Portfolio

While real rates for India are relatively better, developed market bond yields make domestic stocks less attractive

‘If something cannot go on for ever, it will stop’ is a famous quote in the field of economics and is known as Stein’s Law. Global central bankers are now learning it the hard way that money printing and easy money policies cannot go on forever too.

After more than a decade of financial repression, that is, ie. policies that result in savers earning returns below the rate of inflation, the spike in pricesacross the world (see table), is now heralding a regime change when it comes to central banks’ approach to economy. From Ben Bernanke’s “whatever it takes” vow to stimulate the economy in 2009, which kickstarted the longest era of easy money and boom in risk assets, the regime now appears to be shifting to Jerome Powel’s “whatever it takes” to bring down inflation, as he reiterated last week that the Fed is “acutely focussed on bringing down inflation”.

Forcing a stock fall

Thus, for equity investors, the Fed Put that in a way was supportive of global equity markets as well in the past, is off the table. In fact, according to former Fed member Bill Dudley, the Fed might need to force stocks to fall (which has played out to some extent), to cool demand via the reverse wealth effect.

With real interest rates deep in negative territory for many developed and emerging market countries (see table), central bank Puts may not be forthcoming across the world, except maybe in countries like China that appear to be amongst a select few with positive real rates.

What’s ahead for India?

When compared to some developed and emerging markets, India appears to be faring better on the inflation front. While real rates are negative, it is better than some of the developed and emerging economies. These factors, added to the fact that India is likely to remain the fastest growing major economy by far, can be tailwinds for Indian equities. However, there are constraints.

In FY21 alone, the FPI inflows were three times the cumulative inflows of the previous four years. This has been followed by an exodus that picked up steam since October-November 2021 and has continued relentlessly. With global bond yields increasing at an unprecedented speed in the last one year and especially in recent months as inflation fears reign supreme, equity capital outflows may continue for some more time.

For FPIs to return to risk-on mode, two things need to play out. They need to get confidence on inflation getting back under control, which will result in bond yields tempering globally. Given the record levels of inflation and negative real rates, this may be a long-drawn process.

Further, equity markets in emerging economies may also need to get more attractive relative to risk-free assets of developed markets. In India, the trailing earnings yield (1/PE) of Nifty 50 is at 5 per cent. That is not too attractive for FPIs when risk-free 10-year US government bonds are yielding 3.23 per cent and 2-year bonds are yielding 3.17 per cent. The last time the US 10-year bond yield at this level was in April 2011, and the Nifty earnings yield was 15 per cent higher and continued to move up through the course of the year. Further, the earnings yield of Dow Jones and S&P 500 today is better at 6.2 per cent and 5.4 per cent, respectively, when compared to the Nifty.

Edge for fixed-income products

Finally, a rise in domestic interest rates may increase the attractiveness of fixed income products over equities for domestic investors as well. Domestic investors have been supporting the markets taking it to new highs in October 2021 as FPIs were exiting. But they may also soon begin assessing the risk-reward between choosing safe debt investment options and equities.

Published on June 18, 2022