Fed Rate Hike and what Indian Investors can do about it

A lot of noise is being generated these days about the much-awaited US Federal Reserve’s Rate Hike. In fact, I had been adding to that noise indirectly as I was working on a client’s research project, where I had to analyse the impact of possible rate hike on emerging markets among few other things. So now as I am through with my report, I am sure it will be used further to create more noise. 😉

While doing my report, I decided that I will also share my thoughts here, about how a common (long-term) investor needs to think through this development.

As of today, many in India are trying to predict the following:

• Will Fed actually increase rates?
• How much will it increase?
• What will happen to Indian markets after that?

For common investors, there is not much they can do about the above 3 questions, unless they can somehow influence Fed’s decision. But that I assume will pull them out from the crowd of so-called common investors and put them among US policy influencers. 🙂

Caution: Basing your buy/sell decisions on macroeconomic scenarios alone is not right. But ignoring them altogether is not a wise thing either. So if there are chances that a stock, which you are ready to buy at Rs 200 today, will be available for Rs 180 (with no change in fundamentals, atleast broadly speaking) – then I think that you should give a serious thought to staggering your purchases to get a lower buy price. Isn’t it?

I know it sounds like trying to time the market, which is not advisable. But please do hear me out. I am trying to put in place a framework to think through such developments.

Now frankly speaking I cannot analyse the coming Fed rate hike. I am no rockstar economist like our beloved Mr. Rajan. Also, I have absolutely no way of knowing whether Fed guys will even hike rates or not. Its possible that just at the last hour, they might decide not to do it for another quarter or so (in view of say, any last-minute developments).

There are known-unknowns and then, there are unknown-unknowns. So we can never be sure.

But general consensus is that rates will be hiked. And chances of this hike coming through by mid-December are high. As far as impact of this is concerned, there is a perception that is clearly evident from headlines like these in business newspapers:

‘D-Street fears a volatility spike on uncertainty over Fed Hike.’

‘Markets too fall more post Fed rate Hike.’

Now what actually happens when Fed hikes rates?

This simply means that money which was easily available in US and flowed into emerging markets like India, will not be available that easily. According to an article I read recently,

…the US Federal Reserve has resorted to various measures to pump in liquidity in the economy [after the credit crisis]. Three rounds of so-called Quantitative Easing (QE) failed to bring in the required impact on the economy. Though the Fed has withdrawn the QEs, they kept the ‘easy money’ tap open by keeping interest rates near zero. Money was available for free to conduct businesses in the USA. But most of the money was channelized into equity markets and that too in riskier assets [like emerging market equities]. So if interest rates are increased, access to this easy money will become costly. Chances are that inflow of funds will reverse if interest rates are increased…

Now a rise in interest rates in US is expected to further strengthen the dollar. A stronger dollar is expected to attract money back from other markets. Among all recipients of this easy money, riskiest are the ones in emerging markets like India. Hence the first markets from where allocations will be withdrawn will in general, be emerging markets. The recent pullback by FIIs from Indian markets indicate this. Infact, selling by FIIs in last few months have been highest since 2008 crisis (source).

But here is a counter logic. The recent outflow can also mean that a larger part of the so-called ‘hot money’ has already moved out of India in anticipation of rate hike.

Quite possible…

Hence when Fed does increase the rates, then one very important thing which will be removed is the uncertainty – about whether rates will rise or not.

This removal of uncertainty is quite important.

Think of it in personal terms as well. When you don’t have a doubt, your decision making changes. For example: When you pay toll for using a good expressway, you are sure that the roads will be in good condition and free from potholes. Its very easy for you to then take a decision to drive fast (even exceeding 150 kmph).

But if you have this nagging doubt that roads might be bad, you will stay cautious and drive accordingly.

So when uncertainty about rate hike is gone, chances are that investors might take a fresh look at emerging markets, especially India. Interestingly, emerging Asian markets, witnessed one of the best bull runs ever (2004-2007) and it was aided by FII inflows amid rate increases by guess who, the Fed. 🙂

I personally think that India is well placed here. Though we have been wrong in underestimating India’s structural problems and overestimating new government’s ability to solve them*, its quite clear that India’s growth story is still intact. Atleast I believe in it (or else, why will I continue investing in Indian stocks). Think of it in another way. No matter how much the Fed raises rates, India’s growth story will still make it a compelling option as an asset class. So if you are a FII, then even after rate hikes, you will still think about putting money in investments which have a bright future and growth potential. Isn’t it? So sooner or later, India will come back to your investment radar, when dust and noise due to Fed rates settles down.

