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COMMENTARY

How to get ready for a rate rise?

It won't be too much longer now. There are growing signs that the US Federal Reserve is getting its ducks in a row. So, it might just be a matter of weeks before Fed chair Janet Yellen and the members of the Federal Open Market Committee pull the trigger on another interest rate increase.

Admittedly for some, it might feel like an eternity since the last rate hike. But, in reality, it was only nine months ago. Nevertheless, given that the market was expecting an increase shortly after the last hike in December, and three increases in total this year, the suspense for some has been quite unbearable.

But the waiting could soon be over. Recently, New York Fed chief William Dudley warned that markets are under-pricing the odds of a forthcoming rate rise. The operative word being: "forthcoming".

Dr Dudley, who is reckoned to be closely aligned with Dr Yellen, said the US economy is likely to improve in the second half of this year, after a very weak first half. In other words, we should not be too surprised if US interest rates go up between now and the end of the year.

Despite all the efforts this year by the Federal Reserve to prepare the market for the next rate hike, many investors around the world are unlikely to take it in their stride. If the last rate hike, which was a mere one quarter of one percentage point, is anything to go by, we can expect plenty of weeping and gnashing of teeth both in the run-up to and in the aftermath of the decision.

Put another way, there could be extreme stock market volatility, as investors ditch riskier assets, such as shares, in favour of something safer, such as cash.

Some shares, it has to be said, may deserve to fall. In the main, some heavily indebted companies have probably had it too good for too long. These highly leveraged businesses have been clinging on to survival by the thinnest of threads. Consequently, when rates rise, they could find that they will have to spend more to service loans, rather than plough any money they make back into their operations. There could also be less profit, if any, to distribute to shareholders in the form of dividends.

But a rate hike by the United States, on the whole, should be seen as a positive. It means that the world's largest economy has probably recovered sufficiently from the financial calamity of 2008 to tolerate a higher cost of borrowing. That could be good news for exporting countries here in the East, especially manufacturers with a focus on the US market. And let's not forget the banks, which are gasping for a rate rise.

Banks make the bulk of their money from the difference in the interest rates that they charge borrowers and the deposit rate that they pay to savers. When interest rates are low, the margin between borrowing and lending can be wafer-thin. But as interest rates rise, so too does the spread between the interest rate charged and the rate paid. So, some of the main beneficiaries of a US rate rise could be our local lenders.

Indebted companies, on the other hand, could be adversely affected. But generally, Singapore companies look well placed to weather an interest rate hike. Collectively, Singapore's 30 largest companies have debts of around $250 billion. But they also have net assets of almost $380 billion, which would suggest that they are reasonably well capitalised.

Additionally, the 30 companies that make up the Straits Times Index should be able to more than meet their interest payments. With combined annual earnings of over $18 billion and total interest payments of just $3.3 billion, interest payments are covered more than five times by earnings.

However, averages can be deceptive. Whilst many Singapore companies should be largely unaffected by higher costs of borrowings, some could be adversely affected. So, as investors we should study each of our holdings closely.

As our first rule of investing, we should never buy shares in any company without understanding its finances. Some of the biggest losses in investing come from companies with poor balance sheets. So focusing on those with strong balance sheets is crucial.

Knowing everything we need to know about each of our holdings could put us in a good position, if stock markets should tumble in the aftermath of a US rate hike. It could provide just the opportunity to buy more of the shares we like at favourable prices. The important thing to bear in mind is to not get scared out of owning shares when the stock market stumbles. Instead be ready to rumble when the market tumbles.

• This is a regular column on stocks and investing by Mr David Kuo, chief executive officer of The Motley Fool Singapore.

A version of this article appeared in the print edition of The Straits Times on September 05, 2016, with the headline 'How to get ready for a rate rise?'. Print Edition | Subscribe