By 
Ask any seasoned market observer what moves stock prices over the medium term, and two familiar forces will appear near the top of the list: interest rates and inflation. When the Reserve Bank of India adjusts its policy stance, the effect is felt across borrowing costs, corporate profits and investor sentiment. The Sensex often reacts within minutes of a policy announcement, and the trajectory of INDEXNSE: NIFTY_50 over subsequent months is frequently influenced by how these variables evolve. This article examines the relationship between rates, prices and equities in the Indian context, so that investors can interpret policy news with greater clarity and less alarm.
The Link Between Rates and Valuations
Interest rates and share prices
There are two channels through which the rates feed into share prices. The first is the discount rate. The value of a company is the present value of its future profits stream. As the future profits have to be discounted to get their present value, an increase in the discount rate hurts the present value of future profits. When future profits are more distant, the hurt would be greater, making growth stocks more sensitive to the rate changes.
The second channel is the opportunity cost – what else can be done with the money. With the increased deposit and government bond rates, some investors may prefer fixed deposits to equities, and the capital may flow from equity markets to deposit products. Similarly, on the decline of rates, equities become more attractive than deposits and bonds, and the capital flows in the opposite direction. This is the reason why equity markets tend to benefit from the easing cycles (although not always) and underperform during the tightening episodes.
Inflation and its differential impact
While moderate inflation is often associated with healthy economic growth, high inflation is often associated with the deterioration of purchasing power, hurting both consumers and businesses. For businesses, it means higher costs and the need to rethink their pricing strategies. Companies with pricing power (premium brands) and those in non-commodity sectors will be able to offset some of the cost increases, while others (many small businesses) may not.
In India, inflation is largely driven by food and fuel. A poor monsoon (rainfall season) leads to vegetable price increases, lower farm income, and higher grain prices, while volatility in oil prices (influencing transport costs) affects many businesses through higher logistics costs and the import bill. Inflation targeting (target inflation band for the given period) is a policy followed in India, which means that a prolonged period of higher inflation will result in tighter monetary policy.
Differential impact on sectors
Banks and financial companies will be the first to feel the impact both of the rate increases (higher spreads) and decreases (lower spreads). Higher interest rates regimes hurt the demand for loans and increase default risks, while lower rates do the opposite. Real-estate and auto companies are also heavily influenced by the changes in borrowing costs as they are capital-intensive and rely on consumer loans. Similarly, infrastructure and power companies, which maintain high borrowing levels due to heavy capital expenditures, are also sensitive to the rate changes. However, such effects are less impactful on technology companies, for which the domestic rates are less important than the exchange rate (inbound foreign revenues) and consumer spending patterns.
The importance of reading the statements
Markets are quick to react to a given statement. However, they are even more sensitive to the accompanying text. The accompanying text usually contains the inflation assessment by the RBI, as well as overall growth outlook and liquidity guidance, which gives an important context to the single rate decision. Essentially, it shows the market the path of the monetary policy. In case of the shift in the stance, as mentioned above, markets will react as if the rates have changed even when they have not. Pay special attention to the monthly inflation reports, industrial production estimates and credit and tax growth, as this data helps understand the economy and the potential impact on rates.
Avoid taking any big decisions on the day of the announcement, as initial market reactions are often overdone and quickly corrected. Moreover, changes in the consumer behavior (spending patterns) due to easier or tighter credit conditions will eventually affect business performance, consumer spending and thus equity prices. Households with variable income (loans) or deposit income will be the first to feel changes in interest rates. Lower deposit rates hurt the income of older generation (pensioners) and create pressures on the banks’ net interest margins.
Preparing your portfolio
As there is no crystal ball at the RBI, you have to think of companies with strong balance sheets, with prudent leverage and stable cash-flow generation. Diversify across asset classes and utilise the current opportunity to buy bonds with sufficiently long maturity (in case of higher rates) or duration (in case of lower rates). Remember that interest rates follow a cycle, and both equity and debt markets will behave accordingly. By understanding this cycle and not trying to time it, you will minimise your risks and stay ahead of the beat.
Comments