* It is another matter that due to its very nature, markets ran ahead of the fundamentals and performed quite well till July 2015. But when the realization that things at economic front are not as rosy as expected occurred, markets decided to come down. Result is that we are down almost 15% in last 6 months. It seems funny now that stock prices are correcting as earnings are not meeting expectations. But when it all started after election results, it seemed so obvious to everybody that thing will turn for the better in matter of months. People forgot that we are a $2 trillion economy where 1.2 billion people live. We are huge on all parameters. Things don’t happen quickly here. Only opinions are formed quickly here. 🙂 And don’t forget that when earnings fail to meet expectations, many will look for external factors like Chinese slowdown, rate hikes, etc. to put a blame on. As investors, its our responsibility to see through all this. Its tough. But it needs to be done.

I also feel that things like Fed rate hikes, Chinese slowdown, etc. get much more weightage than they deserve. The bigger risk is the risk of reforms not coming through. Things like power sector reforms (and ofcourse their linkages to bank NPA problems), GST rollout, etc. are bigger concerns here.

Then, there is another less discussed scenario. Most people are focusing on impact of hot FII money invested in equities leaving India. But if dollar further strengthens against rupee post the rate hike, then chances of money invested in debt market leaving India also rise. With RBI reducing rates and Fed expected to increase it, the differential between the two will reduce eventually and might kick in more outflows from India. I am not so sure about its actual impact. Its like a known-unknown for me. 🙂

But having said all this and as clear from above few paragraphs, we cannot be sure of anything.

Seriously. Anything can happen.

But we need to be aware of broader happenings around us and how various economic factors interact with each other to effect us.

So will Fed rate hike lead to market correction? The answer is that its possible and seems logical. But I am not very sure as to how much more money will exit India – I am no FII ;-). Having said that, I also have this nagging feeling that fears here are overdone. There is bound to be some volatility (hopefully on lower side so I get to buy more shares at lower prices). But I think that our country is well placed to deal with any short-term market volatility.

I may be wrong in my lines-of-thought above and infact, might look like an idiot if things don’t pan out as they should, according to theoretical thought processes (used above). But when it comes to financial markets, is there anything which happens as per our expectations? You know the answer very well. 😉

In this discussion of predicting and analysing future events, I remember Buffett’s remark in his letter to shareholder in 1992:

We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

So as per Buffett, I am a 30-year grown up, behaving like a child here. 🙂

What should you do?

I love the word ‘Nothing’ when it comes to the general questions like what to do in markets. But I will not use it here. I suggest you think it through.

Thinking is quite underrated. But as Aristotle famously said:

It is the mark of an educated mind to be able to entertain a thought without accepting it.

So if you have been thinking about Fed rate hikes, then whether you agree to what I write here or not, its in your benefit to think it through more deeply.

You need to think for yourself. What will you do if this happens? What will you do if it doesn’t happen?

Here is how you can go about thinking:

You cannot control what Fed does. (Uncontrollable)

You cannot control what Indian markets do after Fed does something. (Uncontrollable)

You can control what you do after above two things take place. (Controllable)

So lets focus on YOU and what you can do.

As a long-term investor, you only invest the money that you don’t need for next few years. Right?

Great. But you can only invest when you have the money to invest. Not talking about borrowing and investing here (though you still can do it).

So you can be in either of the two situations below:

• You have cash to invest, or
• You don’t have cash to invest.

That’s it. Plain and simple.

As for the markets, it can either go up or go down. Lets ignore the does-nothing for simplicity here.

So we only have 4 possible outcomes:

• You have cash. Markets go Down: I get to buy shares at reduced prices. (You win)
• You have cash. Markets go Up: You get small returns on holding cash, and lose out on possible capital gains had you invested earlier. (You don’t win)
• You don’t have cash. Markets go Down: Nothing to worry. Life goes on (but You don’t win)
• You don’t have cash. Markets go Up: You make paper profits. But you don’t get to buy more shares cheaply. (Not sure whether you win or you don’t lose – depends on individual)

You can further think on those lines and do a deeper analysis. But at end of the day, it will depend a lot on whether you have the cash to invest or not, or to simply put on your personal financial situation.

It will be safe to say that you would not be investing even when markets have gone down lower because of fed rate cuts, if you have a strangulating loan EMI to service.

So its more about You than its about Fed.