May 4th was an eventful day, as equity markets reacted sharply to the central banks’ actions both in India and the US. However, the market response on Dalal Street was very different from that of Wall Street.

Same move, opposite reaction

Indian equity markets tanked more than 2% yesterday after the Reserve Bank of India stunned the market with an increase in policy rates, citing inflationary pressures. RBI’s monetary policy committee, in an off-cycle meeting (unscheduled meeting), raised the repo rate by 40 bps to 4.40% and CRR (cash reserve ratio) by 50 bps to 4.50% of NDTL (net demand and time liabilities) effective from 21 May 2022.

In a contrasting move, US equity markets jumped sharply by 3% after the Federal Reserve raised rates by a widely anticipated 50 bps and indicated that it would start reducing its balance sheet in June.

The key difference – surprise element and market performance YTD

It was the biggest rate increase since 2000 for the Fed, but the move was widely expected by investors. While a rate hike was anticipated in India as well, the sudden announcement as well as the larger-than-expected hike spooked markets, leading to a heavy sell-off.

The reaction of equity markets in India and the US was a study in contrast, despite the similarity in central bank actions that were directed to rein in rising inflation.  While the key difference was the surprise element, the market performance of the US and India equity markets year-to-date explains the market moves.

Equity markets globally have tumbled year-to-date (YTD) amid risk-off sentiment, but India has outperformed by a wide margin. MSCI India (in US dollar terms) is down by just 4% YTD while S&P 500 has corrected by 10% in the same period even after considering yesterday’s sharp up move.

Indian equity was one of the top performers in CY21. Though it has corrected by 9 percent since its October peak, India equity still continues to outperform the broader emerging markets index and many of its peers including China in the Asia Pacific region and most of the developed markets from US to Japan.

High volatility with downward bias

There are significant macro challenges for Indian equities.  If crude oil prices stay elevated above $100 per barrel pose a key threat in terms of slowing down the economic recovery (GDP), adds to inflationary pressure, expands the current account deficit and hurts the currency. Rising US bond yields and the end of easy liquidity globally are also a negative. And the current geopolitical situation adds to the uncertainty.

Most importantly, equity markets are staring at risks of earnings downgrades. Persistently high commodity prices can prove to be a double-whammy to corporate earnings due to decline in margins and lower demand, increasing the risk of earnings downgrades.

The silver linings

Hope of soft landing

Amidst these macro headwinds, RBI’s move is a big positive as it attempts to put the inflation genie back in the bottle. The off-cycle policy action and up-front rate hike will help in anchoring inflation expectations. Unanchored inflation expectation and loss of control of the yield curve and could have led to a loss of central bank credibility.

US equity markets rallied yesterday after the rate hike as investors hoped that Fed can slow inflation without causing a recession. Powell clearly stated: “I would say we have a good chance to have a soft, or soft-ish, landing,” helped sooth the markets. Taking cues from US markets, Indian markets can also see some hope/relief rally driven by RBI’s action.

While earnings downgrade risks remain, valuation has moderated

The other factor that could support the market is valuation.  India has seen relentless selling by the FIIs for straight seven months since October 2021. The high valuation of Indian markets led to FII outflows even before the current geopolitical risk emerged. This has helped remove froth. The current valuation of Indian equities (Nifty at 19 times forward earnings), though expensive compared to regional peers, is now almost in line with the long-term average valuation multiple.

FII holding of Indian equities seems to have bottomed out

Sharp FII outflows have reduced FII fund holdings in Indian equities to 18.5% (as a  percentage of market capitalisation), which is the lowest since Jan 2017. Domestic mutual fund holdings have risen, and MF inflows has been supporting markets.

Since FII levels have touched the lowest level in the decade, any peaceful resolution of the Ukraine –Russia crisis can turn FIIs into net buyers.

Valuations supportive in select stocks

Amid slowing growth, inflation concerns and central bank action, the re-pricing of risk is underway. It started with bonds, particularly at the short end of the yield curve, in US bonds. It will soon be seen in equities. The large companies that will be able to pass on the price hike to consumers without denting demand much, will emerge as winners. Hence, the repricing point in equities should see a tilt toward value and quality, which implies a positive outperformance for these sectors.

