By Pradeep Gupta
At its last FOMC meeting, the US Fed raised its interest rate an additional 75 basis points, the third consecutive hike. It also indicated further rate hikes to come at its upcoming meetings. This was done in response to decade-long high inflation that is currently worrying the US economy. Annual inflation hit 8.3% in August 2022, the lowest in 4 months, but above market forecast of 8.1%. The US Fed’s aggressive stance is to fight this decade’s high inflation by raising interest rates and curbing the money supply in the economy. Rising interest rates, in turn, increase the cost of credit across the economy. Higher interest rates make loans more expensive for both businesses and consumers.
In the US Fed’s aggressive liquidity tightening policy, rising interest rates impact the global economy by closing the gap. Taking India into account, as the US interest rate rises, the gap closes, making currency trading less attractive. The technical recession in the United States means two consecutive quarters of negative GDP growth. While the possibility of a technical decision in the United States is very high, the probability of a full-scale recession in the United States or globally remains rather low.
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The resulting link between inflation and the performance of monetary policy and stock markets is not linear. Very high inflation usually leads to a stock market correction, as does very low inflation. During the moderate phase of inflation, stock returns rise as inflation rises. This happens because, during these phases, corporate profits typically rise faster than overall inflation and, as a result, corporate margins also improve. The likely slowdown in global inflation from current highs may lead to some level of equity market correction, but this is positive for the longer-term sustainability of healthy equity performance as inflation eases. stabilizes.
High interest rates affect the equity market through different channels. It increases the debt service burden of the corporate sector and therefore depresses corporate earnings, which is negative for the stock market. More importantly, an increase in interest rates leads to an increase in the rate at which future corporate earnings are discounted in order to arrive at a discounted cash flow based valuation of a corporation. A higher discount rate leads to a lower valuation of companies, which is negative for the stock market.
That said, higher interest rates can also lead to higher future cash flows for a company, which translates into a higher value of future earnings. The valuation based on discounted cash flows therefore depends on the magnitude of upward earnings revisions and the discount rate. In practice, however, the impact of rising interest rates on stock market performance is only marginally negative. The significant stock market corrections since October 2021 appear to have factored in much of the impact of inflation and rising interest rates on the corporate sector. Therefore, unless future inflation and monetary tightening are higher than what is currently expected, I think most of the impact is already in the price.
Forecasts from the International Monetary Fund suggest a serious slowdown in growth, but not a global recession.
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In the short term, the outlook for Indian equities remains tied to global developments. Globally, there are still many risks, including aggressive monetary tightening, a rapid withdrawal of liquidity, the end of fiscal stimulus measures adopted in the past, geopolitical uncertainties and high commodity prices. Global stock markets as well as Indian equities corrected in response to these negative developments. So I think most of the overall risk is already in the price. Meanwhile, the fundamentals of the Indian economy and corporate sector remain solid. The flow of domestic liquidity to the equity market, notably in the form of systematic investment plans in mutual funds, remains strong. With the recent strong earnings growth coupled with the market correction, Indian equity valuations have become reasonable if not attractive. Given all of this, I believe the outlook for the Indian economy and markets is positive over the medium to long term.
There are some early signs of recovery in the corporate capital cycle in India. The proposed investment numbers show some traction, as does the pace of business credit growth. The manufacturing sector is doing reasonably well despite continued input cost pressures. We carefully monitor this data. Labor market figures in terms of new openings placed on job portals and net admission to employment according to data from the Employees Provident Fund Organization suggest continued dynamism in the urban labor market , which will eventually be reflected in economic and business growth.
I think the main downside risk to the Indian economy and markets comes from global crude oil prices and the pace of policy tightening – interest rates, liquidity, and stopping fiscal stimulus – in developed countries. Rising oil prices will limit the outperformance of Indian equities relative to their peers.
In the near term, we expect policy tightening in developed countries to be greater than currently expected and so this would be a negative surprise for global financial markets as well as Indian equities. At the same time, the signs of a general slowdown in growth and the fear of a recession should make the political authorities of the developed countries more circumspect about the continuation of such policies. Therefore, beyond the very short term, policy tightening could slow significantly. This should help stock markets reach the initial bottom and then rally.
(Pradeep Gupta – Co-Founder and Vice Chairman, Anand Rathi Group. Opinions expressed are those of the author.)
