Impact of Inflation on the Stock Market: ETMarkets Smart Talk: Pradeep Gupta highlights 3 ways the Fed hike and inflation could affect Indian markets

“Rising inflation and aggressive monetary tightening by the US Federal Reserve are having a negative impact on global equity markets,” he says Pradeep Gupta – Co-Founder and Vice Chairman of Anand Rathi Group.

In an interview with ETMarkets, Gupta said, “The Indian stock market cannot remain unscathed as global stock markets correct. Therefore, rising inflation and aggressive Fed tightening are also having a negative impact on the Indian stock market.” Edited excerpts:

Benchmark indices tested key support levels in May and weakness continued into June. In between we saw some swings. What are the immediate threats to watch out for?

Global markets remain volatile. The Indian markets are also on a similar path, however, the drawdown percentage in the Indian markets is not as high as in the global counterparts.

The Nifty50 has corrected by over 5 percent in the current calendar year, with volatility continuing through May and June.

Some of the main reasons for this continued volatility are worries about the Russia-Ukraine conflict, decades of high inflation, supply chain issues, rising input costs that are hurting margins, and tightening demand.

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Rising inflation and the consequent tightening of monetary policy are affecting the stock market through three main channels.

• First, they increase financing costs for companies and therefore negatively impact company margins.

• Second, in order to successfully lower inflation by tightening interest rates, it is essential that such measures reduce demand. This in turn implies lower corporate profits.

• Third, an increase in interest rates, and hence the risk-free rate, implies a higher discount factor for future corporate profits. This leads to a lower company valuation.

From all these perspectives, rising inflation and aggressive monetary tightening by the US Federal Reserve are having a negative impact on global equity markets.

As previously mentioned, the Indian stock market cannot remain unscathed if global stock markets correct.

Therefore, rising inflation and the Fed’s aggressive tightening are also having a negative impact on the Indian stock market.

In my opinion, however, the financial markets have already priced in a large part of the effects of high inflation and rising key interest rates.

How do you view small & mid-caps after the recent decline?

While mid- and small-caps underperformed large-caps for a number of years prior to the pandemic, these companies have since outperformed.

In the medium term, we see their prospects as positive. In the near term, however, the outlook does not look particularly encouraging as investors remain risk averse towards stocks with high levels of volatility.

Moody’s Investors Service and now Fitch revised their GDP forecast. Do you think this is a harbinger of the recession most feared?

Significant uncertainties currently exist, particularly on the global front, and these factors are negatively impacting equity markets.

The Indian market cannot remain unscathed if global markets correct. As a result, we can expect some volatility in Indian equities in the near term as well.

At the same time, I believe that the three key equity market drivers – fundamentals, liquidity and valuation – are either attractive or neutral for Indian equities.

Therefore, even if the Indian stock market corrects in line with the global market in the short term, I expect the Indian market to recover faster and more significantly than most. The medium to long-term prospects for the Indian market remain positive.

How do you view the consumption issue – do you think it could take a hit given rising prices and a potential fall in demand?
Indian equities are attractive due to their growth prospects. I prefer growth stocks over others. Some growth stocks, such as those in the capital goods sector, can also be leveraged.

Which sectors can be safe bets in a rising interest rate scenario and rising inflation?

Stocks as an asset class are very volatile in the short term. Still, risk-adjusted longer-term returns on stocks are generally much higher than any other asset class.

This simple fact is often ignored by investors, resulting in significant losses from speculation and attempts to time the market.

So I believe the biggest hidden opportunity is staying invested in equities in the face of near-term negative market sentiment and corrections.

We are positive on sectors such as information technology, telecoms, cement, capital goods, logistics, infrastructure, energy, hospitality and media.

Foreign Institutional Investors (FIIs) turned their backs on the Indian markets but poured money into IPOs. What are your thoughts on when the tide will turn? What is pushing FIIs away from India and is it the same for other Emerging Markets (EMs)?
FIIs withdrew about $2.2 billion from the Indian equity market in April, much less than a net withdrawal of about $5.4 billion in March. However, the sale was largely absorbed by domestic institutions, which were net buyers of ~$3.9 billion in the month of April.

The US Federal Reserve has hiked interest rates to control inflation caused by supply chain disruptions due to the Russia-Ukraine war, the impact of Omicron and other factors that caused inflation to surge.

The rise in US interest rates is causing foreign investors to withdraw money from emerging and risky markets and invest in safer markets in the US like debt funds.

What are your calculations in terms of earnings for the coming quarters? It looks like we may see more earnings downgrades versus upgrades and the whole earnings revival theory could take a hit. What are your views?
Indian companies are also confronted with isolated inflation and higher cost pressures, which will affect profits in the short term. Some companies/sectors will be selective.

Indian equities are attractive due to their growth prospects. Nifty 50’s earnings growth over the past fiscal year has been nearly 100 percent. The consensus appears to be expecting flat earnings growth of up to 10 percent over the next 12 months.

We believe there is more positive than negative earnings surprise possible in this timeframe. On a trailing basis, Nifty50 is currently trading at 20x price-to-earnings.

This is the average that prevailed between 2011 and 2015, and at a significant discount from what prevailed between 2016 and 2021.

With this in mind, I would argue that while Indian equity valuations are not cheap, they are not very expensive either.

How should you structure your portfolio in terms of equity and debt? Is it time to slightly underweight equities or remain neutral?
I believe in strategic portfolio allocation, where the primary decision is asset allocation between competing asset classes such as stocks, debt, fixed deposits, real estate, gold, and various other assets.

Equities are one of the most attractive asset classes for long-term investors. In the short term, however, stocks are very volatile. Therefore, the equity allocation should be made over a longer period of at least three years.

The stage of the interest rate cycle certainly has some implications for returns across asset classes. With that in mind, a rising rate cycle should require some portfolio adjustment.

However, when it comes to strategic asset allocation, the focus is on expected returns, willingness to take risks, the cash flow situation and the investment horizon of the individual investor.

Once the portfolio is built based on these factors, the need to optimize the portfolio based on the business cycle is not essential. It is widely believed that in a rising interest rate cycle, the interest rate sensitive portion of the stock market and bonds underperform.

However, other macros and company-specific situations decide the fate of individual securities. I still believe that the ideal framework for asset allocation is a strategic approach that incorporates the key considerations of individual investors and leaves the portfolio largely unchanged despite short-term market volatility, including the phases of the interest rate cycle.

By staying the course and diversifying your asset allocation strategy, you can help protect your overall investment portfolio from volatility and generate higher alpha over the long term.

(Disclaimer: Experts’ recommendations, suggestions, views and opinions are their own. These do not represent the views of Economic Times)