Exercise caution despite falling interest rates

The local stock market has been performing well lately, with the Philippine Stock Exchange Index adding almost 8 percent in a span of three weeks.

The catalyst for the market’s strong performance is growing conviction that interest rates are finally headed lower. This, as domestic inflation beat expectations for four months in a row and as the US Fed is increasingly expected to start cutting rates in September.

Because of this, the 10-year bond rate is now at 6.25 percent, down from its year-to-date peak of 7.03 percent, while the peso is stronger at P58.38 against the dollar after weakening to P58.86 just last month.

Nevertheless, there is a risk that the performance of the stock market will stay volatile during the second half of the year.

One of the main reasons for this is the possibility that economic growth will stay weak during the period.

Although lower inflation and interest rates are good for the economy, the impact is usually delayed. For example, even if prices of goods go down, it will take a few months to convince consumers that prices will stay low so they can increase their spending on nonessentials.

The same holds true for businesses as they would need to see several months of consistently improving sales before they gain enough confidence to expand their operations. Filipino consumers and businesses currently have no appetite to spend given their poor outlook. This is based on the second quarter consumer and business expectations survey conducted by the Bangko Sentral ng Pilipinas.

According to the survey, consumers have turned more pessimistic about the current and next quarter because of the faster increase in prices of goods and higher household expenses, lower income, fewer available jobs, and ineffectiveness of government policies and programs on inflation management, traffic and public transportation, provision of financial assistance, and labor and employment.

Meanwhile, businesses have become less confident about the short term because of softer demand for goods and services, ongoing international conflicts that may lead to higher oil prices, slowdown in business activity due to El Niño, and persistent inflationary pressures that may weigh down consumer spending.

Weaker spending would lead to poor corporate earnings. This in turn would cause stock market investors to stay on the sidelines until they see more convincing signs that the favorable impact of lower inflation and interest rates is indeed starting to trickle down to the economy and listed companies’ profitability.

Another reason why the stock market could stay volatile is the possibility that the United States will suffer from a recession.

Most economists believe the Fed will successfully bring down inflation while avoiding a recession. However, there are indicators that show otherwise.

For example, payrolls are increasing only because of the increasing number of part-time jobs. Meanwhile, the number of Americans with full-time jobs is going down. Unemployment rate has risen for three months in a row and is already at 4.1 percent, which is already above the Fed’s year-end target of 4 percent.

Credit card delinquencies are also on an uptrend and are at levels last seen 12 years ago.

Finally, numerous companies reported that consumers are turning more price sensitive, leading to weaker first quarter earnings.

If the United States suffers from a recession, stock prices could go down significantly, leading to a bear market. The risk of this happening is even more elevated as the S&P 500 index is currently trading at 21X price to earnings ratio (P/E), which is more than one standard deviation above its 10-year historical average P/E multiple of 18X.

In the past, the Philippine stock market has always suffered from a contagion. Although there is always a possibility that this time could be different, especially since valuations of local stocks are already very cheap, only time will tell.

Because of the risk that the stock market could stay volatile in the second half, investors should manage risk by not being too aggressive in terms of exposure. Focus on more defensive companies that pay cash dividends and whose profits are less vulnerable to economic weakness. The said factors should make these companies less volatile in case the stock market suffers from a sell-off. INQ