Valuations in the current economic climate?

How the current market environment affects valuations and our choices in investments.

9 min readOct 31, 2021

Before we discuss the investment approaches, I would like to discuss our current market environment and how it might affect our decision-making process.

It has been over 18months since the decline in the stock market back in March 2020 due to the pandemic. As governments globally roll out measurements to contain the spread of the virus resulting in further implications in the supply chain and labour markets, unemployment rose to a high of 14.8% in the US back in April 2020. Despite that, we have seen a V-shape market recovery thanks to the actions and policies implemented, preventing further decline in the capital market in an attempt to keep the economy afloat. The FED has introduced various monetary policies, increasing the money supply and reducing the interest rate to an all-time low of 0.25%.

So what does it mean for investors in this current market environment?

The global unemployment rate has reached 6.47% in 2020 and will likely decline to 5.7% by the year 2022. Globally, unemployment is still relatively high, a concern for many economies. In the US, with the unemployment rate at 4.8%, the primary concern is with voluntary unemployment contributing to the majority of the rate. Even though the majority of the unemployed are seeking job security and a better compensation package, some of the employed workforces is leaving due to exhaustion and work-related safety concerns. As work from home has become the new norm, lines between work and personal life have become blurred. Front line individuals have left due to safety concerns in the midst of the epidemic.

In the early stage of the pandemic, countries globally began to implement lockdown measures in an attempt to manage the outbreak. These measures have resulted in the slowdown of the economy and a decrease in an overall aggregate supply as factories are shut down during this period. Many economies only began to reopen when vaccines became available in their region. During this period, the adoption rate in digitalisation has increased drastically as everyone migrated online to conduct their purchases and meetings for both school and work. As such, demand for related products has increased while supply is declining upon reopening.

Additionally, to make matters a little more complicated, we are facing issues such as the supply-chain disruption, China’s Evergrande debt crisis, global energy crisis, concern over the US debt ceiling and geopolitics between nations looming over our heads.

China has managed to emerge from the pandemic earlier than most countries. Being the key manufacturer and supplier globally, China was able to resume production to meet the demands of countries that are mostly in the midst of a lockdown. With production resuming and increasing, so does the demand for electricity. According to a 2019 report, 57.7% of China’s energy comes from coal. This poses an issue when China bans imports from Australia amidst rising tension between them. At this moment, many countries began to reopen their economy as the pandemic eventually came under control. This increases the usage of energy which increases the competition for coal, pushing prices up. With the limited supply and sources for coal, a new problem arises — The China Energy Crisis. Rising coal prices pose an issue for the energy companies within China. Electric prices are fixed and the rising prices would mean smaller profits or net loss for them. This has curbed factory production, affecting goods from Milk to iPhones, resulting in a contraction in their Purchasing Managers Index (PMI).

On 23rd March, the Suez Canal was blocked by a container ship, Ever Given, the largest container ship in the world. The choke in this key trade route has caused supply chain disruption and companies billions of dollars as ships have to either delay their plans or find an alternative route. Over 350+ ships were waiting to pass through the canal during the day of the blockage. Putting its severity into perspective, approximately 12% of global trade, a million barrels of oil and an estimated 8% of liquefied natural gas passes through the canal each day. Even though Ever Given was freed on the 29th of March, after 6 days, the crisis is far from over as disruption has only just begun — we are still affected by this disruption even today.

From the various events mentioned, it has resulted in an increase in prices, pushing global inflation higher. In an attempt to keep the US economy afloat, the FED has set the interest rate at 0.25%. That said, the FED has plans to raise the interest rate in the year 2022 to keep inflation in check. Interest rates have an impact on both the economy and the capital market as it determines the cost of borrowing for individuals and businesses. In a low-interest environment, companies tend to be valued higher due to the lower cost of borrowing, increasing their profit margins. (Companies in the finance industry such as banks would be affected by low-interest rates — unable to service loans at a higher rate).

