GF Securities: Optimistic about stable asset valuation in the low interest rate era. Grab opportunities to run ahead of cyclical assets as interest rates decline.

Starting from the two ways of estimating Generally speaking, there are two ways to estimate: one is the phase of profit growth, leading to an increase in valuation; the other is a low interest rate environment, leading to a reshaping of valuation. The first one: raising valuation from the numerator end: increase in profit phase, leading to an increase in valuation During the phase of accelerated growth or increasing ROE, valuations generally rise, and the current valuation level is not very important at this time. However, during the phase of decelerating growth or decreasing ROE, valuations generally fall, making it easy to fall into the "undervaluation trap." The second one: raising valuation from the denominator end: low interest rate environment, reshaping of valuation In a declining interest rate environment, valuations may also be reshaped. Let's do a simple calculation by assuming asset growth for 15 years and perpetual growth thereafter (growth rate of 2%), simulating the valuation levels corresponding to different combinations of ROE levels and discount rate levels. Sensitivity of valuation to interest rates and ROE: the lower the interest rate, the higher the theoretical valuation; the higher the ROE, the higher the theoretical valuation. However, not all valuations will be reassessed in a declining interest rate environment. During the phase of declining interest rates, when can you make money from valuation? So, will valuations be reassessed in all declining interest rate environments? Let's further analyze the historical experiences in overseas markets over the past few decades. (I) Is valuation determined by ROE or interest rates? Looking at various countries from 1980 to the present, there is a clear positive correlation between valuations and ROE; however, the relationship between valuations and interest rates is unclear, with positive correlations (such as Japan, Singapore), weak correlations (such as UK, Germany), and negative correlations (such as US, France). From the overseas review, we can see: (1) the impact of interest rates on valuations in different countries is not fixed; (2) a decline in interest rates does not necessarily lead to an increase in valuations; (3) likewise, an increase in interest rates does not necessarily lead to a contraction in valuations (II) How do interest rates affect valuation (1) 1980s-1990s Specifically, different countries showed inconsistent patterns in different decades and macro environments. In the 1980s-1990s, interest rates were returning to normal, with relatively high actual short-term interest rates and inflation expectations, and their decline had a clear marginal impact on increasing valuations. Therefore, during this period, valuations in various countries were mostly negatively correlated or weakly correlated with interest rates. Japan is an exception, with a significant correlation coefficient of -0.83 between valuations and interest rates in the 1980s; but in the 1990s, the economy declined faster (with the effect of the numerator greater than the denominator), resulting in a correlation coefficient of +0.60. (2) 2000s Different from the 1980s-1990s, in the 2000s, valuations in various countries showed mostly positive correlations with interest rates. This is because during this period, interest rates in various countries had basically returned to low levels, with central government bond rates in the US, UK, France, and Germany all around 4%. The fundamental changes, along with the effects on the numerator (EPS) and denominator (actual interest rate expectations) of valuations, and the higher sensitivity of the numerator than the denominator, caused valuations and interest rates to change in the same direction. (3) 2010s After 2010, the relationship between valuations and interest rates changed again - the valuation systems in Europe and Japan once again showed a negative correlation with interest rates. During this period, macro factors changed, with the lack of new growth points in the economy and the outbreak of the Eurozone debt crisis leading to fiscal monetization in developed countries, excess liquidity lowering actual short-term interest rates, and to a certain extent alleviating the crisis, reducing term premiums, leading to an increase in valuations; as a result, the sensitivity and dependence of the market on central bank monetary policy changes significantly increased. (4) 2020 to present From 2020 to the present, the relationship between valuations and interest rates has become polarized - countries like the UK and Germany have maintained a negative correlation, while countries like the US and Japan have strengthened their positive correlation. During this period, the US economy has been dominant, and Japan has emerged from deflation, with the economic fundamentals of these two countries determining the direction of interest rates and valuations; meanwhile, there is a greater divergence in Europe, with the UK predominantly in the financial sector and Germany primarily in manufacturing, with a high sensitivity of the economy to interest rates showing negative correlation, while countries like France and Singapore in the service sector have better fundamentals, leading to a positive correlation between valuations and interest rates at this time. (III) Overseas experience - Two ways of increasing valuations in a declining interest rate environment