Mkts may see more corrections, volatility
Money may move out of rate-sensitive stocks into less-affected ones
The Reserve Bank of India (RBI) has decided to tighten money supply and raise policy rates in an out-of-cycle meeting of the monetary policy committee (MPC). The RBI has also preemptively responded to the US Federal Reserve’s (Fed’s) increasingly hawkish stance, with the Fed expected to hike US policy rates this week.
Note that the Wholesale Price Inflation (WPI) print (not a direct RBI trigger) is double the Consumer Price Index-based inflation, which is well above the RBI’S upper limit of 6 per cent. A higher WPI implies corporates cannot pass on inputcost increases. This, in turn, means profit margins are under pressure. The impact of a rate hike is negative for most sectors. The cost of funds increases for the financial sector and if they pass it on, demand for credit slides.
For example, transport and housing tend to see falling demand because sales in those sectors are driven by debt. Capital-intensive and working capitalintensive businesses see costs of finance increasing.
Debt funds also get hit by withdrawals, reducing their assets under management and suffer drawdowns in net asset value. Sectors and companies with low debt tend to be less badly affected.
However, a higher interest rate can help protect the rupee, which is likely to come under pressure as the dollar-fed funds rate goes up.
In general, valuations of risky assets will fall. Some investors use an inverted price-to-equity (P/E) ratio, calculating earnings as a ratio of price as a benchmark to judge equity ‘yield’. The Nifty for example, is trading at a P/E of 22-odd, which may be inverted to calculate an equity yield of 4.5 per cent. Risk-free government treasuries are available at a yield of 7.3 per cent. Logically, equities must correct more to be attractive. The government must also pay more for its borrowings.
Many investors are spooked by the thought that this rate hike and associated cash reserve ratio hike (effective from May 21) is the start of a trend of tighter money. This is likely going by the MPC statement and the governor’s statement.
The RBI kept an accommodative stance with high liquidity and low rates for the last two fiscal years. It may now make several successive hikes and tighten liquidity more. The projected gross domestic product growth rate for 2022-23 is likely to be downgraded as a result.
Another worry: rate hikes may not work. Tighter money reduces demand, but this round of inflation is caused by supply issues, not excessive demand. There are shortages (or fears of shortages) of industrial metals, fuels, and agro-commodities caused by the Ukraine war, and there’s a shortage of manufacturing inputs due to China lockdowns. Monetary policy cannot address such problems.