Turmoils faced by major economies
Inflation in the US is at a 40-year all-time high, and the pace of GDP growth is anticipated to weaken from its current high levels to 2.5% in 2022 and 1.2% in 2023. Supply disruptions may take some time to ease completely, especially given the impacts of the war in Ukraine and COVID-related lockdowns in China.
Wage growth will stay strong, as the labor market is expected to remain tight, despite an increase in labor force participation as receding health risks and higher wages prompt workers to return to the labor force. Inflation will remain above the Federal Reserve’s 2% target at the end of 2023. With the Fed’s aggressive stance on interest rate hikes for the first time in decades, equity seems less attractive than fixed-income investments.
The weak value of the yen, which lost roughly 20% of its value against the US dollar since the start of this year, is primarily due to the interest-rate differential between Japanese government bonds (JGBs) and US Treasuries. The United States is expected to raise rates further, while the BoJ insists it will not. The equity market of Japan seems to be subdued due to the weak yen and high commodity prices.
The struggling property market, global monetary tightening, and lingering effects of Covid-19 have put tremendous pressure on China’s economy. China’s property market is being hurt badly because of shrinking demand, incomplete projects, and capital inadequacies resulting in negative series of events hurting the market sentiments.
Why are interest rates increasing?
The Central Banks around the world, including that of India, are increasing their interest rates with the core aim to cool down inflation as borrowings become expensive and people tend to borrow and spend less, leading to the reduction of inflationary pressure.
Indian Economy at a Glance
Central banks across the world are hiking interest rates to curb inflation. Therefore the impact of it can be seen in the Indian economy too.
The Reserve Bank of India raised its key repo rate by 50 bps to 5.9% during its September meeting, the fourth rate hike in a row, amid rising concerns over soaring inflation, global headwinds, and a plunge in the rupee to its record lows. Since May ‘22, we have seen a 190 bps hike in repo rate, bringing the rate to a level not seen since May 2019, in line with global central banks tightening rates.
RBI Governor Mr. Shaktikanta Das said, “50 bps hike is the new normal for central banks”. We can observe this with several major central banks worldwide, including the US Fed, Bank of England, and the European Central Bank.
As the Indian economy is highly elastic to the decisions taken by the US, any rise in the interest rate forces the Indian central banks to hike its rate as well. We will see limited hikes in the future as India has always been a 7-8% interest rate economy, and with inflation at 7%, the scenario in India is such that corporates’ and individual’s finances are comparatively in a better shape.
Corporates are sitting at the lowest leverage in the last 15 years and the highest capacity utilization, which is favorable for the CAPEX cycle. India has the highest household savings rate of 22%, which is the highest in the last decade. These factors make us believe that such rate hikes would not significantly impact the overall demand in the economy.
Impact on Equity Markets
The dim performance of equities across the globe during the calendar year 2022 has been attributed to rising interest rates and geo-political conflict. Among various macro factors, the interest rate has the highest impact on how the financial market performs, particularly in the short term. The ongoing interest rate dictates the flow of funds to various asset classes, impacting their performances.
In the long run, equity performances are more about earnings growth. Short-term movement is more on account of changes in valuation multiple, and on a fundamental basis, the interest rate is the key to where the valuation multiple is for equities. It is expected that most major economies may undergo valuation multiple de-rating.
In US, Corporate profit to GDP is already at a high of 11%, and hence the market Cap to GDP is high at 200%. The de-rating in multiples will not impact India as the undercurrent of increasing corporate profits to GDP will offset the compression, keeping valuations for the Indian stock market intact. India’s corporate profit to GDP is merely 4% and is expected to rise up to 7% by FY30.
The market Cap to GDP is low at around 100%. As regards PE, multiples for India since the new era of Government (since 2014) have always bounced back after testing 18x one-year forward earnings. At 17700, we are trading at 19 times one year forward earnings.
But the current scenario is changing as rising interest rates may make debt investments more attractive than equities, and investors might start shifting their equity investments to debt which will put a pressure on equity valuations.
The fixed income instruments have also made a comeback as the Govt. of India’s 10 Year Bond Yield is currently 7.5% compared to 6.4% last year. Adding to it, 60% of registered account users on BSE are witnessing a yield of more than 7% for the first time.
Impact on Debt Markets
When interest rate increases, the demand for existing bonds decreases because new bonds now offer higher yields and keep the demand for existing bonds in line with the price of existing bonds decreasing.
3-Point Analysis on Equity Investments
- As Indian equity markets have remained flattish over the past year (YTD returns of Sensex are 5.03% and that of Nifty are 4.89%) with sharp interim volatility, it is advisable for investors to stick to good quality stocks, mainly large caps.
- Indian Equity Markets valuations are expensive and will continue to remain expensive for another few months. This can be attributed to the current Trailing earning yield minus bond yield, which is currently at -3.13% compared to the average of -2.27%. The other reliable valuation metric is Shiller earning yield minus bond yield, which is currently at -4.07% compared to the average of -2.90%.
- G-sec valuation and fixed-income investment options look attractive as G-sec spread vs. equity increased to 262 bps in Sep’22 vs. 243 bps in Aug’22.
Investment Strategy in the Current Scenario
- It is suggested that you retain 40-50% cash which you may later invest in the debt market or equity in a staggered manner for over 4-6 months. Also, mutual fund investors should continue their SIP investments in good quality Mid and Small Cap Funds due to ongoing market turmoils.
- Investors with conservative to moderate risk appetites can invest in short-duration debt funds and gilt funds. Whereas, investors who wish to avail the benefit of increased interest rates or shift a part of their equity investments to fixed-income can choose to invest in Target Maturity Funds and lock in higher yields for their medium to long-term investments.
- Investors sitting on cash are advised to park their funds in bank fixed deposits or liquid mutual funds.
While investing in debt funds, it is advisable to keep your investment horizon equal to the maturity period of the underlying funds, as it will shield your investments from intermittent volatility due to interest rate changes during your investment period. Because when the underlying bonds mature at the end of your investment period, you can be sure that they’ll be priced at issue value.
Concluding it on a note, markets and the economy will always have their ups and downs, and as an investor, one needs to focus on their goals, stick to their asset allocation plan, and avoid making decisions driven by short-term trends.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.
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