Evident in the current market environment, companies, especially ones with optimistic growth prospects have seen their share prices reaching all-time highs. However, it is believed by some that the current valuation may be ‘inflated’. The S&P 500 index which comprises approximately 27% of tech-related companies has gone up by 24.90% Year-to-Date (YTD) and about 97.18% since the bottom in March 2020. Other indexes such as the Russell 3000 and the NASDAQ-100 Technology Sector have seen a YTD return of 21.72% and 22.87% respectively.

So why is the interest rate rising in the near future?

The interest rate is adjusted by the central bank to facilitate support within the economy. Depending on the adjustment, they would have certain effects on the stock and bond market. Interest rates and inflation tend to have an inverse relationship — when the inflation rate increases, the interest rate is raised to slow the economy and bring inflation back down.

Individual expectations have a part to play with the outcome of the inflation rate as well. If the expected inflation rate is to reach 4%, workers would expect a higher wage. Hence, for businesses to pay their employees, they would have to raise the price of goods. The process begins when the central bank sets its intention to use monetary policies to achieve an inflation target, in this case, 4%. And so, the cycle begins. Under normal economic circumstances, the expected inflation rate is around 2% to facilitate employment and price sustainability.

As we enter into 2022, it is expected that the US would have a more resilient labour market with sufficiently stronger wage growth. This would help when the FED raises the interest rate to bring inflation down. The Bank of Canada, the Bank of England and the European Central Bank have plans to raise interest rates in 2022.

So how do we prepare for rising interest rates?

As interest rates increase, future profits are valued less today. This would mean that companies with an optimistic growth prospect will have their valuation tapered lower as margins shrink. Rising interest rates would also mean rising bond yields. The capital market, being forward-looking, will likely see prices falling as they factor in the rising interest rates and yields.

Therefore as an investor, it is crucial we factor in the rising interest rates when making decisions. So the few things to take note of while conducting our valuations; economics moats, current debt level and their financing cost, flexible rates vs fixed rate, cash flows and other interest related entities such as mortgage, leases and loans that are tied to the interest rate. Ideally, we would want to evaluate a company with the mentioned attributes in order to gauge whether it will be able to tide through the current economic climate. Examples of companies that would generally perform well under rising interest rate environments are within the finance and consumer staples sectors.

Why are the mentioned attributes important?

Economic moats — An economic moat enables the company to have a competitive advantage over its peers. This advantage could be in terms of cost, pricing power, network effect, switching cost, high barriers to entry, intangible assets or their scalability. Companies with economic moats tend to outperform their peers and generate sizable returns for investors.

Debt — Debt is not all bad and no good. If used wisely, debt can help a company expand their operations. A company can fund their operations from two external sources — borrowing (issuing of debt) or issuing of capital equity. Debt and interest work hand in hand. With lower interest expenses, a company would have a higher profit margin thus leading to a higher valuation. This is why very often, investors overlook the cost of finance due to low-interest rates. As interest rate rises, future profits shrink thus lowering the valuation of the company.

Cash flows — Cash is King! (referring to the cash flow of a business) A cash flow for a business can be viewed similarly to blood within our body. They are crucial in the business’ daily operations, research and development, debt payment, salaries and operating related costs. Positive cash flow buffers companies during financial headwinds. A company with positive cash flow would also indicate good financial management. They understand where funds should be allocated considering future growth while managing their risk exposure.

In conclusion

We should not be afraid of rising interest — it is an indicator that our economy is recovering.
We do not necessarily have to sell interest sensitive financial assets such as tech-related companies.
Conduct your due diligence of the companies within your portfolio — understand their fundamentals and work within your circle of competency. Figure out how a rising interest environment affects the companies’ prospects.
Research and identify prospective companies that have the ability to not only continue operation but excel in a rising interest environment.
As an investor, we must understand that rising interest will impact interest sensitive companies, be it in a good or bad manner. The impact is often short term as a company’s share prices tend to follow its fundamentals in the long term.

Of course, the content discussed within this article still has room for further expansion and discussion. There are many possible events that might affect the outlook of the direction of the market. Thus, what is happening currently and in the foreseeable future is not limited to what we have discussed. I have also included various links to elaborate certain points made within this article. Feel free to share your thoughts!

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