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Monday, the Indian stock markets fell sharply. Both benchmarks suffered losses. The BSE Sensex lost 2% of its value while the Nifty lost 1.7%.
Several factors played a role, but the most important is the faster than expected pace of interest rate hikes that will be announced by the US Federal Reserve. The Fed, as it is often called, is the most powerful central bank in the world. This is because it regulates the supply of US dollars, which is the benchmark currency on the planet.
The Fed is widely expected to raise the interest rate to counter historic inflation in the United States. Higher interest rates will encourage Americans to save money, which should cool demand for goods and services, thereby lowering inflation.
But the Fed’s interest rate hike has huge implications for the rest of the world’s economies.
Why is the Fed important?
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 to invest in different stock markets. This helped boost several stock markets, with India being one of the top destinations.
As such, the ongoing monetary tightening in the United States – reduced liquidity and more expensive credit – has direct implications for equity markets around the world. It is highly likely that so-called Foreign Portfolio Investors (REITs) will find stock markets in India less attractive because yields in the United States have improved.
But there are also other factors that determine investor behavior.
In fact, over the past year, you may have often read that REITs are “net sellers” in Indian equity markets. You may also have heard that domestic retail investors are “net buyers” in Indian stock markets.
So what explains this difference in behavior of the two types of investors?
A recent note from Kotak Institutional Equities (KIE) explains why REITs and domestic retail investors have performed differently. According to this note, the key factor determining the investment decision is the opportunity cost of money.
“Institutional investors are narrowly focused on government bond yields,” the note said. Why? “Because the government bond yield is the economy’s risk-free rate and as such is the benchmark for making investment decisions,” says Suvodeep Rakshit, senior economist, Kotak Institutional Equities.
In other words, if the risk-free rate of return increases, as an investor you would demand that stocks pay you a lot more for you to choose them over government bonds.
“We assume that institutional investors are worried about the current wide gap between bond yields and earnings. (see TABLE 1), which is at historically high levels,” the note reads.
In other words, an institutional investor looks at Indian bond yields before investing in Indian stock markets. If bond yields are relatively attractive (i.e. the spread between bond yields and equity yields is high), REITs may be net sellers in the stock market. What GRAPH 1 shows is that this gap was significant.
This is why REITs have been big sellers (see TABLE 2).
These two charts could also indicate why REITs may remain net sellers for the immediate future. If domestic inflation remains high, government bond yields will not only stay high, but possibly rise further. Higher inflation, on the other hand, will erode the profitability of listed companies. Between the two effects, REITs could continue to exit the stock market.
So why is the domestic retail investor also doing the same?
Ideally, retail investors should also look at government bond yields to make their decision. But in India, the government bond market is not yet well developed and most retail investors usually compare investing in the stock market to what they can get from investing in fixed deposit products (FD ) such as five-year postal deposits or national savings. certificates.
As the KIE note points out, FD rates have been largely unchanged for nearly two years now. (see CHART 3). They remained stable because the RBI policy rate remained unchanged, despite high inflation. This relatively stable and low level of return from FD products explains why retail investors have been so enthusiastic about investing in equities (see CHART 4).
But the last two graphs also indicate what could happen in the future. If FD rates begin to rise as RBI begins to raise interest rates (as it is expected to do soon), then retail investors may reassess the attractiveness of investing in equity markets. .
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