A few weeks ago, I discussed possible reasons why domestic inflation might stay under control and why I don’t think the stock market deserved to break above its 2021 low despite the Russian invasion of Ukraine. However, what worries me today is the sharp rise in local interest rates, which may prevent the Philippine Stock Index (PSEi) from breaking above the 7400 resistance level and reaching our initial year-end target of 8,400.
The 10-year bond rate is currently 5.96%. That’s 114 basis points higher than its end-2021 level of 4.82%. It is also already above its pre-pandemic level of around 5% and well above its five-year historical average.
Although the average inflation rate in the Philippines was only 3% in the first two months of the year and is expected to average 3.8% for the year as a whole over Based on consensus estimates, one of the main factors driving up the local benchmark rate is the sharp rise in inflation in the United States.
Compared to the Philippines, the US economy is much stronger as it began to reopen early last year due to the wide availability of vaccines for its population. This has made it easier for companies to pass on higher costs with minimal risk of losing sales. As a result, inflation averaged 7.7% in the first two months of the year, a 40-year high. It is also more than double the Filipino average.
Inflation in the United States is expected to rise further in the coming months as the Russian-Ukrainian war drives up commodity prices further. This reinforces the Fed’s desire to tighten monetary policy, which is one of the factors driving up interest rates in the United States. Since the start of the year, the US 10-year bond rate has risen by 87 basis points to reach 2.32%.
As higher US interest rates make dollar assets more attractive, bond yields in other countries, including the Philippines, are also rising.
The problem with high interest rates is that they make stocks unattractive. Higher interest rates increase the discount rate used to value stocks, thereby reducing their potential for capital appreciation. Another reason why high interest rates are bad for stocks is that higher interest rates make fixed income products more attractive, forcing investors to switch asset classes.
The impact of rising interest rates is already being felt in the stock market.
Last year, real estate investment trusts (REITs) were very popular. Although interest rates had already risen as the economy slowly recovered from the COVID-19 pandemic, the average 10-year bond rate was still below 5%. The REITs of the major real estate developers, namely AREIT, RL Commercial REIT and MREIT, saw their share prices increase, which reduced their implied dividend yields to less than 5%.
However, due to rising rates, REITs have not performed well this year, with the three REITs mentioned above falling an average of 5% for the period since the start of the year, and even more compared to at their peak prices. Due to significantly higher yields from alternative investments, REIT prices have had to adjust lower to bring their dividend yields to more attractive levels. Note that the average REIT dividend yield is now much higher compared to last year.
Besides REITs, growth stocks that were trading at high valuations were also sold off due to the sharp rise in interest rates.
Despite the gloomy short-term outlook, I continue to believe that the sharp rise in commodity prices, inflation and interest rates is unsustainable in the long term, as the COVID-19 pandemic and the Russian-Ukrainian war would inevitably end. Thus, investors with a long-term investment time horizon should take advantage of this opportunity to accumulate stocks as they trade at depressed valuations. However, due to the volatility caused by rising interest rates, investors should employ certain strategies to manage risk and enhance returns.
One strategy is to avoid buying stocks that are trading at high valuations. High interest rates would prevent equities from justifying high valuations, with expensive stocks more vulnerable to a sell-off.
Another strategy is to appease his Fomo (fear of missing out), or simply avoid chasing up stocks. Given the high interest rate environment, it would be difficult for equities to maintain a strong uptrend.
When buying stocks, focus instead on the blue chips that are being sold. For more active investors, the strategy of selling stocks as they rise and buying them back as they fall should work well given the current market situation. INQ
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