A surprise 40 basis points hike in repo rate by the Reserve Bank of India (RBI) on Wednesday clearly suggests that the era of low interest rates is over and the interest rate cycle has begun to reverse.
This is because 40 basis points may not be enough to tame the rising inflation. One basis point is one-hundredth of a percent.
Secondly, future rate action by the RBI also depends a lot on the United States Federal Reserve. If the Fed is forced to make aggressive rate hikes from here on to bring down inflation in the US which is now at a 40-year high, then RBI will be forced to follow suit.
This reversal in the RBI monetary policy and rate cycle will have a profound effect on the financial markets and thus on our investment portfolio. The risk assets such as equity and mutual funds are especially vulnerable to changes in the interest rate. This was amply clear on Wednesday when the announcement of a rate hike by the RBI led to a big sell-off on Dalal Street.
The benchmark BSE Sensex was down 1454 points or 2.3 percent on Wednesday.
While selling was fairly broad-based on Wednesday and all sectors ended the day in red some sectors declined more than others. Quite a few index stocks saw a rise in their share price despite a massive selling in the broader market.
A steady decline in interest rate in India beginning in November 2013 had upturned the financial markets and created new winners and losers in the equity market. Investors should expect a similar churn in the market but in reverse over the course of the next few months.
While the overall equity market is expected to remain subdued in a high interest rate environment, some sectors and stocks may rise in prices while others may see a sharp decline.
So what sectors or stocks should you bet on in the new economic environment? Here are five sectors or groups of stocks that are likely to do well.
1. Value Stocks. A steady decline in the interest rate in the last decade has triggered a big rally in growth stocks. The low cost of capital made it less risky to bet on future growth ideas. In contrast, value stocks or companies with profitable but mature businesses languished.
Investors will love the high equity dividend that these companies generate. In contrast, you should stay away from richly valued stocks that promise faster earnings growth.
2. FMCG or consumer staples stocks. A combination of high inflation and interest rate is likely to hit the overall GDP growth. While a decline in economic growth will result in lower demand for goods & services and will affect companies across sectors, investment-related sectors are likely to take a bigger hit. In contrast, the top FMCG companies are expected to be the least affected. The demand growth for essential items like soaps, shampoos, toothpaste and ready to eat food may be slow but it will still grow. The leading companies in these sectors also tend to have the pricing power and thus the ability to control their margins and profits. In contrast, you should stay away from investment-related sectors such as capital goods, construction, cement and metals among others.
3. Debt-free companies. A rise in interest rates will raise the borrowing costs for companies. This may put many companies with high debt in financial trouble if the interest rate rises beyond a point. There is no such risk for debt-free companies or those with minimal debt on their balance sheet. With debt-free companies, you only take growth risk which is easier to navigate.
In comparison, most debt-heavy companies are in sectors such as power, construction & infrastructure, metals & mining and oil & gas.
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4. Banks and financials. The Bank Nifty has grossly underperformed the broader market in the last three years and this coincides with a sharp fall in the interest rates. Now that interest rates are going up, banks are expected to out-perform the broader market. This is because higher interest means that lenders can charge higher interest rates on their loans which will push up the yield on their loans.
This in turn will translate into faster growth in banks’ gross interest income. If they manage to calibrate the interest that banks pay to depositors then it will translate into faster earnings growth for banks and lenders in a rising rate scenario.
5. Utilities with cost pass-through. Electricity and gas utilities such as NTPC, Power Grid Corporation, Gail and Tata Power are also expected to do relatively better in the rising rate and high inflation scenario. Though most utilities have high debt and face cost pressure, they operate on the principle of a fixed return on capital employed and any rise in capital or material cost is passed on to the consumer. This makes these businesses defensive plays during times of volatility in the financial markets. The current year should not be an exception.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).