An investor should be aware of it for better decision-making
The years 2020 and 2021 were good for the markets. Nifty50 – the benchmark index of NSE – gained 14.77 percent and 23.04 percent in 2020 and 2021, respectively. But the performance of the markets over the last five months contrasts with that of 2020 and 2021. Market has remained unchanged and volatile in the last five months.
There were valid reasons for the good performance of the markets in the years 2020 and 2021. The crash in stock prices during February and March 2020 has made the valuation of stock prices attractive. Moreover, to counter the devastating effects the coronavirus pandemic will have on the economy, governments and central banks around the world resorted to massive stimulus measures which injected large liquidity into the economy and markets.
These measures were extraordinary measures taken under special situations and when the economic activities normalize, they will be withdrawn.
Like everything else, these actions will have its consequences. Large government debt, inflation, and asset bubbles are major among the consequences. Presently, the government debts of major developed countries are at the highest level since World War II and the inflation rate at major developed economies has crossed the target rate of the respective countries’ central banks.
The Federal Reserve – the central bank of the United States – has recently announced that they will be done with their asset purchase program (announced in 2020 in response to coronavirus pandemic) by March 2022 and is expected to raise interest rates at least four times in 2022.
In India, our central bank, RBI, has an inflation target rate of 4 percent with a +/- 2 percent range. The CPI inflation rate for December 2021 at 5.59 percent is within the comfort zone of RBI. But it has a rising trend and upward pressure which can take it above RBI’s target range in the coming months. The CPI inflation rate in Oct and Nov 2021 were 4.48 percent and 4.91 percent, respectively.
The policy interest rate of RBI, the repo rate, is 4 percent. It is the lowest level in the last two decades and has been at that level since May 2020. The repo rate has been on a declining trend since 2015, declining from the 8 percent in 2015 to the current 4 percent.
Based on the understanding of the current market and economic environment, I don’t expect the repo rate to decline further. The only plausible direction for the repo rate from here onwards will be on the upside.
The dynamics of ‘Interest Rates’
There is a strong correlation between interest rate changes and stock price performance. It is necessary for an investor to understand how the changing interest rate will influence stock prices for better decision making. The following two past cases will help in understanding the relation between them.
Case 1: In the three-year period between Nov 2010 and Nov 2013, the Nifty50 index grew at an annual rate of 1.02 percent while the Nifty50 earnings grew at a higher annual rate of 12.47 percent.
Case 2: In the seven-year period between Jan 2015 and Jan 2022, the Nifty50 index grew at an annual rate of 11.42 percent while the Nifty50 earnings grew at an annual rate of 9.20 percent.
What is the reason for Nifty50 index to underperform in the first case but outperform in the second case, even though, earnings grew at a moderate rate in both cases?
The reason was interest rates.
In the first case, between Nov 2010 and Nov 2013, the RBI policy repo rate increased from 4.25 percent to 8.50 percent. Meanwhile, in the second case, between Jan 2015 and Jan 2022, the RBI policy repo rate decreased from 8.00 percent to 4.00 percent.
Why did RBI increase interest rates between Nov 2010 and Nov 2013? It is because of the stubbornly high inflation during the period. The CPI inflation averaged 8 percent in 2011 and 10 percent in 2012 – 2013.
As a result of the interest rate actions by the RBI, CPI inflation after peaking out at 12.17 percent in November 2013, started declining and bottomed out at 4 percent by November 2014. The CPI inflation rate in 2015 ranged between 4.50 – 5.25 percent, which is well within the RBI target range.
The rise in interest rate had its consequences. In addition to the poor stock market performance, the GDP growth which averaged 8.5 percent in 2010 declined to 5 percent in 2013.
Conclusion
The developments in the economy since the second half of 2021 have increased the risk factors for markets and economy. High inflation and interest rate increases to counter that are the major risks. Markets have historically underperformed during periods of high inflation and rising interest rates.
The first thing an investor need to do is to tone down his expectations regarding stock price return over the medium-term. The good market performance in 2020 and 2021 were a result of lower valuation, low interest rates, and easy monetary, fiscal policies. These features supportive of stock prices are not present anymore.
The run up in stock prices during 2020 and 2021 has made the market valuation a bit expensive. High inflation has arrived in most developed economy and remains persistent. These developments don’t bode well for stock prices.
There are two factors that determine a stocks’ future return: its valuation and the expectation of growth and profitability of the company in the future. This remains the same, whether the interest rate is rising or declining.
What changes is what we consider as a proper valuation. If we were comfortable with buying a stock up to a PE ratio of 25 when the interest rate was 4 percent, then at 5 percent interest rate buying at PE 25 wouldn’t be considered prudent. The comfortable level of PE at which you will purchase a stock will have to brought down, maybe a PE of 20 would be considered prudent then.
AMN CAPITAL 