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The Indian equity markets have continued to limp downwards in the aftermath of the PNB scam, and the trends witnessed in the recently concluded by-poll elections are making the markets jittery and sentiments sour.

The global markets have somehow shrugged off fears emanating from rising bond yields (which still remain pretty elevated), a rising interest rate cycle (with the FED expected to raise rates by 25bps later this week), cyclical inflationary pressures playing detrimentally on discretionary spending patterns and the narrowing of spreads between the 10yr government paper and riskier asset classes like equities. For now, liquidity still appears fine and there is no undue cause of concern and visible trends being seen as a shift from equity linked assets to other asset classes. Albeit, there are 5 factors that can have a bearing on the equity markets in the coming few months:

Trade wars: First and foremost, we need to understand that a trade war was last seen nearly 80 years ago and that led to the great depression of the 1930s. Technically, trade wars are negative for 2 reasons. Firstly, higher import tariffs do not encourage domestic industry but they surely lead to higher levels of imported inflation. Secondly, trade wars eventually degenerate into currency wars with countries trying to competitively devalue their currencies to make their exports more attractive. While the EU and China have threatened to retaliate, we have not seen any concerted action. Both the EU and China are just seeing their economies recover from a prolonged economic slowdown and they will not be keen to get into a trade war at this point of time. We are confident that more acceptable solution will be found without degenerating into a trade war.

Crude Oil: This might be a joker in the pack. In FY17, India’s import bill was close to $86bn with the presumption of crude prices hovering around $55/barrel mark. With Oil prices around $60/barrel and if they stay this way for the better part of the remainder of this fiscal, the import bill might go up by $8bn assuming the currency movement against the dollar is not adverse. A general rule is that a $10 increase in oil prices can push up CPI inflation anywhere between 0.35 to 0.50%. A higher oil price scenario can thus negatively affect our trade, current and fiscal equations (due to more subsidies), create input cost inflation, affect corporate profits and put a wheel in the spanner in a recovering investment cycle.

Though it is an outside risk for the markets, increase in prices shall lead to higher US Sale production (drawdown in US Inventories need to be closely monitored) offsetting the production cuts by OPEC countries and bring stability to prices. It thus should not be a risk factor until it crosses the $70 mark and stays above it.

Rising Bond yields: It’s been a phenomena that the bond yields have moved significantly higher both globally and domestically. Fundamental factors like fear of rise in crude prices, possibility of more aggressive rate hikes by the US FED, domestically inflation moving higher than RBI’s estimate of 5.1% (though the latest print had a softer number) and the flow of easy money getting reduced with global quantitative easing being reversed shall have a bearing on the short end of the curve. If yields continue to remain on an elevated path there are chain of cyclical events that may be construed to have detrimental impact on equity markets. The obvious foregone conclusion with yields moving up is the deposit/savings rate move up resulting in diversion of money flow towards the safer investment option presented by the debt/fixed income markets. The institutional activity can also have a similar impact and the resultant movement if rates were to go up would be lesser corporate margins and earnings forecast getting lowered. The perceived risks associated with bond prices and yield movement need to be closely and constantly monitored.

Corporate earnings: As mentioned above, an adverse rate cycle can have a medium term negative impact on corporate profitability. The rerating of equity markets from this point onwards shall hinge upon the manner/trend in which the corporate earnings cycle gets skewed. The last quarter’s numbers showed some initial signs of corporate profitability limping back but the next few quarters numbers shall define the direction for the markets. Two things that should work in favour of recovery of corporate earnings are a) on a comparative year on year comparison they should reflect better numbers on a low base due to the Demo and the disruptions caused by GST last fiscal and b) GST in the next few quarters with expectations of pick up in the reported numbers should have incremental flow of business to the organized sector albeit in a gradual manner but which shall ultimately reflect in better earnings profile for India Inc and ultimately this earnings rub-off should reflect in the Index earnings projections over the next few quarters. Our sense is that corporate earnings should compound at 13-14% CAGR over the next two years and that should give the impetus of justification in forward multiples underpinning Index valuations.

Political instability: Much has been discussed about the politically related uncertainties causing upheavals in the functioning of the financial markets. However, historically both globally and domestically it has been observed that political events do not change the course of the markets as markets being torch bearer of economic activity shall comprehend data points related to the same and the indication of the barometer is based on core macro data points. So, though the markets might react negatively or positively based on certain political events occurring from event based perspective they shall always revert back to core economic and financial parameters over the medium to long run. For the year 2018, the equity markets could be driven by a mix of domestic and global factors. Firstly, the hawkishness of US Fed will be the key as anything above 3 rate hikes can be negative for global markets. Secondly, if the trade war actually degenerates into a currency war then the impact across emerging markets could be quite heavy. Thirdly, Indian stocks appear to be fully valued even after the correction and that will limit the appetite for Indian equities. Lastly, Indian economy is likely to go through a political and structural shift in the next few months. It needs to expand spending ahead of elections but needs to keep its fiscal deficit and inflation expectations under control. How the government manages to balance the demands of economics and the reality of politics will eventually determine how the Indian markets pan out during the year.

Last modified on Wednesday, 21 March 2018

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