With a 25bps point increase in Fed Funds rate announced yesterday, US is continuing its path towards interest rate normalisation. Economists are expecting a median funds rate of 2.1% (from current: 1.50%) by end 2018.
A higher US interest rate should theoretically result in corresponding increase in debt and equity yield in emerging markets. The following graph shows the following:
- Some level of correlation exists between 10Y US yield and the earnings yield (being inverse of Price-to-earnings ratio) of respective indices in the ASEAN region (Malaysia, Thailand, Singapore, Indonesia and Philippines)
- Singapore’s STI appears to have the highest earnings yield (i.e lowest P/E) if compared to the rest of the ASEAN indices (possibly due to its developed state, i.e lower growth rate -> behaving more like a fixed income)
- Malaysia’s earnings yield is increasing since 2016. More likely due to falling stock prices (accompanied with a stagnant or declining earnings)
- Thailand’s STI index has recorded major increase in stock prices, resulting in declining earnings yield
- There are expectations that both Philippines and Indonesia will achieve higher future economic growth rate, as both countries’ equity indices are trading at the relatively low earnings yield
My tenets are as follows:
(i) Equity earnings yield should be higher than the yield required on debt instrument
(ii) Foreign funds are expected to flow into equity markets of emerging markets if there is sufficient spread / yield differential between equity earnings yield and US10Y yield
(iii) The lower the spread / yield differential could potentially mean that the equity index is overvalued
(iv) US rate hikes may potentially lead to reduction in the spread / yield differential and thereby, the equity indices have to adjust (i.e a correction in equity indices) in order to restore to the original spread
Historical median differential yield between 10Y US and KLCI equity earnings yield is slightly above 3.50%. In the Malaysian case, when the differential yield has fallen significantly below the historical median yield differential (e.g 2011 and 2014), we saw a subsequent decline in the KLCI index. Currently, the earnings yield of KLCI is above the historical median (could this be a potential buffer towards possible future correction in the index?)
In general, Thailand’s SET index has been trading at yield differential (US10Y vs SET earnings yield) of close to that of its historical median yield differential. Nevertheless, there are ‘subtle’ patterns in the SET index whereby if the yield differential is lower than the historical median, there was tendency for future decline in the index. Currently, there does not appear to be any buffer for the SET index should there be a future correction in the equity index.
In between 2013 and 2016, the yield differential has fallen below that of its historical median. This was followed by a subsequent correction in the Singapore’s STI index. Currently, the index is trading at earnings yield that is higher than the historical median (thereby providing potential buffer for possible future correction?)
Despite the significant increase in the JCI index, JCI is currently trading close to its historical yield differential median. This could be potentially due to strong earnings growth recorded in 2017.
The index may appear ‘overvalued’ as the yield differential / spread has fallen below that of its historical median yield differential. Question remains whether the earnings will continue to grow to support this higher valuation.
Putting everything together….is KLCI overvalued if compared to the equity earnings yield of the regional indices as well as the 10Y USD?
Based on the regression analysis for data of up to 13 Dec 2017 (as shown below), the fair equity earnings yield of FBMKLCI is expected to be approx. 6.02% (or P/E of 16.6x) with a 95%-confidence interval of betweeen 5.62% – 6.41% . The actual current earnings is relatively higher at 6.39% (or P/E of 15.6x). Hence, based on this simple analysis, the FBMKLCI may not appear to be ‘overvalued’.
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