Most recent inflation data of 7.9% may have been a nice surprise compared to expectations of 8.2%. But with interest rates being hiked by 0.25% up to 5.25% by the Bank of England, this could help bring it down further.
UK inflation falls to 7.9% – what it means for interest rates, mortgages, and the economy
The UK base rate is expected to sit between 5-6% for the rest of this year and all of 2024. We’ll need to strap in for higher interest rates for longer than most of us would like.
Higher rates mean a higher cost of borrowing. That’s a challenge felt by both individuals and businesses. But there are some sectors that are better equipped to ride a higher interest rate wave. Here we look at three businesses that we think could perform well.
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Moneysupermarket Group
One key impact of higher interest rates is when valuing businesses. Higher rates mean the value of future cash flows in today’s money are lower. That makes investments with high-quality current earnings relatively more attractive.
Earnings quality (how well earnings are backed by actual cash) is one of Moneysupermarket’s strengths.
It’s now one of the UK’s largest providers of online price comparison services across: insurance, credit cards, loans, broadband, energy and mobile phones. Plus, with the acquisition of Quidco, it has a foothold in the cashback market.
Being an online business means capital requirements are light, which is great given high rates make capital more expensive. But the other benefit is on earnings quality, a high portion of earnings are backed by cash and returns on capital are high.
Earnings backed by cash (£m)
Source: Refinitiv Eikon 31.07.23
In practice, that means there’s plenty of room to return cash to shareholders and the 4.5% forward dividend yield is a testament to that strength. But remember, no dividend is guaranteed and yields are not a reliable indicator of future income.
Aside from the numbers, we’re also encouraged by the direction of travel. Over the past few years, management’s been making subtle shifts to operations with the aim of promoting cross-selling. That’s involved up-skilling the workforce, moving operations onto the cloud, and bringing changes together with new products like the MoneySavingExpert app.
We also see growth potential in existing markets and those with low levels of penetration. Energy markets have been lagging recently, with switching all but non-existent given market turmoil. But things are moving in the right direction and there’s potential for a good chunk of that switching work to come back down the line – even if we don’t expect it anytime soon.
There’s opportunity in areas like mortgages, as higher costs mean consumers are likely to pay close attention to making sure they’re getting the best deal on the market.
The key risk in this industry is fierce competition. Google has dabbled in the area and Amazon has an insurance offering that hasn’t taken off yet but poses a threat, that’s aside from the other big players like Confused.com.
All in, we see the forward yield, strong cash-backed earnings, and evolving model as benefits. The valuation sits around its longer-term average, which we think offers the potential for decent returns on capital in a higher-rate world. But there are no guarantees and there’s plenty of pressure to keep delivering.
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NatWest
In banking, NatWest is what we’d describe as a traditional lender. Most of its income is generated from taking deposits from consumers and businesses and lending at higher rates, receiving what’s known as interest income. A smaller proportion comes from things like fees, or commission from institutional-level deal-making.
That makes it particularly exposed to changes in interest rates. Net interest margin (NIM), a measure of the profitability of lending and borrowing, has been moving higher over the past year or so. It reached 3.20% over the first half, high enough to drive a healthy profit.
But it looks like things have peaked. There was a quarter-on-quarter dip in margins and full-year guidance has been given a slight downgrade, as depositors shift from higher-margin current accounts in search of better rates.
Consumers shopping around for the best rates isn't much of a surprise, given they've spent years getting little to nothing from their cash deposits.
NatWest isn’t the only UK lender with a weighting to interest income, but there are some specific reasons we like this name as an interest rate play.
The deposit mix is one advantage. The split between household and corporate deposits is about 50/50, compared to UK peers whose balances tend to favour households.
Deposit Split
Source: Barclays, Lloyds, NatWest Half Year Results 2023
We see deposit betas, which measure the percentage of interest rate hikes that are passed on, being more favourable to banks for corporate deposits than household. Companies by their nature tend to hold higher current account balances to cover ongoing operations, so there should be less of a move to fixed term accounts.
The flip side to the benefit of higher rates, at least in the current environment, is the very real recession risk that’s hanging over the broader economy in the UK. We favour banks with a lower percentage of unsecured lending, a box that NatWest ticks compared to peers.
We like NatWest when it comes to benefiting from higher rates, and the valuation at current depressed levels looks attractive. But while the economic outlook remains murky, investors should prepare to play the long game.
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Prudential
Rising interest rates are generally a positive thing for insurers, especially those focused on long-term policies like life and retirement providers. Insurers collect premiums and invest in relatively safe investments like bonds. Higher rates mean the new bonds they buy come with higher yields, boosting profitability.
The longer higher rates last, the more lower-yielding assets mature which can be replaced with higher-yielding assets. And so, higher-for-longer interest rates tend to be a positive for insurers.
That’s where Prudential comes in. It’s a life insurance and asset management giant, with its business operations focused on Asia and Africa. Having exposure to these markets offers something different to investors looking to add some geographic diversity to their portfolio.
But it’s not just differentiation for the sake of it, those markets are attractive growth areas. Not least because of the reopening of China, where earlier lockdowns led to significantly lower levels of new business. Mainly due to reduced traffic from China to Hong Kong, which traditionally makes up around 60% of the group’s Hong Kong new business.
We’re starting to see the results, with first-quarter annual premium equivalent (APE) sales, an important measure of new business activity, rising 35% to $1.6bn when ignoring the effect of exchange rates. The consensus among analysts is for APE to rise 47% this year. Momentum, particularly in Hong Kong, has continued into the second quarter. Margins here are still healthy, with the new business profit margin running at 64% in the first quarter.
Change in Annual Premiums Earned
Source: Refinitiv Eikon, *2023 is estimated based on analyst consensus 31.07.23
Looking further ahead, the Asian business could benefit from long-term economic development in its markets, driving increased demand for Prudential's insurance products. A focus on regular premium products like life and health insurance should also make profits reasonably dependable. We feel there’s lots of opportunity with life insurance premiums, given insurance as a percentage of Asian GDP is still very low.
At Eastspring, Prudential’s asset management business, total funds under management rose by around 3% to $228.6bn. This change reflects both positive inflows and a net positive contribution from market movements. Despite this figure heading in the right direction, market conditions are still tough, and redemptions could see this figure come in lower by year-end.
Prudential currently trades on a price-to-book value that’s below its longer-term average and at a level where we feel there’s potential for upside. A big equity raise in 2021 means the balance sheet looks strong but the main risk lies in the China reopening story, and renewed travel to Hong Kong, which is still somewhat of a question mark.
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Unless otherwise stated, estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates aren’t a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.
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