Learning from Rate Hike Cycles: 2004 vs. 2010
•
Key Debate: The rate cycle has inflected with a second rate hike likely tomorrow. Several factors point towards similarities between 2010 and 2004 rate cycles. 2010 like 2004 has been a year of recovery in growth and resurgence of inflation. The RBI successfully pegged inflation expectations in 2004 and thus the equity market multiple was positively correlated with short term rates in subsequent months. We expect 2010 to follow the patterns witnessed in 2004. However, there are some differences between these two rate cycles. The key debate is whether these differences sufficient to derail the current bull market.
•
Four key differences: Trade Deficit, The World, the Pace of Rate Hikes and Yield Curve: The key things for the market to worry when comparing 2010 with 2004 are:
a) Wider trade deficit – very early in the growth cycle India is already running a current account deficit increasing risks to growth and macro in a relatively fragile world. In 2004, the current account had just come out of a surplus situation when the RBI first raised rates.
b) The world itself seems quite delicate versus 2004 both in terms of growth as well as the performance of markets. It is pertinent to note that global markets appear to have greater influence on Indian equities now compared to 2004 if the correlation of returns between the two is any measure.
c) The pace of rate hikes appears to be a bit more aggressive in 2010. The RBI did not increase the repo rate until after 12 months post its first reverse repo rate hike (Oct-04). In this cycle both have gone up together in the first move itself last month. Of course, the starting point of short rates is lower in this cycle and growth recovery seems to be stronger. The RBI seems all set for another rate hike tomorrow whereas in 2004 the second rate hike happened only three months after the first one.
d) The yield curve is a steeper in 2010 and the bond market is suggesting that the RBI may be behind the curve. The equity market does not seem to concur (see our note Key Investor Debates: Inflation, Valuation & Deficit dated April 16) but moves from the RBI could cause the yield curve to flatten a lot more than it did in 2004.
•
2010 Cycle: Growth is Stronger, Relative Valuations are Cheaper: When compared with 2004, growth is distinctly higher and this higher growth has not come with higher inflation compared to 2004 – thus 2010 appears closer to goldilocks than 2004. If anything, wholesale price inflation ex-food is a little lower than it was in 2004 at the same point (i.e., post the first rate hike). Equity valuations on a relative basis are also lower than in 2004. The market is currently trading at a 20% premium to emerging markets whereas it was trading at around a 30% premium at the same point of time in the 2004 cycle.
•
Market Implications: If 2004 cycle is any guide, investors should expect the rupee to continue to appreciate, the 10-year bond yield to peak out soon, implied volatility to rise a bit, the market’s relative performance to EM to level off in the short run, broad market to continue outperformance and earnings/industrial growth to remain more or less intact. From a sectoral perspective, the four trades that emerge from the 2004 cycle are to buy industrials and financials and reduce technology and consumer discretionary. From a 12-18 month perspective we remain constructive on Indian equities given the growth momentum and our expectation that the Central Bank will successfully cap inflation expectations.
