Rate hikes make equities riskier

Written by Jayant Manglik | Updated: Oct 7 2013, 15:34pm hrs
Interest rates have a deep relationship with stock markets and are one of the major factors in determining market direction and trajectory. Since it is basically the cost of money, it affects the entire financial system. Lower interest rates encourage people to borrow and spend which helps the economy. Likewise businesses also benefit from access to cheaper funds to invest and grow the business. However cheap funds can also lead to inflation and loss of purchasing power so it is a delicate balancing act that every government aspires to accomplish. And then there are other related and dynamic factors like currency, CAD and growth issues which have to be taken into account before arriving on the correct number for that brief period.

Currently India seems to have painted itself into a corner. But before we raise a finger at our situation, keep in mind that in 198182 the inflation in the US was 14% and Fed interest rates were about 20%.Within 20 years the rate fell to 1.25% due to a combination of good economy management and a favourable global environment combined with long-term vision. So theres reason to believe that pragmatism and actions towards our long-term goals may yet guide us towards our economic objectives.

The primary reason why the RBI changes interest rates is to influence the amount of money in the system and therefore control inflation. So will the equity markets discount the RBIs latest stance on interest rates very strongly Well, after the strong reversal by the dollar the RBI surprised the markets by raising its key lending rate by a quarter of a percentage point which clearly shows that inflation continues to be priority number one and growth is number threeassuming that a stable currency is a more immediate requirement. While the RBI has the unenviable job of controlling these three together, the markets, unsurprisingly, reacted strongly and immediately reversed the gains accumulated after the US Feds surprisingly unchanged stance on quantitative easing. Stocks from interest rate sensitive sectors fell sharply and bond yields, which move in an opposite direction to prices, rose sharply as this was taken as a signal that money will not become cheap in a hurry. In several trading sessions after the announcement, the Nifty shed more than 5% but this news has now been discounted and there is consolidation at lower levels. Unless there is more news on this or any other front which forces the markets to change direction, adventurous investors can start taking positions again. But overall it does make the stock market a less interesting place to invest.

Of course, even risk-aware investors will have to be cautious about the stocks they pick because the latest comments from the central bank could mean short-term stock market oblivion for debt-ridden companies, the banking sector and the overall earnings outlook for

India Inc. Specifically autos, home and personal loans are most likely to go up due to this sudden and unexpected change in direction. The increase in the key lending rates has dented some of the bullishness which accompanied the new RBI governors installation and the message is clearhe is as keen to control inflation as he is to support growth. The hike in repo rate will increase finance cost and adversely hit housing demand during the critical festive season when the sector sees a significant percentage of its sales. This will be yet another challenge for the realty sector which is already saddled with huge debt, shrinking margins and consequently low share prices.

On the plus side, the Marginal Standing Facility (MSF) rate cut is a welcome change for banks as it reduces their cost of funding and they can actually increase credit availability. This is the rate at which banks borrow from the RBI to meet their CRR and SLR requirements and will augment liquidity in the banking system. But this is offset by the increase in interest rates which will affect demand and lead to reduced consumption and therefore stressed balance sheets of companies. The most immediate effect is likely to be seen during the upcoming Dussehra and Diwali festive season and could be the earliest indicator yet of how the Q3 earnings of certain sectors will fare. However, the consequent reduced inflation will lead to a strengthening rupee which will make imports cheaper. The recent stability in crude oil prices lessen our worries on the CAD deficit front to some extent and will help preserve our foreign exchange reserves. Constricting liquidity will also regulate money supply to some extent and reduce exchange rate volatility.

Equity markets have been fickle in the recent weeks and remain tricky yet. So for everybody, especially retail investors, caution is necessary this quarter. As someone said, it is a good thing to learn caution from the misadventures of others. Of course, there are several factors besides interest rates which determine the outcome of the economy and hopefully a favourable interplay of these forces will give us cause to cheer in future though I suspect that a strengthening US dollar in this quarter will take some of our options off the table. It is also fair to say that just because tapering of quantitative easing in the US is imminent, it does not automatically follow that interest rates will also increase. But if they do then we could well be looking at a completely different set of issues to deal with and the current RBI move may suddenly seem benign in retrospect.

The author is presidentretail distribution, Religare Securities Limited