Inflation, Interest Rates And Equity Markets

Rate Hike Cycles and Equity Markets

The current inflation levels that are at a multi-decade high are causing lot of worries for global equity investors. It is inflation levels and the fear of rising inflation that remains a key risk for the equity markets in FY23. For long-term investors it is worth studying the impact of inflation and interest rates on equity prices. Yogesh Supekar explains the trend while also highlighting which sector stands to gain the most from such dynamic market changes.

The equity market, it is often said, is one of the most sensitive markets of all. Most sensitive meaning every major event, whether economic, geopolitical or natural calamity, has a potential to impact the equity markets across the globe. Also, equity markets tend to get volatile owing to rising commodity prices and asset valuations as well. Similarly, rising inflation, one of the most important macro economic factors, has a telling impact on the fortunes of the equity market. At least that is what leading economists and experts would like to communicate to the investing world. 

After all it is only logical to connect the dots and explain how bad rising inflation and interest rates can be to the cash flows generated by the corporate world. The impact is direct on the bottom-line and when the cost of money is too high for too long, the business expansion plan gets hit, which in turn starts impacting the economic activity and results in lower GDP growth over a period of time. Sentiments turn sour and the animal spirits vanish. It is the unwarranted consequences of rising inflation and asset prices that worry most policy-makers. Sustained levels of inflation if not addressed immediately and deftly can lead to an everlasting impact on the economy and usually impacts the livelihood and wellbeing of the population residing in the country suffering from such a macro economic problem. 

One of the most recent examples is that of Sri Lanka. While politics may grab the headlines it is the sustained level of inflation and the depreciating currency of Sri Lanka that are making matters worse for the country. The world is aware of the problems faced by Venezuela and Argentina where unsustainable inflation level was the key fallout of economic mismanagement. When we go back to the Asian financial crisis which disturbed the world economy, forcing IMF to provide bailout packages to most affected countries such as Thailand, South Korea, Indonesia and Philippines, we find that the interest rate changes induced by rising inflation levels was the key factor behind the whole crisis. 

Inflation management and interest rate management are extremely important tasks overseen by the reserve banks across the world. US economy being the largest economy and the US dollar being the world currency, any interest rate changes made by the US Federal Reserve will have an impact on various economies, including India. The money flow gets directly impacted by the cost of money and any mismanagement of the monetary policy can disturb the market equilibrium, causing disruption in asset prices and leading to a possibility of default for the country. Turkey is a fine example of monetary policy mismanagement. Turkey is on its fourth central bank governor since 2016 and over this period, interest rates have ranged from less than 10 per cent to almost 25 per cent. Turkey is experiencing brutal inflation, with food and non-alcoholic beverage prices rising 70.3 per cent year-over-year for March. 

Now this is as far as the sad story goes. There is no doubt the situation on the ground is worrisome in Turkey and it is only logical to expect negative returns in the equity markets representing Turkish listed companies. Yet, the results are extremely contradictory. The BIST 100 index also known as Borsa Istanbul Stock Exchange is the top performing index globally on YTD basis after advancing by 27.70 per cent. In one year, the BIST 100 index has been up by more than 74 per cent. This contradiction in stock price performance and worsening economic situation on the ground can be baffling for a majority of market observers. This extraordinary performance just goes to show that equity markets do not move only after taking into consideration inflation levels and interest rates. 

Rate Hike Cycles and Equity Markets

There have been several instances where the equity markets have risen and outperformed several other asset classes during an inflationary environment. In spite of several observations where the equity markets have climbed the wall of worry of inflation and rising interest rates, market participants almost always remain cagey about market prospects when a price rise happens. The reason is simple: in the short run the market tends to adjust to the new price levels and the adjustments lead to increasing market volatility as the expected earnings become volatile. With the change in expectation in earnings, the stock prices tend to adjust – mostly downwards as the earnings are expected to take a hit. 

However, it is not as straightforward as we all would like it to be. If one were to study the US’ equity market behaviour during inflationary periods and especially if one were to identify patterns connecting the underperformance of equity markets and rising price level, one might get disappointed. According to the Dow Jones market data, in about five long-term periods of high inflation, the three leading major benchmark indices, namely, DJIA, S & P 500 and NASDAQ, only declined during one rate hike cycle.

