While almost everybody is expecting Uncle Ben to provide another shot of much-needed adrenaline to tiring markets, it’s worth checking out just how these rate cuts have worked in the past. Since the 1990s, this is the fifth time the US Federal Reserve has cut its Fed funds rate. The largest cuts took place during the late 1980s and early 1990s, when the rate was lowered from 9.5% in mid-1989 to 3% by September 1992.
Unfortunately for us, this period also coincided with the first flush of liberalization in India, the throwing open of the stock market to foreigners and the Harshad Mehta scandal. These factors make it very difficult to gauge the impact of the Fed rate cuts on the Indian market at the time. The next Fed rate cuts happened in July 1995 when the rate was lowered from 5.75% to 5.5%. The last cut during this period was in January 1996, when the Fed funds rate was at 5.25%. US economic growth, which had slumped to 2.5% in 1995, revived to 3.7% in 1996 as a consequence.
In India, however, these rate cuts had minimal impact, with the BSE Sensex going up from 3,351 at the end of May 1995 to 3,391 by end-February 1996. Possible reasons for the lack of impact could be the tightening policy followed by the Reserve Bank of India at home, the political uncertainty at the time and the high price-earnings (P-E) multiple for the Sensex—it was 28.5 in May 1995. GDP growth in India, however, was a high 7.3% in 1995-96.
The next bout of Fed easing occurred during September 1998 to November 1998, in an attempt to counter the weakness arising out of the Asian crisis, the Russian default and the collapse of hedge fund Long-Term Capital Management. The Fed funds rate was cut from 5.5% to 4.75% during this period. But the US economy was strong over the period, with GDP growth rates of 4.2% in 1998 and 4.5% in 1999.
The impact on the Sensex of these cuts was immediate, with the index rising from 2,933 at the end of August 1998 to 3,739 by end-March 1999. During this period, India’s GDP growth rose from 4.3% in 1997-98 to 6.7% by 1998-99. The Sensex’s P-E multiple as at end-August 1998 was a very low 11.4. The next cut in Fed funds rate occurred in January 2001, when the US was starting to slip into a recession. The rate was brought down from 6.5% to 6% in January and a series of rate cuts followed, culminating in a 0.25 percentage point cut in June 2003, which brought the Fed funds rate down to 1%. US GDP growth fell from 3.7% in 2000 to 0.8% in 2001 and improved to 1.6% in 2002 and 2.5% in 2003. In India, the Sensex, which was at 3,972 as at end-December 2000, went up briefly to 4,326 by end-January 2001, only to begin a long slow grind downwards, reaching 2,902 in October 2002. The Sensex P-E multiple was 21.4 in January 2001 and GDP growth during the period in India was 4.4% in 2000-01, going up to 5.8% in 2001-02 and down to 3.8% in 2002-03. The question is: How will the current Fed rate cuts affect the Indian market? This time, the similarities are with 2001 rather than with 1998, because of the weak US economy. The positive factors, however, are that this time Indian GDP growth is very high and it’s expected to remain around 8.5% this year and the next. Also, the latest forecasts by OECD put US growth at 2% next year, which indicates that it’s probably not going to be as bad as 2001.
On the negative side, political uncertainty is high at present. More importantly, the Sensex P-E is very high, at around 27. A recent Citigroup report says the Indian market trades at a 65% price-to-book premium to the region, while its return on equity premium is just 17%. It says that current valuations imply an EPS growth of 60%, which is way too high. In short, while the current US weakness is not expected to be as bad as in 2001, high valuations of Indian stocks are weighing on the market.
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