With Fed rate cuts due to kick off this week, which equity sectors could see the biggest gains? In the third of our series looking at the impact on Asian assets, our Asia equity analyst shares her top picks
- Asian equities typically outperform in a lower rate environment. However, we remain cautious in the near term
- Over the medium term, cyclicals should see the greatest boost from a rate cut cycle
- High dividend stocks should also perform well given the need to lock in yields
US Federal Reserve meetings are usually closely watched by economists around the world. But few have been as eagerly anticipated as the one taking place this week.
Having raised interest rates to a high not seen in two decades, the Fed is expected to announce at its meeting on 17/18 September that it is pivoting to rate cuts. Most economists expect the Fed to start with a 25 basis points cut (although some point to 50 basis points), followed by one cut every month until the end of 2024, with more to come in 2025.
Global equity markets, including those in Asia, have already rallied ahead of this announcement. So how much more upside is possible and which Asian sectors have the highest potential?
We ask our Asia equity analyst, Iris Fan, to share her outlook for Asian equities in the wake of US rate cuts.
1. What is the likely impact on Asian equites of a rate-cutting cycle in the US and Asia?
Past precedents suggest that Asian equity markets typically outperform in a lower US interest rate environment. This is because structural US dollar weakness can help Asian countries to reduce their USD debt and attract more capital inflows. In addition, US rate cuts open up the scope for Asian economies to introduce their own monetary easing initiatives, thereby encouraging local credit demand and economic growth.
Despite this, we are tactically cautious in the near term given potential market volatility from heightened geopolitical risks post the US elections. We are also concerned that current high expectations about the pace and extent of US rate cuts have the potential to disappoint.
2. Which geographic markets do you expect to benefit the most/least from the fall in interest rates?
As Asian currencies gain strength against the USD, countries with twin deficits such as Philippines and Indonesia can benefit the most. A stronger local currency helps make their imports cheaper and reduces their foreign debt servicing burdens. There is also room for local consumers and corporates to receive more fiscal support.
US rate cuts can also advantage those economies previously cautious about reducing their policy rates. For example, China had been reluctant to increase its interest rate differential with the US as this risked further capital outflows. However, US rate cuts paves the way for China to support its weak economy by adopting a more accommodative monetary policy going forward.
Hong Kong is another clear beneficiary of US rate cuts. Given that the HKD is pegged to the USD, US rate cuts is directly linked to the HIBOR (Hongkong Interbank Offered Rate) and offers the territory’s consumers and corporates access to cheaper money.
India, on the other hand, has a more domestically driven monetary policy cycle. As such, while it has a promising outlook, its economy will be less sensitive to US interest rate cuts.
3. Which specific Asian industry sectors do you expect to benefit the most/least from the fall in interest rates?
Cyclical industries are likely to benefit as interest rate cuts can help boost countries’ economic growth. Lower interest rate reduces borrowing cost on consumer loans and mortgages, thus increasing individuals’ disposable incomes and promoting higher spending. This in turn leads to higher demand for goods and services, thereby boosting cyclical industries.
Similarly, lower financing costs helps corporates to increase their margins and net profits, reduce balance sheet pressures and improve business sentiment. Companies are also able to borrow more to fund their operations and growth plans. Of course, these benefits particularly apply to those that are already highly leveraged.
On the other hand, risks to financial sector firms’ earnings and profitability increase in a falling rate environment. This is because, as loan yields decline, banks could see a compression of their net interest margin (NIM) and therefore, diminished returns on new loans. In addition, borrowers may be incentivised to refinance their existing loans, which increases prepayment risks.
4. Do you expect a sustained boost for dividend stocks?
High dividend stocks are likely to perform well in a falling rate environment. Faced with declining yield from their savings and bond instruments, investors will tend to seek higher-income opportunities from their equity investments.
In addition, declining interest rates implies a lower discount rate. As dividend stocks offer regular payouts, this increases their present value within a discounted cash flow model, thereby making them more appealing from a valuation perspective.
5. Do you expect a sustained boost for small caps?
The benefits of interest rate cuts will take time to filter through to small cap stocks. Monetary policy actions are transmitted to the real economy with a lag. Hence small caps’ corporate earnings surprises that come with an improved economic outlook will likely only show through at a later stage of an interest rate cut cycle.
6. What are the risks to your view?
Although not our base case, rate cuts can also be driven by US recessionary concerns. If so, most Asian economies and their equity markets would be impacted due to weaker external demand.
In particular, such economic uncertainties would likely limit Asian small cap companies’ ability to take advantage of the lower financing costs, due to their perceived higher risk and/or lower creditworthiness. They may also suffer from weaker investor sentiment.
In the event of rate cuts designed to avert a recession, high dividend stocks would appear more attractive compared to growth stocks given their stable cashflow and defensive nature.
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