When we observe the market data for 2017, we find that the US Federal Reserve raised interest rates three times and the S & P 500 climbed more than 18 per cent in the same year. Another period marred with rate hike cycle was from June 29, 2004 to September 17, 2007, where the US Federal Reserve increased the rates from 1 per cent to 5.25 per cent. During this period of series of rate hikes, DJIA gained ~28 per cent. During the series of rate hikes from June 29, 2004 to September 17, 2007, for example, the federal funds rate soared from 1.0 per cent to 5.25 per cent and the DJIA gained 28.7 per cent. When factored together, the S & P 500 saw a median increase across all five cycles of 30 per cent while the NASDAQ delivered a median gain of nearly 27 per cent and the Dow Jones industrial Average (DJIA) delivered a median increase of 17.4 per cent.

Looking at the data in the above table, we find that the Sensex on an average has gained by ~98 per cent if we consider all the five interest rate hike cycles in the US economy. If we consider the performance of the Mid-Cap index and the small-cap index for periods starting 2004 till July 2019, we find the average returns to the tune of 414.91 per cent and 352.90 per cent. This goes to show that the broader markets outperformed the Large-Caps during the rate hike cycle and that the key benchmark index also outperformed.

Taking into consideration the above data, it will be wrong to assume that the emerging markets underperform during rate hike cycles. The above table reflects Sensex’s relative outperformance during 2002 to 2008. However, during 2015 to 2018 the Indian market underperformed both DJIA and technology-heavy NASDAQ Composite. Also, the data suggests that banks in general outperformed during the inflationary period. 

"The Biggest Risk is Lazy Investing" 

• Siddharth Bhaiya, MD and Fund Manager, Aequitas Investment Consultancy

Runaway inflation (crude oil) and interest rates are the two biggest risks to the Indian equity markets. Two key factors to watch out for will be the USD and INR and the 10-year yield which have both moved up sharply in recent times. While moderate inflation is good for the markets as it helps corporates increase their earnings growth, it is high inflation which poses a very big risk to the equity markets. We have just seen how Sri Lanka has imploded due to a mismanaged economy where first inflation went out of hand and now we have riots. Fortunately, in India we have had a very stable government which has been able to steer the economy well even during the troubled times of the pandemic. 

The biggest risk that we see for investors in 2022 is ‘lazy investing’. From 2013 to 2021 we saw that investors invested into just growth stocks and made decent returns irrespective of the valuation of the stock, making it a very lazy investment. From 2022 we are sure that these lazy investments will cause a hole in the investors’ pockets. This is now a stock-picker’s market where if you are caught in the wrong i.e. high PE stock, you will not only not make money but you could suffer significant losses. And if you are in the right stock, you can make significant gains on your portfolio. 

Hyperinflation

Hyperinflation is said to occur when the prices of goods and services rise by more than 50 per cent per month. In the case of hyperinflation, a particular thing could cost one amount in the morning but quote higher in the afternoon. The severity of cost increase distinguishes it from the other types of inflation. The two causes of hyperinflation can be noted as an increase in the money supply and demand-pull inflation. An increase in money supply is seen when the government of that country starts printing money in order to pay for its spending. As the money supply increases, the prices rise as in regular inflation. 

On the other hand, when a demand-pull inflation occurs, the demand outstrips supply, pushing the prices higher. An increase in consumer spending due to a growing economy, a sudden rise in exports or more government spending can be the causes of demand-pull inflation. As an effect of hyperinflation, unemployment increases as companies get close to the edge of shutting down. Meanwhile, the value of the currency slips in the foreign exchange market and due to the soaring cost of foreign goods the nation’s importers face the brunt of the same in their businesses. Also, the government faces trouble in providing basic services, as a result of which the tax revenues fall. 

Stagflation

Stagflation is a combination of the words stagnation and inflation. It is known as an economic condition involving slow growth and high unemployment (economic stagnation) mixed with rising prices (inflation). Stagflation affects the economy negatively due to slow economic growth, high unemployment and high prices. The two main causes of stagflation that are agreed upon by economists are supply shocks and fiscal and monetary policies. The supply shock theory indicates that stagflation occurs when an economy faces a sudden increase or decrease in the supply of a commodity or service, such as a rapid boost in the price of oil. 

