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Why the rate hike will eventually be positive for Indian markets...


Posted on 17-Dec-2015 Comments  1

So the uncertainty pertaining to Fed rates finally ended when Janet Yellen raised the Fed rates from the range of 0-0.25% to 0.25-0.5%. This effectively sets the tone for a rate hike of another 100 basis points during the whole of 2016. The tone of the Fed has not been too hawkish. The gist of Yellen’s announcement was that they still want to keep the US markets awash with liquidity. There are 5 critical issues to understand pertaining to the rate hike and its implications for world markets in general and Indian markets in particular. 


How big is the risk of monetary divergence?


The big risk from a Fed lift-off was that it would result in monetary divergence.Let us explain. For the past 7 years, the US, Europe and Japan have been following a loose monetary policy of keeping rates near-zero and ensuring sufficient liquidity in the system. With the US raising rates, we have monetary divergence for the first time. This monetary divergence is critical because if the US tightens and the rest of the developed world loosens monetary policy, it could lead to substantial financial market volatility and risk. How important could that be?

There are three key messages in the Fed announcement. Firstly, Fed has underlined that although it has hiked rates, it will keep its stance dovish and keep liquidity abundant. Secondly, the overall trajectory of rates has been brought down substantially in the last few months. At the end of 3 years, rates will still be quite low by overall market standards. Thirdly, the Fed has clarified that further rate hikes are not binding but will be data driven. That means if employment, inflation or GDP growth tends to falter, then the US Fed may change tack and put off further rate hikes. This largely reduces the risk of divergence.


End of uncertainty is reason to celebrate...


The big takeaway for countries like India is that the uncertainty surrounding rates is finally over. At least now the worst case scenario at the end of 2 years is predictable. This will ensure that we do not see a surge of capital out flows from emerging markets like India. Even in case of Indian importers and FCCB borrowers, who are worried about rising dollar liabilities, a calibrated rate hike gives them substantial room for managing their dollar risk. This brings a lot of certainty into the entire rupee/dollar equation. This predictability is something that could be very critical for the Indian economy.


What about capital flows into India?


Here again there are two key things to remember. The outflows in 2013 happened more on the debt side and less on equities. That will be taken care of this time due to the yield spread that India enjoys over the US. Currently, the spread of the Indian 10-year G-Sec over the US 10-year G-Sec is approximately 540-550 basis points. This is at least 100 bps higher than the historical median spreads between the two securities. This higher spread will ensure that FII debt investors will continue to be interested in Indian debt. Secondly, there is the concern over the rupee. Here India has a macroeconomic advantage. The strong CAD position at just 1% of GDP and fiscal deficit at 3.6% of GDP will ensure that there is no undue pressure on the rupee. Over the last 2 years, the RBI has successfully followed the policy of calibrated depreciation of the rupee.Considering that India’s forex reserves at $355 billion are almost 10.5 months of imports, we have a fairly strong cushion to fall back upon. Thus capital outflows and rupee shocks are not exactly worries for the Indian economy.


A rate hike is an affirmation of growth happening...


The big news for India is that a rate hike stems from the confidence that the US economy is growing. Inflation may still be low but that is more because of cheap oil and commodity prices. The rate hike is a proof that the US economy is growing in terms of employment and GDP growth. That is likely to have as pill-off effect on other economies. For India, sectors like pharma and IT are likely to benefit from higher demand and higher spending in the US economy. A pick-up in growth led by the US is the best thing to happen for the world economy. For the last 10 years, China has been the engine that has driven global growth. With China slowing down and going through a process of internal churn, the US is taking up the role of the world economic engine once again.That is great news for India, whose trade and economic relations with the US has been much deeper and stronger than with China.


How will rates impact investment strategy in India?


There are two time frames to look at this question. In the medium to long term rate hikes and rate cuts do not really impact stock markets returns. In fact, a study conducted by Russell Investments over the last 40 years affirms that the US and global equities actually tend to outperform when rates are cut sharply or raised gradually. The latter being the case, India surely has reasons to cheer about.


In the shorter term, there will be some tumult in financial markets and Indian investors need to be prepared for that. Sectors like pharmaceuticals and IT will benefit from this rate hike because it implies a stronger dollar as well as higher US demand. This will benefit companies with a larger share of US business. The import heavy companies like capital  goods and OMCs will suffer in the short run due to pressure on their dollar liabilities. This is likely to reflect in their stock price. But the companies with high proportion of dollar FCCB debt will have to really watch out.


So in the short run the investment strategy will have to focus on dollar defensives and quality companies that are more reliant on domestic markets. But in the medium to long run, the rate decision is unlikely to have any meaningful impact on Indian markets. It will be back to more serious domestic question like earnings growth, inflation macros and GDP. That is the good news for India!

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Vikram Gour

Posted on 12/18/2015 5:21:28 PM

Now when the uncertainty is completely gone and Indian market is placed in better situation than their peers, People sitting on the sidelines could enter into the market. But GST not getting implemented could restrict the up move in the market with immediate effect. I think now the markets move will depend on the Technicals .

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