Should your investments follow the interest rate cycle? - The 5 Minute WrapUp by Equitymaster
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Should your investments follow the interest rate cycle?

Sep 30, 2015

In this issue:
» How does India compare with BRICS on the macro front
» Rate cut to boost credit offtake?
» Market round-up
» ...and more!

The Reserve Bank of India cut repo rates by 0.5% yesterday, bringing cheer to the markets. And why not? The chorus singing the praises of a cut had grown louder after low inflation and poor production numbers raised concerns that the economy may be slipping in to deflation. From corporate India and the policy makers to the analyst community, all seemed unanimous that a rate cut would invigorate the economy.

But will the rate cut actually benefit the common man? A cut in base rates is expected to lower his interest burden on retail loans. At the same time, it means cheaper credit for corporate India for its capital expansion programs.

But is this enough to boost demand and pull the economy out of slumber? Should a retail investor go all out and invest in anticipation of robust company growth?

We do not think so.

If this were true, then the global economy would not have been in a recession in the first place. Major central banks have kept interests rates low for a very long time.

Moreover, debt levels in India Inc have risen sharply. This has inhibited its ability to service debt. As per the RBI's Financial Stability Report, the solvency ratio or debt servicing capability (as measured by the ratio of profit after tax plus depreciation to total debt) of the corporate sector has fallen sharply due to increased debt levels. This ratio declined from more than 30% in FY12 to around 26% in FY14.

In fact, the corporate sector has taken a lot of foreign currency loans to take advantage of the lower interest rates in the overseas markets. As a result, the external debt- to- GDP ratio stood at 23.8% as of March 2015. There is no doubt that the RBI's rate cut can help correct this situation to some extent. But this by itself cannot improve the financial soundness of companies already burdened with debt.

The government needs to take steps to improve the business environment in the country. This includes clearing pending reform proposals, expediting project approvals and implementing measures to improve the basic infrastructure. Until that happens, bringing down interest rates alone cannot push the growth engine.

Therefore, the next time a rate cut entices you to invest in the stock markets, do not forget that only companies with durable moats can create wealth in the long run.

Do you think that lower interest rates alone can resurrect the economy and markets? Let us know your comments or share your views in the Equitymaster Club.

Publisher note: We recently released the "Crash Score" report, which explains a process and parameters to filter out stocks that rank high on several risk parameters. The good news is we've made the report available FREE to all. Do make sure you grab a copy today.

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 Chart of the day
The volatile inflation levels and the Fed's policy action have been the key concerns for the RBI over the past few years. But with yesterday's surprise of a 0.5% reduction in rates, it would be safe to assume that these concerns have been curbed. And with the same happening, the risks of capital flight have seemingly disappeared.

With inflation levels coming down, the nerves of foreign investors will be under control. When compared to its emerging market counterparts, India fares relatively well. As reported by the Business Line, CPI inflation in India stands at levels of 3.7% as compared to 9.5% and 15.8% for Brazil and Russia respectively. In China and South Africa on the other hand, the figures stood at 2% and 4.6% respectively.

The chart below puts this in perspective, along with other key stats of these countries.

India to be the preferred market within BRICS?

The real yield on government bonds is gauged from a debt investors' point of view. Data reported by the business daily shows that India ranks firm with the real yield on sovereign bonds coming in at about 4%, similar to that of South Africa. For other countries, the figures are in the range of negative 11% to a positive 1%.

Will these factors have any impact on equity markets? Well...partly yes. Currency volatility risks do exist for foreign investors. But, when it comes to gauging equity market attraction, a lot of factors come into picture. And this becomes crucial for the Indian markets considering that foreign investors have a big share of the free float potion; as much as 40%. Foreign investors are believed to currently have an 'overweight' position in the markets. This will keep the fund inflows limited and thus the relativity (versus other EMs) aspect gains importance.

Credit offtake in India has been dismal in recent years. In the first half of FY13, FY14 and FY15, the figures came in at levels of about Rs 1.5 trillion, Rs 3.3 trillion and Rs 1.3 trillion respectively. In 1HFY16, the same stood at about Rs 1.7 trillion, which provides an indication of a bounce back.

So the key question remains... will the reduction in rates boost credit offtake in India?

There are a few points to consider. Loan growth has largely remained dull due to slowdown in credit demand by the corporate sector. Moreover the cheaper funds raised via commercial paper have also contributed to the slow credit growth. The issuance of commercial paper rose by 57% YoY as of mid July this year.

Not to mention that while cost of funds has become cheaper, the key issue lies with matters such as lower asset turnovers / underutilized capacities, as well as delayed infrastructure related problems - areas which are still to be addressed. Investment activity by companies did take a back seat in the past few years. Lot of projects are still stalled due to the issues like lack of clarity on policies, land availability, power and labour issues. Unless strong action is taken regarding these aspects, new projects are unlikely to be undertaken, leaving less hope for revival in the credit growth rate.

The Indian stock markets opened the day on a strong footing and continued to soar higher during the course of the day. At the time of writing, the BSE-Sensex was trading higher by 226 points (up 0.9%). metal & realty stocks are leading the gainers today.

 Today's investing mantra
"A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting."- Warren Buffett

This edition of The 5 Minute WrapUp is authored by Madhu Gupta (Research Analyst) and Devanshu Sampat (Research Analyst).

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