Power sector utilities that generate stable returns could outperform in this inflationary and rising rate scenario. Discretionary sectors like automobiles will be negatively impacted. Auto companies have highlighted raw material inflation as a near-term risk, amid the sharp rise in commodity prices and shortage of chips. FMCG sector expectations have come down given margin pressure in the near term.

Last but not the least, the financial sector which is directly impacted by RBI’s rate hikes will see a mixed performance. While NBFCs and HFCs could see cost of funds going up and credit demand getting impacted especially at the bottom of the pyramid, large banks will not be impacted much initially.  As a matter of fact, large banks with high CASA deposits will have some margin support as loans will get repriced immediately and deposit costs will rise only with a lag.

Overall, with no signs of economic uncertainties abating, Indian equities will continue to be volatile. There could be intermittent hope/relief rallies driven by central bank actions and/or positive global cues, but there are more risks on the downside from earnings downgrades. That said, valuation has started to look more palatable in select names, making investment decision very stock specific.Follow @nehadave01

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In a move that sent shockwaves through the market, the Reserve Bank of India (RBI) raised the policy repo rate by 40 basis points to 4.4 percent on May 4.

The Indian central bank raising the rate is not a surprise—many economists expected it to do so at its June meeting. But the outside-the-meeting-calendar nature of it has certainly grabbed attention.

The RBI rate hike is also the latest in a series of monetary policy tightening actions by central banks around the world in recent days.

On May 3, the Central Bank of Colombia increased its benchmark interest rate by a massive 100 basis points to 6 percent. The same day, the Reserve Bank of Australia undertook the first rate hike in a decade, raising the cash rate target by 25 basis points to 0.35 percent.

Last week, Sweden's Riksbank increased its repo rate by 25 basis points to 0.25 percent, its first rate hike since the coronavirus pandemic began. Hungary's Magyar Nemzeti Bank raised the central bank base rate by 100 basis points to 5.4 percent.

Other central banks to raise their policy rate in the last couple of weeks include those of Botswana, Paraguay, and Kazakhstan.

While high inflation due to rising energy prices, among other factors, has forced the hand of central banks, they have also acted in anticipation of similar moves by Big Daddy the US Federal Reserve.

The US central bank's Federal Open Market Committee began its two-day meeting on May 3. The committee's decision is due later on May 4, where it is widely expected to increase the federal funds rate target range.

Also read: Closing Bell: Sensex tanks 1,307 pts, Nifty below 16,700 as RBI stuns with a rate hike

According to the CME Group's FedWatch Tool, there is a 97.9 percent probability the Fed will raise the federal funds rate target range by 50 basis points on May 4 to 0.75-1 percent. And the tightening of financial conditions in the US—which itself is facing the highest inflation in several decades—is sending ripples across the world.

"The prospect of an accelerated increase to US interest rates and the impact on international prices of Russia's invasion of Ukraine could lead to additional inflationary pressures," the Central Bank of Colombia said on May 3. Hungary's central bank said expectations of a Federal Reserve rate hike was driving risk appetite.

Also read: Central bank blindsides nation to derail high inflation expectations, says price rise to remain high in near term

The Fed factor 

As far as India is concerned, RBI governor Shaktikanta Das' statement and the Monetary Policy Committee's (MPC) resolution may not have namechecked the Federal Reserve but there was certainly a reference to it.

The MPC said in its resolution that "volatility spillovers from monetary policy normalisation in advanced economies" was a risk to domestic economic activity.

Das was more forthright. "Further, the normalisation of monetary policy in major advanced economies is now expected to gain pace significantly—both in terms of rate increases and unwinding of quantitative easing as well as the rollout of quantitative tightening. These developments would have ominous implications for emerging economies, including India," the governor warned.

In mid-to-late 2013, Indian monetary policy was actually driven by the Fed's actions. First came the taper tantrum that began nine years ago this month. Then came a series of rate actions to cauterise the wound caused by the massive capital outflows from India. And in what was an explicit nod to the Indian central bank's focus on what its US counterpart was doing, former RBI governor Raghuram Rajan postponed his first interest rate decision by two days to have "enough time to consider all major developments in the required detail".

The Indian economy may now be in a far stronger position than it was in 2013 to counter foreign policy spillovers but one cannot deny US monetary policy continues to play a role in shaping some of our, and others', moves.

