Demystifying party spoilers

Though, our view remains quite constructive for markets but as Mark Twain quoted “It isn’t what you don’t know that gets you in trouble, it’s what you know for sure that just isn’t so.” With such a great macro back drop (low rates + growth), when there is a very high degree of confidence among market participants, one should also not disregard the emerging signs of potential risks that might spoil the carnival.

2020: A year to remember   

2020 will be forever remembered as an extraordinary year in the history of mankind as this year not only disrupted many lives and livelihoods across the global sphere but also made us accustom to new habits which we never thought of adapting in the first place. As far as the markets are concerned, equity markets witnessed a terrific roller coaster ride in this calendar year. The Nifty-50 fell 40% between January & March and then rose by 86% from the lows of March. The aggressive easing of monetary policy by central banks was well supported with the great coordination of various governments in rolling out the aggressive fiscal measures across the global ecosystem. The last 2 months of 2020 turned out to be most eventful and defining months of the year. Where on one hand the markets welcomed the elimination of US political uncertainty on the other hand, the news in regard to the substantial development in Covid vaccines all across the geographies transformed the global sentiments completely.

Current global & domestic macro-economic backdrop remains quite conducive…

Global macro environment in the form of Fed’s assurance to keep rates lower for longer with the clear intent to support growth and financial conditions coupled with the more predictable foreign trade policy and better relationship with allies under Joe Biden’s presidency, all this is likely to auger well for global growth prospects. Domestically falling Covid caseload curve, sharp rebound in economic momentum (recovery on track), urban economic recovery strongly catching up with rural economic recovery, RBI’s intent to keep stance accommodative stance for this year and next financial year (this will keep discount rates lower for longer) coupled with the constant intervention by government and better than expected earnings delivery provides a conducive environment for Indian markets.

…However, amidst sheer optimism, we identify potential risks that can ruin the carnival

Problems with the vaccine rollout: Concerns against too much enthusiasm as availability & distribution in emerging markets may lag behind their developed peers. Wealthier countries have secured extensive supply deals to hedge their bets, while many developing ones may have to rely on international groups that have promised to make vaccines affordable. The logistics of transporting, distributing & administering them require advanced infrastructure & medical expertise that might not be available in every country.

Commodity reflation might turn into a headache for policymakers: Current commodity rally is largely attributed to earlier-than-anticipated global economic revival after the spread of Covid-19 virus coupled with the lag in supply restoration along with the robust demand from China. While the Fed/RBI has pledged low interest rates for the whole of 2021, a sustained build-up of asset bubbles or growing inflationary expectations could very well prompt the Fed (and/or the RBI) to roll back some of the liquidity measures.

Interest rate rise resulting into rising Dollar: Central banks in emerging markets followed their developed peers in cutting interest rates to record lows this year, together easing more than during the 2008 financial crisis. Now, as vaccines are rolled out and the risk of inflation rises, some policy makers might come under pressure to reverse course, a theme that will come increasingly to the fore in 2021.

We feel that H1FY22 will continue to see traction from foreign flows on account of global liquidity flows, progress on the Covid-19 vaccine and the improving economic situation i.e. they are likely to keep the market sentiment buoyant. However, any signs of higher-than-expected inflation domestically or globally coupled with the coerced unfavourable turn in monetary policy or fiscal policy can prove to be party spoiler as low bond yields have been a key peg to high valuations and a sharp increase in bond yields would be negative for equity valuations. Sustained high inflation could pose upside risks to bond yields and downside risks to both bond and equity prices.

