22 January 2019
In 2009, then Federal Reserve chairman Ben Bernanke launched a zero interest rate policy. Photo: Bloomberg
In 2009, then Federal Reserve chairman Ben Bernanke launched a zero interest rate policy. Photo: Bloomberg

Low valuation may also be expensive

Typically, there are three indicators of economic recovery: high economic growth rate, high inflation and high interest rate.

High interest rate is not bad if it reflects fast economic growth. But when the interest rate is 0.2 percent higher than the inflation rate, or the interest rate remains at a high level while economic expansion is weakening, it may signal the start of a recession.

Is there any exception? Of course. When inflation is too high, it will hurt economic growth, and possibly lead to stagflation. The central bank will need to use monetary policy to break the loop.

In the 1980s, the then Federal Reserve chairman Paul Volcker raised the interest rate to 1.8 percent, thereby subduing high inflation. Since then, interest rates have gone down and the US economy recovered. This created a bull market in the United States that lasted for nearly 20 years.

In 2009, then Fed chairman Ben Bernanke launched a zero interest rate policy, seemingly an opposite strategy to what Volcker did.

Low interest rates may have created a long-term bear market. Many of the companies which should have gone bankrupt and quit the market during the global financial crisis survived thanks to the zero interest rate environment.

Keeping these companies in the market will dilute the overall market profitability. Moreover, a zero interest rate environment encourages profit by lending rather than improving production efficiency or innovation.

The market is characterized by “over-investment” and high leverage. As economic growth slows (because it was driven by oversupply instead of increasing demand), the demand for capital will decrease (the arbitrage game of low interest rate and low investment return will come to an end). The economy will be half-dead.

The textbook tells us that the interest rate is a true reflection of the capital cost in the market, while providing a risk-free rate for the market.

The higher the risk free rate is, the lower the stock market valuation will be, and vice-versa. So low interest rate blows up the prices of all asset classes. It’s inevitable.

But, beyond what the textbook tells us, asset prices are not only linked to the interest rate but also the economic growth rate.

High valuation doesn’t mean expensive if it is supported by high earnings growth, while low valuation may not be cheap if the company has low, even negative earnings growth.

Currently, the valuation in Hong Kong and mainland stock markets is at a level even lower than during the financial crisis.

While all the stocks were cheap back then, what we see now is that some companies are still not cheap enough.

On the other hand, the impact of the renminbi devaluation and the deflation on corporate earnings will only be felt until March. 

Also, after years of low interest rates, most companies have incurred high debt levels. What will their performance be like now that the interest rate normalization has started?

Amid a disappointing macro environment, investors are better advised to seek investment opportunities on a micro level. Some companies will outperform the market no matter how bad the macro environment is.

Many US internet companies released better than expected results recently. For those quality stocks, just buy and hold till your retirement day.

This article appeared in the Hong Kong Economic Journal on Feb. 3.

Translation by Myssie You

[Chinese version 中文版]

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Columnist at the Hong Kong Economic Journal

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