The RBI hiked the repo rate (by 0.5%) and the CRR (by 0.25%) yesterday.
For those who might not know, simply put, the repo rate is the short-term interest rate at which the RBI lends to banks. The Cash Reserve Ratio (CRR) is the percentage of bank deposits that the bank have to maintain in cash.
A higher CRR means less money available for lending and hence lesser money in the economy. A higher interest rate means lower demand for credit. Both measures are meant to contain demand and hence bring down inflation.
The RBI move appeared to have surprised most market watchers. After all, the argument went, the RBI has very recently raised repo rates and the CRR, the impact of which would be felt in some time to come. So most people thought that the RBI would wait and watch before it decides what to do next.
I wonder why people were surprised. Inflation was clearly much above the RBI's comfort zone, having reached 13 year highs. Credit growth was still above RBI objectives. After the UPA won the confidence vote in the parliament, its focus would have clearly been on killing inflation. Those who follow the current RBI governor, Dr. Reddy, would have known how he operates. So a rate hike and a CRR hike was to be expected...and I think it will continue for a while unless something changes drastically that brings down inflation.
So less money and higher interest rates will have an impact on the economy. Growth is likely to slow down further, especially after 5 years of fantastic growth rates, as the tightening measures come through. Corporate earnings growths would also come down as will their stock prices. Not good news if you are an equity investor.
But there is a silver lining in all these rate hikes. Continuing interest rate hikes will make stock valuations very cheap sometime down the road. At some point, inflation will (hopefully) turn around and head down. Interest rates will also head down concomittantly. And that would provide a fillip to the stock markets. So, patient investors can wait for stocks to become really cheap to buy.
A similar process happened in USA in the early 1980s. Inflation went up to as high at 12% in the USA and the economy was hurting. It was the then Federal Reserve Governor (equivalent to our RBI governor), Paul Volker, who kept raising interest rates and brought down inflation (which was followed by drop in interest rates). What ensued was a 18 year mega bull market (because of many other factors as well) in the USA till the 2000 technology bubble.
So wait patiently and watch for stocks to become cheap again...
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Interesting stuff!!!
Wonder how much monetary economics can counter inflation stoked by supply side economics.
Speculation more than genuine demand seems to have rocketed prices in oil, metals and probably some food items.
Yes, supply side shortages have led to inflation in a few products.
But, by curbing money supply, the central bank reduces aggregate demand. When demand falls, prices fall thus controlling inflation.
It happened in the USA in the early 1980s. Recall the stagflationary decade of the 1970s when growth was low and inflation high because of supply shocks. Monetary tightening by the US Federal Reserve helped in bringing down inflation to low single digits from 12%+ levels.
But a fall in demand means lower economic growth...
Contrary to popular belief, we are not clear whether speculation causes prices to rise as has happened in oil, metals and some food items.
Those who believe so, say that speculation builds up expectations of higher future prices and hence sellers abstain. So prices rise.
In a counter argument, for every buyer, there is a seller. The battle is even at all prices. Speculators simply bring the price to its equilibrium level quickly. A rise in prices encourages higher supply and brings prices down.
Consider oil: If OPEC thinks that prices are too high because of speculators, let them raise the supply and drown these speculators.
Or if the government (any government, even the USA) thinks that oil prices are high on account of speculation, let it short oil futures on a massive scale and bring down prices. Doing so will boost economic growth and the government will make a neat profit in the bargain on its short positions.
Recall that in 1991, George Soros broke the Bank of England by shorting the Pound Sterling against the Bank which went long. Soros made a cool $1 billion in a day!
Speculators do not cause imbalances; they discount it by trying to profit from existing imbalances.
It is very easy and convinient to blame speculators for existing supply shortages.
Speculator is as much a part of the market as a hedger in commodity markets and an investor in equity markets.
In the Indian context monetary tightening could, however, impact economic growth.
It should be interesting to analyse components of our inflation and understand why it is so high in some areas.
With 10 year GOI bonds at 9.50% - Bond P/E ratio is at 10.5 times. Equities are at 13 - 15 times. So if this continues and equity P/E is equal or lower than bond P/E, stocks can be considered cheap.
