Are rising interest rates bad for the stock market?

Q: The stock market has been falling lately due to fears that interest rates are increasing soon. I am not sure how will this affect my stock portfolio. Should I sell my stocks now and switch to fixed-income investments? Please advise.–Cristine Buenaflor by e-mail

A: While there is a good reason for the market to expect interest rates to rise in the near term, this is not the perfect time for you to give up on stocks.

The market assumes that when interest rates increase, there will be less supply of money for stocks. High interest rates encourage investors to put their cash in money market instruments, which is more stable and less risky. When there is less money flowing into the stock market, demand for stocks weakens, hence share prices fall.

The recent sell-off in the market demonstrates this assumption as initial reaction to the latest pronouncement of the US Federal Reserve that it is terminating soon its monthly bond-buying activities, known as the Quantitative Easing (QE) program.

The QE program is a non-traditional monetary tool aimed to stimulate the US economy by enabling banks to lend more through infusion of new money in exchange for its non-performing bonds.

Now that the US economy has started to improve substantially, the US Fed has decided to end the program. Termination of the bond buying program will mean reduction of liquidity in the system, lessening the risks of rising inflation but putting more pressure on interest rates to increase.

Similarly, the Bangko Sentral has also increased interest rates in an effort to mop up excess liquidity in the system to manage rise in inflation.

While it is a common notion that higher interest rates lead to lower investments and expansion, which result in lower corporate profits because of high borrowing costs, this is true only when interest rates have reached levels that the economy cannot absorb. If the economy is healthy, any increase in interest rates in a fairly restrained manner should be manageable.

Current increases in interest rates are actually good for the stock market because it indicates that the economy is growing strong. An expanding economy means higher sales and earnings for companies. Any increase in interest cost should be more than offset by increase in earnings.

To illustrate this, let’s assume that the projected earnings of SM Prime this year is P0.69 per share and the discount rate where the interest rate is a major component is 3.5 percent. To value the stock, simply divide the earnings by the discount rate and you will get projected target of P19.71 per share. Now let’s say interest rate has increased so that discount rate also increased to 4 percent. At this rate, the valuation of the stock will drop to P17.25.

All other things being equal, higher interest rates lead to lower valuation. However, if your economic backdrop is growing and in this case, you expect SM Prime earnings to grow by 25 percent next year, you will project earnings per share of P0.86. Using this as basis with the higher discount rate of 4.0 percent, you will get projected target price of P21.56, up 9 percent from the previous target despite rise in interest rate.

The other way to look at it is by the use of P/E ratio. Let’s say the current market P/E at the moment is 21x. To compute its discount rate, simply divide the number one by the P/E ratio of 21 and you will get 4.8 percent. Let’s assume interest rate increases by 0.5 percent so that discount rate of the market increases to 5.3 percent. At this rate, the implied P/E ratio will fall to 18.8x, which means the market should fall by 10 percent, which could be a massive correction.

But if you are expecting overall corporate profits of listed companies to grow by 20 percent next year, you simply divide the number one point two by a discount rate of 5.3 percent and you will get higher implied P/E ratio of 22.6x, 8 percent higher than current P/E despite increase in interest rate. This means that the general market must go up further.

What about fixed income instruments like bonds? Rising interest rates are the most destructive to bonds, especially the longer term ones, because when interest rates go up, bond prices fall. Let’s say you have invested P100,000 in a corporate bond that pays P4,000 in interest or 4 percent a year. Bonds are valued based on prevailing interest rates. When interest rates in the market increase, for example at 5 percent and you need to sell it, you will have to value your bonds by dividing the interest income that you regularly receive, which is P4,000 by the current interest rate of 5 percent. At this rate, your bonds will be worth P80,000 and you will lose 20 percent of your original investment if you sell them.

If interest rates continue to rise in the future, bonds may become attractive at some point as there will be new bonds that will be issued offering higher interest rates. Perhaps you can consider buying some bonds by that time to diversify your investments.

But now is not the best time yet to sell your stocks and switch to bonds. For as long as the actual increase in interest rates falls within expectations, the stock market should be able to manage this positively. You may want to focus on banking and low-debt consumer stocks that will benefit the most from higher interest rates.

Henry Ong is a registered financial planner of RFP Philippines. To learn more about financial planning and how to become RFP, attend our free personal finance talk on Nov. 20 at PSE Ortigas. To reserve, e-mail at [email protected] or text <name><email><RFPinfo> at 0917-3464126.