the sense that it's runaway inflation at this point.

Ally Selby: Staying on you, Stuart, what does that mean for interest rates over the short and long term?

Stuart Welch: If we just look at what's happened over the last couple of months, interest rates, particularly at the sort of the midpoint of the curve and the long end, so three-year and 10-year, have actually increased a fair bit and I think that's in a market that is increasingly expecting that inflation is picking up. Along with that, there's also the view that some of the monetary policy and stimulus that central bank's been pumping into (global economies) is likely to get dialled back in the not too distant future as well.

Ally Selby: Rhett, do you agree? What's your take on interest rates over the short and long term?

Rhett Kessler: I think the cost of money is going to go up. We've had 30 years of ever-lower interest rates, a great time to build an asset base, but it's going to be a bit harder going forward. 

And the reason I think the cost of money's going up is because first of all, real rate settings all around the world are quite largely negative. I don't think that's sustainable. 

And so we are watching the US quite closely because Australia and the rest of the countries can't really move the interest rates up until the US moves, because otherwise the currency gets ahead of itself and gives us problems with exports. The big thing is what's inflation going to be like in the States? How do they react? When do they put up rates? And then I expect the rest of the world will follow.

Ally Selby: As you mentioned there, we haven't been in this kind of inflationary environment for a good 30 years. How are you positioning your portfolio with that in mind?

Rhett Kessler: Well, unfortunately, I grew up in an environment with a lot of stagflation and I saw how that impoverished a whole generation. So I'm pretty paranoid about inflation. I do agree with you. My peer group has limited experience on it, as do I, given it was 30 years ago. 

The way we're positioning it is we're looking for hard assets, and the definition of a hard asset very simply is a company that can pass through high inflation or input costs successfully with an inner elasticity of demand, and we're just looking for companies like that all the time.

Ally Selby: Stuart, same question to you. How are you positioning your portfolio in this inflationary environment?

Stuart Welch: Firstly, it's hard to look at it just in terms of inflation. There's also what's the growth outlook for the economy and also what valuations of stocks look like, and then there's a lot of stock-specific stuff. So a lot of our information comes from talking to companies. 

And whilst there is a lot of inflation around, for example, there's a lot of companies that are actually being able to pass through higher input costs. In fact, some of the evidence we've seen in the US for example is that some companies actually have been able to grow margins, and there are some companies here in Australia that are doing just that. 

So a company like Reliance Worldwide (ASX: RWC), for example, facing input cost pressures from higher commodity prices, but they're actually being very successful in passing that through and actually improving margins. And so for us, it's really driven by the company specifics in terms of the outlook for the business and also how they're navigating the current environment.

Ally Selby: So pricing power is really important. Are there any other essential characteristics of the kind of companies that you'd be allocating to in this environment?

Stuart Welch: I think in an environment where you believe that there's better economic growth and that's eating into capacity and with that comes higher inflation and interest rates. 

I think all else being equal, you would probably be avoiding the sort of bond proxy type stocks, the defensive stocks and some of the high growth, high PE names as well, but that's all else being equal. I think there's a lot of company-specific stories here. 

Whilst the cycle's quite strong, we are past peak growth. And so there is some maturation of the cycle if you like. And so we're actually sort of looking at a bit more of a balanced portfolio and trying to find those stocks that can outperform on a stock-specific basis, and we do even have some of those long duration, high PE names in the portfolio because we do think they offer good prospects where their earnings potentially underestimated. Very stock-specific from our point of view at this point in a cycle.

Ally Selby: Rhett, I might touch on something Stuart just said there. What kind of companies are you avoiding in this environment?

Rhett Kessler: So we're avoiding companies that have got long runways to profitability and are burning cash because they're selling a dollar for 80 cents and the valuations require a DCF where you're saying interest rates will remain low, but growth rates will remain high. So there are a lot of tech stocks within that, but there are also a lot of good tech stocks. So you have to be quite selective. 

We typically look for good businesses run by competent management at the right price. A good business for us is a business that has power over its stakeholders and that's pricing power as you brought up, but a lot of other power. 

And so companies that are weak in that situation always gets squeezed in the middle. And so we're avoiding weak companies.

Ally Selby: Rhett, I'm excited for this. We asked you to bring along one stock today that could benefit from inflationary tailwinds. What do you have for us?

Rhett Kessler: Well, it's a really boring toilet paper and toothpaste type company in Medibank. What we like about Medibank (ASX: MPL) and inflation is that if you get higher interest rates, they've got a massive policyholder float and shareholders funds that are currently earning next to nothing because they're all sitting in the bank. 

If interest rates go higher, there's a really big earning space that starts to really flex its muscles. Furthermore, they really are an arbitrage between premiums and claims. And so if they hold their margin steady, if you get inflation, they just make more money. We are looking forward to that protecting us somewhat.

Ally Selby: Stuart, same question to you. What stock have you brought for us today?

Stuart Welch: It's a similar theme actually in QBE (ASX: QBE). So this is an insurer and with the sort of growth that we're seeing in the economy, they should benefit from higher policy growth. But on top of that, they also have a large asset portfolio of bonds that backs those claims, which should benefit from a higher running yield and contribution to earnings as interest rates lift, so that's a similar story. We also like it from a stock-specific point of view. 

The insurance premiums are actually increasing quite rapidly at the moment. These hardening cycles don't happen very often but can be quite good for margin. Assuming you can control your claims and write the right risks, you get price increase on price increase, which can be really positive for margins as well. And so it's a good environment for them. 

They're well managed. There's a new CEO in there which creates some risk that there is a rebasing, but we think a large part of the hard work is done and behind them and that they should be able to benefit from some of those themes that we're talking about.

Ally Selby: So both our fundies are really insuring their bets in this inflationary environment. We hope you enjoyed this episode of Buy, Hold, Sell. If you did, remember to give it a like and subscribe to our YouTube channel. We're adding new content every week.

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