India’s external sector has remained resilient amidst formidable global headwinds, RBI Governor Shaktikanta Das said on May 4, adding that the country’s merchandise exports remained strong in April 2022 and services exports reached a new high in March 2022.

According to Das, potential market opportunities have opened up due to geopolitical conditions and the recent trade agreements. Further, he believes that strong revenue guidance by major information technology (IT) companies also bodes well for the overall external sector outlook in 2022-23.

Also Read: Markets tumble as RBI stuns with 40bps rate hike, 50bps rise in CRR

The worsening of terms of trade, driven by higher commodity prices could have implications for the current account deficit in 2022-23, but it is expected to be comfortably financed, Das said

“Net foreign direct investment flows have remained robust, despite some recent moderation. Long term flows such as external commercial borrowings also remain stable. India’s foreign exchange reserves are sizeable with net forward assets providing a strong back-up. The external debt to GDP ratio remains low at 20 percent,” he added.

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The S&P Global India Manufacturing Purchasing Managers' Index (PMI) rose in April, coming in at 54.7, up from 54.0 in March.

A reading above 50 indicates expansion in activity, while a sub-50 print is a sign of contraction.

According to IHS Markit, the  compiler of the PMI, Indian manufacturing activity in April saw a marked increase in new orders and production, with international sales growing "solidly" after having contracted for the first time in nine months in March.

"Factories continued to scale up production at an above-trend pace, with the ongoing increases in sales and input purchasing suggesting that growth will be sustained in the near-term," noted Pollyanna De Lima, economics associate director at S&P Global.

IHS Markit completed its merger with S&P Global on Febraury 28, leading to the renaming of the PMI for India as well as some other countries.

Manufacturers continued to stock inputs, with April seeing the largest increase since November.

The improvement in activity levels did not do much for employment in the manufacturing sector, with most firms saying their workforce levels were unchanged in April because of little capacity pressures. However, on the whole, there was a "mild increase" in employment last month.

On the price front, concerns remained. Manufacturers experienced higher costs for chemicals, electronic components, energy, metals, plastics, and textiles compared to March. Higher transportation fees and the war between Russia and Ukraine were cited as the primary reasons for input cost inflation rising to a five-month high in April.

Consumers felt the price rise too, with manufactuers passing on some of the increased cost burden. This resulted in selling price inflation hitting a one-year high.

"This escalation of price pressures could dampen demand as firms continue to share additional cost burdens with their clients," De Lima added.

The rise in consumer prices will not come as a surprise, with inflation based on the Consumer Price Index (CPI) surging to a 17-month high of 6.95 percent in March, data released last month showed.  Economists expect CPI inflation crossed 7 percent in April, putting the Reserve Bank of India's Monetary Policy Committee deeper into a corner.

The rate-setting panel is increasingly expected to start raising the policy repo rate in June to cut down inflation pressures and avoid failing to meet its mandate.

The committee is deemed to have failed to meet its mandate if average CPI inflation is outside the 2-6 percent band for three consecutive quarters.

Inflation averaged 6.3 percent in January-March. The central bank's latest forecast pegs average CPI inflation at 6.3 percent in April-June and 5.8 percent in July-September.

The Digital Communications Commission (DCC), the highest decision-making body of the Department of Telecommunications, on Friday accepted Telecom Regulatory Authority of India's (TRAI) recommendations on the base prices of 5G airwaves, according to a report in the Economic Times.

While deciding that the spectrum should be auctioned for a period of 20 years, the inter-ministerial panel also decided against alloting spectrum directly to corporate bodies for private 5G networks - as recommended by TRAI - suggesting instead that they join hands with licensed telcos, thereby accepting a key demand of operators. Telcos have been pushing for an auction of the spectrum but while Bharti Airtel has suggested it should be bundled with 5G spectrum, Reliance Jio wants it to go up for auction independently.

The TRAI proposal had come under fire from telcos, who said it would kill the business case for 5G spectrum as it would dent revenue from enterprises.

The Minister of Communications Ashwini Vaishnaw said on Thursday that the DoT is working to resolve industry concerns on 5G.

The auctions , which will pave the way for 5G services in the country, are likely to be held in early June and services are expected to be rolled out by August-September this year

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