Nifty Slips on Negative Global Cues Amid the Concern of a Higher Fed/RBI Rate

India’s benchmark stock index slips to around 18209.80 in the opening trade Monday, down by almost -140 points on negative global cues amid the concern of a higher Fed terminal rate. Nifty stumbled from a new lifetime high of 18442.15 scaled barely a few days ago amid hopes & hypes of a Fed/RBI pivot coupled with an upbeat report card (Q2FY23).

Overall the U.S. economy is now slowing down. But still, the U.S. employment is now almost at Fed’s maximum level (despite some cooling), while inflation (core CPI/PCE) is still substantially above the Fed’s price stability target of +2.00% (without any meaningful sign of cooling). Moreover, UM 1Y inflation expectation continues to hover above +5.00%, almost double the average pre-COVID rate. Fed needs 1Y inflation expectations around +2.75% consistently for its +2.00% price stability mandate. The primary objective of the rapid Fed tightening is to first bring 1Y inflation expectations back to pre-COVID or even 4% consistently so that the inflationary mindset will change for both consumers and producers and actual inflation comes down. But that’s not happening despite a series of jumbo hikes by the Fed as the real rate of interest is still negative (even considering average core inflation). Fed is still much behind the inflation curve, especially after market expectations of a Fed pivot in the coming days.

Thus Fed is now jawboning the market for a real positive rate, at least wrt average U.S. core inflation (CPI/PCE) of +5.50%. Fed is now preparing the market for a slower rate of increase, but higher for longer. Fed will now focus on an appropriate terminal rate, restrictive enough (real positive) to bring down inflation towards the +2% target over the medium term. When the cost of borrowing turns real positive or there is an elevated cost of capital, overall economic activity/demand bounds to slow down, leading to lower inflation (as lower demand will try to catch up with the constrained supply capacity of the economy).

The market is now expecting Fed will hike +50 bps on 14th December to +4.50% and then another 50-100 bps by Mar’23 to 5.00-5.50% depending upon the actual core inflation trajectory. Fed is now preparing the market for a possible series of smaller hikes (50 bps) and pauses down the road after reaching around +5.50%. But Fed is also confused about levels of an appropriate terminal rate and may start the debate in the December meeting to take a firm decision with a fresh SEP. Fed may go from meeting-to-meeting to a QTR-to-QTR approach in 2023 after Q1 in rate actions if required further hikes. Fed may keep the terminal rate around +5.50% for at least 2023 to bring down core PCE inflation back to +2.00% on a sustainable basis.

There is also a need for supply-side reform to lower inflation. But unless Russia-Ukraine/NATO war/proxy war, geopolitical tensions, and subsequent economic sanctions resolve, supply-side lacunas may continue to linger. Europe, being the net importer of food & fuel and being overly dependent on Russia, is the biggest victim of this Ukraine war.

As per Taylor’s rule, for the US:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%

Here for U.S. /Fed
A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5% (average of core PCE and CPI)

Now Fed’s influential policy maker Bullard stunned the market a few days ago by saying that the present projected terminal rate of +4.75% rate is not restrictive enough and there is a need for a minimum 5.00/5.25 to 7.00% repo rate by Fed.
As per Bullard: A=0.50; B=2; C=1.25-1.50; D=0; E=4-5% and I=5-7%

On Thursday, the St. Louis Fed President Bullard said:
·         Policy not yet in range to be sufficiently restrictive
·         Fed hikes to date have only had a limited effect on observed inflation
·         Even dovish assumptions about the state of mon pol warrant further hikes
·         The monetary rule would set a lower bound at 5%
·         Markets expect disinflation in 2023
·         Despite Fed rate hikes, there are some positive factors for the economy, such as flush state governments, excess household savings, and still a high household wealth
·         Inflation risks may be elevated now as a result of the Fed’s anti-inflation efforts, but this is not the default scenario
·         In the last six months, many of the pandemic supply chain issues have subsided
·         The labor market continues to look very good
·         If inflation begins to fall in 2023, the potential for a very good dynamic exists
·         Any signs of disinflation are ‘tentative at best but I am hopeful for 2023
·         To avoid the mistakes of the 1970s, the Fed will want to err on the side of keeping rates higher for longer
·         So far, any signs of disinflation are speculative at best, but 2023 is hoped to be the year when it occurs
·         The October inflation data was encouraging, but it could easily go the other way next time, with inflation remaining high
·         Recent retail sales indicate that the household spending cushion remains intact; a slowdown for the upcoming Christmas shopping season would be acceptable
·         The Fed has been burned on inflation for the second year in a row
·         I expect rapid disinflation once the process takes effect
·         I am definitely seeing the effects of higher interest rates on housing
·         The labor market has remained remarkably resilient
·         The October CPI report is encouraging but just one data point
·         On rates, I am aiming for a minimum of 5%-5.25%
·         The monetary rule would set a lower bound on the restrictive policy of around 5%, versus the current Fed target rate range of 3.75% to 4%
·         Taylor’s policy rules suggest rates of between 5%-7%

Now from Wall Street to Dalal Street, in October, India’s headline CPI rose around +6.77% from +7.41% in September (y/y). On a sequential basis, the Indian CPI surged +0.80% in October from a +0.57% reading in September (m/m). The Indian core CPI eased to +6.0% in October from around +6.1% in September (y/y).  Although the annual rate of inflation eased to some extent, still average inflation is much above RBI’s upper tolerance levels of +6.00% (average CPI is now around +6.88%; average sequential rate +0.62%; i.e. +7.39% on an annualized basis, while core CPI is around +7.39%); all substantially higher above RBI’s price stability target of +4.00% too.

