ExplainSpeaking: Indian stock markets — What lies ahead?

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Dear Readers,

On Monday, the Indian stock markets tumbled sharply. Both the benchmark indices suffered losses. The BSE Sensex lost 2% of its value while the Nifty lost 1.7%.

Several factors were at play but the most important one is the faster than expected pace of interest rate increases to be announced by the US Federal Reserve. the fed, as it is often called, is the most powerful central bank in the world. That’s because it regulates the supply of US dollars, which is the go-to currency across the planet.

It is widely expected that the Fed will raise the interest rate to counter the historic inflation in the US. Higher interest rates will incentivize Americans to save money and this is expected to cool down the demand for goods and services, thus bringing down inflation.

But Fed raising interest rates has huge consequences for the rest of the world economies.

Why does the Fed matter?

During the phase of monetary easing — where the Fed not only printed a lot of money but also kept the cost of credit (or the interest rate) low — many investors chose to borrow cheap and invest in different stock markets. This helped boost several stock markets — India being one of the key destinations.

As such, the ongoing monetary tightening in the US — reduction in liquidity and costlier credit — has direct implications for stock markets across the world. It is quite likely that the so-called Foreign Portfolio Investors (FPIs) will find stock markets in India less attractive because the returns in the US have improved.

But there are other factors as well that determine investor behaviour.

In fact, over the past year, you might have often read that FPIs were “net sellers” in Indian stock markets. You might have also heard how domestic retail investors are “net buyers” in the Indian stock markets.

So, what explains this difference in the behavior of the two types of investors?

A recent note by Kotak Institutional Equities (KIE) explains why FPIs and domestic retail investors have been behaving differently. According to this note, the key factor determining the investment decision is the opportunity cost of money.

“Institutional investors focus on government bond yields closely,” states the note. why? “Because government bond yield is the risk-free rate in the economy and as such forms the benchmark to make investment decisions,” says Suvodeep Rakshit, Senior Economist, Kotak Institutional Equities.

In other words, if the risk-free rate of return is going up, as an investor you would demand equities to pay you that much more for you to choose them over the government bonds.

Chart 1: The graph shows the gap between bond and earnings yields.

“We assume institutional investors are nervous about the current large gap between bond and earnings yields. (see CHART 1), which is at historically-high levels,” states the note.

In other words, an institutional investor looks at Indian bond yields before investing in Indian stock markets. If the bond yields are relatively attractive (that is, the gap between bond yields and stock market returns is high) then the FPIs may be net sellers in the stock market. What CHART 1 shows is that this gap has been large.

Chart 2: The graph depicts the large FPI outflows in recent months.

It is for this reason that FPIs have been large sellers (see CHART 2).

These two charts might also point to why FPIs may remain net sellers in the immediate future. If domestic inflation stays up, government bond yields will not only stay up but possibly rise further. Higher inflation, on the other hand, will erode the profitability of listed companies. Between the two effects, FPIs may continue to leave the stock market.

Then why is the domestic retail investor also doing the same?

Ideally, retail investors should also look at the government bond yields to make up their decision. But in India, the government bond market is still not well developed and most retail investors typically compare investing in the stock market with what they may get from investments in fixed deposit (FD) products such as the five-year post office deposits or national savings certificates.

Chart 3: The line graph shows the yield of fixed income products.

As the KIE note points out, the FD rates have remained largely unchanged for almost two years now (see CHART 3). They have remained stable because the RBI policy rate has remained unchanged, despite high inflation. This relatively stable and low level of return on FD products explains why retail investors have been so enthusiastic about investing in equities (see CHART 4).

Chart 4: The bar graph shows the strong inflows into equity mutual funds.

But the last two charts also point to what may happen going forward. If FD rates start going up as RBI starts raising interest rates (as it is expected to do soon), then retail investors may reassess the attractiveness of investing in stock markets.


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