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Will interest rate hike hit the stock market?
Mohit Satyanand, Outlook Money | August 22, 2006
Stock prices end the week on a high note as investors welcome signs of an economic slowdown." Honest. That's what I read on the computer screen when I checked out world markets on July 29.
Earlier that week, the chairman of the US Federal Reserve observed that economic growth in the US was slowing. Wall Street celebrated by rallying 2 per cent. Since the US is India's largest trading partner, Dalal Street responded by driving up the Sensex 3 per cent. Are you flummoxed? So was I. Why on earth were investors salivating at the prospect of a downturn in the US economy?
There was a certain logic (I use the word with some reservations) to this apparently perverse reaction. If I understand the thinking right, it goes like this: the last couple of years have been highly profitable for owners of equity across the globe. Especially in emerging markets like India, share prices have benefited on two counts - rapidly growing turnover and profitability of companies; and the growing interest of foreign investors.
Both these factors, namely higher consumer spending and greater investible fund flows, have been driven by an enormous surge in global liquidity. This, in turn, was due to sustained low interest rates in the two largest economies of the world, Japan and the US.
Though the Fed began raising rates a while ago, the real cost of money (interest rate minus inflation) was negative or low for a long time. Over the last couple of quarters, facing the relentless upward march of interest rates, market players have begun to worry that the party may be coming to an end.
Across the globe, thousands of highly paid investment specialists invested a zillion hours in interpreting every shift in emphasis of the Fed chairman's utterance. Type 'Fed Watching' into Google, and you'll end up with 17.9 million hits - trillions of dollars riding literally on one man's every word. This fixation led to its own simplistic, but relevant, formula: interest rate hike = threat to growth = jittery stock markets.
Conversely then no more interest rate hike means, we can breathe easy once again. Specifically, in late July 2006, statistical indicators indicated that US growth was slowing. This, the market hopes, may force the Fed chairman to stop hiking interest rates.
It is interesting that a seemingly logical construct should lead us into this ridiculous situation, wherein people are bidding up share prices at the prospect of lower growth. I prefer my more straightforward logic - lower growth should lead to lower price-earnings multiples.
Even if I were to ignore the possibility that economic growth in the US is slowing, and the focus is on the 'India story', the fact remains that interest rates in the country are hardening. Compared to a year ago, money is already a couple of percentage points more expensive, with more to come.
In India, the liquidity situation is going to be further compromised by our coalition government's need to spend its way out of every political corner. When entrepreneurs have to compete with a profligate government for scarce money, no one benefits - not the young couple who sees EMIs rising, nor the car manufacturer whose sales are driven by loan finance.
And certainly not share markets, because when bank deposits become more attractive, some money will move away from shares. In other words, I fully agree that share prices should be scared of high interest rates.
But this mantra has been hopelessly contorted, hypnotising millions into believing that lower economic growth is good for share prices. Mantras are attractive shortcuts to salvation, but in the financial sphere at any rate, sometimes you need to ignore the pundits and rely on simple logic.
The author is an investment advisor to a select group of clients.