This week we learned that Australia’s economic growth has peaked, but is still too strong. This means the inflation genie is still out of the bottle and interest rates will continue to climb. Nothing new on this front, but for investors a measure of perspective is needed, to counter hyperbolic talk of “recession”, which is extremely low risk.

Instead, what you need to do is to take stock and look at your portfolio.

Investor Take-Outs

Put simply, in the blue chip world, we prefer companies with less risk, which are referred to as short-duration. This means you have a line of sight to growing dividends. We prefer to take more risk at the small end of town, namely Small Caps! Here we use our stock picking to reduce market risk. Long-duration stocks include technology companies that aren’t profitable.

Among blue chips, we view domestic earnings at more risk than offshore earnings, which is why we think that discretionary retailers like JB Hi-Fi (ASX:JBH) and Harvey Norman (ASX:HVN) are more at risk than mining companies like Rio Tinto (ASX:RIO) and BHP Group (ASX:BHP). As far as the banks are concerned, we are happy having lightened or sold some of our holdings but we remain happy owning them because their balance sheets are very strong, which underpins dividend growth. This is, after all, what you want from blue chips! To access our latest Blue Chip dividend plays, Join for only $199 a year.

What are Other Investors Doing?

The trend towards investors' buying up value stocks is continuing. Just look at the takeover bid for Origin Energy (ASX:ORG) and the upward momentum of Qantas (ASX:QAN) and Worley (ASX:WOR). Another thing I know is that it doesn’t pay to panic. It does the opposite! We held firm on Medibank Private (ASX:MPL), instead emphasising the investor dictum, “don’t waste a crisis”. Since the depths of the cyber attack late last year (Issue 116, 2 Nov 2022) MPL is up 16% on a strong earnings result supported by a subdued claims environment and the view that the threat has been contained.

National Accounts Emphasise Rising Rates

The national accounts commentary this week was focused on the net GDP (gross domestic product) number, which includes inflation. But as we’ve been saying the real action is in nominal GDP, which doesn’t include inflation. This the best reading for the state of aggregate demand in the economy, which is what drives inflation, or the lack of it. In economics, perspective is always needed to make any sense of the numbers.

Nominal GDP for the 3 months to 31 December grew 2.1% against the same period a year ago, which was 8.4% annualised. This time last year, Australia’s economy was running hot. In fact, it probably hasn’t ever sizzled to this extent, with nominal GDP growing at 16%.

The rate of growth is just over half of what it was back then, but is still very high. To give you an idea, in the three years prior to Covid the average annual rate was 4.5%.

What is the Reserve Bank Expecting?

Philip Lowe and his team at the Reserve Bank of Australia will want the rate to go back to a sustainable 5-6%, which probably means nominal GDP will have to go lower than that, which means that interest rates will keep going up.

Last month’s 25 basis point hike in official interest rates puts the domestic cash rate at 3.35%, its highest level in over a decade, while our risk free rate, the Australian 10 year bond yield is 3.86%. Three more interest rate rises are projected for this year, putting us on track for a cash rate of over 4% in the next six months.

How will Interest Rates Affect Investments

While talk of recession is overblown, what needs to be considered by investors is the effect on asset prices of higher interest rates.

Asset prices are governed in the main by the present value of future cash flows. Hence there are two key factors that go into valuing stocks: the numerator, represented by future cash flows; and the denominator, represented by the discount rate applied to those future cash flows.

On the denominator, the discount applied to cash flows consists of a risk-free return (Australians use the 10 year government bond) plus equity market risk, which reflects stock specific risk versus the market and the overall stock market risk.

Those watching the 10-year bond yield will see that it has been relatively steady over the past 9 months after aggressively climbing in the first half of 2022. A factor with rising rates is whether the equity risk premium increases, which means that higher risk stocks will be subject to even greater hurdle rates of returns.