>Bonds vs. Equities: Who’s Right? (MORGAN STANLEY)

• Key Debate: The equity and bond markets are telling us different things about the growth/inflation trade off. While the bond market is saying that the Central Bank is behind the curve and needs to raise rates quickly to quell inflation, the equity markets are much more sanguine and focused on the growth upside risks. Which market has got it right?

• Balancing Growth and Inflation: We concur that the growth risks are to the upside and to that extent, the equity markets may be getting this right but we would not be complacent about the inflation risks. We think the Central Bank will have to move firmly in its next policy meeting to assure the bond and equity markets that inflation expectations will be anchored. If it succeeds we expect, as in 2004, the market multiple and the short rates to be positively correlated. Volatility could still rise and, to that extent, the low implied volatility in the options market is an opportunity for investors to hedge portfolios at low cost against a negative surprise from the Central Bank (negative surprise = lack of rate hike by end of April).

• Policy Rate Hike – To Do or Not to Do: The flip side of accelerating growth is that capacity utilization is rising accentuated by the lack of capex over the past two years. Consequently, the output gap is closing fast leading to a buildup in core inflation (and hence higher short rates). History suggests (going back to 1998, 2000 and 2004) that the market multiple tends to decline when short rates inflect in the upward direction. While in 1998 and 2000, the rate rise happened in a slowing growth environment (compounded by negative external events) causing significant damage to market multiples, the 2004 rate change took place in an accelerating growth environment and the fall in market P/E proved temporary. Indeed short rates and market multiples were positively correlated after the initial hiccup. We believe that the current environment resembles 2004 with a rise in short rates likely to pre-empt inflation pressures in an accelerating growth environment. Indeed, the policy environment remains close to emergency levels even as the economy does not appear to be anywhere close to a crisis. The key risk is that the Central Bank falls behind the curve and rising inflation ultimately hurts growth and stock prices in 2011. We believe that the Central Bank will react to incoming data, especially on credit growth, and tighten accordingly. Of course the challenge for the Central Bank is to estimate the impact of stimulus on growth (how much of the current growth acceleration is autonomous), the next monsoons and the global growth (which in turn may depend on behavior of risk assets).

• What’s in the price?: We believe that the bond market is pricing in a 50 bps rate hike – notice how the 91-day yield has moved away from the reverse repo rate. For the equity markets, we believe a rate hike between 25 bps and 50 bps will work well. A 50 bps would generate more comfort for the medium term although there may be a negative short-term reaction. A 25 bps rate hike may leave some risks on the table though they may not be visible in the market immediately. If there is no rate hike by the end of April, the market could be at risk of multiple compression in 2H2010.

• Market Implications: 1. Buy Equities over Long Bonds: While long bonds appear interesting, especially from an ownership, supply, and valuation perspective, we believe the returns from long bonds are likely to be constrained by rising domestic short yields and our out-of-consensus
view on US long bond yields. We think equities offer better returns than bonds.

• 2. Buy Banks and Industrials: We believe the current circumstances resemble 2004, i.e., the first rate hike will confirm the Central Bank’s resolve to tackle inflation as well as recognize a sustainable recovery in growth. In our view, the sectors that are likely to outperform are banks (given their long duration liabilities) and industrials (driven by the likely start of a new capex cycle). We would avoid Technology, Telecoms and Healthcare.

To read the full report: BONDS VS. EQUITIES