Effect of the US Interest Rate Hike on the PSEi
December 2, 2015
We think the biggest question going forward to 2016 is “what is the effect of the US interest rate hike on the PSEi”? We thought about that question because we noticed in the past weeks that the PSEi has gone through a cycle of falling just below 7,000, recovering past it and then falling just below it again. One would say that the market feels that going beyond 7,000 is dangerous with the upcoming US interest rate hike, and that the market feels that buying below 7,000 is just about right as a support when it happens. Well, we’re not in the business of feeling where the PSEi is headed or what stocks to buy. We do have some tools to see where the PSEi is headed given this major development, and we would like to record our findings to compare it later on with what will happen in 2016 to 2017.
First of all, it will affect us and the whole world. When QE took place before, it affected the PSEi positively. The US10YTN rate is 81% correlated with the PH10YTN rate. When the Fed hikes interest rates, the US10YTN rate will head up from currently 2.23% to an estimated 4.44%. This takes into account a full effect and not a gradual one. That is a huge increase, and we are confident about our estimate because it coincides with Bloomberg interviews with various research heads in the US. They see the US10YTN rate at the 4% level post rate hike. One good reason for this is that this level was the average before QE in November 2008. They see the US10YTN rate just going back to where it was before. US GDP also grew at a range of -2.8 to 2.5% from 2008 to the present. The US is a developed country, and this GDP growth is just about right for one.
When the US10YTN rate goes to an estimated 4.44%, the PH10YTN rate goes from 4.06% at present to an estimated 4.65%. Now this is where it gets edgy for us. This is where we have to make a call. For the US10YTN rate, it was less edgy. The US is a developed country. GDP growth is around flat, and the US10YTN rate will just go back to the level where it was before. The Philippines though is an emerging market and a developing economy. Remember that sustained GDP growth rate run at around 6% from 1Q11 to 3Q15? That was impressive and mirrors Singapore and South Korea’s economic development and miracle wherein they sustained 6% GDP growth for 40 straight quarters or ten years. So if the PH10YTN rate will just adjust back, it should be from when this GDP growth rate run first occurred and not during the low GDP growth rate years when interest rates were high and the PSEi was lingering at low PERs. The UK even forecasted Philippine GDP growth at 6.5% in the next two years. Coming from an overseas source, this gives confidence that the run will continue.
One of the main concepts of value-investing is that fixed income securities are inversely-related to stocks. That is why we first started with the US10YTN rate and then to the PH10YTN rate. If the PH10YTN rate is going to an estimated 4.65%, we value the PSEi at 18.5x PER at 6,405. With this, the PSEi ranges from a depressed low of 5,366 to a euphoric high of 7,445. This range also has a PSEi PER of 15.5x to 21.51x. The PSEi is currently 7,059. Being above 6,405, this makes it overvalued post US interest rate hike. Earnings will have to catch up to justify current levels. Even now, the PSEi is already overvalued anyway at 20.01x PER unlike the broader All-Shares Index (ASI) at 17.22x PER. So picking stocks in one’s investment portfolio is critical to weather the upcoming US interest rate hike.
An interest rate hike is not the end of the world for stock investors. It is just a valuation adjustment. Generally, stocks will become a little more expensive. This may trigger some sell-offs especially to high PER stocks like URC and JFC. That is why we have been suggesting on keeping a good amount of liquidity during these times. That cash will be like one’s “bazooka” to fire when that sell-off occurs. We’ve been playing defense at 20-22x PSEi PER all year long, and we recommended high cash dividend yield stocks with low PERs and betas. That stock portfolio will be one’s pillow and blanket amidst the market volatility we are having nowadays.
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