Equity markets had yet another month of strong gains in August, though it ended on a sour note with a sharp sell-off due to the China standoff. Small and Midcap indices led the market optimism for the month with a jump of more than 10% and 6% respectively attributing to a more broad-based rally.
However, the extent of the contraction in Q1 GDP (-23.9%), a first in more than 40 years was a wake-up call to the exuberant market participants. Now, their focus shifts to the next round of stimulus. But, with the current fiscal situation seeming to be already stressed, the resources for the economic impetus would be found wanting by the government.
Rising Covid cases are pushing the country-wide ‘Unlock’ further, prolonging the full-fledged economic activities and the skirmishes on the Chinese border are adding to the uncertainties. Going forward, these uncertainties should keep the financial market volatility high. So expect a bumpy ride ahead and Fasten your seat belts!
On the global front, China is showing some signs of plateauing after the early recovery backed by the pent up demand. The mobility data continues to indicate flattening of economic activity in the US, Europe, and the UK. Acknowledging the concerns, the US has changed its stance from ‘inflation targeting’ to ‘average inflation targeting’ which augurs well for Emerging markets like India, as it keeps interest rates at bay and boosts liquidity.
On the domestic front, a strong rebound in auto sales, expansion in agriculture/rural economy, high liquidity in the system, and low interest rates are some of the positives, but a subdued service economy, geopolitical tensions, low credit offtake, distressed MSME sector and lower capacity utilization does not augur well for corporate earnings.
With current valuations at 32.5x lingering near its all-time high, a further up-move can only come when strong earnings growth supports the market. The corporate earnings currently are in distress and do not justify the exorbitant valuations. The strong momentum experienced in the last few months indicates that market participants are entirely ignoring the subdued earning prospects for FY21 EPS and are already discounting a robust rebound in corporate earnings for FY22. (FY22 Nifty EPS growth is estimated at 46% as per Bloomberg consensus data)
Such steep corporate earnings recovery has never been seen before and the probability of achieving the same is highly questionable, which poses a massive risk towards current market momentum.
Hence, we believe that equity markets may remain volatile in the near term and upside if any is likely to be capped from current levels. We do continue with our cash call until we see reasonable valuations or earnings prospects improving.
On the Fixed Income front, going forward Inflation trajectory will be key for yields to stay down sustainably. As economies gradually reopen, in the wake of supply chain disruptions, stable supply may take time to return and this may lead to inflation uptick and volatility. As a savings grace, a stronger monsoon season bodes well for easing food inflation which is the biggest component (~48%) of CPI.
A steep yield curve and the RBI’s strong intent to keep a lid on yields, may provide tactical opportunities. Meanwhile, we believe that exposure to debt markets should be taken through short term funds for 1-2 year investment period and Banking and PSU debt funds for more than 2 year investment period.
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