Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Global interest rates will decide equity valuations

Companies that have hoards of cash have little to worry from interest rate increases

Equity markets are touching new highs in India, and in markets such as the US. There are two schools of thought regarding the future outlook.

The first school believes that we are recovering after a period of low growth and the buoyancy is just to make up for the past lacklustre returns. Overall, global growth and inflation are subdued. Even in the context of the US Federal Reserve tapering its bond buying programme, the overall monetary policy will remain easy and interest rates will remain low. The stance here is that we are in for a long bull market ahead, and one should stay invested.

The other school believes that asset prices the world over have been given a boost by low interest rates and high liquidity in most of the developed world. Now that the Fed is tapering its bond buying programme and an interest rate hike is visible in 2015, equity investors’ enthusiasm may fade. It is inevitable that when money is easy, it gives rise to complacency and inflated asset prices.

Apart from the fact that low interest rates boost the attractiveness of equities, it is also true that they have been used by many companies to boost the earnings for equity shareholders. This may be in the form of using debt to fund share buy backs or using debt to fund projects. In the past cycles, we have seen that projects that looked very attractive at interest rates of 6% do not look attractive at all at rates of 12%. Further, when the rate cycle turns, apart from the cost of funds, availability itself becomes a question.

A fact that is not widely appreciated is that credit standards become lax during times of ultra-low interest rates. When the cycle turns and rates are high, investors do not wish to take the extra credit risk as their target returns are easily achieved by lending to safe borrowers.

Acquisitions are similar to projects. Easy fund availability fuels optimism and many acquisitions take place, which could cause heart burn a few years down the line. A distress sale always results in low realizations.

Readers will have seen deals in India in the cement, retailing and infrastructure space where promoters of cash-strapped companies had to sell what were once considered crown jewels at low valuations to meet the interest and repayment demands on the debt that they had built up.

Internationally, interest rates are clearly far below average compared with historical levels, and the liquidity pumped in by central banks is at record levels. Indeed, many may be surprised that yields on 10-year Spanish bonds have reached a low of 2.15% and are lower than even the borrowing costs in the US. In fact, according to Deutsche Bank, the yields are lowest since 1789. Just some time back, Spain was a part of the infamous PIIGS acronym (representing Portugal, Ireland, Italy, Greece and Spain) of troubled European economies.

As an antidote to the lower taper from the Fed, some may point out that just a few days back, the European Central Bank lowered interest rates and increased its asset purchases.

Given the fact that there are two divergent views, it may be interesting to look at the current situation in the context of history. Interest rates have been so low for such a long time in the US that it’s difficult to even imagine that US 10-year treasury bonds had a yield of 15% per annum in the early 1980s. In India, in 1995 and 1996, we had 10-year government bonds yielding 14% per annum. AAA corporate names were borrowing money at 18% and some highly rated non-banking finance companies were raising money at 21%.

Being aware of history helps in terms of knowing a range of outcomes from the past. But it does not predict what will happen in the future. Blindly betting on mean reversion can be risky. Japan has shown that interest rates can prevail at levels that were considered significantly below average for long periods of time.

I generally stay away from macro forecasts and do not have a view on the short-term direction of interest rates or stock prices. I do not intend to scare investors or give any tactical asset allocation advice. However, given the backdrop of current low interest rates internationally and the possibility of the rates moving up, it may be prudent on a bottom-up selection process to stay away from companies and sectors that are doing well on steroids of low interest rates, and instead invest in companies that would not be adversely affected by high interest rates.

For one, there is a limit to how much leverage can be employed, and two, it pays to be prepared for the tide to turn.

Such a positioning may, in fact, benefit from any volatility that comes up. Companies that have hoards of cash have little to worry from interest rate increases. They may be able to snap up some juicy acquisitions in a tough environment. If nothing else, their cash hoard will start earning higher returns.

Rajeev Thakkar is chief investment officer and equity fund manager, PPFAS Asset Management Pvt. Ltd.

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