Rising interest rates could weigh on valuations of Indian stock markets

Exporters, and low debt, non-capital-intensive businesses should do better

The Reserve Bank of India (RBI) is playing catch-up after ignoring inflationary trends for long. The out-of-turn rate hike of 40 basis points in May has been followed by a 50 basis point (bps) hike in repo in June. The market was expecting this and even more aggressive measures such as hikes in CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio).

Hence, G-Sec yields actually fell slightly after the Monetary Policy Committee (MPC) meeting. The USD-INR rate remains around 77.70/USD. Among other measures announced along with the Monetary Policy, rural cooperative banks are being allowed to double previous exposure to housing loans as well as offer credit to commercial builders. It remains to be seen what sort of impact this will have on the low-cost housing market in particular.

The MPC projects inflation (measured by CPI) at 6.7 per cent across 2022-23, with Q1 inflation at 7.5 per cent; Q2 at 7.4 per cent; Q3 at 6.2 per cent; and Q4 at 5.8 per cent. The real GDP growth estimate for 2022-23 is held unchanged at 7.2 per cent, with Q1 growth at 16.2 per cent (due to low base effect); Q2 at 6.2 per cent; Q3 at 4.1 per cent; and Q4 at 4.0 per cent. There is surplus liquidity in the system, though it is reducing.

The repo and associated policy rates are still well below Consumer Price Index (CPI) levels, which implies real credit is still cheap. The 10-year G-Sec was traded at 7.494 per cent after the MPC. The Wholesale Price Index (WPI) was at above 15 per cent in April 2022. This reinforces the impression that credit is still cheap. If the RBI is trying to rein in inflation, it cannot leave interest rates at low real levels.
 

There is a high probability that rates will be hiked again--maybe substantially hiked. As far as corporate India is concerned, assume the cost of finance will continue to rise through 2022-23. The rising cost of personal loans, EMIs for vehicles and housing mortgages, may also hurt consumption demand, which was already weak in Q4, 2021-22.

In a scenario of rising rates, low debt, non-capital-intensive businesses will do better than businesses with high debt, or very capital-intensive businesses. Banks and NBFCs in particular, have a difficult time when rates are rising, since cost of funds goes up and demand for credit dips.

Also, in general, equity valuations tend to drop when interest rates rise and vice versa. So, in the current scenario, we can expect market valuations (PE, P/BV) to be downgraded.

Corporate earnings are calculated in nominal terms. Corporate profitability growth is usually 2-3 per cent higher than GDP growth plus inflation. As per RBI projections, we can expect very high EPS growth in Q1 (16 per cent GDP + 7.5 per cent CPI + 2.5 per cent EPS premium over GDP) in the range of 26 per cent. The GDP and inflation estimates also imply that EPS growth will taper off through Q2 to Q4. If we take the full year RBI projections, it’s implied corporate EPS will grow at around 15-16 per cent for 2022-23.

Management guidance by large companies don’t suggest very front-loaded EPS growth patterns. But the full financial year projections of 16 per cent EPS growth may seem reasonable. Businesses that could generate this level of EPS growth without holding excessive debt should outperform.

The other implications of the MPC are on the external front. Exports have been strong. The rupee has weakened and may weaken further. This should be good for all exporters. While IT and Pharma are the obvious bets when it comes to overseas earnings, the adventurous might start looking at textiles, jewellery and auto ancillaries.