Ever since the Reserve Bank (RBI) has started trimming the cash reserve ratio (CRR) (down 125 basis points in 2012 so far), markets are increasingly factoring in a reversal in the high interest rate cycle. Experts, though, are divided about the timing of the cut in the repo rate (at which it lends to banks), on whether to do it now or in June. Though concerns, such as high crude oil price (which may keep inflation firm), will weigh on the regulator’s mind, slowing growth is now pinching all sections of the economy, thus making a strong case for rate cuts. Irrespective of what RBI does this time, there are opportunities for investors to gain from, though a selective approach is imperative.
Repo cut?
While the consensus expectation is that RBI will cut the repo rate by 25 basis points (bps) on Tuesday, the opinion is not unilateral. Sanjeev Prasad of Kotak Institutional Equities says, “RBI may cut repo by 25 bps on April 17, which is in line with market expectations. While some sectors would gain, issues such as weak demand, non-performing loans and policy inaction will restrict strong uptick in stocks post a 25 bps cut.”
Nirmal Jain, chairman of IIFL, says, “We expect RBI to start cutting rates by 25–50 bps soon. A rate cut will be the strongest trigger for positive movement in the market.”
| UPCOMING RATE CUT CYCLE: TOP PLAYS | ||||
| Returns (in %) | 16-Apr closing | 1 year | Since 23-Jan | Since Mar 7 |
| L&T | 1,302 | -24.7 | 1.9 | 5.2 |
| GMR Infra | 29 | -30.5 | 6.2 | 8.4 |
| IRB Infra | 192 | -10.2 | 19.7 | 13.0 |
| YES Bank | 369 | 11.9 | 20.5 | 9.3 |
| DLF | 200 | -18.6 | -9.0 | -0.1 |
| Bank of Baroda | 791 | -19.5 | 2.0 | -0.1 |
| Sobha Developers | 337 | 14.2 | 37.9 | 25.6 |
| Tata Motors | 300 | -75.7 | 37.2 | 12.1 |
| ICICI Bank | 873 | -20.7 | 1.8 | 1.4 |
| Axis Bank | 1,197 | -16.1 | 20.1 | 2.7 |
| Source: Analysts, BSE website | ||||
| CRR CUT IMPACT | ||||
| Sectoral Indices | 13-Apr-12 | Return (%) | ||
Compiled by BS Research Bureau
However, some others such as Sandeep Singal, co-head of institutional equities at Emkay Global, differ. He says, “In our view, the rate cut is about two quarters away.”
Rate easing gainers
Although the timing of a rate cut is debatable, historical data suggests markets witness a knee-jerk rally on the day the rate is cut, and it takes one or two quarters for any sustainable rally to kick in after the first cut. Given the macro environment, wherein inflation is still sticky, this time may not be any different. Nevertheless, investors should start positioning themselves to gain from the expected reversal in rate cycle. The question is who would gain if the repo rate is cut.
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Vinay Khattar, head of research – capital markets (individual clients), at Edelweiss Financial Services, says, “The direct impact would be on rate sensitive sectors like infra/construction, capital goods and banking. Stocks like Larsen & Toubro, GMR, IRB Infra, Sadbhav, YES Bank and City Union Bank would tend to gain.” The gains, however, may not come immediately. In a report in late-January 2012 after the first CRR cut, Manishi Raychaudhuri and Gautam Mehta of BNP Paribas noted, “Our analysis of the 2001 and 2008 cycles reveals rate-sensitive stocks outperform six months after the first rate cut.”
Given that the rate cycle is close to trending down, most experts believe rate sensitives will deliver strong returns from a 12-month perspective. Abhay Laijawala and Abhishek Saraf of Deutsche Bank wrote in a January 2012 report, “With a near 19-month monetary tightening cycle expected to reverse in 2012, we believe the classical rate sensitives—banks (though the sector may have to cross the hump of non-performing loans in the near term) and real estate, together with infrastructure will be the key sectors driving Indian markets in 2012. Our top picks are Axis Bank, ICICI Bank, Coal India, Larsen and Toubro, TCS, Bharti and DLF.”
Beyond sectors, companies that are weighed down with high debt would also benefit from a cut in rates, helping lower their interest outgo.
...and strategies
Within individual sectors, the performance would differ. In banking, wholesale funded financial institutions, such as YES Bank, IDFC, REC and PFC gain the most in the initial easing cycle. This is because a large part of their funds are bulk-sourced from institutions, wherein borrowing rates get reset faster, say experts. On the retail funding side, the rate cuts are passed on with a lag effect. Likewise, in the automobile space, while two-wheeler companies benefit in the initial easing phase, four-wheeler and auto component stocks start rallying in the third and fourth quarters of the rate cut.
Experts say sustainable outperformance of rate-sensitives start only after two to three quarters after the first rate cut. That’s because the rate cuts are spread over a few months and for any meaningful gain for India Inc, the cumulative rate cut has to be 75-100 bps. From that perspective, capital goods and engineering companies tend to outperform from the second quarter (after the first rate cut). In the interim (first quarter after rate cuts), defensive sectors, such as pharmaceuticals, fast moving consumer goods and two-wheelers continue to outperform.
Among the reasons is that consumers, typically, wait in the initial period for more confirmation that economic growth will look up and sustain (pointing to job security, growth opportunity and higher incomes) and, hence, differ big-ticket purchases. Likewise, India Inc would tend to be cautious before committing funds towards capex. Global and local events in recent years, which have resulted in a sharp downturn, with high interest rates, are still fresh in the minds of India Inc and consumers.
What’s also important is that the last two rate cycles were not similar. The first one (2001-2007) saw a gradual cut and rise in rates, while rate cuts and increases were faster in the 2008-2011 cycle. The second cycle also coincided with the return of investors’ risk appetite, which presently looks uncertain. Given the sticky inflation and absence of any reason to panic (like in 2008), this rate cycle (starting 2012) is likely to see a gradual cut in rates.
Finally, after the CRR cut, many high beta stocks and those from rate-sensitive sectors have moved up from their lows, in anticipation of a reversal in the high interest rate cycle. Many have also outperformed broader markets and other sectoral indices, which indicate the gains could be restricted in the initial period.
The upside risk is if RBI cuts the repo rate by 50 bps on Tuesday, which could boost sentiments. In contrast, if it disappoints, expect the markets to react negatively.