When the Fed starts hiking, look to quality | BetaShares

When the Fed starts hiking, look to quality

BY Benjamin Smith | 23 March 2022
when the Fed starts hiking, look to quality

Reading time: 3 minutes

Financial theory suggests that rising interest rates hurt stock valuations due to a rise in the equity risk premium, and therefore an increase in the discount rate used to assess future cash flows.

With the U.S. Federal Reserve indicating a period of rising rates to assist in curbing inflation, investors may fear a period of muted equity market performance. There are even fears of a ‘lost decade’ where, as rates rise and the Fed shrinks its balance sheet (scaling back quantitative easing), equity prices stagnate.

Not all stocks are affected equally

In the face of these fears, it is important to differentiate between companies that have different sensitivities to rising rates.

For example, consumer staples generally grow earnings with inflation, reducing the impact of rising rates. Growth companies are typically much more sensitive to changes in the equity risk premium than others.

Recent research from Goldman Sachs1 suggests that in tightening financial conditions, investors should own companies with ‘quality’ attributes, with high margins, trading at moderate valuations.

Goldman Sachs identified the following factors as those performing best after rate hikes commence:

  • Quality attributes such as high return on equity and strong balance sheets provide a level of underlying business stability as debt becomes more expensive to service and more difficult to raise.
  • High and stable margins, particularly at the gross level, are indicative of high pricing power, which is beneficial as input costs rise due to inflation.
  • Finally, moderate valuations reflect companies that are not overpriced relative to their quality characteristics.

Taken together, these factors represent quality, high margin businesses at a reasonable price.

The index BetaShares Global Quality Leaders ETF (ASX: QLTY) aims to track comprises 150 global companies (ex-Australia) ranked by highest quality score.

The table below compares QLTY’s index to a number of broad market indices, and shows that on most metrics it compares favourably to these indices, particularly when it comes to high return on equity, strong balance sheets, and high gross and net margins.

Quality: past performance
 As of 17/03/2022. Past performance is not indicative of future performance

How has quality performed in previous periods of rate increases?

In the last ten years, there has only been one period of U.S. federal rate hiking, following the GFC.

Beginning in Dec 2015 (and for the first time in seven years), the Fed started to hike interest rates as unemployment rates declined and wage growth improved. Rate hikes were finally halted by the US-China trade war causing economic growth to slow in December 2018.

Over this period, QLTY’s index outperformed the MSCI World Index by 14.7%. Additionally, the Fund also outperformed other factors (namely value and growth).

Quality: Bloomberg

Source: Bloomberg. Performance for QLTY prior to inception on 05/11/2018 comprises index returns after deducting QLTY’s 0.35% p.a. management costs. Performance for QLTY after inception on 05/11/2018 comprises fund returns after deducting 0.35% p.a. management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of Index or ETF.

How can investors gain exposure to quality global stocks?

The BetaShares Global Quality Leaders ETF (ASX: QLTY) is a core global equities exposure providing investors with exposure to a diversified portfolio of 150 quality global companies (ex-Australia) based on high return on equity, strong profitability, low leverage and stable earnings.

The BetaShares Global Quality Leaders ETF – Currency Hedged (HQLT) is a currency hedged version of QLTY.

Investing in high quality Australian companies

We are pleased to announce that we are bringing the focus on quality to Australian equities, with the upcoming launch of the BetaShares Australian Quality ETF (AQLT)* on the ASX.
AQLT will provide exposure to a portfolio of 40 of Australia’s highest quality companies, selected based on high return on equity, low leverage and earnings stability. Register your interest here.

There are risks associated with investment in QLTY and HQLT, including market risk, index methodology risk, international investment risk, concentration risk, currency risk (for QLTY) and currency hedging risk (for HQLT). For more information on the risks and other features of each fund, please see the relevant PDS available at www.betashares.com.au. A Target Market Determination for each fund is also available at www.betashares.com.au/target-market-determinations.

1. Anatomy of the S&P 500 sell-off and Nasdaq correction: Valuation compression and the re-pricing of equity risk, Goldman Sachs Portfolio Strategy Research. 23 January 2022.
* Subject to final regulatory approval

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