How to make money from valuation increases when interest rates are falling?

The golden period of valuation uplift brought about by declining interest rates generally occurs in an environment of extremely loose liquidity, where the economy stabilizes but has not significantly recovered. With the yield on China's ten-year government bonds dropping from 3.2% to a historic low of 1.6%, investors face a key question: can they make money from valuation uplift this time?

The team led by Liu Chenming at GF Securities noted on Monday that historically, A-shares tend to see a decline in valuation during the initial phase of interest rate cuts, with systematic uplift only occurring towards the end of the decline. More importantly, the performance across different industries is highly differentiated; when government bond yields fall to 1.6%, the TMT sector driven by economic prosperity leads the way, rather than traditional defensive sectors.

Interest Rate Decline Trading Strategy for A-shares

Reviewing the history of A-shares, GF Securities found that during the period when government bond yields fell from 3.2% to 2.2%, overall market valuations declined, with only defensive sectors such as utilities and coal seeing valuation increases; however, when rates further dropped to 1.6%, the market began to systematically uplift valuations, with the TMT sector performing prominently while defensive sectors underperformed.

The report stated: “For most of the time during interest rate declines, market valuations tend to fall, and only stable assets can uplift valuations; however, towards the end of the interest rate decline, the market may systematically uplift valuations, focusing on seizing opportunities in prosperity-driven assets, while stable assets fail to achieve excess returns.”

Two Paths to Valuation Increase: Profit Improvement or Interest Rate Decline

GF Securities pointed out that there are mainly two ways for valuation uplift: one is the valuation increase brought about by profit growth, and the other is the revaluation in a low-interest-rate environment. Historical data shows that during periods of rising or accelerating ROE, valuations tend to increase; conversely, during periods of slowing growth or declining ROE, valuations usually retreat, forming a "low valuation trap."

Theoretically, the lower the interest rate, the higher the asset valuation should be. However, in the real world, data from various countries shows that valuations are generally positively correlated with ROE, while the relationship with interest rates is uncertain; some countries show a positive correlation (such as Japan and Singapore), some show a negative correlation (such as the United States and France), and some have weak correlations (such as the UK and Germany).

When Can Declining Interest Rates Uplift Valuations?

Analyzing global data from 1980 to the present, GF Securities pointed out that there are mainly two scenarios in which declining interest rates can uplift valuations:

The normalization process of declining inflation and interest rates: For example, in the United States during the 1980s, interest rates fell alongside high inflation, leading to stable economic growth and a rebound in valuations.

Post-Crisis Environment of Massive Liquidity: After Europe implemented negative interest rates and quantitative easing, the fundamentals stabilized, and valuations were restored. There are also many counterexamples: if the economy continues to decline or experiences long-term deflation, falling interest rates may instead be accompanied by continued declines in valuations, as seen in Japan in the 1990s, and in the UK and South Korea after the financial crisis.

At what level do interest rates need to fall to start raising valuations? Which sectors are raising valuations?

When interest rates fall to a certain level, valuations often begin to rise. Data from major developed countries shows that the average low point for the price-to-book (PB) ratio is 0.85 times, corresponding to an average interest rate of 2.46%; while the average low point for interest rates at 0.20% corresponds to a PB ratio of 1.38 times.

GF SECURITIES points out that the low point of valuations is determined by both fundamentals and monetary liquidity. If the fundamentals are not too poor, the low point of valuations generally occurs before the low point of interest rates. During the process of further liquidity easing and declining interest rates, valuations will be raised, as seen in the United States, Germany, France, and Japan after the financial crisis.

So, which sectors can raise valuations during the interest rate decline phase? The report shows three scenarios:

If the fundamentals are relatively good (such as in the US, Japan, Germany, and France), the valuation increase is mainly concentrated in advantageous sectors such as consumer discretionary, technology, industrials, and healthcare;

If the fundamentals are in a low-level fluctuation (such as in Italy), defensive sectors such as utilities, finance, and consumer staples perform better;

If the fundamentals continue to deteriorate (such as in South Korea and the UK), it is difficult for valuations in almost all sectors to rise.

It is worth noting that during the interest rate decline phase, traditional high-dividend sectors often struggle to achieve excess returns. This is because fundamental expectations change, and as interest rates decrease, the interest rate sensitivity of valuations also declines.

Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial conditions, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investment based on this is at their own risk