The impact of a decline in interest rates on valuations must be understood by looking at the three components of interest rates: expectations of short-term real interest rates (depending on expectations of economic growth or monetary policy paths), inflation expectations (long-term inflation expectations, anchored around 2% by central banks in various countries), and term premiums (compensation for future risks, including macro policies, bond supply, etc.). Starting from the components of interest rates (expectations of short-term real interest rates, inflation expectations, term premiums) and several core influencing factors (economic growth, inflation expectations, monetary policy, bond supply, etc.), we have outlined several common scenarios of the impact of interest rates on valuations, as shown in the table below: From overseas experience, there are mainly two ways in which a decline in interest rates can increase valuations: one is during a normalization process of interest rates, where interest rates fall with high inflation, leading to stable economic growth and an increase in valuations, like in the 1980s; the other is after a crisis mode of extensive easing, as seen in Europe in the 2010s, but at this time, if the economy severely declines, a decrease in interest rates does not necessarily lead to an increase in valuations, as seen in Japan in the 1990s. One characteristic is that stages where interest rates and valuations show a significant negative correlation are mostly seen during times of extremely loose liquidity. However, whether valuations can be increased depends on the state of the fundamentals: If the fundamentals continue to decline or are in a long-term state of deflation, as seen in Japan in the 1990s and Italy in the 2010s, then it is difficult for valuations to increase; If the fundamentals stabilize on the margin, no longer declining, then valuations generally increase, as in Japan and France and Germany in the 2010s; But if the recovery is strong, valuations will follow an increase, and interest rates will also start to rise due to inflation expectations, as seen globally after the pandemic. In the table below, we have compiled information on the timing of zero interest rates, negative interest rates, and quantitative easing policies in various countries or regions. In the following case studies, we will see how valuations, interest rates, and even the trend of fundamentals are closely related to these points in time. (IV) Case studies of a declining interest rate environment + increased valuations (1) Declining interest rates + Increased valuationCase of increasing values: United StatesIn the United States in the 1980s and 1990s, as inflation fell and interest rates normalized, valuations gradually increased. The decline in US bond rates mainly came from several reasons: firstly, commodity prices continued to fall. Since the 1980s, commodity inflation peaked, and in the 1990s, commodities continued to slump, further reducing inflation expectations, pushing US bond rates continuously lower. Secondly, the improvement in the US government's fiscal situation reduced the dependence on debt financing, reduced the scale of new government bond issuance, pushed up US bond prices, and lowered interest rates. Example of declining interest rates + rising valuations: Japan There are two periods of declining interest rates + rising valuations in Japan: one in the 1980s, during the global inflation decline and normalization of interest rates, valuations gradually increased; another in 2012 when large-scale quantitative easing was implemented, setting a 1% inflation target, especially after the implementation of negative interest rates in January 2016, the economy stabilized marginally, interest rates declined, and valuations rose. However, a decline in interest rates does not necessarily lead to an increase in valuations, as fundamentals may decline more rapidly, as was the case in 1990s Japan. Example of declining interest rates + rising valuations: Germany Germany also has two periods of declining interest rates + rising valuations: one in the 1980s and 1990s during the global inflation decline and normalization of interest rates, valuations gradually increased; another after the financial crisis, with the ECB interest rates dropping to near zero levels and further to negative rates in 2014, along with the implementation of quantitative easing starting in 2015, valuations modestly increased as interest rates moved lower. Example of declining interest rates + rising valuations: France Similarly, France has two periods of declining interest rates + rising valuations: one in the 1980s and 1990s, and another after the financial crisis with negative rates and quantitative easing. In 2014, the eurozone CPI fell into negative territory, prompting the implementation of negative interest rates and quantitative easing to alleviate deflation risks. However, the recovery was limited, and countries like Germany and France had better fundamental conditions. Example of declining interest rates + rising valuations: the UK The UK also has two periods of declining interest rates + rising valuations: one in the 1980s and 1990s, and another after the financial crisis during the period of quantitative easing from 2009 to 2012. However, after 2013, despite a continued decline in interest rates due to loose monetary policy, valuations tended to decrease as profit margins significantly fell. Example of declining interest rates + rising valuations: Italy The Italian stock market is an