The economy and stock markets always move side by side. In a healthy economy, there will be usually a low unemployment rate and consumers will have high purchasing power, which in turn creates more demand for goods and services. Companies will begin producing more to satisfy expanding demand, and they will begin recruiting more workers to meet rising demand. As a result, the company's profits raises. Increased earnings boost the value of the company's stock by allowing it to pay larger dividends to shareholders.
Why are Indian stock markets falling? 5 major factors at play
This cycle continues until any global or domestic factors disrupt it. And recently, one such factor that hit the world economies was Russia declaring war on Ukraine, which occurred at a time when the global economy was recovering from the COVID.
The West imposed sanctions on Russia. Due to this, commodity prices skyrocketed, causing high inflation and leaving central banks with no option but to hike interest rates.
The US Federal Reserve raised its benchmark interest rate by half a percentage point, the most aggressive step yet in its fight against a 40-year high in inflation. The 50-basis-point increase is the biggest increase the rate-setting US Fed has instituted since May 2000.
Meanwhile, the Reserve Bank of Australia lifted interest rates for the first time in a decade. New Zealand and Canada have also lifted borrowing costs.
Back in India, on May 04, the RBI raised its key lending rate by 40 basis points to 4.40 per cent with immediate effect. The central bank also raised the cash reserve ratio by 50 basis points. This was the first rate hike in policy rates since August 2018.
Indian markets have corrected by 7% since the RBI rate hike. Since then, the Nifty has dropped roughly 1224 points, or 7%, while the Sensex has down 3,969 points, or 7%.
Let's look at some of the key factors affecting the Indian Economy and Stock markets.
One of the key functions of any central bank is to maintain price stability by controlling inflation. Interest rates are used by the central bank to manage inflation. When inflation is high, the central bank often hikes interest rates to slow the economy and bring inflation down.
Data from the Ministry of Statistics and Programme Implementation showed on Thursday that retail inflation in India surged to an 8-year high of 7.79% in April, owing to higher edible oil and fuel prices. Headline inflation is now at the highest level since the 8.33% hit in May 2014.
The core inflation, which is calculated by excluding "food and beverages" and "fuel and light" from the overall inflation, shot up to 6.8% in April from 6.6% in March.
According to experts, a US $10/bbl increase in crude oil prices adds about 25 basis points to the baseline inflation rate.
Further, wholesale inflation is now at nearly the same level as it was during the 1991 economic crisis that changed India forever.
Inflationary pressures are bad for businesses and for the economy, as high inflation affects purchasing power and increases the cost of living.
During inflation, consumers purchase fewer goods, and when input cost rises, Firms' revenues and profits will fall. As a result, the economy will decelerate until stability is restored.
During these tough periods, companies will face input cost pressures which they are unable to pass on to end consumers due to lower demand.
When interest rates rise, borrowers must pay more for their loans, and some will postpone their purchases. This would undoubtedly reduce demand in the home and vehicle industries, as credit accounts for the majority of sales in these sectors. If housing demand collapses, it will have an impact not just on the industry itself but also on other industries that rely on it, such as cement, metals, consumer electronics, and even labour.
Furthermore, rising interest rates make it more expensive for businesses to raise money since they must pay high coupon rates on existing bonds. High-interest payments may also hurt their near-term earnings, which in turn may impact their stock prices.
For example, when evaluating a stock using the DCF technique, you project a company's future cash flows over the next 3-5 years and discount them at a certain rate to arrive at the company's current value (Net Present value).
Imagine the expected cash flow of a business as:
Year 1 - 10,000
Year 2 - 20,000
Year 3 - 15,000
If you discount it by 3%, the current value of the company will be ₹42,286. However, as interest rates rise, let's say the discount rate rises to 5%. In that situation, the current value of the company will be around ₹40,620.
As interest rates rise, firm valuations may fall, and stocks are expected to become less appealing to investors.
Now even for the government, it would be difficult to finance the fiscal deficit when rates are rising in the economy.
In the Union Budget of 2022–2023, the government unveiled a massive borrowing plan. The government announced a gross borrowing of ₹14.1 trillion and net borrowing of ₹11.6 trillion, both of which were significantly higher than market estimates and beyond the FRBM target level.
If the government borrows at high-interest rates, it must spend more on interest payments and less on capital expenditure.