The only missing link is how long will this phase continue????????
Speculators are present in all asset markets and are essential to the functioning of the markets.
Monetary tightening is intended to reduce aggregate demand and hence is intended to reduce economic growth. It is but one way of trying to curb inflation.
The WPI inflation that we measure may not mean much to the end consumer. We do consume a whole lot of services which are not a part of the WPI. So I do not know what is the real level of inflation for the consumer.
Yes, the 10Yr GOI secs are quoting at a yield of 9.5% While mid cap stocks may not be expensive, the same cannot be said about large cap stocks. DO let me know where you got your figure of 13-15 times current PE for equities. The Nifty has a PE 18.54 and the Sensex has a PE of 18.08 (both figures from the respective websites). A PE of 18 for earnings growth in 12-15% going forward does not look cheap to me.
Nifty PE was 12.7 in Apr 2003 with a Price:Book ratio of 2.04 and a dividend yield of 3.08%. Compare the same figures today of 18.54, 4.04 and 1.26% respectively. You would get similar data for market lows in May-04 and June-06, the previous bottoms in recent years.
FYI, the PE of NSE Midcap was 6.19 in April 2003!! Now thats cheap!! No wonder we had a huge midcap bull market.
But cheap may be an illusion since fall in earnings can raise PE. In bad times, large caps weather the storm better than mid and small caps. So in bad times, small and midcaps fall harder.
My sense for the markets is they would perhaps do nothing for a long period, maybe a couple of years. At the end of this period, stocks will get real cheap.
Of course, the markets are supreme and we are underlings...
Respective websites give trailing P/E.
Sensex closed on 31st March at abt 15650 and with Sensex EPS of abt 865 we have a P/E of abt 18.1x.
If you take EPS consensus estimates for '09 at 1000 you have P/E in the range of 14 - 15 depending on market level.
If you take GDP growth of 8% + avarage inflation of 10%, Sensex stocks shd return 15% profit growth if you factor in abt 3% for volume/profit contraction.
Respective website give trailing PE, thats true. So the PEs on the 2main indices (Sensex and Nifty) are 18+ 12 months trailing.
Note that on March 31st 2008, Sensex closed at 15644 with a trailing PE of 20.11 (Source:BSE website) implying an EPS of 777 (15644/20.11).
Assuming an EPS of 1000 on the sensex for FY09 is ambitious. It implies EPS growth rate of 29%, unlikely to come through.
Consensus forecasts are notorious for getting it wrong in times of change. They got it wrong on the way up and would get it wrong on the way down as well. Anyway, consensus forecasts have started coming down. Its funny how EPS is a moving target.
Sitting today, after Q1FY2009 results, the Sensex is at 14961 and Sensex PE is 18.54 giving an EPS of 807.
I would be surprised if GDP grows at 8% for FY09. But assuming it does and assuming Sensex EPS grows at 15%, we get an EPS of 894 for FY09.
At 14961, this means a forward PE of 16.72, not 14-15 times.
Brokerages in India are a trifle inward looking. We dont understand how the world events are impacting us indirectly even if there is no direct impact. The world is going through a process of massive delevering. Credit is becoming increasingly difficult to get. And foreign money makes our markets move in significant ways than local mutual funds or insurance companies. Locally we can only hold up the markets, we need foerign money to really kick us higher and faster. That is unlikely to come back in a hurry.
We are in an epoch making phase for financial markets and I am not clear yet how the cookie would finally crumble. We do not realise this because we are a part of it looking out from the inside. So we dont see how the landscape is changing. It requires us to step outside our framework and look dispassionately to see if things are changing.
Please do not listen to mutual fund managers or other such experts. They assume that the future (at least the medium term future)would be like the past. I am not sure. Let the chips fall wherever they will and then assess the situation.
(Here is the link to BSE for historical indices data. Do check out April 2003 month, May 2004, November 1998 to see what cheap really is! While like to like comparisons are not justified, it gives an idea)
Sorry, forgot to paste the link.
http://www.bseindia.com/histdata/hindices.asp
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