What the high interest rate environment means for stocks
A few weeks ago, I discussed possible reasons why domestic inflation could remain under control and why I don’t think the stock market deserved to fall past its 2021 bottom despite the Russian invasion of Ukraine.However, what worries me today is the steep rise in local interest rates, which could prevent the Philippine Stock Exchange Index (PSEi) from breaking past the 7,400-resistance level and reach our original year-end target of 8,400.
The 10-year bond rate is currently at 5.96 percent. This is 114 basis points higher than its end-2021 level of 4.82 percent. It is also already above its prepandemic level of around 5 percent and much higher than its five-year historical average.
Although the average inflation rate in the Philippines was only 3 percent during the first two months of the year and is projected to hit an average of 3.8 percent for the whole year based on consensus estimates, one of the main factors pushing up the local benchmark rate is the sharp rise of inflation in the United States.
Compared to the Philippines, the US economy is much stronger as it started to reopen early last year due to the wide availability of vaccines for its population. Because of this, businesses had an easier time passing on higher costs with minimal risk of losing sales. Consequently, inflation reached an average of 7.7 percent during the first two months of the year, a 40-year high. It is also more than double the Philippine average.
Inflation in the United States is expected to go up even more in the next few months with the Russia-Ukraine war further pushing up commodity prices. This is strengthening the Fed’s resolve to tighten its monetary policy, which is one of the factors pushing up interest rates in the United States. For the year-to-date period, the US 10-year bond rate is up by 87 basis points to 2.32 percent.
Since higher US interest rates make dollar assets more attractive, bond rates in other countries including the Philippines are also going up.
The problem with high interest rates is that it makes stocks unattractive. Higher interest rates increase the discount rate used to value stocks, reducing their capital appreciation potential. Another reason why high interest rates are bad for stocks is because higher interest rates make fixed income products more attractive, causing investors to switch asset classes.
The impact of higher interest rates is already being felt in the stock market.
Last year, real estate investment trusts (REITs) were very popular. Although interest rates were already rising as the economy was slowly recovering from the COVID-19 pandemic, the average 10-year bond rate was still below 5 percent. REITs of big property developers, namely AREIT, RL Commercial REIT and MREIT, saw their share prices go up, which in turn reduced their implied dividend yields to below 5 percent.
However, because of rising rates, REITs have not done well this year, with the three REITs mentioned above falling by an average of 5 percent for the year-to-date period, and even more compared to their peak prices. Because of the significantly higher yields of alternative investments, the prices of REITs had to adjust down to raise their dividend yields to more attractive levels. Note that the average dividend yield of REITs is now much higher compared to last year.
Aside from REITs, growth stocks that were trading at expensive valuations were also sold down due to the steep rise in interest rates.
Despite the bleak short-term outlook, I still believe that the steep rise in commodity prices, inflation and interest rates is not sustainable over the long term as both the COVID-19 pandemic and the Russia-Ukraine war would inevitably come to an end. As such, investors with a long-term investment time horizon should take this opportunity to accumulate stocks while they are trading at depressed valuations. However, because of the volatility caused by rising interest rates, investors should employ some strategies to manage risks and enhance returns.
One strategy is to avoid buying stocks that are trading at expensive valuations. High interest rates would make it difficult for stocks to justify high valuations, with expensive stocks more vulnerable to a sell-off.
Another strategy is to quell one’s Fomo (fear of missing out), or simply to avoid chasing stocks that are going up. Given the high interest rate environment, it would be difficult for stocks to sustain a strong uptrend.
When buying stocks, focus instead on blue chips that are being sold down. For more active investors, the strategy of selling stocks as they rally and buying them back as they go down should work well given the current stage of the market. INQ
