There are clear indications now, that given the stubbornly high inflation, the US Fed will be more aggressive in its intensity of rate hikes. Inflation is up, partly due to external factors such as the war in Ukraine and the continuing covid shutdowns in China’s key manufacturing hubs. The US Fed influences employment and inflation levels primarily by using monetary policy tools to control the availability and cost of credit. Here, the Fed’s primary tool is the federal funds rate, changes in which influence other interest rates — which, in turn, influences borrowing costs for households and businesses as well as the broader financial conditions. When interest rates go up, borrowing becomes more expensive; consumption demand is impacted and capex is postponed. All these end up lowering wages and other costs, in turn bringing runaway inflation under control. Foreign portfolio investors (FPIs) tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds/equities of countries such as India in rupee terms to earn a higher interest rate.
A rate hike in the US could have a three-sided impact—make emerging countries such as India less attractive for currency carry trade, a lower push to growth in the US (which could be yet another negative news for global growth), and trigger a churn in emerging market equities (thereby moderating foreign investor enthusiasm). There is also a potential impact on currency markets, stemming from outflows of funds from countries like India. Indian markets had reduced their dependence on FPI flows for the last few quarters, but now the spectre of continuous unloading by them has impacted valuations and affected the risk appetite of retail investors. If this bear run continues, even retail investors could think about withdrawing monies from the markets wherever they are in profit or in smaller losses. Though, the Nifty P/E has come down to 20x, one needs to be aware of the possibility of earnings downgrades which could take the P/E up again. While the FPI selling since October 2021 seems large at $32.3 billion, it is just 4.8% of their holding as on that date (out of their 20.5% stake in NSE 500 companies’ market value of $3,249 billion) and 15% of their cumulative inflows till that date. While this denotes the downside risk, one must be careful of stocks where FPIs have a large holding even after 8-9 months of sales.
For investors who are not fully invested or who have raised cash in the recent past by booking profits, these times provide an opportunity to gradually raise the equity portion of their portfolio. While shortlisting stocks, one will have to be careful of having limited exposure to sectors or stocks that have got de-rated due to very high valuations (including some consumer staple/discretionary companies, new age internet stocks, niche midcap IT companies, retail, multiplexes, and speciality chemicals) or very high financial forecasts that seem difficult to achieve.
Also, stocks that did well due to a run-up in commodities over the last one year need to be examined closely for sustainability of earnings. Quantitative easing and restrictions in China resulted in commodity prices and stocks rising very steeply over the last few quarters. Now, with quantitative tightening in force, these tailwinds will no longer be available especially when the economists are expecting recessionary conditions to set in most parts of the globe. Investors need to focus on structural stories where the financial leverage on books is limited, sales are growing at a CAGR of 15% plus over the past three years and the return ratios are high and rising gradually. They could have a mix of large-cap (high proportion) and mid/small caps (balance) based on their risk appetite.
While the equity markets may take time to find a sustainable bottom, investors could look at debt options (including listed NCDs, RBI bonds, etc.). They may also look at parking some funds in bank fixed deposits (FDs) once interest rates have risen sufficiently and lock in high rates for a long period. They need to be careful about investing in corporate FDs and weigh the rates offered vis-à-vis the risk assumed and compare them with the alternatives discussed above.
High inflation may lead to real estate prices edging up and investors who are looking to buy real estate for self-occupation may accelerate their decision process. REITs and InvITs also offer a window to lock in high returns at a time when interest rates are moving up, and their prices may have been depressed. Equities have not gone out of fashion but could see a period of consolidation/mild correction. Prudent allocation of funds now will enable taking advantage of the next up-run which may be a few months away.
Dhiraj Relli is MD & CEO, HDFC Securities.