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Explained: Interest rates hiked, but equities may do well when inflation is high

Investors must keep in mind that equities may outperform in times of high inflation, as had happened in 2014 and 2016 amid consumer price index inflation.

The rise in indices the day after the shock reaction at the stock markets shows that Wednesday’s fall was a knee-jerk reaction, and that the interest rates were only expected. (Express Photo: Amit Chakravarty, File)

A day after the Reserve Bank of India raised the repo rate by 40 basis points and the US Federal Reserve raised interest rates by 50 basis points, the benchmark Sensex at the Bombay Stock Exchange jumped by close to 900 points, or 1.6%, before losing its gains to close the day at 55,702 — a gain of 33 points over Wednesday’s closing. As inflation remains a key concern, interest rates were only expected to go up. But investors must keep in mind that equities may outperform in times of high inflation, as had happened in 2014 and 2016 amid consumer price index inflation.

What have central banks done?

The Fed’s 50-basis-point hike in interest rates on Wednesday, the biggest in over two decades, came in response to rising inflation that has hit a four-decade high. The hike follows a previous increase of 25 basis points in March, and economists feel there could be several more in the coming months. In addition, starting June, the bank would reduce its holdings by $47.5bn per month, and increase the reduction to $95bn in September.

“The EIU expects the Fed to raise rates seven times in 2022, reaching 2.9% in early 2023. Starting in June, the Fed will shrink their $9 trillion asset portfolio, a policy move that will further push up borrowing costs,” said Madan Sabnavis, chief economist, Bank of Baroda.

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Besides India and the US, even Australia’s central bank recently enacted its first interest rate hike in more than a decade. The Bank of England too raised interest rates on Thursday by 25 basis points to 1%, its highest since 2009.

What will be the impact on the economy?

While the Fed’s rate hike was expected and had already been accounted for by the markets, the RBI’s announcement on Wednesday took everyone by surprise. The RBI’s caution on inflation expectations going forward has led to a decline of sentiment among market participants, who apprehend that the rates could be increased by 100-150 basis points this year. A hike by the US Fed has a bearing on funds flow from foreign portfolio investors.

“This impact will reverberate around the globe with funds moving out of emerging markets. There can be competitive increase in interest rates by various central banks to stay ahead of the curve now to attract foreign investors… The impact will also be felt in financial markets, where asset prices were buoyed by the unprecedented levels of stimulus showered on the economy during the pandemic. This will get reversed now,” said Sabnavis.

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As inflation threatens the economic rebound after Covid-19, the RBI’s rate hike will have a direct bearing on the economy and growth. While on the one hand it will lead to a reduction in borrowing-based consumption, that may in turn delay the nascent process of economic recovery. It will also impact the margins of companies as the cost of funding (both working capital fund requirement and capital investment) would rise going forward. Businesses in the consumption, travel and hospitality spaces, among others, could see a slowdown in their growth as consumers readjust their disposable incomes due to the impact of the rate hikes.

Shrikant Chouhan, head of equity research (retail) at Kotak Securities, said, “The early momentum (on Thursday) failed to sustain as investors turned risk-averse amid worries of high inflation and prospects of more rate hikes that will slow growth going ahead.”

Why should equities be preferred?

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The rise in indices the day after the shock reaction at the stock markets shows that Wednesday’s fall was a knee-jerk reaction, and that the interest rates were only expected. Even as a rise in interest rates will lead to an increase in deposit rates being offered by banks, investors should know that the high inflation of 7% will eat into their interest income and the real interest income will be negative. Only a few small saving schemes such as Public Provident Fund (7.1%) and Sukanya Samriddhi Yojana (7.6%) are generating interest income above inflation.

Equities, on the other hand, tend to fare better in times of high inflation. Consider this: Between February and August 2014, CPI inflation hovered in the range of 6.8-8.5% while the Sensex rose nearly 30% from levels of 20,500 to 26,638. Similarly, between January and August 2016, when the CPI inflation hovered in the range of 4.8-6.1%, the Sensex gained over 14% from levels of 24,870 to 28,452.

Market experts say that theoretically, rising inflation leads to rise in earnings of companies and thus boosts their revenue growth. However, one must keep in mind that companies that are market leaders in their sectors have a better ability to pass on the price rise to consumers and gain from that. So investments have to be in well-run companies or through mutual funds.

Experts say that if investors want to protect themselves against high inflation, they need to have adequate asset allocation in equities. Even debt investors must consider investing in equities for the next three to five years.

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First published on: 06-05-2022 at 04:10:05 am
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