Everyone knows interest rates have risen substantially over the last 12m but markets are still working through all the implications of a higher cost of capital. The three major risks to equity investors are derating, downgrades and debt refinancing, and as we go through this transition period they will take turns in being uppermost on people’s worry lists.
The crisis in mid-sized US banks over the last month serves as a reminder that investors need to be very wary of assets purchased or built with, or business models reliant on, an unsustainably low cost of capital. Ultimately, First Republic’s problem was that their cost of funding, which had already been rising as deposits repriced upwards, skyrocketed when they needed to replace lost deposits at 2% with wholesale funding at 5%.
One obvious response is to run back to the safety of tech stocks with net cash on their balance sheets. The recent rotation in that direction is understandable, although we would caution that derating risk is not dead, just sleeping. It is equally easy to argue that in this environment you should just sell any company where financial gearing is an inherent part of the business model, for example financials or infrastructure. We disagree, but emphasise the importance of being selective. Not all infrastructure is funded in the same way. For example compare these two infrastructure-based companies, CMS Energy, a US regulated utility which we own, with Cellnex, a European telecom tower company, which we don’t.
Both of these companies are expected to face rising interest costs in the coming years but for CMS it is likely to be a much more manageable trajectory than for Cellnex.
We would also make two broader points:
All data Bloomberg or J O Hambro unless otherwise stated.
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