Will I sell DBS Bank stock and buy REITs? With interest rate cuts coming?

  So I received this great question from a reader: Hi FH, With the Feds projected to cut interest rates soon. Do you think now is a good time to sell DBS Bank stock and buy REITs instead? With lower interest rates, bank net interest income may start to drop. While REITs may see improving […]
The post Will I sell DBS Bank stock and buy REITs? With interest rate cuts coming? appeared first on Financial Horse.

So I received this great question from a reader:

Hi FH,

With the Feds projected to cut interest rates soon.

Do you think now is a good time to sell DBS Bank stock and buy REITs instead?

With lower interest rates, bank net interest income may start to drop. While REITs may see improving DPU because of lower interest expense.

Concerned that bank earnings may be starting to peak.

What do you think?

Interest Rate cuts look like a done deal at this point

With the comments from Jerome Powell this week.

It looks like September rate cuts are all but a done deal at this point.

You can see latest market pricing below, there is a 100% chance of a rate cut priced in for Sep 2024.

In fact the market is even pricing in a 32.5% probability of 2 rate cuts in Sep (update: after last night’s labour data, market is actually now pricing in a 69% chance of 2 rate cuts in Sep).

And a total of 3 rate cuts are priced in for 2024 (it’s no wonder that T-Bills yields are dropping so sharply – 6-month T-Bills yields fell to 3.40% at the most recent auction).

Lower Interest Rates are bad for bank stocks like DBS Bank?

The conventional logic of course, is that lower interest rates are bad for banks.

The reason why is that when interest rates go down, banks lend at a lower interest rate (for eg. mortgage rates start to go down).

If the bank lends at a lower interest rate – then profits from lending go down right?

Of course as we all know, things are never so simple.

There are 2 problems with this analysis.

Net Interest Margin for banks will also depend on funding cost

First – the net interest margin for banks depends on 2 factors – the headline interest rate they lend at, and their funding interest rate.

Lower interest rates translate into a lending rate, but if banks can reduce their funding cost, they may be able to maintain net interest margin.

To give a simple example, let’s say DBS Bank used to lend to borrowers at 4.0%, and now because of lower interest rates they lend at 3.5%.

But how much profit DBS Bank makes on the lending, depends on how much the money costs to them.

So if previously they borrowed from depositors at 2.5%.

And now they can borrow from deposits at 2.0% instead.

Then actually DBS Bank may be able to preserve their margins – and maintain their net interest income at current levels.

So… will DBS Bank be able to reduce funding cost?

For the 3 local banks (DBS, UOB, OCBC), actually the bulk of their funding comes from depositors (from retail and institutional customers).

So the million dollar question is whether DBS Bank can pay a lower interest rate to depositors going forward.

And you know I hate to say it.

But I think they can.

Over the past 18 months DBS hasn’t exactly been paying market leading interest rates on their deposits.

And yet we see deposits at DBS remain remarkably steady, all while T-Bills were paying as high as 4.2% at one point.

If DBS decides to pay lower interest rates on their deposits going forward, I don’t why that would suddenly spark a big outflow in deposits given that depositors were already happy to accept a lower interest rate the past 18 months.

What about non-interest income for banks?

The second point of course, is that not all of DBS’s (or OCBC or UOB) profits comes from lending.

You can see that about 30-40% of DBS’s profits is from non-interest income.

The largest of this is from the wealth management business, followed by the credit card business, transaction services, loan services and so on.

These are not so tied to interest rates, and are actually more tied to economic growth.

As long as economic growth remains stable and we don’t see a recession, these may continue to hold up.

But… most investors and analysts seem to think bank earnings may weaken going forward

That being said.

It seems to be fairly consensus (among investors and analysts) that bank earnings have peaked.

Here’s a BT article from this week, reporting that most analysts think that “DBS, OCBC and UOB are likely to post resilient, if unspectacular earnings ahead of impending rate cuts – but it will be difficult to beat the first quarter’s robust results”.

I suppose that’s analyst speak for saying bank earnings may have peaked.

DBS Bank’s share price pulled back this week

In 2024 – DBS share price broke out and went as high as $38+ in early July.

But in recent weeks as talks of interest rate cuts surfaced.

DBS share price has pulled back of late.

And this week as rate cut and economic slowdown fears picked up, DBS share price fell sharply back to the 35 range.

You can see the sharp move in the Singapore 10 year yield below.

From as high as 3.5% in April – to 2.8% this week.

If lower interest rates are not good for bank stocks, they are good for REITs?

So generally speaking the macro picture for banks is slightly mixed.

What about REITs?

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REIT earnings have started to stabilise

A ton of REITs reported earnings this week.

And the general picture has been one of stabilising DPU.

Yes DPU is down on a year on year basis when you compare with 1H 2023.

But vs 2H 2024, it looks like DPU has generally started to stabilise.

Here’s the earnings for CapitaLand Ascendas REIT for example.

DPU is down 2.5% on a year on year basis.

But up 1.1% on a half on half basis.

And this trend was repeated for many REITs this week.

For investors fearing a continued decline in DPU due to higher interest rates.

It looks like the worst may be over for now.

As the pace of interest rate increase slows (and potentially reverses), it allows rental growth to shine

A lot of you asked me in 2022 whether rental increases for REITs can offset the higher interest rates.

My answer was that no – because of the sheer speed and pace of increase of interest rates.

If US Fed Funds Rates are going from 0% to 5.5%, it doesn’t matter how much rental increase you see, interest expense increases will overwhelm everything else.

