Market stands at a crossroads and one cannot be confident about its future direction
The US Federal Reserve cut interest rates by 50 bps as inflation in the USA is normalizing towards the target rate. The US economy has slowed down but remains on a strong footing. The US Fed does not want it to deteriorate further. A soft lending, with inflation coming down without the economy going into deep recession, seems within reach. All eyes are now on what RBI will do on 09 October.
The official chatter does not indicate any interest rate cut by the RBI. It is most likely to get into neutral mode and churn out a dovish commentary, preparing the ground for the interest rate cut on December 6. Headline as well as core inflation in India are fully under control and near the desirable levels. However, food inflation remains an irritant. The RBI is likely to wait for the food inflation to moderate and stabilize at the lower levels before cutting the rates. By December, it will also be clear whether global oil and commodity prices remain subdued even after the larger-than-expected cut in the US interest rate. If global commodity prices flare up, India’ inflation can trend up again.
The Indian economy remains robust. There is no need to rush to cut the rates. After a six-month hiatus of slow growth due to electioneering, heat waves and excess rains, the Indian economy is set to get into a higher growth trajectory from October. The Indian rate cut will likely to be in recognition of moderating inflation and not as a reaction to any setback to the economy.
The concern is that the current goldilocks scenario can unravel if global economies go into deeper recession due to the delayed effect of historically high interest rates. Indian economy also needs to rebound from October without a cut in the rates. If growth falters, fortunately, most of the global central banks, including the RBI, have enough space to go into overdrive in cutting rates and prevent deeper and longer recession.
It is also likely that the upcoming rate cut cycle may prevent deeper recession but may not reinvigorate the growth. As the growth had not crashed, it cannot be expected to jump on a higher base. This cycle may just settle both the growth and inflation matrix at a lower level and leave it there.
Markets are in a confused state. Debt and commodity markets are expecting deeper recession, while equity markets remain confident that economic prospects will remain strong or rebound. Nevertheless, many stock market participants are playing safe. They are increasing their cash levels. The biggest concern remains the high valuations across the board. These do not leave any margin for error. Valuations are already factoring that the strong growth will continue or accelerate. In the Indian context, expectations are very high. These may turn out to be unrealistic.
If historically high interest rates do not have much of a negative effect on economic growth, will lower rates have a significant positive effect on growth? If stock markets and valuations reached historically high levels despite the high interest rates, can lower interest rates lift them further? Can the upcoming cycle of lower interest rates herald lower growth and lower valuation?
We are currently at a crossroads. The need of the hour is for the markets to consolidate and wait to see what happens on the economic front before deciding the future course.
Investors must realize that ultimately stock prices are slaves of the earnings growth. We have already seen an unprecedented phase of robust earnings growth, benefiting from high economic growth and high inflation (all cost rises can be passed on with higher profit margins!). Current valuations are just extrapolating this phase or even assuming acceleration. If we settle for lower economic growth and lower inflation for the next couple of years, the earnings growth trajectory can be different.
Huge domestic flow of liquidity is mainly responsible for the high valuations in Indian markets. Rate cuts can nudge FIIs to buy, taking valuations even higher. The party can run till earnings and outlook surprise. Notably, liquidity is a function of returns. If earnings growth disappoints, stock prices and returns will disappoint. Once returns disappoint, liquidity, instead of acting as a positive trigger, can become a negative factor for stock markets.
