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Investors! Exercise caution

September 22, 2004 14:26 IST

The US Fed has done it again. Though the 25 basis points interest rate hike was largely on expected lines, unlike the previous two hikes of 25 basis points each in July and August respectively, there was some uncertainty this time around about the Fed going ahead with the rate hike.

This arose on the back of falling treasury rates, which are seemingly indications that the US economic recovery could be faltering. In such a scenario, some amount of ambiguity had cropped up amongst investors, and markets at large, with regards to a rate hike.

Nonetheless, on Tuesday, the Fed has reaffirmed its faith in the growth of the US economy and has increased interest rates. We analyse in brief the repercussions of the move on the Indian stock market.

Commenting on the US economy and the hike, the Fed is of the view that "the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.

After moderating earlier this year partly in response to the substantial rise in energy prices, output growth appears to have regained some traction, and labor market conditions have improved modestly. Despite the rise in energy prices, inflation and inflation expectations have eased in recent months.

The committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal".

Globally, interest rates are on the rise, which is evident from the hike in interest rates by The Bank of England and the central bank of Australia in the last 4 months.

The key factor that has prompted this move has been the increasing inflationary pressure being felt in these economies, which has been a factor of hardening global crude prices. Inflation is also a sign of the economy heating up, however it is not so all the time.

While the US economy has not shown any sustained signs of growth the Fed has shown optimism on this front. And thus, to keep the scenario under control and at the same time not hurt economic growth prospects, the Fed (among others) has resorted to the 'measured' hike in interest rates.

It must be noted here that a hike in interest rates would basically affect 3 broad categories i.e. industry, consumers and markets.

Industry: Higher interest rates would increase the borrowing costs for corporates thus increasing their cost of expansion and the gestation period of their project making the relative returns that much less lucrative.
Consumers: A hike in interest rates would make the existing/future repayment/borrowing for the consumers also expensive in terms of loans (housing, personal) thus adversely affecting their spending ability.
Markets: A substantial rise in interest rates would have an adverse impact on corporate profitability, thus making stock market returns that much depressed. This could entice investors to look for safer investment avenues like fixed income instruments as these would now offer a higher interest return. Further, debt markets are also affected as bond prices correct to align to the higher interest rates.

Apart from this, the impact of increase in interest rates in the global markets could impact India also. Given the fact that inflation in India has also increased significantly in the recent past, is there a possibility of Indian interest rates heading north as well? The possibility is high!

There are a number of reasons like exchange rate and so on that determine interest rate policy. However, since these are a bit complicated, we have not dealt with them in detail in this article.

Further, considering that FII inflows have been the lifeline for Indian bulls since the last 15-18 months (near $7 billion in 2003 and approximately $5 billion in the current year to date), some of this amount could change course back to the US, albeit only temporarily.

This is because the case for India is not just based on long-term growth prospects but also the relative attractiveness (for a given level of risk, if US becomes more attractive than India, institutional investors could pare their exposure to India).

To conclude, we would like to re-iterate our suggestion that investors exercise caution, especially when it comes to capital-intensive sectors and the so-called mid-caps. While valuations are supported by reasonable expectations of earnings growth in the next three years, it is better to invest in a staggered manner to diversify risk over a period of time.

Plan your investment and borrowing decisions, keeping in mind that possibility of interest rates heading north in India this fiscal.

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