Fed rate hikes
The Dollar is a world reserve currency, which means that each country must have some dollars in reserves in order to pay for imports. The strength of the Dollar is determined by interest rates: if the US Fed raises rates, the dollar strengthens; if it lowers rates, the dollar weakens.
Foreign institutional investors invest in Indian stocks or other emerging markets when they have excess liquidity (low borrowing costs).
When US bonds pay close to 0% interest, foreign investors look for better investments all around the world.
If emerging countries like India offers interest rates close to 6-7 per cent, Some part of the surplus liquidity will move to Indian stock markets, which in turn will strengthen the rupee.
Let's look at an example: how a change in interest rates and a weak currency will have an impact on Foreign investments.
For instance, a trader notices that rates in India were close to 6%, while they were 0-1% in the USA. This means a trader expects to profit by 5–6%, which is the difference between the two rates. In the first step, he will borrow dollars and convert them into rupees. In the second step, he will invest those rupees in Indian bonds paying interest in rupees. Assume the current exchange rate is ₹75 per dollar and the trader borrows $1000. Once the amount was converted, that would have been:
₹75,000 = $1000*75
After a year invested at the 5 per cent Indian rate, the trader has-
Ending balance = ₹78,750 (5* 75,000 ÷100)
If the exchange rate stays the same over the course of the year and ends at 75, the amount owned in US dollars will be:
$1,050 (78,750 ÷ 75), The trader makes a $50 profit from this trade. Suppose the trader pays 1%($10) interest on his initial borrowing of $1000. The net profit will be $40 ($ 1,050 - $10).
If interest rates go up this trade makes it less attractive, because investors need to pay more interest in domestic currency. Further falling rupee also affects their return on investments.
Moreover, the equity risk premium tends to go down due to high-interest rates. As a result, it makes investing in equities less attractive. Due to this, the incremental flows to equity may go down. And many more FIIs may pull out from the Indian stock market as the incentive to invest in equities remain low.
Meanwhile, foreign funds’ ownership in domestic equities fell to pre-COVID lows and hit a multi-year low of 19.5 per cent in March this year in NSE500 companies valued at USD 619 billion, according to a study by Bank of America Securities India.
FPI ownership is at its lowest level in three years, at 19.5 per cent in March 2022, compared to 19.3 per cent in March 2019 (pre-COVID period).
Foreign funds’ ownership in the domestic equities was at 18.6 per cent in December 2017, the lowest in five years, and the peak was in December 2021, when they owned 21.4 per cent of domestic equities.
Furthermore, Goldman Sachs expects FPI flows into India may remain weak in 2022, which now forecasts $5 billion in foreign portfolio investment into India in 2022, down from their previous prediction of $30 billion.
The rupee hit an all-time low of 77.63 against the US dollar on Thursday. A weak rupee always makes imports costlier. The biggest impact of a weakening rupee is on imported inflation.
India currently imports more than 80% of its crude oil. Oil has been trading around $100 a barrel since Feb, and a weak rupee further adds inflationary pressure.
A depreciating rupee might also cause the CAD to rise. In the absence of dollar inflows from foreign investors, a bigger CAD could force India to delve into its foreign exchange reserves to pay the deficit.
Experts believe that even if global crude stabilises at around $100 per barrel, India’s current account will go beyond 3 per cent of its GDP.
Furthermore, India imports edible oil, fertilisers, and consumer electronics from foreign countries. Prices for the items are at all-time highs. If the rupee falls more, it will lead to more inflation.
In addition, the domestic fertiliser industry is largely dependent on imports to meet its raw material requirements for both urea and finished fertilisers. The government provides a subsidy on urea. So, if the value of urea imports increases, the subsidy burden on the government will rise too.
Fertiliser subsidies are pegged at ₹1.4 lakh crore for the current financial year and at ₹1.05 lakh crore for 2022-23.
However, a weakening rupee benefits a country’s exports as exporters get more value for the same amount of goods that they export in dollars.
Indian industries like software and textiles, where the dependence on imported raw materials is limited, could actually benefit more from the rupee depreciation.
The country’s merchandise exports during the April-February period stood at $374.05 billion, a jump of 45.80 per cent over $256.55 billion in the year-ago period.
A weaker currency would also increase the cost of imports for Indian consumers while making home-grown products relatively cheaper. As a result, certain domestic enterprises that are facing intense competition from cheaper imports may profit.