For equities drunk on liquidity, party is over
3 min read 06 May 2022, 12:14 AM ISTAs US Fed shrinks its balance sheet, benefits of cheap liquidity will wane, caution analystsWith that, cost of borrowing could rise for corporates, leading to earnings downgrades
PremiumAmid rising global temperatures, it is pouring interest rate hikes. Equities face troubled times ahead, especially as they are used to easy access to cheap funds in the post-pandemic world.
On 4 May, the Reserve Bank of India (RBI) stunned us with unexpected repo rate and cash reserve ratio (CRR) hikes of 40 basis points (bps) to 4.40% and 50 bps to 4.5%, respectively. One basis point is 0.01%. Recall that the repo rate was kept unchanged since May 2020. On the same day, the US Federal Reserve hiked rates by 50 bps. This was the Fed’s biggest interest rate hike since 2000, but was lower than the feared 75 bps increase. The outcome: The US equity market closed higher on Wednesday and Asian equities saw a relief rally on Thursday.
As equity market participants prepare for greater chances of more and faster rate hikes, analysts cautioned that the withdrawal of liquidity could be a lot more challenging to digest.
“Historical evidence suggests that when liquidity tightens in developed countries, it does impact emerging market (EM) equities. With the US starting to reduce the size of its balance sheet, the benefit of lower cost of capital that EM equities, including India, saw from ultra-easy monetary policy and gush of liquidity pumped in by global central banks at the peak of the pandemic, would wane," said Sanjay Mookim, head of research at JP Morgan India.
To combat inflation, the US Fed decided to reduce the size of its balance sheet, a process also known as quantitative tightening (QT). From June, it will start selling $47.5 billion of bonds and mortgage-backed securities a month, and ramp it up to $95 billion a month by September. The US Fed has done this in the past, too, but what’s different this time is the uncertainty surrounding inflation.“Lost in the noise, the Fed announced the start of QT. It will be interesting to see if we can avoid a ‘taper-tantrum’ this time. In 2013, the previous exercise was quickly halted as EM started to meltdown, and that was in a low inflationary environment," said Jeffrey Halley, senior market analyst, Asia Pacific, at broking house Oanda.
In his note to clients on 5 May, Halley said that QT could have a far more important downstream impact on markets than Fed funds rate hikes.
In India, the CRR hike would suck excess liquidity of ₹87,000 crore from the banking system. Some economists are now pencilling in a 100 bps increase in CRR, expecting it to touch 5.5% in 2022.
“When the central bank raises CRR, banks have relatively lower funds to disburse. So, banks may price their loans at higher rates, thus pushing up the borrowing cost. A simultaneous increase in the repo rate also means that the cost of borrowing for corporates would rise," said Suvodeep Rakshit, senior economist at Kotak Institutional Equities. “So, if everything else remains unchanged, it does hurt domestic business sentiment at the margin and could eventually lead to some trimming of earnings estimates for listed corporates," he said.
CRR is the percentage of a bank’s total deposits needed to maintain as liquid cash reserve with RBI.
Meanwhile, the MSCI India index is trading at a one-year forward price-to-earnings multiple of 17 times, a premium to MSCI Asia Ex-Japan’s 11 times multiple, according to Bloomberg data.
True, India’s valuation has cooled off from highs, but a further moderation is on the cards now.
Mookim pointed out that the valuation of Indian equities is expensive and some stocks are trading at multiples higher than their pre-pandemic levels. “With normalization of policy rates and tightening of liquidity conditions, valuations of Indian stocks would correct sooner than later," he cautioned.
