Getting Ready for US Interest Rate Rises

After talking about it for 2 years, the US Federal Reserves (Fed) is finally about to raise interest rates. For a good part of these 2 years, I had not been too concerned about interest rate rises and was happy to pick up REITs beaten down by interest rate worries. It was 2 weeks ago that I realised that while interest rate rises were not too worrisome, things do not work in isolation. Here are my thoughts and actions taken in response to interest rate rises and their secondary effects.

Wave 1: US Interest Rate Rises

As mentioned, interest rate rises should not be too worrisome. My guess is that US interest rate should not rise to more than 0.75% by the end of this year and 2% by the end of next year. By pre-Global Financial Crisis standards, 2% interest rate is considered very low. Thus, I am not too concerned over the increased interest that stocks and REITs have to pay on their debt obligations.

Wave 2: US Dollar Rises

When US interest rate rises, US Dollar will become more attractive and rise as well. In fact, this has already happened. Since the middle of last year, US Dollar has started to rise against Singapore Dollar, Euro and Yen. The rise is approximately 7% against SGD and 20% against both EUR and JPY.

USD Movement Against SGD, EUR & JPY

Considering that Japan is in the middle of its Quantitative Easing (QE) at a rate of 80 trillion yen (equivalent to USD650 billion) per year and Europe has just started its QE in Mar this year for a total of EUR1.1 trillion, it suggests that USD will continue to rise. Essentially, the more money that Europe and Japan inject into their respective economies, the more money is available to invest in US assets. Both the World Bank and International Monetary Fund (IMF) have in recent weeks advised US Fed to defer its interest rate rises until next year. Should USD continue to rise due to interest rate increases, it would hurt the competitiveness of US manufacturers and might force Fed to reverse course and lower interest rates again.

Among the regional currencies, SGD is usually the strongest. Against USD, Malaysian Ringgit (MYR) has fallen by 16% and Indonesian Rupiah (IDR) has fallen by 11% since a year ago, as shown in the figure below.

USD Movement Against SGD, MYR & IDR

The effects of the above foreign exchange movements mean that companies that earn revenue in USD will benefit, while those that earn revenue in EUR, JPY, MYR and IDR will suffer. Among the stocks in my portfolio as at end May, LippoMalls earn its revenue in IDR while its debts are denominated in SGD. Metro also has retail operations in Indonesia. Both were sold in early Jun. For more details on LippoMalls, you can refer to A Tale of 2 Indonesian REITs.

The strengthening of SGD against regional currencies also means that it has become more expensive to visit Singapore for holidays, leading to lower revenue for hotel business trusts such as CDLHTrust, FarEastHTrust and OUEHT. All 3 were sold in early Jun.

There is another stock that is based in Indonesia, namely First Resources. However, it earns its revenue in USD, so there is not much concern. It is possible to understand the impact of foreign exchange movements on companies' earnings by referring to their annual reports. There is usually a section that discusses the impact to earnings and equity if the major currencies that the company is exposed to rise or fall by a certain percentage.

Wave 3: US Dollar-Denominated Assets Fall

When USD rises, assets that are denominated in USD tend to fall. Such assets include gold and oil. As at end May, I have about 8 oil-related stocks in my portfolio, such as BakerTech, CH Offshore, ChinaAvOil, CSE Global, Keppel Corp, MTQ, PEC and Rotary. None of them will be sold for 2 reasons. Firstly, oil prices had already fallen by almost half since the middle last year! Going forward, it is unlikely that oil price will fall by a similar extent even if USD were to rise further. Secondly and more importantly, none of these 8 stocks carry a lot of debt. The highest debt/equity ratio among the 8 stocks is 50%. Hence, no massive rights issues are expected from these 8 stocks going forward.

I also have Lyxor Commodity that has exposure to both gold and oil. But it is sitting on paper losses and I gave up hope on this stock (for now).

Wave 4: Stock Market Volatility Rises

With so many effects happening, the stock market may become more volatile. Even if a company has very little debt, foreign currencies and exposure to gold and oil, its stock price may still fall in tandem with the general market. While there are trailing stops to protect the paper gains on some of the stocks, I generally do not expect many stocks to be sold on this ground. The key reason is as long-term investors, we should be more concerned over the economics of the company rather than the short-term volatility of the stock price. A company can lose money if it has a lot of debt, foreign currencies and/or exposure to gold and oil, but it cannot lose money because the stock market is volatile (unless it is a financial company). Hence, not many stocks will be sold on this ground. On the contrary, I will be waiting at the sidelines to pick up good-quality stocks if they were to be beaten down.

On the Passive Side

There are a lot of things happening on the active side of investments. However, on the passive side, all the above effects can be considered as noise. It is business-as-usual for passive investment strategies like Dollar Cost Averaging and portfolio re-balancing. They have in-built defence mechanisms to handle any volatility in the stock market. You may wish to refer to The Anti-Fragile Portfolios for more info.

See related blog posts:

• Why Singapore Interest Rates Might Rise Faster than Expected
• A Jittery September
• Interest Rate Hedging Smoke Screen