When a breeze becomes a storm: How to navigate the share market’s winds of change

Favourable conditions have a way of empowering investment decision-making. It’s like jogging with a tailwind — it delivers a feeling of assurance.

But a breeze at the back can also create overconfidence and nothing reminds investors — and runners — about their true level of fitness like a headwind.

Until relatively recently, investors benefited from multiple decades of investment tailwinds created by low or falling interest rates.

However, the rise of inflation and expectations it could remain stubbornly entrenched have analysts suggesting a rate cut is unlikely before 2025.

At the start of the year markets were factoring in interest rate cuts, which lifted investor sentiment, before June’s inflation “shocker” faded any hopes of a breeze returning to their backs.

This means that company earnings will need to do more to compensate investors for the investment headwind of higher rates.

Why do higher rates impede expected returns?

One reason is valuations. Assets are often valued by forecasting future cash flows and then discounting these by the risk-free interest rate — so as interest rates fall, the value of future cash flows increases, justifying a higher valuation.

Another factor is relative returns. As interest rates retreated, so did the returns on cash and deposits, leading yield-hungry investors to seek other asset classes, which created a wave of money and pushed prices higher.

Lower interest rates also encourage large volumes of cheap debt, supercharge earnings and increase the supply of money chasing asset prices higher, like an out-of-control auction.

Essentially, stocks, bonds, and real estate will likely trade at higher valuations when interest rates are low.

Navigating the new terrain

In this less familiar landscape, it’s good to remember that interest rates are closer to the long-term average now than they have been across the past decade.

Although investors may yet see interest rate cuts this financial year, it is likely this will be a short-term normalisation, not a multi-decade trend.

If falling interest rates are the tailwind, earnings growth represents running downhill.

Although higher interest rates discount future cash flows, which in turn reduces valuations, growth in earnings cash flow can offset this pressure.

With debt no longer cheap, and the higher cost of capital buffeting valuations, investors will need to demand higher levels of future earning cash flows to justify prices.

As we head towards the main reporting season for Australian shares next month, the importance of growth in future cash flows is rising.

Australian company earnings earlier in the year were as expected, but markets were buoyed by the expectations of interest rate cuts. That won’t be the case this time around.

Active vs passive investing

So how can portfolios respond to this environment? Is now the time to take a more active or passive stance, given the ongoing challenges facing investors? These passive or index funds require fewer resources, making them significantly cheaper than their active peers.

And with an emphasis on cost, this has provided fertile grounds for growth, accelerated by the fact that many actively managed funds have struggled to beat their respective benchmarks.

While there is a role for passive investments in a portfolio, the trade-off is often responsiveness — a quality which may become more valuable amid an environment of lower growth and higher inflation.

Such an environment will certainly deliver some home truths about the financial fitness of investors, and may require a significant rethink of strategy.

Winds of change and accepting reality

Although runners can change their stride length, speed, or route to improve results, they also need to be honest about their capabilities and realistic in their expectations.

Similarly, although a change in strategy may improve investment returns, a higher interest rate environment is likely to deliver lower returns than those seen in recent history, irrespective of the approach taken.

With the winds of change, investors seeking longer-term returns need to understand the current environment and develop a strategy that suits their goals.

Simply wishing and waiting for a return to previously favourable conditions won’t deliver results. Instead, adapting to headwinds will be crucial to navigating this challenging investment landscape.

Just like a jogger choosing their route for a morning run, navigating an investment path to limit the headwinds can make your journey a lot more enjoyable.

Christian Golding is a director at Pitcher Partners