By Pradeep Gupta
In its latest FOMC meeting, the US Fed raised its interest rate by another 75bps, the third straight hike. It has also indicated more rate hikes to come in its near future meetings. This was done as a response to decade-high inflation currently worrying the US economy. The annual inflation rose to 8.3% in August’22, the lowest in the last 4 months, yet above the market forecast of 8.1%. The aggressive stance by the US Fed is to combat this decade’s high inflation by increasing interest rates and curbing the money supply in the economy. The increase in interest rate, in turn, increases the cost of credit throughout the economy. Higher interest rates make loans more expensive both on the business and consumer side.
In the aggressive liquidity tightening stance by the US Fed, the increase in interest rate impacts the Global economy by bridging the gap. Taking India into consideration, as the US interest rate increases, the gap bridges further making currency trade less attractive. Technical recession in the US means two subsequent quarters of negative GDP growth. While the possibility of a technical decision in the US is very high, the likelihood of a full-scale recession either in the US or globally remains rather low.
The link between inflation and the consequent monetary policy and equity market performance is nonlinear. Very high inflation generally results in equity market correction and so does very low inflation. During the moderate phase of inflation, equity returns go up along with rising inflation. This happens because during such phases corporate earnings generally rise faster than overall inflation and thereby corporate margins also improve. The likely softening of global inflation from the current elevated levels can result in some level of equity market correction but this is positive for the longer-term sustainability of healthy equity return as inflation gets stabilised.
High-interest rates impact the equity market through different channels. It increases the debt servicing burden of the corporate sector and therefore depresses corporate earnings, which is negative for the equity market. More importantly, an increase in interest rate results in an increase in the rate at which future corporate earnings are discounted so as to arrive at a discounted cash flow-based valuation of a corporation. Higher discounting rate results in a lower valuation of companies which is negative for the equity market.
That said, higher interest rates also can result in higher future cash flow for a corporation resulting in a higher value of future earnings. The discounted cash flow-based valuation, therefore, depends on the extent of upward revisions in both earnings and discounting rate. In practice, however, the impact of higher interest rates on equity market performance is only marginally negative. The significant equity market corrections since October 2021 seem to have factored in a large part of the impact of inflation and higher interest rate on the corporate sector. Therefore, unless the future inflation and monetary tightening are more than what is currently expected I feel the major part of the impact is already in the price.
The forecast by the International Monetary Fund suggests a serious slowdown in growth but not a global recession.
In the short term, the outlook for Indian equities remains tied to global developments. Globally still there are lots of risks including aggressive monetary tightening, rapid liquidity withdrawal, discontinuation of fiscal stimulus measures adopted in the past, geopolitical uncertainties and elevated commodity prices. The global equity markets and also the Indian equities have corrected in response to these negative developments. So I think that the major part of the global risks is already in the price. Meanwhile, the fundamentals of the Indian economy and the corporate sector remain robust. Domestic liquidity flow towards the equity market especially in the form of systematic investment plans to mutual funds continues to remain buoyant. With the recent strong earnings growth coupled with the market correction, the valuations of Indian equities have become reasonable to attractive. In view of all these, I think the outlook for the Indian economy and markets is positive in the medium to longer term.
There are some early signs of recovery of the corporate capital cycle in India. Proposed investment numbers are showing some traction as also the pace of corporate credit growth. The manufacturing sector is performing reasonably well despite continued input cost pressures. We are closely watching this data. The job market numbers in terms of new openings being placed on job portals and net payroll job admission according to Employees Provident Fund Organization data suggest continued buoyancy in the urban job market, which eventually would get reflected in economic and corporate growth.
My view is that the main downside risk to the Indian economy and markets are coming from global crude oil prices and the pace of policy tightening – interest rate, liquidity and discontinuation of fiscal stimulus – in the developed countries. Higher oil prices will keep the outperformance of Indian equities versus peers limited.
In the near term, we expect policy tightening in the developed countries could be more than what is currently being expected and therefore it would be a negative surprise for the global financial markets as well as Indian equities. At the same time, signs of broad-based growth slowdown and the fear of recession are likely to make the policy authorities in the developed countries more circumspect about the continuation of such policies. Therefore, beyond the very short term, policy tightening may slow down substantially. This should help the equity markets to the former bottom and go up subsequently.
(Pradeep Gupta – Co-founder & Vice Chairman, Anand Rathi Group. Views expressed are the author’s own.)