Shifting cycle

Bond yields have risen and equity valuations have fallen as financial markets adjust to the reality of the Reserve Bank of India’s (RBI’s) move towards policy normalisation. The central bank has increased the repo rate by 90 basis points in the past two months and investors must brace themselves for more hikes as well as other measures such as raising the cash reserve ratio to tighten surplus liquidity. The RBI’s projections imply inflation as measured by the consumer price index will average 6.7 per cent —well above its upper limit of tolerance of 6 per cent — for the rest of FY23. The wholesale price index inflation is at 15 per cent. The RBI’s estimates of high inflation imply interest rates will have to be increased significantly. It also says there is surplus liquidity in the system. A combination of higher interest rates and lower liquidity is strongly associated with lower valuations for risky assets like equity. Investors don’t look at price-earnings (PE) discounts in isolation; they compare these to known returns from debt. As debt returns rise, the expected returns from equity must also rise for valuations to remain in sync. This means that PE discounts usually fall when interest rates rise.

The past two years have seen an extraordinary situation where the RBI flooded the economy with liquidity and maintained low interest rates to compensate for the pandemic. As a result, real returns net of inflation from debt turned negative, and equity valuations shot up. The benchmark indices — the Nifty and Sensex — were trading at a PE of 31 (last four quarters’ earnings) in early 2022, and the five-year average multiple was 26. A combination of earnings growth and share price corrections has pulled that down to PE of 23 in the past two months. But even PE of 23 is high by historical standards — the 10-year average PE is in the range of 19-20.

Investors use some rule-of-thumb measures to judge if a stock market is fairly valued. One is to compare the earnings yield to price (the inverse of the PE) to the return from risk-free debt such as government treasuries. Another related measure is to compare the difference between the two yields. Both measures suggest that the stock market is currently still overvalued. The 10-year government bond is trading at a yield of 7.5 per cent — the equivalent fair-value PE would be 14, which is roughly 35 per cent lower than the actual market PE. The differential between the 10-year government bond yield and the market earning yield is at 260 basis points and this difference has historically sustained at around 105 basis points.

Most investors are hoping for earnings growth of around 16 per cent this fiscal year — taking inflation (6.7 per cent) plus real gross domestic product growth (7.3 per cent) plus an expected outperformance of corporate earnings of around 2 percentage points. But even if earnings do rise at 15 per cent, and interest rates don’t harden too much from here, the market valuation can be expected to fall somewhat. Changes in asset valuations are normal in cyclical terms. But the past few years have seen extreme volatility due to easy central bank policy, global supply chain issues, inflation arising from the pandemic, and the Ukraine war. Many of those problems remain. Investors should be prepared for further turmoil across financial markets as monetary policy normalises.