Do it yourself

Little did Edward A. Murphy, Jr., an American aerospace engineer, realize that one of his design advice would become one of most popular epigrams and be termed Murphy’s Law. In the late 1940s, Murphys told his team that “If there are two or more ways to do something and one of those results in a catastrophe, then someone will do it that way.” This advice was later restated by Arthur Bloch in his book Murphy's Law, and Other Reasons Why Things Go WRONG as “Anything that can go wrong, will go wrong.”

In 1997 Sebastian Junger wrote a creative account of the 1991 ill-fated fishing expedition of the boat Andrea Gail from Massachusetts. The boat was caught in a severe sea storm and all the six crew members were reported dead. The book, titled “The Perfect Storm”, was later adapted into a movie with the same title. ‘The Perfect Storm’ is one of the perfect examples of Murphy's law applying in real life situations.

As of this morning, the Indian equity markets appear heading into a perfect storm. Anything that can go wrong appears to be going wrong. Let’s pray Murphy fails this time.

Economy stuck in slow lane

The broader economic growth momentum has stalled, completely negating the impact of the massive Covid stimulus. After a couple of years of denial, most agencies are gradually acknowledging that the real GDP growth might be settling in the 6%-6.5% band. As the latest Union Budget depicts, the fiscal leverage to stimulate growth has now mostly dissipated.

It is worth noting that FY26BE fiscal deficit of 4.4% may appear encouraging in recent context, but is far higher than pre Covid FRBMA mid-term target. Besides, as per FY26BE interest payments are projected to be 37.2% of total revenue receipts (vs ~23% in FY18RE). Obviously, the present debt and deficit levels are not sustainable.

For record, FY19BE projected fiscal deficit at 3.3%; to be cut to 3% of GDP by FY21. If the government aims to achieve this target by FY29, there would be hardly any fiscal leverage available to the government for increasing expenditure.

The central government capex, as percentage of GDP, may have already peaked around 3% of GDP. Even taking into account the state level capex, the total public capex is now stuck at 4%-4.5% of GDP, with significant risk of slippages due to resource constraints and execution failure.

The scope for increasing government consumption (revenue expenditure) is limited and would depend entirely on the tax buoyancy. The finance minister has assumed an income tax buoyancy of 1.4 in her estimates for FY26BE. This implies the government expects 1.4% rise in personal income tax revenue for every 1% rise in GDP. Even the STT collections, which are entirely a function of stock market trading volumes & MF flows, are assumed to be growing 41.8% in FY26.

Even with these aggressive tax revenue assumptions, government revenue expenditure (ex-interest) is expected to settle around 5% of GDP, much lower than ~7.5% seen during pre-Covid years.

Aggressive tax buoyancy assumptions, despite exempting personal income upto Rs12 lacs from income tax, indicate continued pressure on the upper middle-class segment consumption. This is the segment which has provided material boost to consumption growth, especially in the premium segments like SUVs, premium liquor, travel & tourism, clothing etc.

Despite all the efforts and incentives, private capex for new capacity addition has not picked up. Most private capex in the past five year has been in technology (improving productivity), real estate accumulation, brown field expansions, and consolidation through merger and acquisitions. There have been only a handful of greenfield manufacturing projects. Consequently, the share of manufacturing in GDP has not improved (in fact declined marginally). With sub-optimal consumption demand, positive real rates, and global headwinds on exports, the visibility of any material pick-up in the private capex remains low.

Thus, all the macro drivers of growth (consumption, investments, exports) are facing headwinds. At this point in time, it appears unlikely that in the next 4-5 quarters we shall witness any substantial improvements in most of the growth drivers. However, if the Mother Nature gets angry (a hotter winter, just like the warmer winter this time); or the ongoing global trade war triggered by President Trump gets uglier, the things could worsen further and we may witness growth trajectory collapsing further to pre Covid trajectory of 5-5.5%.

