Graphic: Mint
Graphic: Mint

The impact of rising interest rates on equity valuations

Following the latest hikes in minimum support prices for most kharif crops, economists foresee another 25 basis point rate hike in August

Despite unimpressive earnings growth, valuations of Indian equities have remained quite expensive in the past few years. As the charts alongside show, in the last four years, the Indian stock market’s rally has been driven by multiples, i.e. price-to-earnings—a stark contrast to the market cycle during 2003-08, where the rally was led by corporate earnings growth. This, say market analysts, was largely due to low interest rates/cost of capital.

But that environment is now changing.

Global central banks are in a tightening mode. Domestically as well, the Reserve Bank of India (RBI) raised the repo rate by 25 basis points in June after a hiatus of four-and-a-half years. And following the latest hikes in minimum support prices for most kharif crops, economists foresee another 25 basis point rate hike in August. A basis point is 0.01%.

So what does this mean for valuations?

Theoretically, equity market valuations should correct in a situation of rising interest rates and subdued earnings performance.

“The low gravitational pull of low interest rates was the key reason behind the rally in equities in the post-Lehman world. In fact, in India in last 4 years, multiple expansion accounts for nearly 70% of return. India’s 10-year bond yield is up nearly 100bps in the past six months. Our analysis indicates that 1% change in cost of equity results in 10-15% knock on valuations, unless offset by higher earnings growth," Edelweiss Securities Ltd said in a report dated 29 June.

And some pockets of the Indian stock market are already feeling the heat. The mid-cap and small-cap stocks, for instance.

According to recent a research note by UBS Securities India Pvt. Ltd, during tightening periods, mid-caps and small-caps have outperformed large-caps in key markets globally and in India, but the economic growth cycle is less strong now than in historical tightening periods; so, rising interest rates remain an overhang for these stocks.

Sharing a similar view in a report dated 18 June, Morgan Stanley cautioned, “We need to bear in mind that the RBI now has an explicit mandate to keep inflation under the lid. This means that the historical relationship between short rates and equities cannot be relied upon in the coming cycle. At the minimum, there is likely to be more volatility in stocks as the rate cycle inflects upward."

As for corporate earnings, Edelweiss Securities Ltd expects earnings to accelerate to at least mid-teens in fiscal year 2019 from 5% CAGR (compound annual growth rate) of the past 10 years.

In short, with interest rates expected to remain elevated, valuations could undergo a sharp derating if earnings fail to pick up meaningfully.

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