Interest rate hikes are not necessarily bad for the equity market

Interest rate hikes are not necessarily bad for the equity market if past experience is anything to go by, feels Mr Nandkumar Surti, Chief Investment Officer, J.P. Morgan Asset Management India. In an interview with Business Line Mr Surti gives his opinion on the short-term concerns in the equity and debt markets and the opportunities the latter offers currently.

Excerpts from the interview:

Have the inflationary/interest hike concerns and credit crisis in certain European economies affected fund flows into emerging markets?

In the short term, the developments in Europe will affect the fund flows to the emerging markets. By and large, Asia will adopt the interest rate normalisation process in the course of CY2010. This is likely to be non-disruptive for most of the markets. What one has to realise is that we are seeing a much better growth in the Asia region as compared to the rest of the world. We believe that once the current crisis is resolved, one should see money chasing growth economies and India along with China is obviously the fastest growing economies.

Even as earnings hobble to normalcy, higher raw material costs and interest rate hikes could be threats once again to corporates. Do you believe the turnaround could be short-lived?

Rising input costs as growth finds a stronghold is obviously something which corporate India will have to contend with. In general, we have seen raw material costs rise and margins compress. But this is likely to be compensated by a gradual rebound in volumes.

Also, as mentioned earlier, we see the interest rate reversal more as a rate rationalisation process rather than a tightening. We see liquidity conditions to be, by and large, comfortable. Even though the RBI will start raising the repo/ reverse repo, we see lending rates, by and large, stable as spreads continue to be very attractive.

There could be some short-term pressures in the first half of the next fiscal on account of the borrowing programme. But that presents more of an investment opportunity on the bond side.

Do you believe that the market has fully factored in inflationary concerns, monetary tightening and the impending rollback of stimuli?

The worst expectations on the street are a close to lower double digit on inflation. The bond markets are more concerned about the imminent government bond supply rather then the rate increase. We expect the government borrowing programme as well as rate hike to be front-loaded in FY2011. Liquidity mismatches amidst higher supply could put some pressures on rates.

However, we see the bond markets at the short end of the curve aggressively pricing in rate hikes of close to 150 bps in the next year. We see this as an investment opportunity. We have seen in the past that interest rate hikes are not necessarily bad for the equity market.

An ascending interest rate scenario can spell trouble for long term debt funds?

We see interest rates more a function of high government bond supply rather then the fear of RBI rate hikes. 10-year government bonds could trade in the range of 8-8.25 per cent in the first quarter of FY-11 on the back of the large supply.

However, we see lot of value in corporate bonds in up to three-year segment where we see bonds trading at a much higher spread compared to our assessment of RBI rate hike.

With improved performance by corporates has the risk perception of corporate bonds come down?

In the worst of 2008, we have seen only a few corporates being affected by the liquidity/ credit crisis. This is largely on account of the derivative/ forex exposure of these corporates. With improved fundamentals, good local and internationally liquidity, we see the worst for the corporate bonds to be over.

With narrowing credit spreads, does corporate bond market offer good investment avenues for debt funds? What is JP Morgan's strategy with its debt fund?

AAA Corporate bond spreads have narrowed in the bench mark 5 and 10 years. In the segments up to 3 years, we see bonds trading at much higher yields on account of temporary factors like CRR hike and impending traditional March tightness. We see value in these segments.

What should a debt fund investor's strategy be at this point in time?

We are advising our clients to increase asset allocation to short-term bond funds. A short-term bond with high current cash exposure stands a very good chance to build portfolio for next 3-6 months by taking advantage of the current high short-term rates. We believe that investors should avoid long bonds for the next three months and wait for more clarity on the borrowing calendar and the RBI's April Monetary Policy Review.

Q What is your reading of the Q3 earnings in India? Have valuations run ahead of earnings growth?

The aggregate financial performance of corporate India for the quarter ending December 2009 was in line to a little better than expected. Excluding oil PSUs (where quarterly data can be misleading due to subsidy etc.), operating profit of Sensex companies rose about 22 per cent YOY, about 1 percentage point higher than estimates. Net profit for Sensex companies rose about 17 per cent YOY, 2 percentage points higher than estimates. A broader universe of corporates delivered faster growth with aggregate operating profit rising 34 per cent YOY (higher by about 3 percentage points) and net profit by about 26 per cent YOY (in line).

With the correction in the equity market from the middle of January we believe that valuations are actually starting to look reasonable. With more evidence of accelerating growth emerging we would expect market to get valuation support in case it continues to correct owing to external or macro factors.

Q. Can India Inc's revenue growth be said to be back on track? Is the growth indicating volume as well as pricing power traction?

GDP for current fiscal is expected to grow at 7.50 per cent and for FY2011 at 8-8.50 per cent and inflation at an average 6 per cent. Given this, a 13-14 per cent nominal growth of the economy is expected. Within that one can expect better managed companies to post a 20-25 per cent earnings growth. Some of the growth we have seen in the last 6-8 months has obviously been aided by the fiscal and monetary policies in India. We have seen latest IIP number at 16.8 per cent, with a sharp upward movement in the index itself. This is a very positive sign. We see fiscal and monetary environment to be reasonably conducive to growth. While we see volumes coming back, we think that corporate India would allow volumes to pick rather then look for aggressive price increases.