Rate Hikes, Markets and Whats Next!

With the Fed raising rates yet again, markets went into a tailspin and ended with one of the worst weeks on record , with the Nifty and the Sensex dropping about 5.5% each. FPIs sold close to Rs 42,000 crore so far in June though DIIs have balanced this somewhat with an inflow of Rs 32,000 crore. So what lies ahead? Is this start of rising rates across the globe the death knell for markets? What does history tell us?

Why Rates rising Impacts Valuations

There is a very complicated relationship between interest rates and stock prices, with higher interest rates sometimes coexisting with higher stock prices and sometimes with lower. As interest rates rise, though, the effects on value will vary across companies, with some companies being hurt more and others being hurt less, or even helped. The effects often depend on the stage of the corporate life cycle of each constituent of the index in discussion.

Note that interest rate rises during a growth led inflationary environment are different from a supply side led inflationary environment but in both situations, companies with pricing power and efficient cost structures can actually improve their competitive position while those with weaker market or balance sheet structures may undergo weakness.

Historically, highly profitable, well-capitalized firms perform best when financial conditions tighten as they are able to withstand shocks and also leverage the situation to gain over competition.

Past Evidence – The USA

The start of Fed hiking cycles typically tend to coincide with a strong economy which can help to lift cyclical sectors such as materials, industrials and energy.  Financial stocks typically outperform as well.

According to Goldman Sachs, strong balance sheet stocks have outperformed weak balance sheet stocks by a whopping 24% during a Fed hiking cycle.

Another analysis examines the performances of the US and Emerging Markets during the four most recent extended rate hike cycles in 1994, 1999, 2004 and 2015. In these rate hike cycles; interest rates went up between 175 to 425 basis points. Looking at the 12-month returns following the first hike in each of this episode, it appears that it is not a foregone conclusion that rate hikes always lead to poor market returns. During these four rate hike cycles, there have been instances where the Emerging Market and Asian markets delivered positive returns, and at times, outperformed the US market. This goes to show that every rate hike cycle is different, and many other local factors can come into play to influence the market’s performance.

LPL Research also looked at major extended periods of rising rates dating back to the early 1960s . In nearly 80% (10 of 13) of the prior periods, the S&P 500 Index posted gains as rates rose. In fact, the average yearly gain for the index during the previous rising-rate periods, at 6.4%, is just a little lower than the historical average over the entire period of 7.1%, while rising rates have been particularly bullish for stocks since the mid-1990s.

Past Evidence – India

A study by Edelweiss MF also has a similar conclusion from its study where equities have mostly returned positive during stretched cycles of rate hikes.

The rate hike cycle is often a result of high inflation and the study sees high returns in most scenarios where inflation was above 6% – meaning that evidence suggests that high inflation scenarios often have favored certain sectors like Auto Banking Pharma and Metals

Similarly, the National Stock Exchange also recently analyzed Nifty 50 stocks to see what history says about stock market returns in these periods. The analysis illustrates that during these long-term periods, the stock market indexes only declined during three rate hike cycles.

The Starting Point Matters

If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments.

If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power.

How the markets react also depends on the starting point of valuations. A stretched valuation is always susceptible to corrections and in the last couple of years since 2020, the indices have been trading at much higher historical valuations than the mean of 20.5x or so. One of our previous articles had indicated that the markets were looking stretched at a level of 3 standard deviations and any rate hike can therefore start the process of mean reversion.

Historical PE RATIO

The monthly charts on the Nifty have been showing fatigue for some time and therefore, the mean itself, as another of our articles pointed out, in a bearish scenario lies somewhere around 14000 levels on the Nifty and we seem to be positioned to reach somewhere there with a slow timewise correction.

There may be upward temporary surges but unlikely to sustain till the growth momentum recovers and we ride over the potentially damaging Covid escalation – though of course Crude dropping sustainably could change the hypothesis.

What Should You Do

As of June, 2022, the 10Y Treasury bond rate was has reached somewhere around its mean levels while with the last weeks corrections in the S&P500 we are also near the trendline mean. Summed together, this gives a composite value of near nil standard deviations above normal, indicating that stocks are currently Fairly Valued. For India, such levels lie somewhere between 14200-14800 levels and its unlikely that we may go below these except in a very exceptional situation.

But it’s pretty tricky to get the timing right, even for professionals, and sectoral winners change dramatically and it is important to keep portfolios well aligned and diversified as the economy goes through one final “power wash” tumble!

Our Head Advisory, Vikram Kasat believes this to be a temporary prick in the economic buoyancy that we are experiencing and with the current levels reached of about 20x PE, believes investors should start putting money selectively into our top picks .(https://www.plindia.com/viewreport.aspx?rpt=indiastrategy-q4fy22%20review-10-6-22-pl.pdf)

Please do visit our Strategy Shop page to visit expert third party advisory strategies including asset allocation baskets, value baskets and simple trading strategies. To get started on these, all you need is your online username password that you use for trading on our web or mobile applications!

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