The common theory is that higher interest rates take up risk premium on equities leading to falling equity values. This theory can be debated across economic cycles but when the economy is slowing down considerably and inflation is trending up leading to higher interest rates, the sense for equities going up does not make sense. Or does it, if one takes a different approach to viewing equity markets at present.
The Sensex and Nifty have risen by 3% and 3.5% since 20th September 2013 even as the RBI has hiked the repo rates twice since then. RBI hiked the repo rate by 25bps on the 20th of September and 25bps on the 29th of October even as it brought down GDP growth forecasts for 2013-14 from levels of 5.5% to below 5%. Inflation as measured by the CPI (Consumer Price Index) and WPI (Wholesale Price Index) have trended higher over the period with CPI rising by 9.84% and WPI rising by 6.46% on a year on year basis.
The Indian Rupee (INR) has strengthened by over 1% while the ten year bond yield has stayed flat since September 20th. Why have equities markets outperformed the INR and ten year bond following double rate hikes by the RBI? Are equities factoring in better times for the economy given that the RBI is keen to control inflation? Or are equities reacting to the fall in overnight money market rates on the back of the Repo-MSF rate being normalized at 100bps from panic mode levels of 300bps seen in July 2013?
Equities could well be ignoring RBI and focusing on the US Federal Reserve (Fed) postponing the tapering of its USD 85 billion a month asset purchase program. FII’s have invested around USD 4 billion in Indian equities in September and October while they have sold USD 2.25 billion of INR debt. Equities are either ignoring growth and inflation risks or are factoring in something that the bond market is not factoring in given that the Sensex and Nifty are close to record highs.
The global equity markets performance have been mixed with equity indices in the US and Europe trending higher since 20th September while indices in China, Hong Kong and Japan have trended down. The Sensex and Nifty are following US and European markets in trending higher. Do corporate results have to do anything with the Sensex and Nifty trending at close to record highs?
Corporate results have been mixed with the IT sector delivering better than expected growth in revenues and profits on the back of higher demand for outsourcing and on the back of a weak INR that had fallen to record lows against the USD in August 2013. The banking sector has shown rising non performing assets across banks indicating stress on loans due to weak economy. Other sectors have felt impact of weak consumer and investment confidence, In short corporate results have not been encouraging enough for the markets to trend to record highs.
The question is will the Sensex and Nifty come back to ground reality or will they continue to trend up against all expectations? The latter looks more probable as global equities may just go through what is called a Santa Claus rally as the Fed and other central banks from the developed economies continue to pump in money to spur economic growth. The liquidity flows will impact domestic equities positively and by the time the Fed starts tapering and India enters elections, market levels may just be way higher than what it is now.
The best way to navigate the equity market at present is to identify stocks that are showing uptick in growth and profitability margins and are trading at reasonable valuations. Sticking to the index is also a good idea as one gets to rise the markets with less volatility. Invest in equities but be prepared for volatility and be optimistic that the RBI is doing the right thing by raising the repo rate.