Today the biggest challenge for the world economy and equity markets is hyperinflation. During the early quarters of the pandemic, when inflation started to improve from negative, it was presumed to be an essential element for economic growth. And then when inflation started to rise into the uncharted territory, it was assumed to be transitory. The central banks were late to realize that inflation had got entrenched, requiring drastic steps today. In 2022, inflation became worse due to the Russia-Ukraine war and the Covid zero-tolerance policy of China. Both these factors made the availability and supply of essentials from raw materials to final products difficult and dearer. If both the points relax, for which we have early signs, it will be a big favourable surprise for the world equity market.
Be choosy during an inflationary period
Inflation is expected to stay in the short term. But will drop in the next two to four quarters with hopes that the war may slow down and manufacturing capacities and transportation will improve from China. Some sectors that directly benefit from these disruptions are energy, metals, mining, and agriculture. Sectors that were negatively affected were the discretionary and non-discretionary consumer sectors and the logistics. The sectors which were neutral to hyperinflation are IT, Pharma/Chemical (marginally impacted due to raw material import) and Banks. Banks have short-term volatility due to interest hikes and FII selling. However, the long-term impact is positive due to the rise in yield and credit. If the issue escalates to the long-term, it will start to affect the long-term private spending and impact the domestic growth story, which is not anticipated today.
This high inflation did not impact the equity market till the time central banks started tackling inflation and announced a very aggressive policy to cut quantitative support. They were late to realize the problem, hence adapting hawkish steps which are impacting the current performance of the equity market.
We can have a caveat here: If war subsides further, which is possible as the focus has shifted to the eastern part of Ukraine-Russian territory, and exports from Ukraine improve, sentiments will improve. Secondly, the covid cases in China are reducing, opening the possibility of relaxation in public restrictions in the future. China’s zero tolerance policy has impacted the world’s supply of goods as it is the largest exporter in the world. If these factors stabilize, it will be drastic ease in the inflation forecast, providing legroom to the central banks in the future.
Risk-off in global market impacting domestic performance
FIIs are on a selling spree, foreign net equity outflow was Rs.1,57,556 crore in CY22, till 18th May 2022, compared to inflow of Rs.25,750 crore in CY21. This negative trend in the global equity market is visible from the rise of the Dollar index, which indicates the strength of the US Dollar compared to the mix of other developed currencies. The Dollar index is at a 20-year high as investors are preferring haven assets like the US Dollar and bonds due to the rising instability of the equity market.
FPIs have started to sell heavily in India from October 2021. The resilience of the market was due to the strong inflows from DIIs and retail investors. However, the retail inflows have started to slow down recently leading to underperformance of the Indian market. After bearing real losses post a gap of two years, it has wavered their optimism. In this range bound market, we advise you to stick to the sectors which are expected to be least impacted by inflation and yield rise, like banking, IT (though expensive), Pharma, FMCG, and themes like green energy.
On a broad term, valuations have moderated marginally. But it is still on the higher side compared to a long-term basis. Valuation will undergo a period of transition on a stock and sector basis. The pockets which are expensive today will moderate while value stocks emerge. Valuations of sectors like FMCG, Pharma, Capital Goods and Manufacturing are reasonable on a long-term basis while business is expected to grow and trade stable during the volatile market trend.
Expect improvement in market trends in the coming days
Central banks are forced to shift their policies to aggressive rate hikes and reductions in liquidity measures. This is impacting the trend of the world equity market. Markets feel that the decisions were late and not good enough as the economy takes time to cool down inflation due to elongated supply issues. More than the rate hike plans, the fall in liquidity measures has impacted the sentiment of the equity market, having a direct effect on the pricing of assets and risk of recession.
As discussed above, moderation in inflation, and a sharp fall in equity market will force central banks to bring a rebalance in policy approach. This may happen in the next one to three quarters during which the market will have a negative bias in which defensives will outperform the market.
The buoyancy of few sectors like IT, Pharma and FMCG will help the market during this hostile period. IT and Pharma are supported by the positive movement of the Dollar and Euro, as a major part of the income is generated from exports. Whereas, for FMCG the price elasticity of the consumption business adds stability with strong cash flows. Generally, these three sectors are supported by the defensive nature of their performance in the equity market. Recently, the performance of FMCG was impacted due to high inflation, drop in volume growth and profitability. Given recent corrections and in anticipation of normalization of inflation, FMCG is a worthwhile investment idea.