Goola Warden Thu, Jun 02, 2022
The answer — in a word — is “yes”. As part of the discussion during The Edge Singapore‘s Mid-Year Investment Forum, attendees asked about the impact of higher interest rates on the stock market. Paul Ho, senior director, Asia Pacific equities, at UOB Asset Management, pointed out that higher interest rates mean lower valuations for growth companies.
“So, if inflation is rising and interest rates are going higher from here, then you should expect a lot of pressure on these stocks. The mathematics behind it is because interest rates are used as [proxy for] discount rates. So, if discount rates go up, the value drops,” he explains.
Let’s dissect that a bit. When money is easy, interest rates are low, policy rates are near zero, and quantitative easing is in full swing, most assets rise, including equities, bonds and apparently cryptocurrencies.
The US Federal Reserve has articulated that it plans to rein in inflation by raising the US Federal Funds Rate (FFR). This is likely to be done via several rate hikes such that the FFR rises to around 3%.
According to Vishnu Varathan, head of economics and strategy, Mizuho Bank, the FFR is likely to rise by 275 basis points (bps) by end-2022, and by another 100-150 bps by mid-2023, taking rates up to 350 bps higher from the beginning of this year.
In the meantime, the Fed will drain liquidity from the system in quantitative tightening or QT. By the end of this year, some US$522 billion ($718 billion) is likely to be drained from the system; and by the middle of 2023, a total of US$1 trillion would have been taken out.
Singapore is a price-taker as far as interest rates are concerned because of its exchange-rate policy. “For Singapore, we are global price-takers of interest rates. So typically, if US rates are rising, our costs are going to go up by quite a bit. In this case, we may witness even sharper rises as QT sets in. QT simultaneously raises the term premium in credit premium, so you have a higher add-on to the baseline interest rate. The other reason, of course, is actual dollar funding because it squeezes the dollar funding,” Varathan points out.
For both the US and Singapore, even before the hikes started, yields on their 10-year government securities had already risen. Yields on these 10-year Singapore Government Securities or SGS are the local equivalent of risk-free rates.
The direction or trend of discount rates is likely to follow those of riskfree rates. Markets take valuations of equities off risk-free rates. In a discounted cash flow (DCF) model, the cash flows of a company are estimated for the next five or 10 years, and discounted back to the net present value depending on the discount rate; the higher the discount rate, the lower the valuation.
“For high-growth companies, you are expecting the most cash flows to come in the future, and those are the ones that get discounted back [heavily]. So unfortunately, growth companies are the ones that are hit more than normal companies with [plentiful] cash flows,” Ho explains.
Companies’ cash-flow and earnings growth would need to rise such that they offset rising discount rates. Are there any such companies? “Banks do better in a higher rate environment. But it also depends on the shape of the yield curve. If you have a situation of an inverted yield curve, it’s actually bad for a bank’s margin. But it should be no surprise that financials have done much better as a sector than most of the other sectors,” Ho elaborates.
The local banks have ample liquidity, as evidenced by their liquidity coverage ratios and net stable funding ratios. All three have sufficient US-dollar funding as well. Unlike other developed-market banks, the local banks rely less on wholesale funding with most of the funding coming from deposits, mainly Casa (current accounts, savings accounts).
Of course, as Varathan points out, none of us can escape pricing risk, but the local banks have escaped the worst impact of the market decline. As a case in point, DBS Group Holdings is down just 5% year-todate, while Oversea-Chinese Banking Corp is up 3% and United Overseas Bank is up more than 7%. As a comparison, iFAST Corp is down more than 42% this year.