May 4th was an eventful day, as equity markets reacted sharply to the central banks’ actions both in India and the US. However, the market response on Dalal Street was very different from that of Wall Street.
Same move, opposite reaction
Indian equity markets tanked more than 2% yesterday after the Reserve Bank of India stunned the market with an increase in policy rates, citing inflationary pressures. RBI’s monetary policy committee, in an off-cycle meeting (unscheduled meeting), raised the repo rate by 40 bps to 4.40% and CRR (cash reserve ratio) by 50 bps to 4.50% of NDTL (net demand and time liabilities) effective from 21 May 2022.
In a contrasting move, US equity markets jumped sharply by 3% after the Federal Reserve raised rates by a widely anticipated 50 bps and indicated that it would start reducing its balance sheet in June.
The key difference – surprise element and market performance YTD
It was the biggest rate increase since 2000 for the Fed, but the move was widely expected by investors. While a rate hike was anticipated in India as well, the sudden announcement as well as the larger-than-expected hike spooked markets, leading to a heavy sell-off.
The reaction of equity markets in India and the US was a study in contrast, despite the similarity in central bank actions that were directed to rein in rising inflation. While the key difference was the surprise element, the market performance of the US and India equity markets year-to-date explains the market moves.
Equity markets globally have tumbled year-to-date (YTD) amid risk-off sentiment, but India has outperformed by a wide margin. MSCI India (in US dollar terms) is down by just 4% YTD while S&P 500 has corrected by 10% in the same period even after considering yesterday’s sharp up move.
Indian equity was one of the top performers in CY21. Though it has corrected by 9 percent since its October peak, India equity still continues to outperform the broader emerging markets index and many of its peers including China in the Asia Pacific region and most of the developed markets from US to Japan.
High volatility with downward bias
There are significant macro challenges for Indian equities. If crude oil prices stay elevated above $100 per barrel pose a key threat in terms of slowing down the economic recovery (GDP), adds to inflationary pressure, expands the current account deficit and hurts the currency. Rising US bond yields and the end of easy liquidity globally are also a negative. And the current geopolitical situation adds to the uncertainty.
Most importantly, equity markets are staring at risks of earnings downgrades. Persistently high commodity prices can prove to be a double-whammy to corporate earnings due to decline in margins and lower demand, increasing the risk of earnings downgrades.
The silver linings
Hope of soft landing
Amidst these macro headwinds, RBI’s move is a big positive as it attempts to put the inflation genie back in the bottle. The off-cycle policy action and up-front rate hike will help in anchoring inflation expectations. Unanchored inflation expectation and loss of control of the yield curve and could have led to a loss of central bank credibility.
US equity markets rallied yesterday after the rate hike as investors hoped that Fed can slow inflation without causing a recession. Powell clearly stated: “I would say we have a good chance to have a soft, or soft-ish, landing,” helped sooth the markets. Taking cues from US markets, Indian markets can also see some hope/relief rally driven by RBI’s action.
While earnings downgrade risks remain, valuation has moderated
The other factor that could support the market is valuation. India has seen relentless selling by the FIIs for straight seven months since October 2021. The high valuation of Indian markets led to FII outflows even before the current geopolitical risk emerged. This has helped remove froth. The current valuation of Indian equities (Nifty at 19 times forward earnings), though expensive compared to regional peers, is now almost in line with the long-term average valuation multiple.
FII holding of Indian equities seems to have bottomed out
Sharp FII outflows have reduced FII fund holdings in Indian equities to 18.5% (as a percentage of market capitalisation), which is the lowest since Jan 2017. Domestic mutual fund holdings have risen, and MF inflows has been supporting markets.
Since FII levels have touched the lowest level in the decade, any peaceful resolution of the Ukraine –Russia crisis can turn FIIs into net buyers.
Valuations supportive in select stocks
Amid slowing growth, inflation concerns and central bank action, the re-pricing of risk is underway. It started with bonds, particularly at the short end of the yield curve, in US bonds. It will soon be seen in equities. The large companies that will be able to pass on the price hike to consumers without denting demand much, will emerge as winners. Hence, the repricing point in equities should see a tilt toward value and quality, which implies a positive outperformance for these sectors.
Power sector utilities that generate stable returns could outperform in this inflationary and rising rate scenario. Discretionary sectors like automobiles will be negatively impacted. Auto companies have highlighted raw material inflation as a near-term risk, amid the sharp rise in commodity prices and shortage of chips. FMCG sector expectations have come down given margin pressure in the near term.
Last but not the least, the financial sector which is directly impacted by RBI’s rate hikes will see a mixed performance. While NBFCs and HFCs could see cost of funds going up and credit demand getting impacted especially at the bottom of the pyramid, large banks will not be impacted much initially. As a matter of fact, large banks with high CASA deposits will have some margin support as loans will get repriced immediately and deposit costs will rise only with a lag.
Overall, with no signs of economic uncertainties abating, Indian equities will continue to be volatile. There could be intermittent hope/relief rallies driven by central bank actions and/or positive global cues, but there are more risks on the downside from earnings downgrades. That said, valuation has started to look more palatable in select names, making investment decision very stock specific.
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