India’s central bank, which is scheduled to take a call on interest rates on Tuesday, will set the trend for stock markets in the coming week. Share indices have leapt to record highs in anticipation of a rate cut, and if the monetary authority belies expectations brace for a pullback as investors take some profits off the table.

Pressure has mounted on Reserve Bank of India Governor Raghuram Rajan after China lowered rates this month, and the fall in world oil prices means domestic inflation — already at a multi-year low — would further ease. Finance Minister Arun Jaitley is leading the clamour for a reduction in borrowing costs to help bolster sagging growth.

Data released on Friday showed GDP grew 5.3 per cent in the September quarter, below the 5.7 per cent rise in April-June, weighed down by a sluggish manufacturing sector as high rates deterred consumer spending and investment. The latest figure was slightly better than expectations thanks to a strong services sector and a surprisingly improved farm output despite delayed rains.

There is little doubt that the faltering growth needs a helping hand from the central bank to claw back to a rising trend.

Easing inflation

“Inflation, which has plunged substantially below mean, permits a relaxed monetary policy while growth is still so weak that it demands an easier policy,” analysts Nilesh Jasani, Govindarajan Chellappa and Piyush Nahar at brokerage Jefferies said in a note to their clients.

Surjit Bhalla, chairman of emerging market advisory firm Oxus Investments, is another strong proponent for an easier policy.

“Right now there is no argument, literally, for the Volcker RBI not to start cutting rates, and cutting aggressively,” he wrote in the Indian Express, referring to former Federal Reserve Chairman Paul Volcker who was also obsessed with fighting inflation demons.

After raising rates thrice between September last year and this January, Rajan has followed a long pause saying inflationary expectations remained a worry. However, with consumer price inflation in November likely to drop to around 4.5 per cent, a slower rise in rural wages as well as minimum support prices for farm produce and cheaper crude oil should provide a huge comfort on this front.

“The RBI cannot keep fighting perceived risks in the face of overwhelming evidence demanding a change. The direction of government policies indicates that both fiscal and current account deficit would remain at comfortable levels,” the Jefferies analysts wrote.

“Once RBI decides to change its risk priorities, we feel that it should cut rates by 200+ basis points in the next three-four quarters.”

The RBI’s main policy rate, the repo rate, currently is at 8 per cent, one of Asia’s highest. Markets are pricing in a quarter point rate cut, and the 10-year government bond yield has dropped 19 basis points this month to 8.09 per cent.

Record indices

Falling interest rates should create a positive support for the underlying equity market through reduction in cost of capital for leveraged companies and valuation support through lower risk-free rate, Jefferies said.

“If risk-free rates were to decline by 100-120 basis points (as against a 200 basis points rate cut), Nifty could see 18 per cent upside to 10,080,” it said.

The 50-share Nifty hit a record high of 8,617 on Friday and closed at 8,588.25, up 3.2 per cent in November, with banks among the major gainers on rate cut hopes and a government announcement it plans to raise more than $14 billion by lowering holding in state-run banks to 52 per cent.

The top-30 Sensex also climbed to an all-time high, of 28,822.37 before ending at 28,693.99, gaining 3 per cent in November. The widely tracked benchmark has risen 36 per cent in 2014, making it the biggest gainer among the world’s major stock markets.

Ambit Capital expects the Sensex to reach 30,000 by next March.

Financials, industrials and discretionary would be the key beneficiaries if rates are reduced, Jefferies said.

“Among our Buy-rated stocks, we believe ICICI Bank, Axis Bank, Voltas, Ashok Leyland, Maruti and Tata Steel stand to gain the most,” it said.

Economists wary

Although there is consensus that rates are set to drop, many economists at foreign and domestic brokerages as well as financial institutions believe the RBI may stay pat on Tuesday and wait until early 2015 for lowering rates.

“We think that market expectations of a December repo rate cut are premature as the RBI will likely want to look through the strong base effects in October and November CPI inflation numbers,” economists Indranil Sen Gupta and Abhishek Gupta at DSP Merrill Lynch, who believe a rate cut is likely only by February, said in a research note.

Morgan Stanley and HSBC also expect the RBI to remain on pause mode.

“While we do not expect the RBI to drop its guard against long-term inflation pressures, we think the RBI will find it difficult to ignore the large easing in inflation momentum and is likely to tone down its hitherto hawkish policy rhetoric,” Barclays Bank economists Siddhartha Sanyal and Rahul Bajoria said in a report. There’s an “outside chance” of a cut next week “if Governor Rajan wants to surprise.”

Banks, which have rallied more than 17 per cent since early October, could see a correction if the rate cut does not come through. However, this should be an opportunity to accumulate stocks, according to JP Morgan.

“There is the risk of heightened volatility in the short term. We see these are speed bumps and would buy into any correction. While we are positive on the sector as a whole, our top picks are Axis, ICICI and HDFC; the top public sector undertaking is SBI.”

The writer is a journalist based in India.