Why does interest rate differential affect capital flow in equities?

Question

With the recent news of US fed hikes, there are emerging markets where central banks have decided not to raise rates, like in India, Indonesia, China, etc. The common theme I read everywhere is this - "we expect capital to flow out of these EM countries and flow into the US". I read a lot of articles where they explain the recent equities sell off in India as FIIs rotating out of EM equities due to US rate hikes.

What I don't understand is this:

1. The assertion that capital will flow from, say India to the US, seems true only for the subset of investments in the fixed income space. Although US rates might not be higher than Indian rates even after the hikes, but US treasuries might be comparatively safer investments.
2. However, for risk assets like equities, US rate hikes are bearish for US equities since short term borrowing will become expensive for everyone alike, which will have a ripple effect on the buying power of customers and hence the demand, and also affect businesses' ability to grow due to expensive credit. Whereas the RBI (Indian Central Bank) has clearly voiced that they're going to support economic growth and not raise rates anytime soon, which is bullish for Indian equities. So in that sense, Indian equities might outperform US equities.

So,

1. Why would investors not prefer shifting capital from US equities to EM equities? Or at least not rotate out of existing EM equity investments? The only reason I can think of is the ripple effect of US equities on Indian equities. India is a net exporting country, and US might be one of the main customers for Indian listed firms, because of which weaker US economy might affect them as well. Also, if fixed income capital moves from India to the US, I can imagine how that can make the dollar go up relative to INR, which will impact the Indian equity returns in dollar terms for these investors. I'm not sure if these reasons are correct or substantial enough.

I had a slightly unrelated question as well, about inflation.

2. Intuitively it makes sense that if inflation is above nominal interest rates, businesses/central banks can erode away their debt. If I take some examples,

(a) say I borrow at 3% for my business activity and inflation is 5%. Now unless my business activity revenue is able to use inflation to grow the debt by 5% this argument doesn't hold, right?
(b) similarly what mechanism would central bank use to utilize inflation to grow its borrowings at the inflation rate, so it has surplus on top after paying off its debt in the future, since inflation is above nominal rate?
(c) for an individual wage worker, this will work only if his nominal wages keep up with inflation, which might not always happen? So maybe for individuals, the argument is for the aggregate economy in which you can assume that statistically, cashflows are able to keep up with the inflation rate and hence able to outpace debt?

Answer 1

Think in terms of portfolio rebalancing. Summary is that when you are consuming more than two commodities which are all are (imperfect) substitutes then a decrease in price of one will decrease (ignoring the possibility of very strong income effects) the equilibrium quantity consumed of all commodities in the basket.

Imagine an investor who has only EM's FIA and equity in portfolio (I am constructing such an investor to highlight the channel other than dollar appreciation that you have already covered). As capital move out of EM's FIA, its return will go up - nudging the investor to rebalance the portfolio from EM's equity to EM's FIA. This is the monetary channel. The very important point made by you about decrease in demand and so on is often referred to as real channel.

• A note here: you said that US equity markets are bearing because of expending borrowing. Another important channel is the discount rate. A firm's valuation reflects present value (pv) of future cash flows. Even if future cash flows are unaffected (i.e., no impact of, say, increased borrowing costs), the discount factor (which is basically an indicator of opportunity cost - returns on alternate assets), will increase, eroding the pv of firm's cash flows.

Second, think of EM firms with external (US's) borrowing on their books. As interest rates in US go high (and also as dollar appreciates) they might prefer to borrow from domestic markets - again pushing domestic rates to increase, feeding into the whole rebalancing of portfolio again.

Three, having established that borrowing costs of firms (whether they have external debt or only internal) will go up, so will be the debt servicing. A very destructive consequence of continued low interest rates over the past decade is that corporate debt has bloated. Servicing this debt in face of increased rates directly impact their bottom line.

Another issue is credibility. No matter what RBI (or concerned EM's central bank) claims, sustained inflation is both politically and economically toxic. Sooner or later the rate hike may be inevitable.

All this considerations make equity market much less attractive than they were just a year ago.