By Tanvi Kanchan
Global markets were and continue to be volatile in the month of May’22. The Indian markets are also on a similar trajectory, however the percentage of drawdown in the Indian markets isn’t as much as its global counterparts. Nifty in the current calendar year has corrected by -6.3%, with volatility continuing in the month of May. Some of the major reasons for this continued volatility is the worries surrounding Russia Ukraine conflict, inflation at multi-decade high levels, supply chain issues, increase in input cost resulting in margins getting impacted, demand compression.
The rate hike by the Reserve Bank of India was aimed at controlling inflation. While there are various channels through which increase in policy interest rate is likely to dampen inflation, it inevitably reduces demand in the short term, consequently, the near term impact of a rate hike on growth and thereby corporate earnings is negative.
We expect India’s medium term inflation to hover in the range of 4.5%-5.5%. Historically, the Reserve Bank of India has aimed at keeping the real repo rate at 100 to 150 basis points. In view of this, we expect the peak of the cycle repo rate around 6-6.5%, accordingly, we expect the RBI to tighten the repo rate by another 200 basis points over the next 24 months.
Interest rates and bonds have an inverse relationship, i.e. when interest rates rise, bond prices fall and vice versa. The newly issued bonds will have higher coupons after rates rise, making bonds with low coupons issued in the lower-rate environment worth less. When the interest rate fluctuates, the market rate of a bond also fluctuates, but not all bonds are impacted equally. Bonds with shorter maturity may be impacted less in comparison to bonds with a longer maturity which may incur a greater paper loss.
In contrast to bonds, interest rate changes do not directly affect the stock market. However, the interest rate increase can have trickle-down effects that, in some cases, impact stock prices.
The policy rate hike also increases the risk free rate and thereby the discount rate for future earnings. These, in turn, reduce the valuation of companies. Taken together, the near term impact of a rate hike may be negative on corporate earnings and the equity market.
However, since rate hike and thereby inflation control aims at stabilizing both growth and inflation in the medium to longer term, monetary tightening should have a positive impact on longer term corporate earnings, discount rate as well as equity valuation multiples. Therefore, unless the rate hikes are too stringent, a tighter monetary policy during a phase of high inflation should be long term positive for the equity market and corporate earnings.
The phase of the interest rate cycle certainly has some impact on returns by various asset classes. In that sense, a rising interest rate cycle should require some tweaking of the portfolio. However, in the strategic asset allocation approach, the portfolio objectives are looked at like return expectations, risk tolerance, cash flow situation and investment horizon of the individual investors. Once the portfolio is constructed on the basis of these factors, the requirement for tweaking the portfolio based on business cycle is not substantial. It is generally perceived that in a rising interest rate cycle, the interest sensitive part of the equity market and bonds underperform. However, other macro and corporate specific situations decide the fate of individual securities. I think the framework for asset allocation continues to be the strategic approach which incorporates the key considerations of the individual investors and keeps the portfolio largely unchanged despite short term volatilities of the market including the phases of interest rate cycle.
A study conducted in 1986 by Brinson, Hood and Singer on the US pension fund, substantiated that more than 91.5% of the variability of a portfolio performance is attributed to asset allocation.
Interest rate changes should not affect the long-term outlook for an investor with a long time horizon and an appropriate mix of equity and debt. Staying the course of your asset allocation strategy and diversifying can help to preserve your overall investment portfolio against the effects of changing interest rates in the long term.
(Tanvi Kanchan, Head — Corporate Strategy, Anand Rathi Shares and Stock Brokers. Views expressed are the author’s own.)