exception, as even during the period of negative interest rates and quantitative easing after 2014, the relationship between valuations and interest rates was not clear. This is due to Italy being a severely affected area during the Eurozone debt crisis, with slow economic recovery and continued pressure on interest rates and valuations due to fundamental and inflation expectations, leading to a continuous decline in valuations until 2016. Example of declining interest rates + rising valuations: Canada Canada experienced a sustained period of declining interest rates + rising valuations in the 1980s and 1990s. However, after the financial crisis, valuations fell as interest rates declined, showing a strong positive correlation mainly due to a decline in overall profit margins. Example of declining interest rates + rising valuations: South Korea South Korea has not experienced a clear period of declining interest rates + rising valuations. Valuations, interest rates, and fundamentals have generally moved in the same direction. In conclusion, a situation where declining interest rates lead to rising valuations generally occurs in an environment of extremely loose liquidity (0 interest rates, negative interest rates, QE) with a stable economy but not significantly recovered. If the recovery is strong, valuations will rise, and interest rates will begin to rise under the push of inflation expectations. If the economy experiences deflation and fundamentals deteriorate, profit prospects and inflation expectations will continue to push valuations lower. III. At what point does the decline in interest rates lead to an increase in valuations? Which sectors see an increase in valuations? Where is the bottom of the valuation decline and the interest rate decline? Based on overseas experience: (1) The average PB valuation low point is 0.85 times, corresponding to an interest rate level of 2.46%. The valuation low point generally corresponds to the low point of fundamentals, such as after the financial crisis in the US, UK, Germany, France, Italy after the Eurozone crisis, when the CGB interest rate fell to 2.2% in August 2024, and the A-share PB was about 1.34 times. (2) The average low point of interest rates is 0.20%, corresponding to a PB valuation of 1.38 times (average 1.1 times excluding the US), with the low point of interest rates appearing at the bottom of fundamentals in 2019 or in the stage of significant stimulus after the epidemic. (3) The valuation low point depends on fundamentals, while the interest rate low point depends on monetary liquidity. If the fundamentals are not too bad, the valuation low point will be earlier than the interest rate low point. In the process of further liquidity easing and interest rate declines, valuations will rise, as seen in the US, Germany, France, Japan after the financial crisis. The long-term pricing of valuations (the stable valuation center) depends on fundamentals (ROE) while the low points of valuations and fundamentals to some extent depend on the low points in the real estate cycle. When valuations stabilize, which sectors lead in increasing valuations? During the phase of rising valuations, the leading sectors are mainly in discretionary consumption, technology, industry, and healthcare industries. This is related to the stimulus to consumption, tax cuts, and the development of the technology industry in various countries since the financial crisis. Some industries may show weaker performance, such as energy, utilities, telecommunications, and finance. Of course, if fundamentals are only at a low level and continue to decline, various industries are also less likely to have a trend market or may show significant differentiation, as seen in the UK, South Korea, and Italy.It should be noted that during the phase of downward interest rates, traditional high dividend sectors such as utilities and telecommunications have not achieved excess returns. On one hand, the ability to raise valuations indicates that at this time, the fundamentals have already ruled out the risk of continued weakening, and safe-haven assets are not preferred. On the other hand, as interest rates decrease, the upward valuation brought by the same downward rate is narrowing (analyzed below), and the advantage of undervalued high dividend assets is also weakening.4. How to quantitatively characterize the impact of interest rate declines on valuation? So, how does the decrease in interest rates affect valuation? What is the elasticity of valuation to changes in interest rates? Let's establish a simple model to discuss this. (1) How much can the valuation increase be brought by the decline in interest rates for stable income assets? For stable income assets, further calculate the valuation sensitivity to the decline in interest rates using a discount model. Assuming a company with a 15-year growth stage (ROE 12%, dividend payout ratio 50%), followed by perpetual growth (growth rate 2%, dividend payout ratio 70%), where the discount rate = risk-free rate + risk premium, and the risk premium takes the average of the Shanghai and Shenzhen 300 Index over the past 10 years, which is 4.8%. Measuring the impact of the decline in interest rates on valuation: (1) When the risk-free rate is 4%: a 20% decrease in interest rates leads to a 16.9% increase in valuation; (2) When the risk-free rate is 2%: a 20% decrease in interest rates leads to an 11.1% increase in valuation; (3) When the risk-free rate is 1%: a 20% decrease in interest rates leads to a 6.6% increase in valuation; Conclusions: (1) Valuation rises as interest rates decline; (2) As interest rates fall, the magnitude of the increase in valuation brought by the same decrease in interest rates narrows (the sensitivity of valuation to interest rates decreases). For assets with different profit capabilities, the elasticity of valuation to interest rates also varies, as shown in the figure below: Conclusion: The higher the ROE, the greater the increase in valuation that can be brought by a decline in interest rates. In other words, the higher the ROE, the higher the sensitivity of valuation to interest rates. (2) When the government bond rate drops from 3.2% to 2.2% and then to 1.6%, how does the market trade? Since 2021, the yield on the 10-year government bond in China has continued to decline, falling below the long-term range (2.8% to 4.5%); In early 2021, when the interest rate was 3.2%, the P/B ratio of A-shares was about 1.9 times, by August 2024 when the rate dropped to 2.2%, the P/B ratio was about 1.3 times, during this time, the pricing was mainly based on the fundamental decline; After September 2024, as the interest rate further fell to 1.6%, market valuation began to rise, mainly driven by policy expectations and the outbreak of structurally prosperous industries. At the industry level: When the government bond rate drops from 3.2% to 2.2%, the industries with increased valuation are only utilities and coal, reflecting the defensive demand during the phase of fundamental decline and the valuation reshaping during the process of interest rate fall; When the government bond rate drops from 2.2% to 1.6%, the industries with increased valuation are mainly driven by TMT sectors driven by prosperity, while defensive sectors are seen decreasing in valuation during this period; In summary: In most of the time when interest rates are falling, market valuation tends to decline, and only stable income assets such as utilities can increase in valuation; while at the end of the interest rate decline, the market may systematically increase in valuation, heading towards prosperous assets. 5. Key Conclusions 1. Most cases where interest rate declines significantly increase valuation occur when liquidity is extremely loose (excessively loose liquidity leads to a sharp decline in short-term real interest rates). However, whether valuation increases depend on the fundamental status: (1) In an environment of loose liquidity, stable economy without significant recovery, the decline in interest rates will lead to a significant increase in valuation, as seen in Japan, France, and other European countries after 2012. (2) If the recovery is strong, valuation will increase, and interest rates will also rise due to inflation expectations, as seen in the United States after the pandemic. (3) If there is economic deflation, profit and inflation expectations will continue to drive valuation downwards, as seen in Japan in the 1990s, and Italy and South Korea in the 2010s. 2. Where is the endpoint of valuation decline? Where is the endpoint of interest rate decline? (1) Overseas markets: the average low point of P/B valuation is 0.85 times, corresponding to an interest rate level of 2.46%; the average low point of interest rate is 0.20%, corresponding to a P/B valuation of 1.38 times. (2) The low point of valuation depends on the fundamentals, the low point of interest rates depends on monetary liquidity, and the cyclical low points of valuation and fundamentals to some extent depend on the low point of the real estate cycle. 3. After the stabilization of valuation, where are the market investment opportunities? Should we continue with dividend strategies or move towards prosperity investments? (1) If the fundamentals are good (such as the US, Japan, Germany, and France), the industries that will see increased valuation are those with comparative advantages in the consumer discretionary, technology, industrial, and healthcare sectors; if the fundamentals are volatile (such as in Italy), the defensive varieties, such as utilities, financials, and essentials, will see increased valuation; if the fundamentals continue to decline (such as in South Korea, England, Canada), valuations will not rise. (2) During the phase of valuation increase due to declining interest rates, high-dividend sectors such as utilities generally find it difficult to achieve excess returns. On one hand, the expectations of fundamentals are changing; on the other hand, the interest rate sensitivity of valuation is decreasing, and as interest rates fall, the magnitude of the valuation increase brought by the same decrease in interest rates narrows: when the interest rate is 4%, a 20% decrease in interest rates leads to a 16.9% valuation increase; when the interest rate is 1.6%, a 20% decrease in interest rates leads to a 9.5% valuation increase. 4. Back to the A-share market, in most of the time when interest rates are falling, market valuation tends to decline, and only stable assets can increase in valuation; at the end of the interest rate decline, the market may systematically increase in valuation, heading toward prosperous assets, at this time, stable assets may not achieve excess returns. Risk Warning Geopolitical conflicts beyond expectations leading to a higher-than-expected global inflation; the resilience of the US economy causing a moderation of global liquidity (timing of the Fed's interest rate cuts, extent of decline in US bond rates) falling below expectations; the policy stimulus for stable growth in China is not as expected, among others.