February 2018: Rise in interest rates could cap PE expansion

The month of February saw all global markets hit by a bout of volatility as equity indices across the globe saw cuts of 7-10% within a week and a half. The cause for this volatility seems to be the fact that the US 10 year bond yield spiked to very near 3.0% from about 2.1% in Sept-17. One of the factors feeding into this spike in US bond yields is the strong labour market which is now beginning to feed into higher wages and hence higher inflation for the economy as a whole. What may have also spooked the US markets is that the US budget deficit is set to go up significantly to $1 trillion for the coming financial year. So, while the market has till now been focused on the tax cuts and the benefits to corporate America, the recent volatility has shifted attention to the resultant higher fiscal deficits going into the next few years. In any case, interest rates have been kept artificially low since the mortgage crisis a decade back, and at some stage we need to start facing up to reality.

In India too, the 10 year bond yield has climbed from 6.5% in Sep-17 to 7.7% now, though the yield on 1 year bonds has moved up from 6.4% to only 6.8% in the same period. Bond funds with long duration have seen negative rates of return over the past few months, on the back of this move (bonds fall in value as interest rates increase). It has been tough times for fixed income investors in India over the last few months. The spike in bond yields also affects the balance sheet strength of an already fragile set of Indian PSU banks, as they have to recognize mark to market losses because of this move.

This sharp move in the 10 year bond yield in India has taken many market participants by surprise. One plausible explanation for the sharp move is that while the government may not account for the 2.11 lakh crore recapitalisation of the PSU banks in its book, the market has seen through that and is factoring the bank recapitalisation along with the fiscal slippage (fiscal deficit in the financial year ending Mar-19 is now projected to fall to 3.3% instead of 3.0% earlier) of the Indian government.

Interest rates have a twin effect on stock prices. At one level, the cost of borrowing goes up for corporates and this has an impact on the interest cost that corporates have to bear, and thus an impact on corporate earnings. Also interest rates for consumers go up, which can have an impact on consumer demand at the margin. Interest rates also affect the PE ratio of stocks, because when we discount future earnings back to today, the formula has the discount rate in the denominator, which is directly impacted by interest rates. As a result, a rise in interest rates should have a negative impact on the PE for stocks.

Rising interest rates can to some extent cap the Price to Earnings expansion we have witnessed in India over the last few years. In any case, PE ratios in many pockets of the market had gone up way beyond historical levels, on the hope of rapid earnings growth. We expect the market to scrutinise earnings coming in over the next few quarters very closely. The case for PE expansion seems limited from here and the market would need to see sustained earnings increases to sustain momentum in the equity market.