The road ahead for equities

With the first hike by the Federal Reserve, after a gap of seven years, a major uncertainty has ended for the Indian stock market. Equities have been rather subdued this year due to concerns on global growth, especially in China, and fears over the impact of the Fed rate hike. Indian stocks began the year on an upbeat note but they have lost their way since March. While the Sensex is down 5 per cent over the last year, the Nifty has lost close to 4 per cent.

So what will be the impact of the Fed action on Indian equities? Its repercussion will be felt in two ways, through the actions of the foreign portfolio investors (FPIs) and the effect on company balance sheets due to their borrowing in US dollars.

FPIs have pulled out ₹12,365 crore from the equity market and ₹5,297 crore from the debt market in November and December this year. Foreign portfolio flows are directly impacted by the increase in the US rates as roughly a third of FII assets in India originate from the US. As yields on the US bonds head higher, investors there might want to reduce their investments in emerging market equity. These investors might also have bought assets in emerging markets with the aid of cheap dollar loans. With the cost of these loans moving higher, they may want to repay loans by selling assets purchased with this money.

Another reason why foreign portfolio flows are affected is because foreign investors tend to view all emerging markets as a homogenous asset class. The poor performance of other commodity-dependent emerging markets such as Brazil and Russia has made them exit Global Emerging Market funds, which also invest in Indian equity. This has also affected fund flows into India.

But the superior prospects of the Indian economy, and its advantageous position as a net commodity importer, should be able to attract portfolio flows again, after this bout of risk aversion ends. Expected improvement in company earnings is likely to be another draw for these investors.

Foreign borrowing

Indian companies have increasingly been turning to foreign borrowings to fund their needs. The era of cheap money facilitated by interest rates close to zero in many countries has resulted in this jump. Dollar carry trade, where people borrow in dollars to lend to other borrowers or buy assets elsewhere in the world, has reached alarming levels of late. According to an estimate put out by the Bank of International Settlements, non-bank borrowers had outstanding dollar loans worth $9.8 trillion towards the end of June 2015 of which $3.3 trillion had been taken by borrowers from emerging markets. India’s share of dollar credit taken by non-bank borrowers stood at $118 billion at the end of the June quarter of 2015.

Indian companies have been increasingly skirting the high cost of borrowing in India by borrowing overseas at much cheaper interest rates, thanks to the near-zero rates in many countries. According to the Reserve Bank of India, external commercial borrowings towards end-March 2015 stood at $182 billion. This is up from $57 billion towards end-December 2007. The proportion of debt denominated in dollars has risen from 54 per cent in December 2007 to 59 per cent by December 2014.

Indian companies such as Reliance Communications, Reliance Power, Essar Steel and Adani Enterprises have a large portion of foreign currency debt, financing of which will get more difficult as interest costs on these loans move higher.

But the pain will not be immediate as the era of cheap money will last at least for two more years.

Going forward

This year, investors were chasing stocks in consumer durables (sector index up 31 per cent), healthcare (up 14 per cent), and IT (up 7 per cent). Sectors relating to urban consumption such as media and entertainment have also been finding favour with investors. With economic recovery set to gain traction, there could be sector rotation with stocks in beaten down sectors such as capital goods and infra gaining attention in the coming days. Some correction is likely in overheated mid-and small-cap stocks too that are yet to correct significantly.

While investors need to be wary of stocks that are debt-laden, they can start taking selective bets on stocks that can gain from the economic recovery.