One day after the The Reserve Bank of India has raised its repo rate by 40 basis points and the US Federal Reserve raised interest rates by 50 basis points, the benchmark Sensex index on the Bombay Stock Exchange jumped nearly 900 points, or 1.6%, before to lose its gains to close the day at 55,702 – a gain of 33 points on Wednesday’s close. As inflation remains a major concern, interest rates were bound to rise. But investors should keep in mind that equities can outperform in times of high inflation, as happened in 2014 and 2016 amid consumer price index inflation.
What have the central banks done?
The Fed’s 50 basis point interest rate hike on Wednesday, the biggest in more than two decades, came in response to inflation rising to a four-decade high. The rise follows a previous 25 basis point increase in March, and economists believe there could be several more in the coming months. Additionally, starting in June, the bank would reduce its holdings by $47.5 billion per month and increase the reduction to $95 billion in September. “The EIU expects the Fed to hike rates seven times in 2022, to 2.9% at the start of 2023. Beginning in June, the Fed will reduce its asset portfolio by $9 trillion , a political move that will further increase borrowing costs,” said Madan Sabnavis. , Chief Economist, Bank of Baroda.
Besides India and the United States, even the Australian central bank recently decreed its first interest rate hike in more than a decade. The Bank of England also raised interest rates on Thursday by 25 basis points to 1%, its highest level since 2009.
What will be the impact on the economy?
While the Fed’s rate hike was expected and had already been priced in 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 lower sentiment among market participants, who fear rates could be hiked by 100 to 150 basis points this year. A rise in the US Fed affects the flow of funds from foreign portfolio investors.
“This impact will reverberate around the world with funds flowing out of emerging markets. There may be a 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 have been supported by the unprecedented levels of economic stimulus during the pandemic. It will reverse now,” Sabnavis said.
As inflation threatens the economic rebound from Covid-19, the RBI rate hike will have a direct impact on the economy and growth. While on the one hand this will lead to a reduction in consumption based on borrowing, this in turn could delay the nascent process of economic recovery. This will also impact corporate margins as the cost of funding (both working capital requirement and capital investment) will increase in the future. Companies in the consumer, travel and hospitality sectors, among others, could see growth slow as consumers readjust their disposable income due to the impact of rate hikes.
Shrikant Chouhan, Head of Equity Research (Retail) at Kotak Securities, said: “The initial momentum (Thursday) failed to sustain as investors became risk averse amid fears of a high inflation and the prospect of further rate hikes that will slow growth going forward.”
Why focus on stocks?
The rise in indices the day after the reaction to the stock market shock shows that Wednesday’s fall was an epidermal reaction, and that interest rates were only expected. Although a rise in interest rates will lead to higher deposit rates offered by banks, investors should be aware that high inflation of 7% will eat into their interest income and real interest income will be negative. Only a few small savings schemes such as the Public Provident Fund (7.1%) and Sukanya Samriddhi Yojana (7.6%) generate interest income above inflation.
Stocks, on the other hand, tend to fare better in times of high inflation. Consider this: Between February and August 2014, CPI inflation hovered between 6.8 and 8.5 percent, while the Sensex rose nearly 30 percent, from 20,500 to 26,638. , between January and August 2016, when CPI inflation hovered between 4.8 and 6.1 percent, the Sensex gained more than 14 percent, from 24,870 to 28,452.
Market experts say that theoretically, rising inflation leads to higher corporate profits and thus boosts revenue growth. However, it should be borne in mind that market-leading companies in their sector have a better ability to pass on price increases to consumers and profit from them. Investments should therefore be made in well-managed companies or through mutual funds.
Experts say that if investors want to hedge against high inflation, they must have an adequate asset allocation in equities. Even bond investors should consider investing in stocks over the next three to five years.
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