News Analysis

Is the RBI signalling ‘iceberg’ right ahead?

Hari Viswanath |BL Research Bureau | Updated on: May 07, 2022
The Reserve Bank of India (RBI) seal is pictured on a gate outside the RBI headquarters in Mumbai

The Reserve Bank of India (RBI) seal is pictured on a gate outside the RBI headquarters in Mumbai

Given the headwinds ahead, getting on to lifeboats appears a more sensible option.

When you are smooth sailing in the North Atlantic ocean at full throttle in the world’s largest ship with confidence, nothing can go wrong; you might be setting your sights on new records. That is, of course, until you encounter icebergs. Despite warnings on icebergs from other ships travelling in that zone, the crew in charge of the Titanic continued to throttle at a good speed. This was until its lookouts screamed ‘iceberg  right ahead’,  but it was too late.

Is the same thing happening now for markets with RBI, the country’s inflation watchdog, rising rates in an unscheduled surprising policy meeting? Is the country’s own lookout screaming to markets ‘iceberg right ahead’, after clear warning signs from similar trends in developed economies with their central banks turning hawkish?

One can quickly recollect the last time the RBI had an unscheduled policy meet to reduce interest rates, with the most recent one being in May 2020. However, one will have difficulty recollecting the last time the RBI increased policy rates in an unscheduled event before today. This indicates that they too may have fallen behind the curve in controlling the ‘beast of inflation’ and markets may not have prepared for this.

Resilience in the midst of headwinds

India’s benchmark indices, till recently, appeared to be fixated on setting new records. Despite recent volatility, Indian markets have shown unexpected resilience. DII inflows have cushioned the FPI exodus, and the benchmark Nifty 50, before today’s correction, was down only by around 8 per cent from all-time highs reached on October 21. This is a significant outperformance versus global benchmarks and reflects remarkable resilience, as during this period, many things that were thought to be of lower probability, but fundamentally negative for markets, materialized.

These include the persistent multi-decade high inflation in developed economies, the significant pivot by the US Federal Reserve, the surge in global bond yields making equities less attractive, and of course, the Russia-Ukraine crisis. As compared to Nifty 50, the Dow Jones Industrial Average (DJIA) is down 13 per cent from all-time highs, S&P 500 is down by 16 per cent and the Nasdaq Composite is down 23 per cent.  

While one could argue the country-specific dynamics can result in outperformance in a country’s index, it would be interesting to note that on a five-year basis, the correlation between Nifty 50 and the DJIA is very strong for the most part, with the indices closely tracking each other, till Nifty started outperforming from June 2021. While some of the global indices may have started factoring for the negative impacts of inflation and the Russia-Ukraine crisis, Indian markets have not reflected these adequately.

What should investors do amidst RBI warning

With RBI’s unscheduled rate hike and that too by 40 bps, versus the typical 25 bps, the indications are clear we may be set for a stronger than expected rate hike cycle. Aggressive rate hike cycles will negatively impact equity valuations as the discounting rate for future earnings increases . This will reduce the net present value of future earnings for current investors and pressure valuations downwards. There may also be the case of corporate earnings getting revised downwards -  highly leveraged companies may see a reduction in profitability as interest costs increase. Some business that earlier benefitted from consumer demand funded with loans will also be impacted. In the end, the purpose of the rate increase is to cool the demand that is driving inflation.

Thus, while it is anybody’s guess whether the rate hike cycle amidst global uncertainties can sink the bull market that started in March/April 2020, investors have two options – either get on to a lifeboat (value stocks and staying in cash/liquid assets to invest later), or be like the musicians of the Titanic – staying put and providing liquidity to those exiting the markets via buying the dips. Given the icebergs ahead, getting on to lifeboats appears a more sensible option. If this bull market remains resilient, one can re-enter when the ship has passed the iceberg zone.

Published on May 04, 2022
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