In late September, the Federal Reserve, the central bank of the US, said it plans to raise interest rates once more before 2017 comes to a close. It also has plans to further raise rates three times in 2018, and twice in 2019.
Putting it all together, investors could be facing a total of six interest rate hikes by the end of 2019. I don’t know for sure what would happen to interest rates over the next two years – the Fed’s plans could change in the future. But, it’s still worth thinking about how rising interest rates could affect the stock market.
What to know about rising interest rates and stocks
In theory, stock market valuations would fall if interest rates climb. This causes stock prices to fall, if stocks’ earnings stay constant. But as the saying goes (this is often attributed to American baseball player Yoggi Berra), “In theory, there is no difference between theory and practice. In practice, there is.”
Economics professor and Nobel Prize winner Robert Shiller has a wonderful free database on long-term US stock market prices and interest rates, going back to the 1800s. Within his set of data lies an interesting chart which plots the movement of US long-term interest rates with US stock market valuations as measured by the CAPE (cyclically adjusted price-to-earnings) ratio. I’ve used his data-set to recreate a part of his chart for the period from 1930 to today.
Source: Robert Shiller
As you can see, beginning from the early 1930s, there was a good three decades-plus period when rising interest rates coincided with rising valuations. It was only in the early 1980s when falling interest rates were met with rising valuations. For me, this chart is a great example of how the movement of interest rates can’t tell us much (if anything at all) about where stocks would go next.
What a sustained increase in interest rates can likely do to stocks, is to make debt more expensive. This would result in a negative impact to the business results of heavily-leveraged companies without a strong ability to generate cash flow. In turn, the stock prices of such companies would then likely fall over the long-term.
To find the largest companies in Singapore’s stock market that could be in trouble because of rising interest rates, I ran a screen for Singapore-listed stocks based on the following criteria: (1) A market capitalisation of over S$100 million; (2) a net-debt to equity ratio of over 100%; and (3) negative operating cash flow over their past three completed-financial years.
The first criterion is meant to identify large companies. The second is to pick out companies with debt-laden balance sheets. The third is to find companies that have trouble generating operating cash flow.
Highly leveraged companies that lack the ability to produce cash flow even in the low interest rate environment that we have been in for the past few years would likely face an even steeper uphill battle to generate cash and service their borrowings if and when interest rates start climbing.
Of the companies that meet all three criteria, the five with the largest market capitalisations are: Cosco Shipping International (Singapore) Co Ltd (SGX: F83), Noble Group Limited (SGX: CGP), Hyflux Ltd (SGX: 600), Moya Asia (SGX: 5WE), World Class Global Ltd (SGX: 1E6).
Here’s a table showing their market capitalisations and net-debt to equity ratios:
Source: S&P Global Market Intelligence (data as of 2 October 2017)
None of all the above is meant to suggest that these companies are definitely stocks investors should stay clear of. These companies might just be on the cusp of a turn-around, or management could be in the midst of implementing positive and effective changes to the health of these businesses. There’s also the possibility that interest rates would not increase in the next few years, thus allowing these companies to continue operating in a low interest rate environment.
But given the poor track record of the five stocks, investors who choose to wade in should do so with their eyes wide open to the potential risks involved.
What stocks should we buy
After looking at what we should avoid, an important question then comes: What should we buy then?
Whether interest rates are falling, stagnant, or flat, investors should be looking for stocks with strong balance sheets, strong cash flows, businesses that have solid long-term growth potential, and a capable management team that also has integrity. Ultimately, what we – as stock market investors – should focus on is the businesses of the stocks we’re interested or invested in.
Editor’s note: A version of this article appeared in the 5 October 2017 edition of Take Stock.
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Disclosure: The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Cosco Shipping, Noble Group, and Hyflux.