But that is behind us today.

Worst case the Fed Funds Rate is going to stay at 5.5%, much more likely is that it is going to drop down going forward.

And once interest rates come down, it allows the REITs strong rental growth to shine through.

This is why we’re starting to see a stabilisation in REIT DPUs, and this may continue in the quarters ahead.

REIT share prices have started to pick up of late

Because of that, REIT prices have started to pick up of late.

CapitaLand Ascendas REIT is up about 10% from its lows.

I’ve charted CapitaLand Ascendas REIT (candles) against DBS Bank (orange below).

You can see that after news of interest rate cuts broke in mid July – DBS share price has come down, while REIT prices have gone up.

So… Sell DBS / Bank Stocks, Buy REITs?

That being said.

If there’s one thing I’ve learnt in investing.

It is that if the whole market agrees on something.

You’d better start questioning how that view could be wrong.

What’s the wildcard? What could go wrong with this thesis?

And there are quite a few things that could derail the analysis above.

Here’s a question I got from another reader, that basically sums up the concerns:

Hi @Financial_Horse can you write an article on path forward of interest rates? will fed reduce continuously or will it increase once inflation comes back?  with the US budget deficit being $2 tn each year, tarriffs, decoupling, wouldn’t inflation be persistent?

Also is a recession in play? inverted yield curve has been there for 2 years

To sum it up, there are 2 key concerns:

Will inflation come back after rate cuts?
Is there still recession risk?

Interest rates stay high due to sticky inflation

The first one is not hard to imagine.

If Trump wins in November, he is going to spend a lot of money, enact a lot of trade barriers, and pressure Jerome Powell to cut interest rates.

Let’s say all that happens, we are in 2025, and now inflation is picking up again.

What happens next?

As the reader said – Does Powell continue to cut interest rates, or will he be forced to raise interest rates?

And if Powell has to stop cutting rates and start raising rates instead.

Boy that would not be pretty for REITs, although it may benefit bank stocks like DBS Bank.

Economic slowdown turns into a recession

Historically speaking, recessions only occur after the Feds start cutting interest rates.

The reason why is a bit theoretical / academic, but it has to do with the delayed effect of interest rates, and how Feds only start to cut once they see signs economic growth is weakening.

The reader asked: is a recession in play? inverted yield curve has been there for 2 years

And my answer is that yes, it is definitely a risk investors should be aware of, as we embark on this rate cut cycle.

There are definitely signs that the US economy is weakening, together with the labour market and consumer sentiment.

Whether it tips over into a recession – depends very much on how quick the Feds cut rates, and what the next US president does.

Not an easy call, and a risk that investors should be alive to.

If we get a recession, that would not be good for bank stocks (higher loan default, lower interest rates).

REITs may benefit from lower interest rates, but the question would be whether their rents can hold up.

So… Sell DBS bank stock to buy REITs?

If anything, I hope that the analysis above has stressed upon investors the fact that there is no easy answer to this question.

As investors, you should always be thinking in terms of probabilities, and not binary outcomes.

This is a game of poker, not a game of checkers.

Until the cards have been revealed (metaphorically), you should always be thinking in terms of shifting probabilities.

And think about how much you make when you’re right, vs how much you lose when you’re wrong.

What will I do? Sell DBS bank stock to buy REITs?

My base case is for interest rate cuts going forward.

Because of that, I would be inclined to hold more REITs than bank stocks today, because of the analysis above.

But there are definitely a lot of wildcards going forward, namely on the path of inflation, and whether we see a recession.

Because of that I think it makes sense to hold assets that could do well if inflation returns, or if interest rates stay high.

Stuff like bank stocks, commodities, gold etc.

Cash even, just to cater for the possibility that something goes wrong in ways that you cannot predict.

It doesn’t mean that 100% of my portfolio needs to be in those assets.

It just means that I want to have some exposure in the event that I’m wrong on the path for the global economy, and economic growth roars back under a Trump administration.

I just updated the FH stock watch last week for names that I am keen to buy, do sign up on FH Premium if you’re keen.

Closing Thoughts: 80% of returns come from macro factors?

I came across a quote from Stanley Druckenmiller this week that I thought encapsulated this discussion very well:

I was at a money manager roundtable dinner where everyone was talking about “my stock this” and “my stock that”. Their attitude was that it doesn’t matter what is going to happen in the world because their favourite stock is generating free cash flow, buying back shares, and doing XYZ.

People always forget that 50% of a stock’s move is the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking. And stock picking is full of macro bets. When an equity guy is playing airlines, he’s making an embedded macro call on oil.

Sometimes, there’s no need to be too clever as an investor.

Interest rates are going down, so I want to hold more REITs than bank stocks at this stage.

But I frankly could see many ways that inflation comes back, and interest rates go up, or we see a recession.

So I still want to hold stuff that could do well in the scenario we described above (rates to stay high / recession).

I just updated the FH stock watch last week for names that I am keen to buy, do sign up on FH Premium if you’re keen.

There have been huge moves in stock prices the past 2 weeks, with lots of opportunity in markets.

I just updated my stock and REIT watchlist on the names that I am keen to buy, do sign up for FH Premium if you are keen.

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   So I received this great question from a reader: Hi FH, With the Feds projected to cut interest rates soon. Do you think now is a good time to sell DBS Bank stock and buy REITs instead? With lower interest rates, bank net interest income may start to drop. While REITs may see improving
The post Will I sell DBS Bank stock and buy REITs? With interest rate cuts coming? appeared first on Financial Horse.