Drivers of recovery

Growth risks could affect stocks

There is an apparent disconnect between market action in the past four weeks or so and the fundamentals. Stock markets in most major economies have seen a recovery — the Nifty has gone up by over 10 per cent, for instance, during this period. Yet, the prognosis is not cheering. Based on the corporate results of Q1 (April-June), there have been more earnings downgrades than upgrades to the stocks constituting the broad NSE500. The consensus forecasts for the large companies in the Nifty 50 are also down. The rupee remains under pressure, while the Reserve Bank of India (RBI) has hiked the policy rate and is expected to push it up further. Globally, the Ukraine war drags on, affecting global supply chains, triggering volatility in commodity prices. China has gone into repeated lockdowns this year, cutting growth rates to multi-decade lows. The US and the EU are suffering from high inflation and the world’s two biggest central banks have instituted tighter monetary policy and hiked policy rates. The global growth forecast is also being revised downwards.

So, why are most stock markets undergoing a recovery and why are the Indian markets in particular trending up? The first proximate cause is the return of foreign portfolio investors (FPIs) to emerging markets. After selling stocks worth Rs 2.16 trillion between January and June, they have been net buyers over the past six weeks. While domestic institutions have sold in moderate quantities, mutual funds have continued buying. Inflows into the equity mutual fund segment remain strong, suggesting that retail investors continue to be optimistic about equity. Among investment professionals, the consensus seems to be that the worst is over, barring another wave of the pandemic or some other risk. Inflation is still unacceptably high but it moderated in July. Some of the pressure on the trade account has eased, with the key variable of energy prices moderating. On the flip side, industrial metals have seen sharp corrections, which affect India’s major producers.

Overall earnings prospects continue to look reasonable despite the downgrades, with most firms posting a positive guidance for the second half of 2022-23. There are encouraging signs visible in high-frequency data such as railway freight movement, power generation, aviation traffic, port traffic, sales of vehicles, and goods and services tax collection. Consumer demand is still weak, going by Q1 results, but it is picking up, and a good monsoon could be a booster. The economy is certainly not out of the woods, given that energy prices remain high in absolute terms, and earnings growth has been downgraded. Indeed, at least one major FPI expects the Indian markets to see another 10-15 per cent correction by December. But investors do seem to be more optimistic than they were a quarter ago.

Valuations may be the key to sustaining the rally. Between January and June, the markets corrected by 17 per cent and despite the subsequent rally, valuations have dropped since earnings have also risen over the previous two quarters.  Consensus forecasts suggest the Nifty is discounting its likely 2022-23 earnings at a price-to-earnings ratio of about 17. This is higher than other emerging markets but it is closer to the historical valuations that Indian stocks have usually enjoyed. Investors would be well advised to remain cautious, given the likely headwinds to growth.