US Fed may cut rates this month; here's what it means for Indian equity markets, investors

The impending rate cut by the US Federal Reserve this month is expected to mark the onset of a new phase in monetary policy and market movement. In theory, lower rates should lift equity valuations. However, history shows that equities suffered large drawdowns in 2001 and 2007–08, and were flat in 2019, times when interest rates were at historic lows. Several analysts believe the US central bank may cut rates by 25 basis points at the US Fed’s September 17-18 policy-setting meeting. However, ING thinks the US Fed will go for a 50 basis points rate cut.

The benchmark NSE Nifty crashed nearly 40% between February 2000 and December 2001 when the US Fed lowered interest rates by a total of 5.25 percentage points with steady rate cuts throughout 2001. During the initial rate cuts in Q4 2007, markets—particularly Nifty and emerging markets—jumped, rallying more than 30% in three months. In 2008 though, they shed all the gains and more with the Nifty correcting 60% from the end-2007 level.

Why did the benchmark equity index decline after the rate cuts and can investors expect now? Nuvama Institutional Equities explained that this is because rate cuts usually lag an earnings slowdown. Essentially, EPS (earnings per share) downgrades and weak growth outlook more than offset tailwinds from lower cost of capital. It’s only when rate cuts are deep (and valuations cheap) that they have a healing touch. “The previous two of three cycles ended in recessions,” it said in a report.

How can investors position their portfolios? The brokerage added that delayed rate cuts have hurt expensive pockets the most in past—Nasdaq and Indian IT in 2000-01 and emerging markets as well as domestic cyclical in 2008.

“Today, Indian mid-caps and cyclicals (autos, PSUs, industrials, metals) are such pockets—with decadal-high valuations—we are large underweight [on]. We maintain a defensive bias (overweight on consumer, telecoms, pharma and insurance). The private banks space is our only key cyclical overweight given its large underperformance, cheap valuations in a very expensive market and narrowing earnings differential with the broader market,” Nuvama said.

The financial services firm also said that many US labour market indicators (full-time jobs and hiring rate) are at levels indicative of a recession, domestic demand is weak (BSE500 top line sub-10%) and valuations are elevated. This warrants caution.

Explaining the fall of 2001 and 2007-08, Nuvama said that in 2001, the US Fed rate cuts were delayed (nine months after Dot-com Bubble burst). Furthermore, domestic demand was weak (BSE500 top line below 10%). Hence, Nifty fell sharply in 2001. In 2007, when the Fed cut rates domestic/EM demand was booming even as the US economy slowed—driving a 30% jump in Nifty during initial cuts. But high valuations and global financial crisis caused a crash in 2008. In 2019, the Fed pivoted in a timely manner (US yield curve had not inverted; labour market stable) and broader markets had de-rated in 2018. Thus, rate cuts were effective.

What to expect now? Nuvama added that in 2007, demand in all emerging markets was very strong and so were commodity prices till the very end of the cycle. “This time around, such buoyancy is completely missing and with domestic earnings also slowing, we think reconciliation with global will likely occur sooner than later,” it said.

If one looks at the current market performance, there has been a strong rally in markets over the last year, particularly in mid-caps. “This is similar to what we had seen in the 2007 cycle where there was a strong rally led by cyclical,” said Nuvama. However, it added that it must be noted that, unlike 2007, fundamentals of India Inc. are significantly better marked by strong free cash flows and non-leveraged balance sheets. This should smother some of the cyclical issues.

“Overall, the global backdrop is deteriorating and the Fed could be already delayed. Furthermore, fading earnings support and elevated valuations cloud the market outlook. This warrants a cautious approach,” said Nuvama.