Corporate earnings fatigued

After compounding at a rate of ~18% over five years (FY20-FY24), the corporate earnings appear fatigued. Nifty50 FY25E earnings are expected to grow at a meager 2%-3%. As per the current consensus estimates, FY26E Nifty 50 EPS may grow ~12-13% yoy. However, given the macro headwinds, INR weakness, tariff headwinds for exports, persisting slowness in consumption demand, indicate some downside risk to the current consensus estimates.

The earnings growth in the recent past particularly led by banking, commodities (metal & energy) and capital goods & construction sectors.

Recent performance of the banks indicates that the growth drivers are now tired. Asset quality has peaked for most banks. Any further slowdown in the economy may actually trigger a reversal. Some segments like microfinance, unsecured personal loans and gold loans etc. are reportedly already showing considerable deterioration. Beginning of rate cut cycle with emphasis on immediate transmission, indicates that net interest margins may also be closer to peak and might begin to stagnate or moderate from current levels. Rising stress on household balance sheets, slowing demand for automobile and other consumer discretionary items, and slower private capex growth may keep the credit growth under check. Any substantial improvement in earnings growth for the financial sector in the near term is unlikely.

The demand growth for building material, steel, and other metals has moderated in FY25. The management commentary indicates only moderate improvement in FY26 with continuing margin pressures, given low-capacity utilization and lack of pricing power. Durable tariff by the US, might result in EU and Chinese dumping in countries like India, further pressurizing the domestic prices.

Several mega infrastructure projects like expressway, airports, freight corridors etc. are nearing completion. The pipeline of large infrastructure projects is diminishing in size; and the focus is on completion of the stuck projects. The visibility of large contracts for construction companies, except in the power sector, is poor in FY26 at least.

It is important to note that a large part of stock price rise in the past four years has occurred due to PER re-rating in anticipation of strong earnings momentum. Lack of sustained earnings momentum might result in some PE derating also; while there is no case for a further PER rerating.

Overall, any material upgrade in earnings estimates and PER rerating looks unlikely. However, there is a decent probability of earnings slowdown and PER derating persisting through FY26.

Technical indicators pointing to further downside

With a material erosion in stock prices over the course of the past six months, the investors’ buoyancy has eroded to a large extent. The broader markets with over 20% correction from recent highs are already showing a bearish trend. Benchmark indices are down ~13% from their recent highs and are showing distinct technical weakness – trading below all key moving averages. The technical studies indicate 4-5% further downside from the current levels.

However, if the earnings deteriorate and global noise rises, the immediate technical support may break and markets may head for much lower.

The perfect storm

Deteriorating macro, global headwinds, stagnating earnings growth and PER derating, and weak technical positioning could forma perfect storm for the Indian equities. Murphy’s law says it is more likely to happen. Let’s pray Murphy fails this time.

Presently, the total market capitalization of the NSE is close to Rs415 trillion, almost the same as it was during the last week of May 2024. The benchmark indices like Nifty 50, Small Cap 100, Nifty 500, Bank Nifty etc. are also trading almost at the same levels as prevailed during the last week of May 2024.

The benchmark Nifty50 scaled a new all-time high-level yesterday. Analyzing the current market trends, I get some signals that suggest that a significant correction (8% to 10%) in the benchmark Nifty50, though not imminent, is certainly on its way. I feel not imminent, because (i) the top stocks that could have caused an immediate slump are notably underperforming the Index, and (ii) a much deeper correction ought to occur first in the broader market indices that materially outperformed Nifty50 in the past one year.

YTD2024, the benchmark Nifty50 has been supported mostly by the energy, healthcare, and auto sectors; while the heavyweight financials and consumers have massively underperformed. Though there are no significant triggers for a strong recovery in the financial and consumer sectors, a technical upmove cannot be ruled. This might result in a Nifty50 spurt before a correction sets in.

It is pertinent to note that a correction in the outperforming energy (ex-Reliance), auto, and healthcare sectors may not trigger a material correction in Nifty50, as the weightage of these sectors is not enough to trigger a major correction in Nifty50.

