My last article regarding the effect of rising interest rates on the UAE’s equity markets sparked quite a bit of debate on LinkedIn and got me to thinking about how the equity markets have been performing. So I looked at the year to date (YTD) return for Abu Dhabi’s market at found out it is 9.82% as of today (source Bloomberg). For Dubai’s financial market the YTD return is -12.62% (source Bloomberg). This doesn’t tell me much about the overall equity performance on a national level.
Understanding the UAE’s Equity Market Performance
I decided to look at the MSCI UAE Index. This is denominated in US dollars, but given the dirham peg to the dollar there shouldn’t be much difference. It also only includes a small number of stocks, albeit a portfolio that is supposed to represent the whole market. The MSCI index shows a YTD return -5.32% as of the end of last month. Conveniently, MSCI also presents the MSCI Frontier Markets YTD for the same period which is -10.70%, so the UAE has outperformed other frontier markets by quite a large margin.
The MSCI provides some other interesting statistics. The 10 year returns for the UAE and the Frontier Markets are -1.95% and -2.18% per annum respectively. So although the UAE performance edges out the Frontier Markets, the idea of equity out-performance in the long-term might need revisiting. Perhaps 10 years isn’t long-term enough?
But two other points caught my eye that are important in terms of understanding volatility / risk. The first is that the 10 year annualised standard deviation, the main risk measure for equity prices, for the UAE is 31.87% which is 70% greater than the Frontier Markets standard deviation of 18.79%. Double the risk for 23 basis point out-performance (-1.95% – (-2.18%)) doesn’t seem worth it. It is worth noting that the volatility of the UAE equity markets as measured by the MSCI has dropped drastically over the last 10 years.
The second measure that is related to risk was the maximum drawdown. For the UAE, the maximum drawdown was 87.25% from the peak on 22/9/2005 to the bottom on 5/2/2009. For those who can’t remember, or weren’t in the UAE, there was a massive equity bull market in the UAE that started in the early 2000’s and popped in the mid-2000’s. Then the global financial crisis hit us sometime in 2008. Double whammy of bad luck.
Now let me explain what a drawdown of 87% means. If you invested 100 dirhams, you’d be left with 13 dirhams. To simply return to your starting point you would need a total return of a staggering 670%. To understand what that means, consider MSCI’s USA Investable Market Index which had an annual return of nearly 10% from May 31, 1994, the earliest date MSCI provides. If we assume that we can get that return of 10%, then the 13 dirhams left will compound back to the original 100 dirhams in 22 years.
The Effect of Rising Interest Rates
Going back to my previous article on the effect of rising interest rates, it makes sense given various discussions to elaborate how this affects the equity markets.
Deposits are an Asset Class
As interest rates rise banks will normally have to raise their deposit rates. Bank deposits usually pay less than other investment classes but are also usually much safer.
For the equity markets, looking at their performance we see that the results are mixed, with some equities performing extremely well and others in negative territory. If we pause here and consider the choices of an investor: a volatile market with clear examples of upside while at the same time some serious examples of risky stocks. There is no clear cut answer, as the trade off is not just about returns, it is about risk as well.
The long-term proponents will argue that equities are cheap now and investing in equities makes sense. But as we have seen, it can take a long time for things to change.
Rising Interest Rates Push Equity Prices Down
There are several angles here. The first is the concept that the price of equities is determined by the risk free rate (RFR), conventionally accepted as the interest rate on US government bonds, plus an equity risk premium which is the extra return over the RFR that investors ask for taking equity risk. By definition, as the RFR goes up, and the US Fed has signalled that this will continue, then equity returns demanded by investors will go up.
A different way to look at this is that the value of a company is derived from the discounted future cash flows (DCF). What the DCF model does is try to determine the future cash flows of a company and then discount to today to get a total value. Discounting simply means dividing each cash flow by a discount rate adjusted for time. The discount rate begins with the risk free rate. So if the RFR goes up, the discount rate goes up, and the present value of the future cash flows automatically goes down.
Cost of Capital
First, if anyone mentions Modigliani-Miller, there will be trouble. I mean it.
This one is easy. Cost of capital goes up, then absent a corporate income tax offset, there is a decrease in profits or a decrease in opportunities. Either way, the price of equity goes down.
Conclusions
I am not giving investment advice. I am simply highlighting some ways that rising interest rates and the equity markets are related. We’ve been living in a low interest world for so long that perhaps some of us have forgotten that deposits (fixed income instruments) are a viable part of an investment program. It’s worth reviewing whether they are useful to you personally.