Chennai, Dec 3 (IANS): Is there a see-saw battle between the interest rates and the stock market indices? When one goes up, the other comes down.

Curiously, this time around there is a conundrum. When the interest rates are going up and also set to go up further, the stock market indices are touching new heights.

"It is true that the biggest enemy of equity markets is rising interest rates. This is the normal relationship. Rising interest rates lead to higher cost of funds and that eats into profitability especially in medium and small enterprises," Dr. Joseph Thomas, Head of Research, Emkay Wealth Management told IANS.

Agreeing with was Jayant R. Pai, Chief Marketing Officer, PPFAS Mutual Fund who told IANS: "This is an unarguable truism. Interest rates serve the same purpose as 'gravity' does. When they rise, they pull down earnings and valuations soften. Apart from factors intrinsic to the stock market, rising rates also increase the number of relatively safe fixed income options. This also serves to reduce flows into the stock market. The opposite transpires when rates fall and we have been experiencing this since 2009 or so."

A short-term exception to this rule is banks and financial institutions who have lending books with their lending rates rising faster than the deposit rates, said Thomas.

"So, they (the lenders) tend to benefit from the rising rates. Yet another factor is that when rates are low it is possible to borrow at low rates and invest. This gives a push to the equity market. As rates start rising such positions are gradually liquidated," Thomas said.

Giving a contrary view Santosh Meena, Head of Research, Swastika Investmart Ltd, told IANS: "History suggests that this apprehension may be a little overblown. While higher interest rates frequently result in dramatic sector rotations and can momentarily disrupt stock values, historically higher rates have been linked to higher, not lower, stock prices."

According to Meena, the empirical relationship between rates and equities is more nuanced than textbooks suggest.

"Theoretically, lower stock prices should result from higher interest rates because you can discount future cash flows at a higher rate. Although the rationale is sound, this model fails to take into account the fact that higher rates are typically accompanied by a faster pace of economic growth," Meena added.

Pai also wondered as to the term rising interest rates in the Indian context.

"The term 'high interest rate regime' is relative. Indians are used to regimes when rates have been in excess of 18-19 per cent. Over the past 15 years, rates have generally declined, rather than risen. Also, after every fall, the subsequent rise has often been of a lower magnitude," Pai said.

Queried about companies borrowing less and having slower earning growth due to high interest rates, Thomas said the negative impact will be restricted to those businesses which need to borrow money to fund their business expansion.

"Sometimes rising interest rates may be accompanied by dwindling liquidity too. These two things happening together reduces the debt servicing capacity of small enterprises. Therefore, it affects them," Thomas remarked.

According to Thomas, larger entities, mainly the large caps, have well established business models and comfortable cash flows and therefore, they may not borrow much, even if they do they get competitive rates unlike the smaller entities.

He also said the dependence of companies on funding has come down by about 15 per cent to 20 per cent over the last five years or so. Therefore, the impact of rising rates might be limited.

According to Pai, cash-rich companies, and those which do not require constant capital infusion, will outperform, as they will be more immune to rate hikes, and will be regarded as 'safe-harbours', by investors.

Sector and style preferences do alter in response to changes in the rate environment, remarked Meena.

"As rates increase, defensive names (companies that perform in a stable manner irrespective of market cycle) that are frequently purchased for their dividends suffer. It is generally believed that investing in growth stocks will result in larger returns, but on the contrary, owing to their higher discounting rate, they underperform," Meena remarked.

"On the other hand, areas like banking, industrials, infrastructure, and real estate typically outperform since higher rates coincide with an expanding economy," Meena added.

Pointing out that stock markets are forward looking, Pai said, it is quite likely that after some time, they may begin factoring in 'peak rates' and cease to react adversely. However, many times such trades are akin more to 'hope' trades than those which are grounded in reality," Pai said.

When pointed out the current situation where the interest rates are on the rise and the stock market is on the upswing, Thomas pointed out that the interest rate may go up due to reasons like inflation, central bank's policies or even on account of high credit growth and others.

"Rates may rise as economic growth accelerates. In such situations when there is high intensity of economic growth, rates may rise as demand for funds rises. But the interesting thing about this situation is that till the rate of interest or the cost of funds reaches a certain threshold level it may not adversely impact growth, and therefore, the market sentiment and market levels," Thomas said.

Meena said every time the US Fed talks about rising interest rates, which was the case in the most recent cycle of 12 to 15 months, we saw a significant outflow from emerging markets like India.

"Despite everything, strong fundamentals allowed Indian markets to outperform. Significant flows will start shifting towards emerging markets as that rate now approaches its peak, with India's market being the top pick despite its high valuations," Meena said.

Pai, who said Indians are used to high interest regimes, added the rising interest in equity markets has led to Price/Earnings Ratios expanding slowly over time.

"The role of domestic investors and the trend towards participating in equities via systematic investment plans (SIP) as well as through national pension scheme (NPS) etc. has also contributed to this," Pai said.

(Venkatachari Jagannathan can be reached at v.jagannathan@ians.in)