Q4 to reflect impact of high crude oil prices, interest rates

Equity investing is always challenging and there are various macro and micro factors that investors need to consider during their decision-making process. The two macros currently topping investor mindshare are — rising interest rates and hardening crude oil prices and their possible impact on corporate performance and stock prices.

Market PEs tend to contract in a rising interest rate environment. Midcap stocks generally quote at a discount to largecaps and, though at times they may not be affceted by a rise in interest rates, if the broad market PE contracts the valuations of midcaps, smallcaps will accordingly suffer. When fixed income instruments start giving 9-10 per cent returns (currently) retail investors tend to shy away from equity investments, further affecting the markets.

The ability of companies to pass on the impact of increase in interest cost should be of more importance than the absolute rise in interest cost. So far, we have not seen any impact on the demand for two- and four-wheelers, despite increase in lending rates, since 85 per cent of two-wheelers are self-funded. Banks generally re-price their assets first and liabilities gradually follow. Initially, their core profitability may go up, but simultaneously they may be negatively impacted on their bond portfolios. If interest rates go beyond reasonable levels, they may face challenges on their assets and a possible increase in NPAs.

Infrastructure companies will be severally impacted as most of them are over-leveraged. For example, every 100-basis-point increase in interest rate will reduce earnings per share (EPS) of IVRCL and JP Associate by 7 per cent and 10 per cent, respectively. Similarly all power companies, except NTPC, will see their bottom lines falling. Real estate companies like DLF and Unitech should definitely struggle with increase in borrowing costs and slowdown in consumer demand. A 10 per cent increase in interest cost will impact EPS of Tata Steel (standalone), JSW and SAIL between 2 and 5.5 per cent.

In the last few months, crude oil prices have toughened by almost 20 per cent, following the North Africa/West Asia crisis. Rising crude oil prices have a cascading effect across the value chain. Most chemical companies try to pass the cost increase to end customers. In many cases, the supply contracts, as well as customer pricing, are linked to crude oil prices. However, sometimes there are lags due to inventory problems, creating temporary fluctuation in margins.

The cumulative impact of rising interest rates and hardening crude oil prices have been so far marginally reflected in the December 2010 quarter numbers. The overall impact should be reflected in March quarter (Q4) numbers. FMCG companies may struggle to pass on the increased raw material costs. Banks may not negatively surprise on earnings, but their valuations will be a function of interest rate expectations for the next 6-9 months.

The author is managing director, Emkay Global Financial Services