2020: A year to remember

2020 will be forever remembered as an extraordinary year in the history of mankind as this year not only disrupted many lives and livelihoods across the global sphere but also made us accustom to new habits which we never thought of adapting in the first place. As far as the markets are concerned, equity markets witnessed a terrific roller coaster ride in this calendar year. The Nifty-50 fell 40% between January & March and then rose by 86% from the lows of March. The Global equity rally has been led by the Big Tech companies which has taken the Nasdaq Composite Index up by a whopping 43% in this calendar year. In 2020, Nifty-50 and BSE Sensex have delivered returns of 15% & 15.9%, respectively which is at par with the MSCI Emerging Market Index and better than MSCI World Index. Unlike past two years 2020 saw a broad based rally with higher participation coming from mid & small caps. In 2020 the Nifty Mid Cap 100 Index & BSE Small Cap Index have gained 22% & 32%, respectively beating the Nifty-50. Two defensive sectors namely BSE Healthcare (up 62%) and BSE IT (up 56%) gave exceptional returns in this year. Recovery across risk assets supported mainly by easy monetary policy by global Central banks. Three sectors delivered negative returns in 2020 which are BSE Bankex (-2%), BSE Oil & Gas (-4%) and BSE Utilities (-1%). The covid-19 fear that engulfed markets in March was immediately followed by unprecedented optimism of significant recovery across the board that reinvigorated animal spirits via mammoth liquidity injections which were boldly undertaken by major central banks. The aggressive easing of monetary policy by central banks was well supported with the great coordination of various governments in rolling out the aggressive fiscal measures across the global ecosystem. The last 2 months of 2020 turned out to be most eventful and defining months of the year. Where on one hand the markets welcomed the elimination of US political uncertainty as the outcome was broadly in line with the set up expectations, on the other hand, the news in regard to the substantial development in covid vaccines all across the geographies transformed the global sentiments completely and paved way for further global risk on rally.

The current global & domestic macro-economic backdrop remains quite conducive

Global macro environment in the form of Fed’s assurance to keep rates lower for longer with the clear intent to support growth and financial conditions coupled with the more predictable foreign trade policy and better relationship with allies under Biden’s presidency, all this is likely to auger well for global growth prospects. With Biden coming into power, a key area of change will be in the external policy, trade policy and immigration policy, i.e. these policies are most likely to differ from the previous administration, given Joe Biden’s more reconciliatory approach. This will significantly ease out global tensions both on economic and political level, thus paving the way for higher global growth. Alongside, even domestically, falling covid-19 caseload curve, sharp rebound in economic momentum (recovery on track), urban economic recovery strongly catching up with rural economic recovery, RBI’s intent to keep stance accommodative stance for this year and next financial year (this will keep discount rates lower for longer) coupled with the constant intervention by government and better than expected earnings delivery provides a conducive environment for Indian markets. Along with these developments, strong global and domestic economic rebound have forced major central banks to revise 2020 and 2021 growth projections upwards. With major central banks ensuring availability of liquidity into the system and maintaining ultra-accommodative stance, we expect dollar index to continue its downward trajectory, which augurs well for the EM markets and paves way for commodity reflation. Thus, we expect foreign flows to continue gain traction in 2021. ‘GOLDILOCKS’ macroeconomic backdrop (strong growth and low rates) for equities is driving risk on sentiment globally which should benefit Emerging Markets, including India.

Amidst sheer optimism, we identify potential risks that can ruin the carnival

Problems with the vaccine rollout

The market has high hopes for a successful and on schedule rollout of the COVID-19 vaccines globally, anticipating a majority of people having been immunized by July for major countries like the United States and United Kingdom. November’s good news on Phase 3 vaccine trials contributed to the strongest month for global equities in over 45 years as markets priced in a more rapid timeline for economic recovery. There is potential for the stock market to pullback some of those gains if vaccine distribution, adoption, or efficacy lags, resulting in delays to the recovery timeline. Bottlenecks with virus testing capacity and turnaround times in both the U.K. and U.S. raise concerns about the ability to roll out widespread vaccination, an even larger operation. Also, we believe the market has not yet discounted the potential return to lockdowns in early 2021 if there are new waves of cases and hospitalizations, or the potential for the virus to mutate and render current versions of the vaccine less effective.

Thus, we flag caution against too much enthusiasm as availability and distribution in emerging markets may lag behind their developed peers. Wealthier countries have secured extensive supply deals to hedge their bets, while many developing ones may have to rely on international groups that have promised to make vaccines affordable. The logistics of transporting, distributing and administering them require advanced infrastructure and medical expertise that might not be available in every country.

