monetary policy: here is how a stricter monetary policy could have an impact on the valuation of your share

Foreign Institutional Investors (IFIs) have become relentless sellers of Indian stocks in the face of emerging global risks. The group unloaded more than $5 billion in January alone.

To take a step back, Indian stock markets have seen a linear rise since the low reached in March 2020. The main reason for this rapid recovery was the “extraordinary” fiscal expansion and monetary stimulus that developed countries provided as a countercyclical strategy. in response to the pandemic-induced slowdown in economic expansion.

The world’s top 10 central bankers after increasing the size of their balance sheets from $7 trillion to $20 trillion before the pandemic – in response to the 2008 global financial crisis – quickly increased it to over 30 trillion dollars in response to the Covid-19 pandemic. Some of that easy money obviously ended up in several assets, including stocks. It is therefore no surprise that all global equity markets have been trending towards new highs with the Indian market following the global trend.

In short, historically high levels of money supply at near-zero interest rates have been the main driver of the stock market rebound during the pandemic.

But there are consequences to such an extraordinary increase in the money supply, namely inflation.

The December 2021 reading of US CPI inflation was 7% and the nominal fed funds rate was effectively at zero. This translates into a real funds rate of -7%, an all-time negative real rate record.

But the U.S. Federal Reserve has woken up to rising inflation and, at its last meeting, abandoned its dovish stance and turned hawkish, signaling a faster and sharper-than-expected rise in interest rates while simultaneously reducing its asset purchases to zero by next March to prevent inflation. to take root. This means, in effect, that the US central bank must begin to normalize or tighten its monetary policy.

However, how much and how fast Fed tightening will remain a blind spot for the market. Such uncertainty coming at a time when equities were celebrating new highs means a stock market reset to the downside.

Add to that inflation calculations and escalating geopolitical tensions around Ukraine that send oil prices to record highs. Additionally, persistent supply chain bottlenecks and skyrocketing rates of Omicron infections are pushing prices of key commodities to higher levels amid strong demand.

Indeed, these factors aggravate the inflationary concerns of the Fed and the markets.

The effect of inflation is also reflected in corporate earnings globally and in India as well.

With demand remaining weak in several pockets of the Indian economy, companies have been unable to pass on input price increases to end consumers. Higher inflation also translates into lower corporate profits for a select group of companies. This will lead to a downward revision of corporate earnings estimates going forward.

Tight monetary policy also means higher interest rates translating into lower price-to-earnings (P/E) ratios for companies as their cost of capital and borrowing costs will rise.

FIIs are indeed concerned about whether the main trend driver, which is the easy money policy, which is coming to an end, will erase equity market gains since March 2020, at least in part. Investors should therefore assess the impact of inflation, changing monetary policy stance and economic dynamics as the situation evolves.

The withdrawal of stimulus funds, rising policy rates and rising prices are the main downside risks to equity markets and investors should be cautious about this.

National Opportunity
Domestic investors, however, see the glass half full. They see an India that is a $3 trillion economy, recording the fastest economic growth in the world, on the cusp of a new cycle of credit and profit growth. They believe FIIs sold as much as they could and yet Indian stock markets rose, thanks to domestic liquidity. Now, if inflation turns out to be transient, then India would be the most coveted country to support and the FII funds would flow back to India.

It would be safe to say that the markets are at a crossroads. The direction of Indian equity markets depends on how inflation, especially in the United States, moves and, therefore, how fast and how deep the global monetary stimulus reverses.

(The author is MD & CIO – ITI Long Short Equity Fund. Opinions expressed are personal.)

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