Sustained rally hinges on interest rate direction

Updated: Oct 15 2012, 09:03am hrs
Unless there is a structural lowering of the cost of capital, it is difficult to see a long-term bull run sustain valuation

Tushar Pradhan

It would be fair to say that there is no simple answer to this question. I say that on three counts. One, the key consideration when offering advice on equities should be the risk profile and risk appetite of the questioner, which in this case is not available. Two, it presupposes that this is the only opportunity one can get to enter the markets, which again may not be a correct assumption. Three, as is the oft- repeated advice, equities as an asset class should be looked at from a long-term perspective, and timing the market is not necessary if you consider the asset class for the longer horizon. In any case, this is in my opinion, not the correct way to address exposure to equities.

Equities represent ownership in companies, made convenient by the stock market in a proportionate measure. Owners of any enterprise should know that meaningful gains accrue only over many cycles and that too if the business is well positioned, well-run by competent personnel and is highly profitable over up and down cycles. Thus, it will be well mentioned here that there is a difference between owning stock and renting.

If one wants to make use of low valuations (i.e. rent) in the face of a growing economy and, in turn, growing corporate profits, this is not the time to reap sustained gains since valuations are now in a reasonable range, but are not as cheap as a few months ago. The economic cycle which is on a downturn following various external (Eurozone) and internal events (sluggish growth in the face of high inflationary trends resulting in high interest rates) is not looking to rebound immediately.

So in both cases it looks to be a weak argument given what we know at this time. Is there a case for looking forward to see that things may indeed change very dramatically in the future Well, to begin with the government appears to have seized the moment and is displaying great urgency to push forward major reform-oriented measures. While the same may be well intentioned, there is a healthy dose of skepticism that exists across participants at this time since these need to be passed to through a difficult process in Parliament.

Industry is reeling under the twin pressures of high commodity prices, driven by a weak currency and a high interest rate regime ruling the economy. This has made working capital more expensive, leading to pressure on margins and has, in turn, generally led to a slowdown in the investment cycle. One cannot see a dramatic change in this environment unless some structural issues are tackled with utmost speed.

If fiscal imbalances are resolved by a permanent resolution, and not by the current opportunistic lowering by way of a stronger rupee and stabilising inflation, there is hope for a structurally lower interest rate regime to stay, leading to a long stable bull run in equities. But unless there is a structural lowering of the cost of capital in this country it is difficult to see a long-term bull run sustain valuations. While there may be surges in valuations led by hope and expectations, they may not survive unless strong remedial measures address the deep and entrenched imbalances in the system.

There are bright spots on the horizon that indicate a reversion to the mean on certain counts. The balance of payments deficit is reducing on the back of some significant FII inflows and also a substantial increase in inward remittances from NRIs. This is leading to a stronger currency in the interim.

A stronger rupee is leading to a reduction in under-recoveries in the energy sector. While demand is slowing down as well, some changes in the pricing of some of the petroleum products are leading to a reversion to a better deficit than earlier feared. However, the fact remains that this is an unfolding story which is yet to be completed.

A delayed but generally well-distributed monsoon can lead to a better-than-expected output from agriculture and full reservoirs. Added to that, an improving water table represents a secure winter crop. The expectations of lower food prices, as a result, cannot be ruled out. This does have an impact on inflation and in turn some downward pressure on interest rates, which would be positive for equity markets.

Globally, central banks have been flexible and have tried to induce growth by reducing interest rates and infusing liquidity in their banking systems. With low growth rates, this at the moment is not leading to inflation, but in the long run may indeed be the case. The RBI has been very prudent in this regard as it understands the ramifications of high inflation in a country like India. However, if it does see this downward impact on inflation becoming a permanent feature, at least in the interim period, it can indeed signal lower interest rates.

A lot in fact will be determined by the direction interest rates take from here on to see if equities stage a sustained rally. If interest rates do indeed come down structurally in the next few months, we may hope to see a big run in equities. This, in addition to global liquidity finding its way into the country, can ignite a much larger rally that will defy purists on measures such as valuation, etc. This would mean that the market can remain unreasonable for a considerable period of time.

In summary, there is a likelihood of higher stock markets from hereon if there is a reduction in interest rates, higher liquidity and lower inflation. If any of these variables remain stubborn, returns can yet be tepid from here.

The author is chief investment officer, HSBC Global Asset Management