The US Fed’s bittersweet pill for stock markets
As widely anticipated, the US central bank kept the key borrowing rate in a target range of 5.00-5.25% on Wednesday.
The brakes have been applied. The US Federal Reserve (Fed) has decided to pause the interest rate hiking cycle, which began in March 2022 leading to a cumulative hike of 500 basis points. As widely anticipated, the US central bank kept the key borrowing rate in a target range of 5.00-5.25% on Wednesday. But in a negative turn of events, chairman Jerome Powell left the door open for more rate hikes. He acknowledged the progress made so far, but sees upside risk to US core inflation.
While the Fed has acted in a dovish manner, its commentary is hawkish signalling two more interest rate hikes in 2023. The pause by the Fed in the June meeting gives it room and flexibility to evaluate the impact of the stress in US small banks and also assess the lagged transmission of past rate hikes.
While the equity markets had largely priced in a pause, the increased probability of two more rate hikes could cause jitters. “The US market is ripe for correction, especially as participants factor in the Fed’s hawkish policy statement. So, a decline of about 5-8% in US equities is on the cards in the near term and that could have a negative rub-off effect on Indian equities as well," said Ritika Chhabra, quant macro strategist, Prabhudas Lilladher PMS.
A concern now is that the transmission of interest rate hikes happens with a lag, so the Fed’s hawkishness could weigh on economic growth prospects. “A key takeaway for equity market participants from this Fed meeting outcome is that the scenario of higher interest rates for a longer period is here to stay," said Rajesh Cheruvu, managing director and chief investment officer, LGT Wealth India. This means that the cost of capital will remain elevated and this is a negative from a risk-free rate perspective, he added. Little wonder then that key Asian markets have ended Thursday’s session with a marginally positive bias. Back home, India’s benchmark index the Nifty50 closed 0.4% lower.
The return of foreign institutional investors (FIIs) into Indian equities is positive. FII inflows are likely to continue given India’s relatively better macro-economic position and a cooling retail inflation. “Over the past month we have met with more than 50 FIIs in the US and Europe. We found most were quite optimistic on India, as reflected in FII equity flows that have recovered to $9.5 billion since March 2023. This compares to a $4 billion outflow from India in the previous three months against the backdrop of China reopening and adverse news about certain Indian corporate groups," said a report by UBS Securities India on 15 June.
However, valuations do not offer much comfort. The MSCI India index continues to trade at a premium to Asian peers. (See chart). UBS analysts are cautious on Indian equities and believe that there is a dichotomy between fundamentals and India’s high valuations.
These rich valuations are despite some looming concerns. Jefferies India’s analysts said that the 20% year-on-year Nifty earnings growth projected by consensus in FY24 appears high on a head-line basis. “Our detailed earnings analysis though suggests that the earnings growth is far more disperse than financials/ domestic driven earnings for FY23; distributing earnings cut risk," said Jefferies’ analysts in a report on 14 June.
Even so, there are potential risks in the near term if 2023 turns out to be an El Niño year and impacts monsoon and accordingly, agricultural output. That would hurt rural incomes as well as food inflation outlook. Plus, investors also need to gear up for some volatility in the equity market led by the potential increase in political uncertainty in the run up to the general elections in 2024.
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