This makes prices surge and production costlier and less profitable, leading to slow economic growth. A second theory states that stagflation can be a result of a poorly made economic policy. To quote an example, the government can create a policy that harms industries while growing the money supply too quickly. The simultaneous occurrence of these policies can lead to slower economic growth and higher inflation. Going at its deepest level, stagflation is one of the most difficult economic environments for central banks and policymakers to overcome. Beating high inflation when the economy is stagnating is a tough nut to crack for any investor. A decent solution for such a situation is to be prepared to take a risk, invest in companies that are capable of making money despite the conditions or wherever they stand in the world. 

Inflationary Trend in the US

•  BMO Capital Markets

Spurred by Russia’s war on Ukraine and the continuing economic fallout from the pandemic, US inflation rose in March by the most since late 1981, reinforcing pressure on the Federal Reserve to raise interest rates more aggressively. The main sources of pain during the month were gasoline and food. Though some economic experts contend that the current inflation reading of 8.5 per cent is likely its peak, the path down the mountain can’t come soon enough for many consumers. That said, when excluding volatile food and energy components, so-called core prices increased just 0.3 per cent from a month earlier, due in large part to the biggest drop in used vehicle prices since 1969 and a price deceleration in other categories. Used car prices, which had been a driver of higher goods inflation for months, were down 3.8 per cent in March, the second straight monthly decline. The figures are a welcome respite from the sustained heated core increases of late, and fuel costs look to ease in response to the recent pullback in oil prices.

Conclusion

Equity analysis is a tough job as it is impossible to factor in the innumerable developments that impact the stock prices in the short or medium term. The current situation is highly unpredictable and hence any kind of forecasting the markets could prove to be frustrating. Several risks face the equity markets as of now. However, the biggest risk facing the markets right now is not inflation or rising interest rates but a feeling of complacency amongst the investing public who think they have figured out all the risks in both the short and medium term. There is also a tacit understanding amongst the investing crowd that no matter how serious a financial crisis we may be in, the central banks of the world will eventually bail us all out and that should support the equity prices. 

What is required at this point of time is realistic assessment of investing opportunity keeping in mind the valuations of stocks and markets. Apart from the rising inflation and the unexpected rise in interest rates, stretched valuation is one of the biggest concerns facing the equity markets. That said, the earnings’ uptick is a pleasant reality that can keep the bulls engaged in both the short and medium term. To predict market movement, a very close monitoring of Nifty 50 stocks’ earnings is also required to be able to assess if we can inch higher or lower. In the long-term, earnings’ growth is the single most important factor that dictates the market moods. 

Nifty earnings have grown by a CAGR of just below 7 per cent over FY10 to FY20. Nifty index has delivered ~8.6 per cent return in the similar period. This goes to show that the stock prices and earnings’ growth converge in the long term. The earnings’ growth has shifted to top gear in the past couple of years by recording approximately 52 per cent growth cumulatively. This surge in earnings is the highest since 2004. With spectacular growth in earnings, if sustained, we may see record highs in FY23 in terms of index levels. 

While it is true that inflation and interest rate fears allow bears to dominate, long-term investors should not give undue weightage to the problem. Equity investors will have to keep a tab on inflation levels and interest rates only up to a point where we don’t reach stagflation or hyperinflation. A sagflation situation will be a damaging condition for the equity markets. Per se, only inflationary levels should not bother long-term equity investors. In fact, an inflationary situation can be good for several sectors and companies. Banks and financials may see improvement in the margins. Commodity players tend to thrive and make record profits in an inflationary environment. 

Commodity producers such as oil and gas and metals are the obvious beneficiaries of rising inflation. It is possible that the damage will be done in those sectors and companies where the pricing power is low. Growth stocks tend to underperform during a harsh economic environment where the rising cost of money threatens to slow down economic activity. The market will punish growth stocks when the expected growth is not delivered. Value stocks in such a challenging environment can provide some cushion and alpha-generating opportunity. 

The investors’ focus should be on quality companies with pricing power and compounding growth in earnings and cash flows. Investors will also have to keep a close eye on the exchange rate. As the rate increase in US’ economy gathers pace and as the Reserve Bank of India (RBI) shows reluctance to increase rates, the flight of capital from the Indian markets to the US markets is inevitable. Depreciating rupee beyond a certain level makes it unattractive for FPIs as their return on investment is impacted negatively. Investors will have to watch closely the RBI’s decisions and even more closely the US Federal Reserve’s decisions to understand FPI behaviour.