Published On: Thu, Nov 7th, 2013

DR and equity markets: more than meets the eye

Facebooktwittergoogle_plusredditpinterestlinkedinmail

With another hike expected in the upcoming (Nov ’13) MPS (Monetary Policy Statement), investors are concerned about the resultant implications on the equity market. Theoretically, increasing interest rates bode adversely for equity markets; however anecdotal evidence suggests a contrarian picture. Drawing example from neighboring India, the country’s benchmark index has reached a record high level given that the Reserve Bank of India (RBI) raised its policy rate by 50bps in the last 2 months. On the other hand, while Indonesia yielded a negative return of 3% after its central bank raised its policy rate by a total of 150bps since Jun’13, the country’s index has provided a return of 2% since its last increase in the DR in Sep’13. To highlight, both countries faced, i) inflationary pressures and, ii) weakness in currencies. In our view, this anomaly is likely attributed to, i) positive relation of inflation with corporate profitability and, ii) foreign investment association with currency stability. Therefore, increased interest rates may not necessary bear negative implications for the market, provided the PkR stablity. 

India and Indonesia: examples to be observed

Investors have shown their concerns about the expected hike in the discount rate in the upcoming MPS and its impact on local equity markets. Commonly cited concerns are potential fund flows away from the stock market and negative implications for stock valuations. Where the quantum of fund flows is hard to gauge, theoretically a 50bps (our expectation of next MPS) increase in the interest rate may reduce stock valuation by ~4%, in our view. However, recent regional examples suggest this may not always be the case. India and Indonesia, both facing inflationary and currency pressures opted for monetary tightening yet their equity markets have shown resilience. RBI has increased its DR (in 2 stages) by 50bps since Sep’13, while its stock market reaching a record high and has yielded a return of 3% in the duration. The Indonesian market has provided a negative return of 3% since the start of its monetary tightening in Jun’13 but ever since the last hike in Sep’13 it has managed to provide a positive return of 2%.

Our take on the anomaly

This apparent anomaly is likely attributed to two major reasons, in our view. Firstly, the positive reflection of inflation on corporate earnings partially offsets the negative impact on valuations due to the interest rate hike. Secondly, stability in the domestic currency as a result of the rate hike provides much needed comfort to foreign investors. Therefore, expected increase in the policy rate should not bear negative implications for the equity market necessarily, provided the PkR remains stable against the greenback.

About the Author