The D-day has most likely arrived. All year, emerging markets, especially India have been on pins & needles trying to guess, “will she or won’t she” this time. The person referred to here is, of course, Janet Yellen, the all powerful chief aka Chair of the board of governors of the US Federal Reserve – the central bank of United States.
The repercussions of this move from the US Fed has been a topic of many a discussions. However, since the D-day for this to happen is most likely Dec 16, 2015, it merits another look.
The first & foremost fall-out of this impending rate hike will be flight back of capital to the US This has, indeed, recently, already been happening in anticipation of the rate hike. FIIs pulled out more than Rs. 2300 crore from the domestic stock market in the first week of December itself. We’ve been beneficiaries of this near zero rates in the US for a very long time & now, the tables will be reversed. In 2014 alone, FIIs pumped in Rs. 2.56 lakh crore that took Sensex & Nifty to new heights. Accordingly, they could withdraw billions of dollars from Indian equity & debt markets within a period of a few weeks as well. This withdrawal of funds has been happening in recent past & will most likely continue for almost the same reasons they came our way in the first place.
Borrowing in a low interest rate country currency & investing in a country with high interest rate is called carry trade. Traders have been indulging in this trade through this time as the rates in the US stayed at near zero levels. This trade was profitable despite the hedging cost that was required to protect against currency volatility. Now, with the US embarking on the interest rate tightening cycle, this trading strategy may not be that worthwhile, especially as currency volatility may increase & hence the accompanying hedging cost. The underlying assumption here also is, this will, almost certainly not be the last of the US Fed rate hikes especially if the underlying economy in the United States continues to improve.
Between 2004 & 2006, the US Fed raised rates seventeen times from 1 percent in June 2004 to 5.25 percent in June 2006. This time too, further rate increases will almost, certainly come. The key will be to watch the pace of these hikes. Recent US Fed statements peg the target Fed funds rate by the end of 2016 to be 1.875 per cent from near zero currently (Federal Open Market Committee or FOMC of US Fed meets eight times in a year). Reserve Bank of India Governor, Raghuram Rajan has been vocal in his suggestion that due to the impact that change in US monetary stance may have on emerging markets including India, this process should be embarked upon with as minimal a volatility as possible.
So, in all likelihood, the pace of US Fed Funds rate hike will be snail like compared to the rate hikes between 2004 & 2006 or even earlier in 1994. On both occasions, the impact on emerging markets was quite detrimental. On both of these occasions, both the GDP growth rate as well as inflation was significantly higher than what is being projected for the year 2015-16. At the latest US Fed funds meeting, the GDP growth rate, both for the current year as well as for 2016 were pegged at between 2.3 per cent and 2.7 per cent
Withdrawal of these funds from emerging economies back to the US already has & will continue to manifest itself in the strength of the US Dollar.
It would behoove one to understand both the direct effect of withdrawal of funds from India as well as the ensuing strength of the US Dollar.
Monies from equity markets has already been coming out in droves and we’ve witnessed the accompanying fall in the Sensex & Nifty. According to Kotak Institutional Equities, foreign investors own nearly 25 per cent of BSE-200 shares.
Similarly, monies from debt markets too will continue to be withdrawn putting an upward pressure on yields. RBI has repeatedly indicated that it has a number of tools at its disposal that it will utilize should this start to happen. Thirdly, outward migration of funds will also put a downward pressure on the Indian Rupee. Most likely, Rupee should not weaken beyond Rs 70/USD with prudent management of the currency by the RBI. It has already taken steps including activism in Over the counter market as well as the Exchange traded currency markets to forewarn speculators not to exploit the likely weakness of the INR vis-à-vis USD. The only catch here is going to be, the relative lack of control RBI will have on the off-shore market & non-deliverable forwards in terms of managing the INR
Also, Indian corporate have been heavy borrowers over the last few years from oversees as interest rate regime stayed benign ever since 2006. Now, with this reversal & the strengthening of the USD, re-payment has & will continue to become more expensive for them thus affecting their bottom line.