I guess that a deeper and more meaningful correction is more likely to occur in a traditionally weaker market period of May and June. I say so for five simple reasons.

a)    The number of large daily movements in benchmark indices on closing, as well as intraday basis, has increased substantially in the past month. This trend usually weakens the technical fabric of the market.

b)    There are clear category preferences visible in investors' activities along with unreasonably higher valuations in preferred categories. Normally a sign of a bubble in the market.

c)     Policy focus is driven by the market and the market is obsessed with policy focus. Usually, this harmony of market and policy is unsustainable - because it leads to misallocation of resources and higher volatility due to political events.

d)    Despite higher interest rates, a larger number of household investors are driven to equities. Logically, it is an unsustainable trend.

e)     The household investors’ participation in highly speculative options trading is scaling new highs. Historically this trend has never ended well. (more on this tomorrow)

f)      Policy rate cut speculations, that had initially driven the global equity rally, are losing steam. A hawkish Fed in March might adversely impact the risk-on mood.

I will be the happiest person on this earth to be proven thoroughly wrong on this count. But till it happens, I shall hold this view and stay cautious on my equity portfolio.

 For the stock markets, the 2023^rd year of Christ is beginning on a cautious note. The global narrative is swinging between an orderly decline to a precipitous crash. With the last man standing Haruhiko Kuroda (BoJ Governor) falling this week, it is clear that the “crusade” against inflation will continue in 2023 - and money will be expensive and tighter. This is most likely to reflect in slower economic activities, and aggressive trade and currency conflicts.

The developed markets that have thrived mostly on the steroids of cheap and easy money will show withdrawal symptoms which may include volatility, recession, protectionism, financial instability etc. The emerging markets largely dependent on exports to developed markets (commodity or merchandise) shall also suffer the collateral damage. However, the emerging market with strong domestic economies, stable fiscal conditions and stronger financial markets might find themselves in a position to take advantage of flight of capital from the developed and weaker emerging markets and lower commodity prices. India, arguably, is placed in the latter category of emerging markets.

It cannot be denied that a precipitous crash in the global markets will hurt the Indian market badly, just like it did during the market crashes of 2000, 2008-09 and 2020. However, in case of an orderly decline in the global economies and markets, India may stand out again in 2023, just like it did in 2022.

As of this morning, the risks to Indian markets are evenly balanced. Absence of bubble in any pocket of the market, low volatility, strong domestic flows, economic growth still close to past decade’s trend, and stable fiscal & financial conditions support the markets; while rising probability of a precipitous crash, a deeper recession than presently estimated and the geopolitical conditions taking a turn towards the worst, pose material threat to the markets.

The investors are therefore faced with high uncertainty in formulating an appropriate investment strategy. I would be extremely untruthful and dishonest to claim that my situation is any better than most of the investors. Nonetheless, after evaluating the entire situation I have shortlisted the following factors that would support my investment thesis for next 9-12 months and help me in navigating the turbulent waters.

1.    There are no signs of a bubble in the Indian equity market.

2.    The earnings growth is likely to stay positive for at least a couple of more years.

3.    Margins may bottom as inflation, rates and USDINR peak sometime during 2023.

4.    The leverage in Indian markets is substantially lower as compared to 2000 or 2008-09. The chances of a sustained crash are therefore much less this time.

5.    Despite the outperformance, foreign investors have not been enthusiastic about Indian equities in the past couple of years. The foreign ownership of Indian stocks is at a multiyear low. Besides, India's weight in MSCI EM has seen steady increase. The probability of an accelerated selling is therefore low.

6.    The valuations are not cheap though closer to the long term averages. Given the slower growth and higher bond yields, it is likely that Indian markets may witness some PE de-rating and trade below long term averages.

7.    The bull case for Indian equities as a whole is weak. The upside from the current levels is limited, given slowing growth momentum and higher rates; whereas a panic bottom could be deep.

