Heavyweights have contrary opinions on what the Fed should do – IMF and World Bank (against) vs the BIS (for); so clearly the decision is not an easy one.
Too many trees have been felled debating whether the Fed will raise rates on 17 September. A rate rise is coming – whether it is now or in 3-6 months – to start reducing risks to the system – many not understood – from ultra-low interest rates over 6 years, and because of Asset price inflation (Stocks, Real Estate) which, among other things, has worsened inequality in developed markets.
In our opinion, the Fed should start raising rates now but communicate clear intent on future pace and timing to reduce uncertainty
- The arguments against raising rates at present are the impact of China’s slowdown on growth, the concern of an equity markets collapse which will dent consumer confidence, and low inflation which provides further headroom for easy monetary policy to continue for longer, fragile recovery etc. These reasons will still exist 3-6 months down the line.
- The Fed has also given the markets over 2 years to prepare for this rate rise. So no excuses that someone is not ready.
- Policy Certainty is important – lot of emerging market Central Bankers are urging the Fed to raise and end the uncertainty which is contributing to volatility.
- What is critical is not the first rate increase, but the pace of further rate increases. If the path is gradual, which we think it will be, the Yield Gaps in the US will still favour Equities and hence we should not have a deep Equity markets sell off as is feared. Of course, this assumes that earnings of US companies will not surprise negatively.
- The more the Fed delays, the greater the impact of instability down the line, especially as conventional monetary and fiscal tools are almost exhausted.
If we had to have an opinion, it would be that they will raise by 1/8th of a point (0.125%). The Fed voting members cannot be seen to be influenced by Wall Street, yet, they would not want to be at the helm and having contributed to a market crash, were it to happen because interest rates were raised too soon which killed the recovery.
Implication for Indian markets and investors
The immediate reaction in the Indian equity markets will be to follow trends in the global market. Independent of the Fed’s decision, we believe volatility, principally imported, will be high because there is uncertainty on many other variables at present, principally on the extent of slowdown in China and its spill over effects.
However, we believe that a gradual, Fed rate raise is in India’s favour and Indian markets will start outperforming global markets after a lag.
- We are connected to the world through financial flows much more than through the real economy. Sure, some export sectors e.g. textiles should be affected; however, at an aggregate level, the real economy should be more resilient and with significant potential for faster growth from monetary and fiscal stimulus.
- We believe that a key reason Dr Rajan has not reduced rates faster is because he wants to gauge the impact of the Fed rate raise on the Rupee. If there is a FII stampede for the exits, and a pressure on the Rupee as a result, then he would wait for that to stabilize before reducing rates. However, a stable Rupee will set the stage for multiple 25 bps rate cuts, especially as all other variables – FX Reserves, inflation etc. are well under control. This will provide a significant boost to sentiment and reprieve for earnings
- Unlike behaviour during previous global sell offs, this time the Retail investor has been investing money into Equity MFs despite FIIs selling; hence, corrections, if any, should not be deep because of buying support from local funds.
This event then provides another opportunity to the long term investor.Over the last year, the Valuation Gap between “Quality franchises” and “Others” has widened considerably. A correction, were it to happen, will provide an opportunity to accumulate Quality franchises at a reasonable price. What is most critical is self-awareness and control of your own behaviour. Volatility, and non-linearity is an integral part of Equity investing and cannot be wished away. While one may not have the stomach to buy during a fall, one should ensure that one does not sell into it because of panic.