Gear up for more headwinds

Gear up for more headwinds

Investors must be well-prepared to grab bargain opportunities in the coming future.

Over the past two years, the world has seen phenomenal monetary and fiscal intervention to forestall the economic effects of a COVID-19 recession.

After continuous easy monetary and fiscal policy, central banks and governments worldwide are tightening their belts.

The U.S. has promised several rate hikes over the next few quarters, setting the trend for the rest of the countries. The U.S. dollar acts as the reserve currency, which means that a hike in the U.S. interest rate will lead to the depreciation of most other currencies while the dollar swells in strength.

The swelling dollar is especially detrimental to India on two accounts: 1) The price of imports, namely oil and food imports, will become much more expensive, and 2) Money will flow out of our capital markets chasing the dollar. This scenario is reminiscent of the famous speculator George Soros’s Reagan’s imperial circle, wherein the U.S. Budget deficit increased while interest rates rose. This meant that the U.S. economy recovered while making its currency stronger.

Consumption, as well as growth, was funded by foreign goods and capital. However, the circle was vicious for other countries.

High inflation, low growth

India will face high inflation and low growth due to a multitude of factors. The inflation from import prices will surely hurt the economy, and accounts of both industries and ordinary consumers.

A higher interest rate regime would mean that the government’s fiscal deficit increases further due to a higher borrowing rate on G-Secs. The government will have to cut down on fuel taxes to account for the rise in oil prices, further decreasing revenue. As Warren Buffet had stated, interest rates act as gravity for stock prices.

The stock market should ideally correct accordingly to a rate hike by the RBI. Moreover, current G-sec holders might also face a haircut due to rising rates depending on their yield and coupon rate.

Principle of shrinkflation

Additionally, the FMCG industry (and others) will find it difficult due to narrowing margins from high inflation and the inability to raise prices. However, they deal with rising costs and stagnant prices by utilising the principle known as shrinkflation. One reduces the quantity of the goods sold while keeping the price constant (you might have noticed your biscuit packets getting lighter).

Although FMCG companies could try to sustain their profit margins, it is hard to imagine a world where they can support growth in sales and earnings.

The two big export industries which India boasts of are IT and Pharma. On the one hand, a depreciating rupee is a positive factor for these companies as they make their money in dollars. Therefore, at least in the short run, they gain from changes in the exchange rate.

Signalling recession

However, rising rates in the U.S. would signal a recession leading to a reduction in consumption. Lower business activity levels would transition into problems for the IT industry especially. Moreover, domestic business activity is also set to face hurdles due to rising rates and tightening fiscal expenditure. These factors have a double-whammy effect in hurting the IT industry, which had weathered the COVID-19 storm relatively well. Additionally, export duties and bans play a significant role in harming metal exports. The metal industry, which had done well, now faces growing pressures from trade restrictions imposed on it. Therefore, it will be challenging to benefit from the depreciating exchange rate.

The increase in exports due to depreciation acts as a stabilising factor for the currency, without which the depreciation could be more potent. Furthermore, higher interest rates also affect the cement industry, which thrives in a low-interest rate regime. Cement companies will face muted demand due to higher rates and higher costs due to rising fuel prices.

The automobile industry is another sector that benefits from a low-interest rate regime. Higher import costs combined with a high interest rate act as headwinds in the automobile industry.

These factors, however, are excellent indicators for the investor as they signal lower prices ahead.

Investors should currently sit tight and wait for further developments in the next few months, avoiding any bouts of investment while passively indexing.

In times like these, it is essential to remember a quote by Baron Rothschild (a formidable 18th-century banker), “buy when there is blood in the streets”.