Have US stocks priced in rate hikes fully?

Posted on

The environment in which the Federal Reserve is raising interest rates now is a world apart from where the two preceding tightening cycles were in. When the Fed hiked rates in the past, the stock market would typically rally because the central bank did so with the objective to pre-empt overheating risk in the economy, and to keep its powder dry for future needs to reduce rates, which suggested that the economy was sustaining a certain level of growth momentum. In today’s economy, however, the Fed has had to raise rates and shrink its balance sheet rapidly and aggressively, in the hope of making up for lost time because the central bank’s tightening cycle had lagged behind rising inflation significantly.

The recent market sell-off, however, raises the question of how much rate increases have been priced in. Before we answer this question, consider the following proprietary interest rate valuation model. Assuming that the terminal federal funds rate is settling at 3%, coinciding with a flattening yield curve, the model shows that the price-to-earnings ratio (P/E ratio) of the S&P 500 index will fall 24% from its peak of 24x to 18.3x, taking the index down to around 3600, 12% below round about 4100 as of June 6.

In another scenario in which we assume the terminal federal funds rate reaches a higher-than-estimated 4%, coinciding with an inverted yield curve, the fair P/E ratio of the S&P 500 index will drop further to 16.5x, bringing it down to around 3250, just two-thirds of its peak value.

Our calculations currently assume that its earnings per share remain unchanged, but one can certainly expect a bigger drop in the S&P 500 index than our estimates above in an economic downturn as corporate earnings will also fall.

Another question is: How is the US economy performing at the moment? Will it hold up under the pressure of rate hikes?

An inverted yield curve has historically been one of the most accurate indicators of the US economic outlook, but one should be mindful of the specific tenor of the US Treasury notes with which investors use to calculate the yield curve. Typically, most would look at the differences on yields between the 10-year US Treasury note versus that on the 2-year or 3-month notes. The 2-year/10-year spread and the 3-month/10-year spread have been largely in sync in the past seven years, until Q4 last year, when they started to go separate ways: The former predicted a looming US recession in the near future, but the latter said otherwise. 

According to a research report published in early May by the Federal Reserve Bank of San Francisco, both conceptual and empirical arguments suggest that the 3-month/10-year spread proves to be more accurate in foretelling where the US economy is heading than the 2-year/10-year spread. As of now, there is still some way off before the former becomes inverted, so the possibility of the US economy entering a recession over the short term should be modest.

Both the Conference Board Leading Economic Index and Purchasing Managers’ Index – another two gauges – have also shown similar results, pointing to moderate growth in the US economy over the short term. But if inflation does become unbridled, thus forcing the Fed to raise rates continuously, chances are the economy may struggle to remain stable.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

How will banks fare amid rising rates?

Posted on

In the 15 years after the global financial crisis, the MSCI World Banks Index rose by 14%, a small fraction of the 195% in returns global stock indexes gained during the period. The difference in performance can be explained in part by the tightened regulations restricting banks’ ability to leverage their balance sheets to boost the rates of return for their shareholders. Combined with an increase in labour costs and capital reserves required to meet compliance standards, banks have had to raise their expenses, which impinged on their profitability. Falling interest rates worldwide have also been a factor that most would attribute to have impacted banks’ net interest incomes.

But would banks benefit from an increase in interest rates aimed at stamping out inflation? Before we get to the bottom of this, we think it makes sense to unpack the relationship between net interest rate spread and interest rate. According to a research report authored by economists from the Bank for International Settlements and the US Federal Reserve surveying more than 3,400 banks in 47 countries globally, a bank’s net interest rate spread will typically decrease alongside a drop in short-term interest rate (3-month Treasury bond yields). The narrowing effect on banks’ net interest rate spreads is also more evident in countries with lower interest rates than those with higher rates such that, in the former, banks’ net interest rate spreads will drop by as much as 17bp when the short-term interest rate is lowered by 1%. In the latter, however, a drop in short-term interest rate of the same degree will only reduce banks’ net interest rate spreads by 9bp. Banks in areas with higher interest rates should also have relatively higher returns on assets.

Clearly, in times of economic growth and rising interest rates, bank stocks generally make a prime investment opportunity: An increase in interest rates will widen banks’ net interest rate spreads and returns on assets, while economic growth will also stimulate demand for loans and reduce risks of bad debt – both conducive to the profitability of banks.

Having said that, despite the Fed hiking rates in the past few months, the S&P Bank ETF underperformed the broad market. This is contributed by economic uncertainties emerging across China, the US and Europe: The US, for one, saw its Q1 GDP drop by 1.4% YoY; Europe has also been confronted with recessionary pressure due to elevated natural gas prices resulting from the Russia-Ukraine conflicts; lastly, China’s battle against the pandemic will likely lead to a slowdown in consumption and export, potentially curbing its economic growth. With one of the two requisites missing, the time is perhaps yet to be ripe for banks’ outperformance.

What about the net interest rate spread in China, then? It certainly will require more than one round of regression analysis to untangle the correlation between net interest rate spreads and interest rates in China. The marketization of its interest rates only approached the final stages of completion in 2015, before which the net interest rate spreads were largely in the hands of the government, making deciphering the spread’s correlation with the rise and fall of interest rates difficult.

Only six years’ worth of data since 2016 is currently available – a dataset far from sufficiently populated from which to extract any concrete conclusion. However, when we compared China’s 3-month Treasury bond yields with the net interest rate spreads of China Construction Bank (CCB) and China Merchants Bank (CMB), some might notice what appeared to be a positive correlation where rises in interest rates led to the widening of net interest rate spreads. But such an observation would go against our analysis of changes in interest incomes and interest rates found in the annual reports of domestic banks in China: the numbers provided respectively in the 2021 annual reports of both CCB and CMB point to a decline in their net interest incomes when interest rates rose.

For investors on the prowl for specific banks that stand to benefit from interest rate rises, we think those in Hong Kong and overseas markets should be given higher priority over domestic Chinese banks. So far, the policy direction in China looks to be skewed towards lowering the interest rate, rather than increasing it; still, another uncertainty lies in exactly how a rise in interest rate, unlikely as it is, will affect the net interest rate spreads across domestic banks.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.