Will lower rates boost equity returns?

Theoretically, there is an inverse relationship, but other factors need to fall in place for it to work well this time

Historical evidence and financial textbooks suggest a link between the trend in long-term interest rates and market valuations. As interest rates fall, many companies tend to save on interest costs. Lower interest expenses apart, lower interest rates also induce higher spending, leading to job creation and more demand, in turn boosting revenue growth. And, all these results in higher corporate earnings and stock valuations. However, it is easier said than done but experts only agree though with some caveats.

Sunil Singhania, Chief information officer (CIO)-equity investments, Reliance Capital Asset Management Limited, says, "There is a co-relation between interest rates and earnings and price to earnings (PE) but it is not necessary that it will be one-to-one. Even in the past, when interest rates have come down, PE and earnings have gone up and vice versa but when it will happen is something that can be predicted."

Ajay Bhodke, chief executive officer and chief portfolio manager - PMS, Prabhudas Lilladher, has a similar view. "The past is proof that earnings and valuations get positively impacted as interest rates fall. This time too we should see gains. But this time it is a bit complicated given that global demand is anaemic and the domestic investment cycle is at an early stage of recovery."

Experts believe a meaningful improvement in demand is a pre-requisite for rise in corporate earnings and PE valuations.

Nitin Bhasin, head of research, Ambit Capital, adds, "While this relationship exists in the textbook description, actual situation is different. Whenever rate cuts have led to meaningful demand push, corporate earnings and price to earnings ratio have improved".

Higher growth in earnings typically positively impacts return on equity (ROE) of companies. As the ROEs go up, the market valuation (PEs) also tends to get re-rated upwards. Bhodke says PE valuation is a function of multiple factors, but ROE is among the key factors that drives the valuation up or down. He adds, "What we need to ensure is that free cash flows (from operations after working capital changes and minus capex) should also improve. Astute investors look at free cash flows, as it determines the real financial health of any company." Lower rates also make debt instruments less attractive and consequently, certain sections of people start gravitating towards instruments like equities for higher returns, which also helps expand valuations or prices.

  But, the stage is not yet set for expansion in valuations. Currently, the state of the economy is feeble even as it is growing at the fastest pace in the world. Compared to the 2001 and 2005 (end) period when the interest rate cycle moved south remained benign for some time, corporate India delivered strong earnings growth and the market PE surged from a low of 12.6 times to over 25 times (see chart), though with some lag. So, there was a multiplier effect of earnings growth and valuation expansion. Data show when the repo rate is at or above eight per cent, valuations seem to take a hit, whereas when repo rate is around six per cent, valuations look up.

This time, many world economies (like US, China and Europe that were growing fast) are in bad shape or slowing down. So, the growth in earnings for Indian companies (given that exports forms about 15 per cent India's gross domestic product and many companies now have large exposure to global markets) is unlikely to see a swift increase. There are other issues as well.

Bhasin explains, "We don't see rate cuts alone changing, economy in a big way. A large amount of debt is sitting in the books of infrastructure or commodities/metals companies. Will the banks cut rates for these companies? I don't think so. Long-term demand is not there. The rate cut will improve sentiments, though. We need better transmission to have a positive impact. We believe economic weakness is a larger factor in near term the given the high demand uncertainty." Moreover, even if transmission improves, rate cuts can 'aid' demand but can almost never make-up for the absence of households' desire to spend or corporate sector's desire to invest, he adds.

But over a period of time as and when India's GDP growth picks up, domestic-focussed companies will stand to gain.

Bhodke says, "Interest rate-sensitives like banking, financial services and insurances (BFSI), capital goods and construction, auto ancillaries, and those investment plays (which are capital-heavy) will be among key beneficiaries of a downturn in interest rate cycle."

Bhasin believes good companies in cement, automobiles with large capacities and negligible debt stand to gain.

Notably, interest coverage ratio (Ebitda/interest cost) of Indian companies has halved from 8.6 times in the March 2010 quarter to 4.5 times in the June 2015 quarter, indicating increased pressure from both weak demand and higher leverage. This metric stood at a peak of 12 times in the March 2006 quarter.

Going ahead, any meaningful gains will come only in FY17. Mahesh Nandurkar, executive director, CLSA, says, "The inverse correlation between PE and interest rates usually requires time to unfold. Banks have already cut lending rates by about 50 bps year-to-day and we expect another 100 bps of lending rate cut over the next 12 months. This should improve interest coverage ratio. Given the low base, corporate earnings performance should improve on a year-on-year basis from December quarter. But a genuine improvement is unlikely before FY17."