Defensives are on the radar

Funds could flow into stocks of pharma, FMCG and tech sectors

The Reserve Bank of India's (RBI’s) Monetary Policy Committee has hiked the policy rate for the second time in a row. It has also hinted that it will not be averse to hiking again, if inflation doesn't ease off. Pressure on the rupee might now lessen due to a couple of factors. The US Federal Reserve has kept its policy rates unchanged although it has indicated that it will probably hike in September.

So, rupee yields will rise while dollar yields will stay at current levels. The yield differential is in favour of a carry trade investing in the rupee. This could lead to a comeback by Foreign Portfolio Investors, which in turn, could mean rupee strengthening. Indeed, the dollar could temporarily soften versus most other currencies. Another key variable, the price of crude, may just stabilise at current levels or even move lower, if the US soft-pedals its threats against Iran. That would ease pressure on the current account.

However, the cost of rupee-financing goes up, even as credit demand is picking up. This could lead to a slowdown in consumption though the RBI is presumably expecting the higher Minimum Support Prices (MSPs), Pay Commission benefits, etc., to be a counter-balance. For the real economy, higher rates mean working capital intensive businesses will see a rise in costs. Businesses considering longterm investments might also hold off seeing a trend of rising rates.

Debt funds are already in a bear market and will go more bearish. Banks and NBFCs will have to book treasury losses by marking to market since the value of bond portfolios will decline. The only safe debt funds in a scenario of rising rates are the ones dealing in short-term money-market instruments. Mutual fund flows indicate that there has already been a big shift from long-term and medium-term debt into money market funds.

The valuations for equity will also be adversely affected. The debt-equity equation is simple enough in theory for an investor. If the yield on risk-free (or low-risk) debt goes up, equity becomes less attractive and investors are less willing to buy stocks trading at high PE ratios.

Some investors compare the earnings-price (EP) ratio (the inverse of the PE) to the available yield on debt instruments. Ideally there should be a margin of safety where the EP is higher than the debt yield. For example, if the one-year Treasury Bill is trading at 8 per cent yield, the cautious value-investor will want an EP ratio of 9 per cent. That's the equivalent of PE 11.

Different investors will benchmark debt yields to different instruments. Some will look at the one-year fixed deposit rate. Others will look at the returns from debt funds. And, of course, investors will also examine growth rates for businesses before making a call.

However, by any reasonable criteria, the vast majority of profitable Indian stocks are extremely over-valued at the moment. The Nifty is trading at a PE of 28, the Next Nifty is at PE 46, the large mid-caps 250 is at PE 38, and the small-caps 250 are at PE 110 . This works out to EP ratios in the range of 0-3 per cent at a point of time where basic savings accounts are offering over 4 per cent interest.

Obviously there are pockets of growth and there is the odd undervalued share. But these are difficult to find. The bulk of the market may start easing down if higher rates start to bite. The long-term trend in global currencies is also clear — interest rates will rise everywhere. Rising rates lead to risk-averse behaviour, which means a shift away from equity and from Emerging Market assets.

We may see a defensive attitude even among domestic investors. The Q1 results indicate that FMCG has done quite well. Pharmaceuticals also seem to be making a comeback after several years of pain. Tech stocks have been targeted because of the weaker rupee.

These are all seen as defensive sectors and it's possible to make a case for each of them. Another key factor to note is that these three sectors don't need too much investment, or working capital, so they are less affected by higher rates. In valuations terms, tech is the cheapest, though it is also objectively high-valuation. There could be some fund flows into these areas.