The investment landscape has significantly changed over the past two years because of higher interest rates. What could it mean for ASX shares if interest rates stay higher for longer?
Central banks hiked interest rates so that some demand would be taken out of the economy and it would reduce the rate of annual inflation. As Pengana Capital Group Ltd (ASX: PCG) has pointed out, inflation is reducing compared to the peak rate seen in 2022.
However, consumer spending remains stronger than some may have been expecting, with other categories also showing quite strong growth, such as rent and wages.
Pengana suggested that "inflationary pressures are likely to linger due to weak productivity growth, deglobalization, lower levels of immigration and the cost of the energy transition. A higher neutral rate of interest will also impact central bank decisions."
What would this mean for ASX shares?
Debt becomes more expensive as interest rates rise and stay higher, so businesses with substantial debt on their balance sheet could suffer from higher costs and the loss of investor confidence.
A tough economic environment may mean some businesses are not able to pass on price rises to their suffering customers, and there may be less demand for businesses related to discretionary spending.
Businesses that are only just able to afford to pay their interest payments may struggle to repay debt when it's due, or fund new investments. These businesses "are likely to struggle in periods of high interest rates", according to Pengana.
Higher interest rates can also play havoc with valuations. As Warren Buffett once said about interest rates:
The value of every business, the value of a farm, the value of an apartment house, the value of any economic asset, is 100% sensitive to interest rates because all you are doing in investing is transferring some money to somebody now in exchange for what you expect the stream of money to be, to come in over a period of time, and the higher interest rates are the less that present value is going to be. So every business by its nature…its intrinsic valuation is 100% sensitive to interest rates.
Which stocks could do well?
Pengana suggested that businesses that generate positive free cash flow "should fare better" and can enable them to fund growth without needing new debt or to do a capital raising.
The fund manager also suggested that companies with strong balance sheets are less vulnerable to higher interest rates and adverse credit environments.
I'd point out that if a business has a net cash position (or no debt at all) it means that the business could generate pleasing interest income from its cash balance.
Free cash flow and/or a good balance sheet means that a business could acquire a financially distressed competitor and significantly improve its market position during these uncertain times.
Pengana also pointed to some sectors that could be good to hunt for opportunities:
Companies that grow earnings and dividends – through aligning to structural growth trends such as artificial intelligence, decarbonisation, automation, global travel, onshoring or the ageing population – may enjoy greater resilience than those marketing discretionary items to stretched mortgage holders.