As the month of August started off, my view was that the level of the Nifty at around the 5200 levels should hold unless and until some catastrophic event takes place. Unfortunately for all of us such an event took place right at the start of the month with the downgrade of the credit ratings of USA from AAA to AA+. This resulted in a sharp selloff in most equity markets globally and did not spare the emerging markets too. The sell off initially started off from the crisis in the Euro Zone countries with the bond yields of Italy and Spain shooting up with fears of the crisis spreading to these countries. With both these countries coming out with significant Austerity measures and with the ECB coming in to buy the bonds of these countries (albeit reluctantly) the bond yields fell down sharply and now the yields have come down to the levels that prevailed around a year back when markets were much higher and stable.
The downgrade of USA’s credit rating was unlikely to have a long term impact on equity markets in any case and resulted in a panic bottom formation in global markets. Given the fact that the US FED has committed to keep short term rates at virtually zero for the next two years and the 10 year bond yields have come down to nearly 2.2% levels the equity markets are looking abnormally cheap relative to bonds in that country with the Equity Yield (defined as the EPS of the S&P index divided by the value of the index) at around 8% today. In this scenario either equities are very cheap or the markets think that growth is going to fall off sharply and there is a strong chance of a deep recession. I believe that the probability is now high that we will start seeing some revival in the US economy. The biggest drag has been high food, garments and fuel prices and all of these are now showing signs of softening.
With the severe sell off in the global markets we have now seen most global factors being factored into the markets. As such the focus has shifted back to the domestic factors. The domestic factors were essentially two
High inflation and RBI tightening – The high and stubborn inflation rate has been one of the biggest factors that has resulted in India underperforming the global as well as emerging markets. I have talked of this topic a lot earlier so I will not go in much detail except for reiterating the fact that most of the inflation is food and global commodity driven which is totally out of the hand of RBI. With the government not taking much of steps to augment the supply side high inflation at periodic intervals will continue to plague the Indian economy. The good part is that the slowdown in the global economy has resulted in lot of commodity prices coming down sharply and good monsoons and better productivity will result in food inflation coming off over the next few weeks. A large number of central banks globally have avoided hiking rates in the recent past citing global concerns. However, the RBI believes that India is a country that is totally immune to global concerns and has continued to tighten aggressively. This is a significant policy misstep which the RBI might regret at a later date. Twice over the last 6 months the markets have started to make a base and move up but have been stymied by 50 basis point hikes by the RBI. Any further tightening might lead to a significant slowdown and it is time for the central bank to look around and see the global scenario before taking any action. Domestic interest rates now seem to have peaked out, however we have to see when they start declining. However as things stand now my view is that a year from now we should have rates that are atleast 200 basis points lower. However market could be concerned about the next RBI action till the next policy announcement in September Mid.
Lack of Policy making – This has been the second biggest concerns for the markets. Over the last couple of weeks we have seen positive news bites from the government on this front. However the anti corruption protests have the potential of delaying these things further. There was an expectation of things moving forward during the current Parliament session which seems less likely now. This has resulted in India underperforming most global and Emerging Markets over the last 3-4 days. This could continue in the near term as these concerns are unlikely to go away in the near term. This could create further underperformance in the near term and in case the global markets weaken further we could see a further selloff.
In terms of fundamentals based of the now downgraded earning of around a 1200 EPS for the current financial year and a 1400 EPS for the next year for the SENSEX, the markets are now trading at valuation of 12X next year earnings. This creates a very strong base for the markets as far as valuations are concerned at a time when the interest rate cycle seems to be peaking out. In terms of pure fundamentals the markets are looking very cheap; mid and small cap stocks that were already cheap have become cheaper with the complete capitulation seen across the board over the last few days.
The downgrade of USA’s credit rating was unlikely to have a long term impact on equity markets in any case and resulted in a panic bottom formation in global markets. Given the fact that the US FED has committed to keep short term rates at virtually zero for the next two years and the 10 year bond yields have come down to nearly 2.2% levels the equity markets are looking abnormally cheap relative to bonds in that country with the Equity Yield (defined as the EPS of the S&P index divided by the value of the index) at around 8% today. In this scenario either equities are very cheap or the markets think that growth is going to fall off sharply and there is a strong chance of a deep recession. I believe that the probability is now high that we will start seeing some revival in the US economy. The biggest drag has been high food, garments and fuel prices and all of these are now showing signs of softening.
With the severe sell off in the global markets we have now seen most global factors being factored into the markets. As such the focus has shifted back to the domestic factors. The domestic factors were essentially two
High inflation and RBI tightening – The high and stubborn inflation rate has been one of the biggest factors that has resulted in India underperforming the global as well as emerging markets. I have talked of this topic a lot earlier so I will not go in much detail except for reiterating the fact that most of the inflation is food and global commodity driven which is totally out of the hand of RBI. With the government not taking much of steps to augment the supply side high inflation at periodic intervals will continue to plague the Indian economy. The good part is that the slowdown in the global economy has resulted in lot of commodity prices coming down sharply and good monsoons and better productivity will result in food inflation coming off over the next few weeks. A large number of central banks globally have avoided hiking rates in the recent past citing global concerns. However, the RBI believes that India is a country that is totally immune to global concerns and has continued to tighten aggressively. This is a significant policy misstep which the RBI might regret at a later date. Twice over the last 6 months the markets have started to make a base and move up but have been stymied by 50 basis point hikes by the RBI. Any further tightening might lead to a significant slowdown and it is time for the central bank to look around and see the global scenario before taking any action. Domestic interest rates now seem to have peaked out, however we have to see when they start declining. However as things stand now my view is that a year from now we should have rates that are atleast 200 basis points lower. However market could be concerned about the next RBI action till the next policy announcement in September Mid.
Lack of Policy making – This has been the second biggest concerns for the markets. Over the last couple of weeks we have seen positive news bites from the government on this front. However the anti corruption protests have the potential of delaying these things further. There was an expectation of things moving forward during the current Parliament session which seems less likely now. This has resulted in India underperforming most global and Emerging Markets over the last 3-4 days. This could continue in the near term as these concerns are unlikely to go away in the near term. This could create further underperformance in the near term and in case the global markets weaken further we could see a further selloff.
In terms of fundamentals based of the now downgraded earning of around a 1200 EPS for the current financial year and a 1400 EPS for the next year for the SENSEX, the markets are now trading at valuation of 12X next year earnings. This creates a very strong base for the markets as far as valuations are concerned at a time when the interest rate cycle seems to be peaking out. In terms of pure fundamentals the markets are looking very cheap; mid and small cap stocks that were already cheap have become cheaper with the complete capitulation seen across the board over the last few days.
However technically there seems to be a further downside of 5-6%. Under the changed circumstances I now believe that markets should now bottom out at around 4800 levels for the NIFTY and 15700 levels for the Sensex. Markets are cheap but could get cheaper as absolute panic sets in. However this does not change the longer term outlook in any way and subsequent to the current phase getting over a strong rally should unfold. The movement of the markets over the last few days reflects a complete capitulation on the mid cap side of the market which should typically result in a durable bottom being formed. Global and Emerging Market Equity funds have also seen the most outflows since the end of 2008 which is also typical of a capitulation from the side of investors. In terms of timing the next upmove should start over next 6 to 8 weeks as the shock of the current fall gets absorbed and the base for the new move gets formed.