8.    There are some pockets of the economy (and market) that are witnessing a sustainable transformation. These pockets offer once in a decade type opportunities. Some examples are Defence production; Biofuels; Real Estate; Manufacturing Modernization; Self-reliance in Intermediates’ Manufacturing; and Modern Retail. These pockets of growth have been well identified and analyzed, therefore, the risks are mostly known and the growth path well illuminated.

9.    Presently the opportunity cost of holding cash is minimal as liquid funds and short term fixed deposits are offering decent returns. There is no rush to go out and deploy cash in equities and other assets.

10.  The developed markets may hit the rock sometime in 2023, though a sustained recovery may elude them for a couple of more years at the least. The stronger emerging markets may find favor with the yield hunters in this scenario.

 The benchmark indices in India are now trading at their highest ever levels. In fact, in the past one year, India (+9.6%) has been one of the best performing equity markets in the world, in line with the emerging market peers like Brazil (+8%), Russia (+9%), and Indonesia (+7.5%) etc. Only a few emerging markets like Venezuela (+107%), Argentina (108%), and Egypt (+15%) have done much better.

For many Indian investors these statistics could be meaningless. To some it may actually be annoying as the performance of their individual portfolio may not be reflecting the benchmark performance. Regardless, largely the equity market returns have been reasonable, considering the challenging environment. It is therefore a moment to celebrate.

Once the celebrations are over, it would be appropriate to ask ourselves “whether at ~18700, Nifty is adequately taking into account all the factors that may impact the corporate performance, risk appetite, liquidity and financial stability in 2023?” In particularly, I would like to assess the risk-reward equation of my portfolio especially in light of the factors like the following:

Stress on discretionary spending

In the recent months several companies have rationalized (or announced the plans) their workforce. A significant number of highly paid workers are facing prospects of job loss. Anecdotal evidence suggests that the uncertainty created by a 2% workforce rationalization could temporarily impact the discretionary consumption plans of at least another 48% employees who retain their jobs.

Reportedly, IT hiring from the top colleges in India are likely to witness a 50% fall in 2023 (see here). We might see similar trends in other sectors also as most management have guided for a moderate growth in next few quarters.

My recent visits to several rural areas indicated that discretionary consumption in farmer households has already been impacted by poor income in the 2022 Kharif season. As per reports La Nina (excess rains) conditions that impacted crops for the past four seasons, are likely to persist through Rabi season, while the 2023 Kharif season might witness El Nino (drought like) conditions. (See here)

Erosion in wealth effect

On the last count India had more than 115 million crypto investors (see here). About two fifth of these investors were below the age of 30, thus having a strong risk appetite. These investors had seen sharp gains in their crypto in 2020-21m but apparently they are now sitting on material losses in their portfolio.

A significant number of new listings, especially from tech enabled businesses, are trading at material losses to their immediate post listing prices. These businesses typically have a material part of their employee compensation in the form of ESOPs. Many employees who had seen substantial MTM gains in their ESOP values have witnessed material drawdowns in their portfolio values. A few of them might be facing double whammy of material MTM losses and tax liability.

A number of small and midcap stocks that jumped sharply higher in 2020-21 have corrected significantly in 2022.

Obviously, the wealth effect created by the euphoric movement in stock and crypto prices has subsided to some extent. This submission of wealth effect shall also reflect on risk appetite, consumption pattern and investment behaviour of the concerned investors.

Tightening fiscal conditions

Lot of market participants are betting on continued fiscal support to infrastructure & defence spending, and incentives like PLI etc.

It is pertinent to note that the forthcoming budget would be the last full budget before the general elections to be held in 2024. It is likely the government chooses to increase the social sector funding at the expense of capital expenditure next year. The disinvestment program might also be slowed down to avoid adverse publicity for the government. Imposition of additional tax(es) or hike in capital gains tax could also be considered. All these events could impact the investors’ sentiment.

Rising external vulnerabilities

The external sector has been weak for a few quarters now. The trade deficit in October 2022 widened to a worrisome US$26.91bn. Exports dropped ~17% in October 2022 on slower global demand; while imports were still higher by ~6%.

