The Constant Investor: Should Australian investors be wary of rising US interest rates?

Higher rates drive higher capital return

Rising US interest rates are ultimately a benefit for Australian investors, as higher rates drive higher returns on capital. The journey from low rates to higher ones has some bumps along the road however, and investors need to avoid these potholes in order to benefit from the better returns that lie ahead. Here are some obstacles to watch out for.

The Fed’s most recent statement says they intend to tighten rates. The majority of the Fed’s open market committee, which sets interest rates, are projecting one more rate rise this year, likely in December, and a further three increases in 2018.

Higher rates mean higher discount rates. Investors in bonds and equities are purchasing a stream of future cash flows, either low but certain ones in the case of bonds, or high but hopeful ones in the case of equities. Higher rates mean that the present value of these future cash flows is reduced. This could lead to a reduction in asset prices, all else equal. Of course, higher growth also means better economic conditions, which should ultimately offset this over time.

Fixed income will eventually benefit from higher yields. Fixed income investors will be able to invest at higher yields once cash rates have risen, but the transition from low rates to high rates must be managed carefully in order to minimise any hit to valuations from higher rates.

Equities and other growth assets will have higher funding costs. Higher cash rates mean higher borrowing costs for companies should they wish to expand or invest. This could create some headwinds for equity returns initially, but should be offset by a rising revenue base in the long term.

Higher US rates increase the likelihood of an Aussie rate hike. The RBA has been quick to reassure us that there is no mechanical requirement for Aussie cash rates to rise in lock-step with the Fed funds rate. That said if US rates are rising because of an improving global growth outlook, then Australia benefits from this too. If large enough, this may tip the balance closer to rate hikes in Australia too.

The US has long enjoyed a safe-haven advantage. Australia has traditionally had to pay a premium to attract global capital, and as US rates rise, this premium is eroded. Investment returns in Australia may need to rise, simply to attract capital in the face of better returns on offer in the US.

While the transition to higher US cash rates poses a number of challenges for Aussie investors, the positive message is that higher US cash rates ultimately
reflect better economic conditions. This in turn creates better prospects for long term investment returns, provided that care is taken during the journey there.

Tamar Hamlyn, Portfolio Manager, Macroeconomics

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Should Australian investors be wary of rising US interest rates?