Why the Nifty should actually celebrate Powell's hawkishness

29 Aug 2022 , 06:21 AM

The US markets panicked after Jerome Powell completed his Jackson Hole speech. On Friday, the Dow fell by over 1,000 points while the NASDAQ was down 497 points. Post the speech, which hinted at aggressive rate hikes continuing, treasury yields surged to 3.05%. Since the start of August 2022, the US 10-year bond yields are up from 2.54% to 3.05% on expectations that Powell would be more hawkish that expected. In response, the SGX Nifty was also down by nearly 220 points, pointing to weak trading on Monday 29th August.

The extreme Fed hawkishness is likely to be sentimentally negative for the Nifty and Sensex so a negative opening cannot be ruled out. In any market reaction, there is the obvious story and the bigger question of what the markets should be actually doing. Let us first look at the positive side of Jerome Powell’s hawkish tone at Jackson Hole. Investors and trade have to brace themselves for more rate hikes. On the positive side, they have a much clearer time table of the peak rates and the timeline to reach these peak rates. Let us address five key issues on why the Nifty must not misinterpret the Jackson Hole address.

Myth 1: Fed hawkishness will make markets uncomfortable

The is the most likely reaction when the markets open on Monday, 29th August. Reactions tend to be knee jerk in the short term but things tend to gravitate towards the real story once more data points are digested. Let us look at the positive side of the Fed hawkishness. The Fed has been unambiguous that given a choice between boosting growth and price stability, they would prefer to focus on price stability. After all, once inflation and inflation expectations are managed, it gives a lot more confidence to investors.

But there is another side to this. For investors and traders, there is now a clarity on two things. Firstly, more rate hikes are on and most of the rate hikes will happen in 2022 itself. The Fed has not tried to mince words nor has it tried to be a fish and a foal. With the peak rates or the terminal rates now being just about 130 bps away, investors and traders know perfectly well what is the worst-case risk they need to build into their predictive models.

Myth 2: Focus on growth is accretive, but inflation is not value accretive

That is being cited as one of the reasons the Indian markets would be unhappy. On the contrary, the Fed is right that today inflation control and price stability are more relevant than trying to boost growth. Let us understand why! If you look at the second estimate of US real GDP data for the June quarter, it has contracted by -0.3%. However, the nominal GDP growth is around 8.5% and the only reason the real GDP is in the negative is because of high inflation. Assume that the nominal growth remains static but the inflation reduces by 200 bps, then the real growth directly gets a 200 bps boost. Powell is right that at this juncture, a focus on inflation control can be a lot more accretive for real GDP than trying to push growth. That is the message that Indian markets should look at.

Myth 3: But, too much hawkishness will kill consumer demand

That argument may sound logically appealing but the reality would be something entirely the opposite. Here is why. For instance, what drives consumer demand. It is not just income levels, but it is inflation expectations. When the inflation expectations are high, people tend to become more cautious about spending money as they know that the value of their savings will erode. That negatively impacts the level of consumer spending.

On the other hand when the central bank is hawkish, it reduces inflation expectations, as we have seen in the US and also in India. People are confident that the government is intent on reducing high inflation. This reduces inflation expectations and actually incentivizes people to spend. In reality, the Powell hawkishness should help to reduce the inflation expectations and help to boost consumption spending.

Myth 4: Higher interest rates will hike cost of capital and reduce valuations

That argument is broadly correct. However, if you look at the experience of the US during its previous rate hikes in the last 40 years, the experience has been interesting. The stock markets have seen a knee jerk reaction in the short term, but over a period of 2 years, indices have actually gained valuations amidst rising interest rates. Why does this happen and will it repeat in India also?

In the US, the March quarter showed -1.6% real GDP contraction. However, the rate hikes began only in March. In the June quarter, the GDP contraction at -0.6% is 30 bps lower than the first estimate and 100 bps less than the Q1 contraction. Clearly, that belies the assumption of an inverse relationship between interest rates and stock market indices. Even in India, Sensex has given 16.5% CAGR returns over 43 years, through a number of rate cycles That hints at a market that is largely immune to the gyrations in the interest rates in the medium to long term.

Myth 5: Higher rates will hit solvency of companies

This risk can be said to be quite high in India considering that with the shift to external benchmark lending rate (EBLR), the transmission has become speedy. The impact was already visible for Indian companies in the form of a rise in interest cost on a sequential basis for June 2022 quarter. However, there is an interesting counter-argument that can be offered to this point.

India Inc deleveraged substantially in last 2 years. Leverage for Indian companies was down 3% in year 2021 compared to 2020. The trend of deleveraging was led by Reliance. Many of the large conglomerates belonging to the Birla, Tata, DLF and Bharti group have aggressively deleveraged. The biggest of the case studies was Reliance which became a zero net debt company. Sectorally, if you leave out telecom and retail, the outstanding debt of other sectors is either flat or lower. That would largely offset the impact of higher rates.

To cut a long story short

There is too much hype over the impact of the rate hike on stock markets. Needless to say, there will be a negative short term reaction. However, better judgement should prevail in the medium to long run. The bigger lesson from the entire story is the message for the RBI. For too long, the RBI has maintained a stance wherein it would withdraw accommodative without impacting growth. MPC members like JR Varma have pointed out that the focus on growth need not be emphasized.

Instead the RBI must also focus on making its stance more explicit. It is not necessary to stay ambiguous and run with the hares and also hunt with the hounds. Indian markets should thank Powell for the clarity provided. It is time to think long term.