Utility-style companies are in, new companies are out as inflation rates climb
With interest rates still climbing after one of the worst years in the bond and stock markets, one portfolio manager says the central banks need to take stock of the impact they’re having, but we may be at a turning point with certain portfolio picks being much better than others.
“The central banks need to acknowledge that they’ve had an impact thus far and we may see a kind of slowdown, or pause, here from their very aggressive rate hiking cycle. Then, we may see a bit of relief for funding the second and third tier companies that aren’t necessary at the top,” Geoff Castle, PenderFund’s portfolio manager, told Wealth Professional.
With the central banks combatting inflation by raising interest rates to 3% to 3.5%, Castle said a lot of today’s portfolio picks “come back to how people feel about individual companies and their ability to handle higher interest rates. The question that has come to people’s minds is how individual companies are going to handle a debt cost that is significantly higher than they had before, whether that is going to challenge them in terms of meeting interest costs or refinancing debt.” That’s a particular concern for businesses exposed to rate hikes, such as real estate companies, which he said may be deemed a little less valuable or find it harder to raise money.
“What’s been happening over the last four or five months is people have been reconsidering the effect of higher interest rates, not just on inflation, but the ability of issuers to pay,” said Castle.
PenderFund is looking at companies one by one to ensure they’re value-backed, and it’s optimistic about how the next year may play out. But, right now, it’s particularly interested in companies with consistent demand, regardless of the state of the economic cycle. One category is companies that register .com domain names as people consistently need those.
“It’s not the kind of thing that is the first cut when a company cuts back,” said Castle, noting it is a utility-type operation with a consistent level of demand with a fair amount of pricing power. “Companies with utility-like demand characteristics obviously have the highest probability to do well.”
So, too, will companies with relatively stable demand, especially when you factor in the yields that they would have to pay to borrow, which could be impacted by the central banks’ rising rates.
At the other end of the spectrum are companies that have a business plan, but are not yet operative as he said, “they need to burn cash for a number of years to get to the point where they earn more money than they spend on expenses.” He noted these kinds of companies, which were in vogue a couple of years ago, may now struggle to find credit investors until they can demonstrate that they’re focused on not just growing revenue, but progressing toward generating cash.
Now that the banks seem to have taken the edge off inflation, though, he said they should acknowledge that they’ve slowed inflation because we now seem to be at an inflection point with bonds beginning to rebound.
Advisors should also look at putting funds in cash or GICs as rates rise because, he said, “from a client statement point of view, the price doesn’t move”. They should also consider participating in the bond rebound, “particularly if they haven’t suffered the big drawdowns. This might be a good time to reallocate”.
