By Unmesh Sharma
A month can be a very long time in financial markets. In late July, the FOMC policy statement and press conference saw a clear acknowledgement that there is one eye on growth risks. In essence, markets saw the re-emergence of the “central bank put” at an appropriate time. As was to be expected, the market breathed a sigh of relief. The resulting relief rally in risk-assets benefited long duration assets including Emerging Markets (and indeed Indian) Equities.
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Chairman Powell used brevity as a proxy for forcefulness- indeed that also leaves less scope for reading between the lines. There was a marked hawkish pivot with the statements that price stability is the “bedrock of the economy” and an unequivocal signal for possible recession (“pain to households and businesses”). More concerning for us were clear signals that rates could go higher than we think and stay higher for longer. Chairman Powell made it clear that “estimates of longer-run neutral are not a place to stop or pause”- indeed the Fed would lift its foot off the pedal only if it judges that inflation is under control. And if there was any doubt left, he even invoked former Chairman Volcker. Markets reacted accordingly.
The question now remains whether the 1.5% drop in the Indian market has absorbed this or is there more to come. Many commentators from equity markets pointed out over the weekend that this hawkishness was expected and priced in. Not so. While the currency and bond markets were better prepared, the equity markets, which are near all-time highs, are definitely not prepared for this.
We maintain our stance, which we had initially highlighted in this publication in late July, that this is going to be a long grind. This would mean pressure on long duration assets such as Emerging Market Equities and indeed Indian stocks within that.
Four key factors
– First: We believe the task has got tougher due to the political scenario. Many economists believe that President Biden’s student debt forgiveness could cost anywhere between US$400-600bn and add 0.2-0.3% to inflation. This adds another element to the risk that inflationary expectations will get anchored, further elongating the fight.
– Second: Quantitative Tightening remains the elephant in the room. This is an unprecedented event in the careers of most current market participants. We believe there is a more than equal chance that risk assets globally will see another leg down with profit booking in the next 3 months.
– Third: Volatility would remain high due to divergence in the scenario faced by various major central banks. The ECB for example is staring at a grim economic scenario and indeed a completely cloudy outlook on inflation and geopolitics. The Indian economy seems to be holding up with stronger domestic fundamentals, signs of moderating inflation and well capitalised CB and corporate sector. However as seen on the day after the Jackson Hold event, we may see volatility affect reserves as RBI intervenes for orderly movement in the INR.
– And finally, on valuations, the market is expensive. In an uncertain environment which we currently face, the usual rule of thumb we use is that valuations should be 1 standard deviation below the long term mean. We are far from that.
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How does one navigate this? Brace!
We continue to believe that Active Strategies will work in this environment. The model portfolio by the HSIE Research Team maintains its bias towards value and domestic economy-facing sectors. We remain underweight on stocks at the high risk end of the duration curve (like new-age technology), consumer (staples and discretionary), energy, NBFCs, and small banks. Our preferred sectors are large cap banks and IT, industrial and real estate, power, autos and we continue to add positions in long-term thematics (eg. City Gas, financial inclusion – Insurance and Capital Markets). Our big call for the next 12 months is “Industrials over Consumer”.
(Unmesh Sharma is the Head of Institutional Equities at HDFC Securities. The views expressed in the article are of the author and do not reflect the official position or policy of FinancialExpress.com.)