Will rising interest rates hurt corporates badly?
November was another choppy month for Wall Street and global stock markets. Despite robust corporate earnings in the US, expectations are that earnings have peaked as interest rates start to rise and the US-China spat affect trade. A decade of pump-priming amid low interest rates and easy credit has reflated asset prices and led to growing indebtedness, and this has to be unwound.
A key driver behind the market rout was fears that interest rates were likely to rise more than expected. The US Federal Reserve had raised interest rates by 25bp to 2.00-2.25% in Sept. It foresees another rate hike in Dec and three more next year.
However, as stock markets face increased volatility, there are also expectations the pace of rate hikes may be tempered. Case in point, Wall Street rallied sharply on Wednesday after the Federal Reserve Chairman said interest rates were “just below” neutral.
The worries over US interest rates comes amid fears of peaking economic growth, with added inflationary pressure from the ongoing US-China trade war, which is likely to see higher input costs and consumer prices. The US had slapped a 10% tariff on about US$200 billion of Chinese goods in Sept 2018, with the tariffs expected to increase to 25% in Jan 2019.
A counter balancing factor to inflation is lower commodity prices, especially crude oil prices which have recently slumped. If commodity prices stay low, inflationary pressures can be kept in check.
What will higher interest rates bring to the corporate sector?
A decade of low interest rates and easy money has seen total corporate debt in the US surging 86% from US$4.9 trillion in 2007 to nearly US$9.1 trillion in mid-2018, according to the Securities Industry and Financial Markets Association. Nonetheless, the general consensus is that these concerns are unlikely to manifest themselves in the near term as bond default rates remain low and the US economy is on a strong footing. Fitch Ratings forecasts bond defaults for 2019 at the lowest since 2013 and US corporates are in good shape.
The 2017 tax breaks saw US companies’ nominal tax rates reduced from 35% to 21% and many have used it to reduce debt. According to Moody’s, the top 100 US corporate non-financial companies have spent US$72 billion of new cash flows repay debt, while US$81 billion went to shareholder returns through buybacks and dividends.
As a result, new debt issuances have also fallen as debt refinancing and expansion needs eased. Fitch estimates that new investment grade issuance dropped 15% y-y to US$531 billion for the first 3 quarters of 2018 while high-yield issuance declined 32% to US$138 billion.
How about Malaysia’s corporate sector?
Much has been written on the high indebtedness of Malaysian households but surprisingly little about the state of the corporate sector.
One measurement for total private sector indebtedness is “Domestic Credit to Private Sector”, which refers to financial resources provided to households and businesses by financial corporations in the form of loans, purchases of non-equity securities, trade credits, and other accounts receivable.
In Chart 1, we have compared the Domestic Credit to Private Sector for Malaysia and the US, measured as a percentage ratio to GDP over the last 20 years, from 1997 to 2016. As can be seen from the table, in 1997 during the onset of the Asian financial crisis, Malaysia had a ratio that was higher than the US, at 158.4% of GDP, vs 146.1% for the US. By 2016 though, Malaysia’s ratio had fallen to 123.9% while the US had risen to 192.2%
From its highs of over 150% in 1997-98, Malaysia’s ratio fell to as low as 96.7% in 2008 as borrowers, especially corporates, de-geared after the Asian Financial crisis. Meanwhile, in the US, the ratio had been steadily climbing, reaching a peak of 206.3% in 2007, just before the sub-prime crisis, and ending at 192.2% in 2016.
More interestingly in the case of Malaysia, household debt has been the main driving force behind private sector debt, rather than corporate lending. Chart 2 shows the ratio of Malaysia’s household debt to GDP, which surged from 48.4% in 1997 to 88.4% in 2016.
By deducting the figures of Chart 2 from Chart 1, we would arrive at the implied corporate debt ratio as a percentage of GDP for Malaysia, and the figures, as outlined in Chart 3, are very interesting. Implied corporate debt as a percentage of GDP has fallen from 110% in 1997, and levels of above 100% in 1997-1999, to just 35.5% in 2016.
Malaysian companies have also resorted to the capital markets to borrow but by and large, they are relatively lowly geared and on strong footing – unlike the last Asian Financial crisis two decades ago. As such, there is much more room to withstand rising interest rates and external shocks.
Our Global Portfolio benefitted last week from the rally on Wall Street, as concerns over a faster than expected acceleration in interest rate hikes started to ease. Our portfolio rose 2.0% for the week, led by Amazon and DIP Corp, which rose 8.8% and 8.9%, respectively, for the week. Our Global Portfolio’s returns stand at -8.9% since inception, marginally lower than the benchmark index , MSCI World Index, which is down 6.9% over the same period.
Our Malaysian portfolio declined 1.7% for the week as we were dragged down by heavy losses in Genting Malaysia. This has reduced our portfolio’s total gains to 54.4% since inception. Nonetheless, our portfolio continues to outperform the benchmark index, FBM KLCI, which is down 7.3%, by a long way.
Genting Malaysia’s shares tumbled after it announced it was filing legal suits against 21st Century Fox Inc and Walt Disney Co over the termination of an agreement to licence 21st Century Fox’ intellectual property for Genting’s earlier proposed theme park. The theme park was to be a major driving theme for visitor arrivals in Genting, which is facing increasing competition from casino resorts around the region. With these setbacks, we have sold all our shares in Genting Malaysia at RM3.06, and have realised a loss of 39.6% on our investment.
Top Glove was our top gainer last week, gaining 4.6% to RM6.12, and up 11% since our acquisition in September. The gains came amid expectations that Top Glove could potentially replace Telekom Malaysia as a new component stock in the FBM KLCI 30 index, when the FTSE Russell announces its next review in December.
Stocks in the Malaysian Portfolio fared better, gaining 1% in the past one-week. FPI was the biggest gainer, rising 15% on the back of stronger 3Q18 earnings.
Total portfolio returns improved to 57.2% since inception. This portfolio continues to outperform the benchmark index, FBM KLCI, which is down by 7.3%, by a long way.
A Note to Readers
It is my pleasure to share with you my Value Investing Portfolio. However, I must emphasize that it is by no means a recommendation or a solicitation or expression of views to influence you to buy or sell any stocks. I am just sharing openly on what I am doing with my stock portfolio.
Further, I like to remind all investors that investing is not just about the profits or returns. You will inevitably suffer stock losses too. You need to understand your own investment objective, risk appetite and the amount of loss you can afford to bear. So, while many investors talk only about absolute returns, I am also sharing the computed risk-weighted returns of my portfolio.
Tong Kooi Ong