Reserve Bank of India’s Deputy Governor Michael Patra recently gave some telling warnings that stock market investors should take note of.
While Patra asserted that the domestic economy has what it takes to weather some increase in interest rates necessitated by persistently high inflation, he warned that monetary policy action “is not likely to be painless”.
The pain Patra alludes to could be two-fold for the stock market – slowing economic growth leading to cuts in earnings expectations and rising fixed deposit rates weaning away retail investors from underperforming equities. Of the two, the last one would bother market watchers more.
Positive real interest is generally perceived to be an anti-thesis to stock market rallies in the West, although, evidence of the same in India remains limited.
The real interest rate, which is the repo rate minus the average expected inflation for 2022-23, stands at a negative 1.8 percent or 180 basis points. During the course of the pandemic, the negative real interest rates not only in India but across the world have been a driving factor of the bull market in global stocks as such a policy state drives risk appetite.
Negative real interest rates force households to reconsider how they save their money and force them to take risks to protect their capital. According to the International Monetary Fund, investors often look beyond nominal rates and base their decisions on real rates—that is, inflation-adjusted rates—which help them determine the yield on assets.
“Low real interest rates induce investors to take more risks,” the IMF said in January.
In India, with the savings and fixed deposits rates offering negative yield on an inflation-adjusted basis over the past few years, more and more households have taken to the stock market to earn better returns on their savings.
Retail investors, according to Finance Minister Nirmala Sitharaman, have acted as a safety net for stock prices even on the face of the longest spree of selling pressure from foreign investors seen in recent history. Foreign investors have net sold nearly Rs 3 lakh crore of Indian stocks over the past nine months.
No surprise then that the number of dematerialised accounts in India have more than doubled to 95 million since the beginning of the pandemic, bringing in fresh inflow of nearly Rs 3 lakh crore in the same period.
Going ahead, holes may start to appear in this safety net of the market if the RBI has its way.
“Households, the biggest lender to the economy, are going to the stock market because of negative real interest rates and we need to change it very soon,” Patra argued when asked about the RBI’s view on positive real interest rates.
Patra’s words suggest that the central bank wants more of households savings to flow into the real economy instead into financial assets like equities. While equities still remain a small share of households savings, its share has been on the up in recent years driven by low yields in traditional savings products like fixed deposits and a battered real estate market.
As real savings rates and fixed deposits rates gradually turn positive and simultaneously, returns from the stock market become less and less lucrative, investors are likely to reconsider where the next penny they save goes.
One-year returns on the Nifty 50 and the Nifty 500 indices have turned negative recently, while more than half of the listed stocks on the National Stock Exchange have given negative returns in the past 12 months. In such an environment, brokerage firm Kotak Institutional Equities argued that retail investors could look at more traditional instruments like fixed deposits and real estate instead of stocks.
From the central bank’s perspective, weaning away retail investors who are directly approaching the stock market instead of, say, through a mutual fund, it will also be able to reduce any significant threat to macroeconomic stability.
An increasing proportion of direct equity investors become vulnerable, as consumers, to the vagaries of the stock market and can become a threat to financial stability given that many of such individuals have some form of debt on their balance sheets, not to mention the daredevils who have left their salaried jobs to embrace the market full-time. Wealth effects, after all, can work both ways.For the stock market, though, not having the billions of dollars in inflows from directly participating retail investors could weaken the defence against unceasing foreign selling.