Expect high volatility

As we enter FY23, markets have turned excessively volatile. The one-way bull phase which started from April 2020 ended in October 2021 and since then volatility has been the norm. The Ukraine war and the consequent spike in commodities, particularly crude, has impacted economic growth in many countries. With the US inflation touching a 40- year high at 8.5 percent in March, the Fed has no choice but to tighten monetary policy aggressively and the tightening cycle has begun. The Fed rate hikes will be the most significant event in 2022 impacting markets globally unless, of course, the Ukraine war turns nasty with global implications.

There are strong headwinds and equally strong tailwinds for the markets this year. The Fed tightening cycle is the strongest headwind that can impact markets. For India, there are tailwinds like sustained retail investor enthusiasm facilitating large capital flows into the market, strong consumption demand in many segments, signs of the beginning of a capex cycle, a strong external sector assisted by large foreign exchange reserves and a strong and steadily improving financial sector.

The important question, from the market perspective, is: Can growth revival and retail enthusiasm counter the headwinds of rising inflation and Fed tightening? Let us cross the t’s and dot the i’s to get the issue in perspective.

Fed tightening – the strongest headwind
The Fed finally gave up its ‘transient inflation’ theory, admitted to the inflation threat, turned hawkish and started hiking rates in the March 22 policy meet. Now the market expects around 200 bp hike in rates in 2022 finally ending the tightening cycle with rates at 2.75 percent by the end of 2023 and remaining there through 2024. The Fed is attempting a soft-landing of the economy, but the task is not easy since the Fed is tightening when the economy is weakening. There is the threat of excessive tightening tripping the economy into a recession. Markets would be concerned about that. The US 10-year bond yields have spiked above 2.8 percent, dollar index is at 100 and more money is likely to move into bonds. Worse, the bond yields have inverted – the two-year yield higher than the tenyear yield – indicating the possibility of a recession. But the yield inversion has been brief. If it becomes persistent investors have to be cautious.

RBI set to hike rates
Inflation in India, too, is all set to rise. The RBI has revised CPI inflation forecast upwards to 5.7 percent for FY23. With CPI inflation for March at 6.95 percent and WPI inflation at 14.5 percent RBI has no choice but to raise rates. Policy rates can go up three times by 25 bp in FY23. RBI has already declared that inflation control will be the top priority in FY23. A hawkish RBI is sentiment negative for the equity markets.

The Ukraine war and the crude spike
Commodities, which were in a bear phase for more than 10 years, had started firming up even before the war. The war aggravated the price rise in commodities. Crude which was stable at $75 at the beginning of the year shot up to a high of $139 and then cooled a bit. Metals like steel, aluminium, copper touched record highs. Disruptions in Russia and Ukraine caused steep spikes in rice, wheat and edible oils. This commodity inflation will soon reflect in CPI inflation forcing the RBI to raise rates. Worsening of the Current Account Deficit can depress the INR-Dollar exchange rate, too.

Retail investor enthusiasm is supportive of the market
The strongest support to the market has come from retail investors who continue to be bullish and optimistic. Data regarding retail demat accounts is revealing. For the 20-year period ending 2020 March, 40.8 million new demat accounts were opened. Then, in the 2-year period ending 2022 March, 40.2 million demat accounts were opened. Now, the total demat accounts in India stand at 80.9 million and are rising steadily. Mutual fund inflows too hit record highs. Net inflow into equity mutual funds in FY22 was Rs 1,64,399 crores. The SIP book grew to Rs 12,328 crores in March and the total SIP accounts now stand at 5.28 crores. This robust domestic equity investment is imparting great resilience to markets. Domestic investors have grown as a strong counter to the fleet-footed FPIs.

Strong rebound in the economy
Booming exports ($417.8 billion in FY 22), buoyant tax collections exceeding estimates (total tax revenue at Rs 27.87 trillion in FY 22), big investment under PLI scheme and major capex in segments like renewable energy indicate a strong rebound in the economy. Consumption is coming back strongly in segments like hotels. The financial sector is in the pink of health. With improving asset quality, rising credit demand and adequate capitalization, the banking sector is robust.

In sum, while the Fed’s inevitable monetary tightening and persistent inflation are strong headwinds for the markets rebound in economic growth and enthusiastic domestic investor participation are strong tailwinds. The inevitable consequence of these opposing forces will be a volatile market.

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