Risk-free rates matter when it comes to equities. This is the yield of 10-year Treasuries in the US or the yield on 10-year Singapore Government Securities (SGS) locally. Just ahead of the US Federal Reserve hiking the Federal Funds rate (FFR) by 75 basis points (bps), the yield on 10- year SGS rose to a multi-year high of 3.24% (see chart 1). There has been a small dip since then.
However, with local risk-free rates at 3.24%, the average DPU yields of S-REITs need to rise to an average of 6.8% to 7% to maintain the yield spread of around 360–370 bps. Hence, the S-REIT sector is likely to be under some pressure till the Fed completes its rate hike cycle later this year.
It isn’t just the REITs that take their pricing from risk-free rates. Stocks with higher risks require a higher equity risk premium to be attractive to investors. Selected tech stocks, listed fintechs, listed superapps and possibly cryptocurrencies carry higher risk premia. For risky assets such as these, investors need to be compensated by a risk premium, which is a rate of return greater than the risk-free rate. Hence, when risk-free rates rise, these stocks will have to compensate by falling.
Equity valuations are also likely to be impacted. Just in case there are those who still look at the capital asset pricing model (CAPM) in this age of cryptocurrencies and decentralised finance, risk-free rates matter.
The CAPM is commonly used to estimate a discount rate for cash flows in a DCF calculation, in particular, the cost of equity. Hence, quality stocks with rising cash flows that outstrip the rise in discount rates are likely to do better than those with no cash flows. The key to picking some sort of a bottom is likely to be towards the end of the Fed’s rate hike cycle.
The Fed has telegraphed that it is likely to raise FFR by another 50 to 75 bps at the next Federal Open Market Committee (FOMC) meeting and by the end of the cycle, the FFR is likely to reach 3.8%. Following the hike on June 15, the FFR is at between 1.5% and 1.75%. Against this background, markets may remain volatile, temporary rebounds notwithstanding.
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However, as we get towards the end of the rate hike cycle, there is likely to be a divergence between the performance of various sectors. One way to play the risk premia theme is by buying into the Straits Times Index (STI), which comprises stocks with the largest market capitalisation (hopefully blue-chip) on the Singapore Exchange.
The best proxy for the STI is the STI ETF. There are a couple of these. According to the SGX ETF Screener page, the SPDR STI ETF (see chart 2) and the Nikko AM STI ETF have expense ratios of 0.3%. There isn’t much to choose from in their tracking error either. The SPDR STI ETF reports a 1-year rolling tracking error (0.1597% as at March) and Nikko AM STI EFT reports a three-year annualised tracking error (0.15% as at March). Both disburse dividends semi-annually. SPDR ETF STI has a dividend yield of 2.93% as at June 16 while Nikko AM STI ETF’s dividend yield is 2.49%, according to the SGX ETF Screener.
Technically, based on the chart of the SPDR STI ETF, support is at $3.1 and it last traded at $3.19. The 200- day moving average was breached at $3.256 and prices moved below a minor support level of $3.20 which is a small gap. While short-term RSI is at the low end of its range, medium-term indicators such as quarterly momentum have yet to bottom.
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