The markets are making investors nervous. The Sensex and Nifty are down 10% from record highs seen in March, the ten year gsec yield is up 25bps from lows seen in January and the INR is down over 2.5% against the USD from highs seen in January. Your expectation has been high on equities and bonds given a healthy rally in the year 2014 on the back of domestic political stability and on the back of global liquidity.
The question on your mind right now is why are the markets falling and will it continue to fall going forward? Is the fall temporary or permanent and what should you do with your investments in equities and debt? Taking each question by turn?
Why are the markets falling?
The easy answer to this question is profit taking at higher levels of equities and lower levels of bond yields. However the answer is anything but easy as there are solid reasons for fall in the Sensex and Nifty and rise in yields on the ten year gsec.
On the domestic front, the fact that valuations on the Sensex and Nifty had risen from 18x earnings to around 24x earnings has played a role in the fall in the indices. The fourth quarter earnings from tech majors have disappointed while other sectors including banks are showing mixed results. Read our analysis Performance does not Support Valuations – Be Careful. Higher market valuations are not being supported by on the ground corporate performance.
Issues such as IT demand of MAT on FIIs have also caused a bit of uncertainty on portfolio flows.
Bond yields are rising on the back of factors such as worries on absorption of government borrowing, monsoon effect on food prices and government’s ability to contain fiscal deficit of 3.9% of GDP as budgeted for this fiscal. Banks running a SLR of close to 29% of NDTL against regulatory levels of 21.5% of NDTL is causing concern amongst market participants on banks demand for government bonds. Read our analysis on Government borrowing demand and supply for this fiscal.
Chart 1: India CPI Monthly
The meteorological department has forecast below normal monsoon and EL Nino warnings are rising globally. RBI may hold rates in June against widely expected cuts to judge monsoon progress and its effect of food inflation.
Government is taking on higher fuel subsidy of around Rs 100 billion as it has scrapped subsidy sharing by upstream oil companies. Weak equity markets may hit disinvestment plans while key tax reform of GST struggled to get through parliament until today, when it was passed. Government revenues falling short of budget may lead to higher government borrowing.
The INR has depreciated against the USD on the back of FII selling equities and debt on MAT issues and global risk aversion.
Global risk aversion is rising as seen in the fall in in global equities with indices from US to Europe coming off record highs. Global bond yields have risen from lows. Read our analysis on Global Bond Bubble. Worries of Fed rate hikes despite a weaker than expected economic data from the US with first quarter GDP growth at 0.2% against 2.2% seen in the fourth quarter of 2014, is hurting US equities. Greece’s ongoing bailout talks are hurting sentiments in the Eurozone.
Chart 2: US PCE Inflation
Chart 3:Eurozone CPI
Will the markets continue to fall going forward and is the fall temporary or permanent?
In the short term, until near term risks to the markets play out, markets can continue to fall. However the fall is temporary and not permanent and the reasons are as follows.
1. Corporate performance is likely to improve over the longer term as both domestic and world economy recovers on the back of lower interest rates, high liquidity and improved macro economic fundamentals. Improved corporate performance will make valuations look inexpensive.
2. The government is working to resolve MAT issues with FIIs and that resolution will prompt FII flows
3. Monsoons do have good and bad periods in India but long lasting effects on markets are not apparent
4. Government is committed to its fiscal road map of 3% of GDP in 2017-18 even as RBI has adopted a target of inflation at 4% in the same year. Low fiscal deficit and low inflation is extremely positive for interest rates coming off in the economy. GST was passed in parliament today and when implemented in April 2016, it will give a major boost to indirect tax collections.
5. Fed rate hikes will not cause long term damage to markets as rates are just being raised from closed to 0%. Fed is likely to gradually hike rates over the next two years to take it to levels of around 1.25%, which still offers a comfortable spread to domestic interest rates assuming repo rate is at 7%.
Interest rates in US, Eurozone and Japan are at close to 0% and except for the Fed, the ECB and Bank of Japan are likely to keep rates low for at least two years. ECB and Bank of Japan are together pumping in USD 125 billion of liquidity through asset purchases every month. Inflation is at 0% in the Eurozone and at 0.01% in Japan and outlook for sharp increase in interest rates is not apparent. Oil prices are down on the back of excess supply over demand and China growing at below trend levels of 7% is hurting other commodity prices.
Fed expects inflation in US at around its threshold level of 2% over the next two years even as economic growth is expected to be moderate rather than high.
High global liquidity coupled with low interest rates will find its way to higher yielding currencies like the INR. India’s Balance of Payment position is healthy with Current Account Deficit kept down on the back of low oil prices while capital flows are robust on positive sentiments on the INR as the government and RBI is committing to lower fiscal deficit and inflation respectively.
Foodgrain production has been robust over the last four years and government is revamping its distribution system to make sure that prices are kept down even if monsoons fail. Rural economy may take a hit as consumption slows due to bad monsoons but stronger industrial production and urban consumption can negate the weakness in rural demand. Interest rates are also likely to be brought down to help the rural economy.
Chart 4: Production of foodgrains in million tonnes
Chart 5:Sensex returns and Monsoon
What should you do with your investments in equities and debt?
Given that the market correction is more temporary than permanent and that the threat to macro fundamentals are low, you should hold on to your investments in equities and debt. You can look to make fresh investments in this market correction but you should have a time frame of at least three years for the investments to get the best results.