War is never a pleasant reality for anyone and, since equity markets hate uncertainty, the formal attack on Ukraine by Russia after weeks of posturing, met with jitters in global markets. Mirroring the global sentiment, the Indian benchmark Nifty went into a tailspin with a single-day fall of close to 5 percent on Thursday.
Drawing from history …
Geopolitical conflict tends to cause market volatility, at least in the beginning. Logically, investors may assume that the volatility will continue throughout the war period. However, history shows that this isn’t the case.
From the beginning of World War II to its end, the US benchmark Dow was up more than 50 percent, over 7 percent per year. During both the combined world wars periods, the stock market grew 115 percent.
The Vietnam War and the two Gulf wars are examples of conflicts that brought about extremely short-lived drops followed by long upward trajectories.
On an average, the S&P 500 (US) had been 6.5 percent in the negative territory for 3 months following an armed conflict (either global or smaller), and around 13 percent in the positive zone 12 months after the said conflict. But there are times when the market reactions have been more positive.
Investors can, therefore, see some discerning trends here. War and conflict bring sudden crashes, varying in their degrees and depths. But usually, the recovery is relatively solid and predictable.
Markets worry more about inflation than a WW III
The reason why the current geopolitical tension is so crucial is because the armed conflict coincides with one of the highest threats of inflation since World War II. The Covid-led supply disruption, coupled with unprecedented fiscal stimulus, had already pushed inflation in most nations much beyond the comfort zone. Moreover, with a key commodity and crude exporter at the heart of this conflict, the escalation in commodity prices is here to stay.
However, Ukraine being neither a member of the EU or the NATO, we do not see the Western powers getting involved on the ground at this stage. However, harsher western sanctions on Russia cannot be ruled out. The sanctions imposed so far are wide-ranging but they fall short in terms of severity. Russia is reasonably well prepared to face sanctions and the only meaningful blow could be the exclusion of Moscow from the global payment system. But given Europe’s dependence on Russian gas, a drastic escalation in tension, involving others, is improbable. In a larger war, it's possible to see trade disruptions, but a localised conflict in Ukraine is unlikely to incrementally affect global supply chains.
While every time market capitulates it seems “this time is different”, going by history, the armed conflict in Ukraine will not have a much long-term impact on the markets. Rather, we will continue to be led by the Fed and its policy changes with regard to inflation and overall interest rates. After a long run-up in global equities, war could be a perfect excuse to take profits.
Rather than worrying to catch the bottom, investors should gradually start nibbling at good quality stocks.
What to buy as the guns fire and markets capitulate?
Investors cannot take refuge in fixed-income instruments as rising inflation is bad for bonds.
So the focus should be on bargain-buying quality companies. Investors should look for at least a 10-20 percent undervaluation to conservative fair value for investments. Once this principle is followed, a 5-10 percent drawdown in the general market won't really matter, given the historical appreciation within 12 months.
Companies with business moat, leadership position, and solid balance sheets should be looked into — in short, buy the Blue Chip stocks that you don't get cheap unless there's a drop. This is not the time to experiment with the next multi-bagger.
Isn’t US rate hike round the corner?
The geopolitical jitters could delay the intensity of the US rate hike. Emerging markets, including India, have already seen FII outflows that could aggravate in the coming months.
However, unlike the past, when FIIs used to rule the bourses, the long-term journey of Indian markets will ride on domestic liquidity. India’s changing demographics, with a young population having no social security benefits, and negative real interest rates augur well for domestic inflows into equities. The record number of new demat accounts and the soaring monthly contribution to SIPs (systematic investment plans) stand testimony to the same. This domestic liquidity should provide downside support to equities.
Earnings, which we believe is the ultimate driver of equities, are also looking strong. The recovery from Covid’s deadly second wave and the short-lived third wave has been swift. The recovery is gathering momentum across sectors. Monsoon, which has a great bearing on the rural economy, consumption, and agri-related businesses, is also expected to be normal. Order bookings of capital goods companies are looking up and, after two years of disruption, discretionary consumption is making a comeback while supply chain issues are easing. However, commodity prices remain a niggling worry.
We do not expect any major negative earnings impact on the Nifty in the next couple of years, as the two heavyweight sectors — financials and technology — look to be in fine fettle. Riding on the recovery and better asset quality, we expect financials to manage the marginal pressure on interest margin. The unprecedented demand for digitisation and the gradual easing of talent shortage augur well for technology earnings, while currency depreciation could be a feather in the cap. The diversified heavyweight conglomerate Reliance Industries should continue to benefit from the recovery in all its businesses. With very little weightage of cyclicals, we rule out a meaningful downgrade to Nifty earnings.
The correction is beginning to take away the froth from the market’s valuation. The gap between the bond yield and the earnings yield is down to 1.38 percent, showing that markets are fast entering the value zone.
From the peak of October 21, the benchmark Nifty index has fallen close to 12 percent. However, over 66 percent of the stocks in the BSE 500 have corrected more. So a bottom-up stock picker can land a bargain.
However, if investors are little more risk averse, buying into the Nifty index gradually, with every correction, is a great way of building long-term wealth.
From a top-down perspective, we would go with export-oriented sectors, ranging from technology to chemicals. Leaders from the financial pack and high-touch sectors benefitting from Covid recovery could see strong earnings. The discretionary as well as the non-discretionary consumption should benefit from the normalisation of demand. On the industrial side, companies with order-book visibility, lean balance sheet with minimum leverage, and companies gaining from Atmanirbhar Bharat and, hence from the various PLI (production linked incentive) schemes, should be on the radar
War presents a unique opportunity to buy quality cheap and smart investors got to be greedy when others are fearful.
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