How you should structure your portfolio given the above factors?
If you’re an equity market investor, first and foremost, keep in mind, markets don’t dislike anything more than they dislike uncertainty. The ‘on again – off again’ saga in regards to the prospects of the US Fed raising rates has taken a toll on emerging markets including India. Once this rate hike most likely happens on Dec 16, in a counter-intuitive way, that uncertainty will be out of the system & will assist in planning for positioning of portfolios for the future.
One option, especially for long term investors is, to actually do nothing. A case can be made that since stock prices are slave to earnings in the long run, earnings of Indian companies will be what will drive the stock markets. Since India continues to be largely a domestic, consumer led economy, one can make the case that if India grows at apr. 7.5 per cent – 8 per cent rate for the next few years while keeping inflation in check, then, earnings of companies in India too will grow at a healthy pace. Hence, stock market indices will move up accordingly. So, for a long term investor, the impending US Fed rate hike should be of little concern.
For a short to intermediate term investor, he can elect to take some of the following steps to better position himself to weather this fed rate increase:
- He should avoid companies that may have a large amount of oversees borrowing as their debt servicing cost will tend to rise. While External commercial borrowing (ECB) by Indian firms has been falling lately in anticipation of stronger US dollar, many Indian firms hold a large exposure in foreign debt on their books. Some of these companies among others are: Reliance Communications, Reliance Power, Bharti Airtel, JSW Steel & Powergrid.
- He could look at some of the export oriented sectors as the INR due to its moderate weakness may assist these exporters. Companies in sectors such as IT, Pharma & Autos should benefit from this.
- He should avoid companies which have a high percentage of FII holdings as FIIs have been & likely will continue to trim their holdings in these companies. Some examples are:
However, he should keep in mind that price movement in these stocks will not singularly depend on whether or not FIIs have trimmed their holding but a combination of factors.
- Alternatively, he could choose to tilt toward companies that may have low to zero FII shareholding. The caveat is, these companies will tend to be mid to small cap and hence will warrant careful homework before purchase. Facts & figures of smaller companies are, relatively speaking, not readily available and therefore the risk of choosing wrongly exists. Notwithstanding the percentage of FII holding in the company, the fundamentals of the company should be strong.
An easier solution for an individual investor to find such companies is to invest through a superior mid-cap fund. Some acceptable choices are ICICI Value Discovery Fund, DSP small & Midcap fund.
- Allocating new monies toward gold should be avoided. Since gold is priced in US dollars, and with the foregoing commentary on monies getting attracted toward US dollar, other asset classes such as gold will, likely, stay weak. One should wait for the equilibrium price to be reached before dipping into gold again.
- FII monies will flow out of bonds as well. This may put upward pressure on yields. However, if India gets its growth story right, there will be domestic investors ready to lap up what the foreigners would have sold. Where this balance would fall will be more accurately told with the passage of time. Therefore, for an individual investor, it may be prudent to choose a superior dynamic bond fund where a professional fund manager makes these decisions. Some choices that may be considered are, Tata Dynamic Bond Fund or Franklin India Dynamic Accrual Fund.
In conclusion, the impending US Fed rate hike and then the possibility of further rate hikes to follow cannot be good news for emerging financial markets. However, if one were to look at the relative scenario amongst BRICS economies, Brazil’s rating has been cut to junk by the rating agency, Standard & Poor’s, Russia is under pressure because of twin shocks of sanctions as well as a spectacular drop in oil prices, China is clearly suffering & its woes are well known. Therefore, India, with a projected sustained superior growth rate, manageable inflation & a reigned in current account deficit emerges as probably the best choice for FIIs.
After the current storm subsides, it may indeed be better days for the Indian financial markets. To take full advantage of this US Fed Fund rate hike cycle, one would need to be alert, intelligent & courageous and in turn be rewarded with handsome profits.
Columnist
Maneesh Kumar is Director, Burgeon Wealth Advisors, a firm offering family office services based in Gurgaon, India. He has over twenty five years of experience advising some of the wealthiest families in the world.