Notwithstanding the efforts of the government to improve trade account by import substitution and export promotion; the exports have grown at a slow 4.3% CAGR in the past three years; whereas the imports have registered 14.3% CAGR in the same period, resulting in larger trade deficit. The external situation thus remains tenuous.

It is pertinent to note that the World Trade Organization (WTO) has projected a sharp slowdown in world trade growth in 2023. (see here) Obviously, the pressure on balance of payment will remain elevated in 2023.

Cash on sidelines may protect the downside

Overnight (liquid) funds are now yielding a return of ~5% p.a. Bank deposits are offering 5.5-6% return. Under the present circumstances, at ~18700, the upside appears limited to 8-10% while the downside could be much more than 10%. Obviously, the risk-reward equation is not favorably placed at this point in time, and the opportunity cost of holding cash is not bad. This could keep a lot of money waiting at the sidelines.

Higher cost of carry and margins have also resulted in lesser leveraged positions in the market. 

The cash on the sidelines and lower leverage may keep the downside somewhat protected.

In the past one month the benchmark Nifty50 index has gained over 7%. With these gains Nifty returns are now positive YTD2022 as well on a one year basis. In fact, the August 2022 Nifty Future expiry was the highest since October 2021 Future expiry of 17857. Even for Bank Nifty, the August 2022 Future Expiry was highest ever; since October Future expiry of 39508. Indian equities are now outperforming most major global markets on a one year basis.

On one year bsis Nifty is now higher by ~6%.In this period, IT (-15%), Pharma (-8%) and Small Cap (-4%) are notable underperformers; while Energy (+39%), Media (+33%), Auto (+33%), PSU Banks (+30%), Realty (+21%) and Midcap (+14%) are notable outperformers.

The ~7% gain in the past one month has been led by Metals (+13.5%), Private Banks (+9.9%) and Energy (+9.8%). Pharma (+2.3%) and FMCG (3.3%) have been notable underperformers.

This strong market performance has occurred in spite of  – (i) below par 1QFY23 corporate performance; (ii) continued monetary tightening; (iii) elevated inflation; (iv) worsening current account and weakening currency; (v) weakening global growth impairing export growth outlook; (vi) erratic monsoon impacting kharif sowing and clouding rural demand outlook; and (vii) worsening geopolitical situation in China Sea as well as Ukraine. Obviously, there are doubts over the sustainability of the current market up move. The question thus arises “how does market look in the near term (next 6 months)?”

In my view-

(a)   The economic situation in Europe, US, and China may continue to worsen materially into summer as the energy crisis worsens; drought intensifies further; food inflation rises further; monetary tightening continues and global demand slithers further down.

(b)   Macro challenges in India may continue to remain intense in India as food inflation stays elevated in festival season; RBI tightens further in busy season; exports slowdown keeps CAD elevated; manufacturing growth continue to disappoint on poor export order flow; overall growth remains below the budget assumptions impacting the revenue collection estimates & public expenditure; election to some key states keeps reform agenda in check.

(c)    Relative stability and growth may keep the foreign flows positive. However, some of this could be neutralized by poor domestic institutional flows, as we have seen in the month of August.

(d)   The earnings downgrades may accelerate post 2QFY23, as even the current consensus on earnings growth (~15%/16.5% for FY23e/FY24e) looks slightly optimistic.

(d)   Technically, most Indian indices are in a neutral zone as of now – implying even risk reward in near term. The benchmark indices may rise or fall by 5-7% in the next 2-3months. However, in case Nifty does rise by 5% from the current level, the risk reward shall become very negative. For BankNifty though it may still remain neutral.

So in my view, Nifty may move in the 16250 – 18750 range, with occasional violation on either side, in the next 6 months. Most of the Nifty upside could be contributed by financials. BankNifty could therefore outperform materially. In technical terms the range for BankNifty could be 36800-44000, with occasional violation on either side.