RBI sees resilient domestic economic activity but elevated inflation till at least FY23, not only substantially above RBI’s +4.0% target but also above the upper tolerance band of +6.0%. RBI also sees sticky domestic inflation as a function of imported higher inflation and global supply chain disruptions rather than elevated domestic demand and constrained supply. RBI virtually blamed global supply chain disruptions and elevated fuel & food prices for sticky domestic inflation as a result of Russia-Ukraine geopolitical tensions and subsequent economic sanctions (on Russia). RBI is now also concerned about global financial stability after U.K. policy chaos and BOE bailout of British Pension funds amid a plunge in bond prices; i.e. surging bond yields and also USD led by Fed’s faster policy tightening.

Thus RBI will continue to tighten to keep interest rate/bond yield differential and also under control, which will also control imported inflation and manage overall price stability. RBI has to tighten in a calibrated way to bring inflation down by curtailing demand; i.e. slowing down the economy to some extent without causing an all-out recession for a safe and soft landing.

As per Taylor’s rule, for India:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.50+4+ (1.5+0)*(6-4) =0+4+1.5*2=0.50+4+3=7.50%

Here for RBI/India:
A=desired real interest rate=0.50; B= inflation target =4; C= permissible factor from deviation of inflation target=1.5 (6/4); D= permissible factor from deviation of output target from potential=0; E= average core CPI=6

As per Taylor’s rule, which Fed policymakers generally follow, assuming India’s ideal real interest at +0.50%, the RBI repo/policy/interest rate should be +7.50% against the present +5.90%. Thus RBI may hike +150 bps cumulatively in December, February, and April to reach a +7.40% repo rate against Fed’s similar move in December, February, and March for a +5.50% repo rate, so that the rate differential remains around +2.00%. In his monetary policy statement on 30th September, RBI Governor Das pointed out pre-COVID era (June 19) real repo rate was around +2.00 to 2.50% as the repo rate was +5.75% against headline CPI around +3.00%, core CPI around +4.00% and 6M inflation expectations was around +3.4 to +3.7% (for H2FY20).    

Fast forward, now RBI inflation expectation for H1FY24 is around +5%. Previously, Das also indicated that RBI will go by 6M inflation expectations, actual average CPI, and also core inflation. India’s core CPI is consistently hovering around +6.00% for the last few years even before COVID and Russia-Ukraine war led to global supply chain disruptions. India has its domestic supply chain issues and also higher demand, mainly due to the rampant flow of corrupt money in the economy generated from various government projects/CAPEX/grants and also fraudulent bank lending. Thus RBI has to tighten the policy and keep the repo rate around +7.50% by April’23, so that the real rate would be around +1.50 to +2.00% wrt at least core inflation (6.50-5.50%).

In FY22, India pays around 45% of its core revenue as interest on public debt, which is quite high compared to the US ratio of around 9%, the EU around +4.5%, and Japan around 15%. Although most of the Indian public debt is the domestic and local currency, India needs to balance inflation, borrowing costs (bond yields), and CAPEX/grants in a calibrated/sustainable manner. There are huge opportunities in improving the country’s infra, especially in railways. India now needs targeted fiscal stimulus and population control policy to improve productivity and per capita GDP/income. Also, the Indian government and high levels corporate employees have substantial salary/increments to beat inflation, which is positive for the country’s discretionary consumption story. 

At around 833.40 TTM EPS (consolidated), the current PE of Nifty (around 18160) is around 21.8. The FY22 (31st March 22) consolidated Nifty EPS was around 762; considering an average CAGR of +20%, the FY23 Nifty consolidated EPS should be around 915, and assuming a fair/median PE of 20, the fair value of Nifty should be around 18300 (already scaled around 18440).

Now looking ahead to FY24, Nifty EPS may grow around 15% considering higher borrowing costs, economic slowdown, but deleveraged corporate and India’s appeal of 5D (demand, demography, deregulation, digitalization, and deleveraging) and political stability/appeal of democracy coupled with the bunch of blue chip companies having impeachable corporate governance.

Thus FY24 Nifty consolidated EPS should come to around 1050 and assuming an average PE of 20, Nifty may scale 21000 levels by Dec’23. Also higher USDINR because of the stronger and ultra-hawkish Fed policy (despite Fed pivot) may help as almost 60% of Nifty earnings come from exports. Fed may keep the 5.00% or even 5.50% terminal rate at least till Dec’23 unless core PCE inflation stabilizes around +2.00% targets. But Fed may also go for rate cuts and even launch QE-5 in early 2024 to boost US economy/Wall Street ahead of Nov’24 U.S. Presidential election; needless to say, RBI  is bound to follow Fed. RBI may also pause after April’23.

Looking ahead, whatever may be the narrative, technically Nifty Future now has to sustain over 18350 for a further rally towards 18600 (lifetime high); otherwise sustaining below 18300-18100, Nifty Future may again fall to 17800/600-500/400 and lower levels in the coming days.