If commodity reflation turns into a headache

The current commodity rally is driven by - 1) An earlier-than-anticipated global economic revival after the Covid-19 spread, 2) lag in supply restoration and 3) robust demand from China. While metal prices have seen a sharp rally YoY (+20%), the overall commodity price rise is still modest vs. previous commodity cycles- Bloomberg commodity index at 60% of the average value of 2003-20, and 30% of the peak value. Inflation has been rising for several months and with crude oil inching up, prices may remain high. The factor that we need to take cognizance of is the likelihood of persistently higher inflation leading to some central banks initiating partial unwinding of the liquidity already infused into the economy. This may adversely impact the earnings profile as well as valuations over a period of time, especially if it proves to be the beginning of a period of gradual tightening of policy. This assumes greater importance as oil prices seem to be poised to move up, as well as some other commodity prices. Crude has already crossed USD 55 a barrel, the highest in last 11 months, pushing up petrol and diesel prices in India. Another major factor that catapulted the markets to such heights was the unprecedented liquidity that was pumped in by the governments and central banks around the world, along with massive rate cuts and loose monetary policy. A large part of this liquidity has gone into financial assets, creating asset bubbles, which the central banks would be keeping an eye on. On the other hand, inflationary expectations are also picking up. A spike in crude prices beyond USD 70-75 a barrel, too, would weigh on the country's finances and corporate profitability.

While the Fed/RBI has pledged low interest rates for the whole of 2021, a sustained build-up of asset bubbles or growing inflationary expectations could very well prompt the Fed (and/or the RBI) to roll back some of the liquidity measures.

Interest rate rise resulting into rising dollar:

An unexpected jump in inflation, surprise surge in bond yields or plunge in the dollar might lead to higher stock market volatility. Inflation expectations have been rising fast, as you can see in the chart below. Any breakout above the five year range may spark tighter financial conditions and prompt investors to reassess stock market valuations.

Central banks in emerging markets followed their developed peers in cutting interest rates to record lows this year, together easing more than during the 2008 financial crisis. A number of them even took a page from the developed-market playbook by buying bonds. Now, as vaccines are rolled out and the risk of inflation rises, some policy makers will come under pressure to reverse course, a theme that will come increasingly to the fore in 2021.

Fiscal and/or monetary policy tightens:

Markets are clearly betting on continued easy policy in 2021. Premature monetary or fiscal policy tightening in major economies could slow the recovery and deal a setback to the stock market. This happened when the global economy emerged from the last recession. Fiscal and monetary tightening in the name of austerity following the Great Financial Crisis of 2008-09 contributed to corrections of more than 15% in both U.S. and global stock markets for 2010 and 2011. The Fed signalled a coming slowdown its QE bond purchases in 2013, causing the “taper tantrum” which sent emerging market stocks down more than 15%. Policymakers are unlikely to tighten policy anywhere near as rapidly following this global recession compared to recent history. But signs of less easing may prompt a market pullback, should policymakers begin to seek ways to contain runaway budgets and balance sheets. This could take the form of discussions of tax increases or lightening up on QE asset purchases.

We feel that H1FY22 will continue to see traction from foreign flows on account of global liquidity flows, progress on the Covid-19 vaccine and the improving economic situation i.e. they are likely to keep the market sentiment buoyant. However, any signs of higher-than-expected inflation domestically or globally coupled with the coerced unfavourable turn in monetary policy can prove to be party spoiler as low bond yields have been a key peg to high valuations and a sharp increase in bond yields would be negative for equity valuations. Sustained high inflation could pose upside risks to bond yields and downside risks to both bond and equity prices.

The expected recovery in earnings and the economy in 2021 seems to have been priced in by the market. If these disappoint, then the market can nosedive. Markets expect earnings and economic growth to be in double digits in 2021 against the low base in 2020. Domestically, market participants will be keeping a close eye on the overall recovery in the economic environment and corporate earnings, as the markets have already started pricing in a healthy growth trajectory; hence, any disappointment on the earnings front can pose a risk. On external front, market participants will remain watchful of the build-up of inflationary pressures resulting into the rise in US 10 year bond yield and thus posing risk to the low interest rate environment as rising inflationary pressures might prompt in withdrawal of liquidity from central banks thus causing havoc in equities.