After a smart rally from the March lows, the market is now facing some near-term headwinds. There are global and domestic headwinds which may weigh on the markets in the near-term. The major global headwinds are the rising dollar and US bond yields. The major domestic headwind is the rising inflation (7.44 % in July) which may keep interest rates high, longer than expected. The dollar index which had dipped below 100 is now above 103 in mid-August. The US 10-year bond yield has spiked to above 4.2 %. This is negative for capital flows to emerging markets. Foreign Institutional Investors (FIIs) started selling in August after sustained buying witnessed in the last three months. Since FII buying during the last three months had contributed to the rally in the markets, FII selling now can impact the market if the selling sustains. The market situation may change, but in the near-term the headwinds are strong.
It is important to understand the differences in the approaches of FIIs and DIIs.
FII strategy is influenced by several external factors. Since FIIs invest across geographies, currency movements influence their investment decisions. Dollar Index movements play an important role in capital flows to emerging markets: when dollar declines and is expected to decline further, FIIs invest more and vice versa. Similarly, the US bond yields are important. When bond yields rise, more money will move into bonds and vice versa. Apart from these currency and bond movements, there are other external factors like growth and earnings prospects across countries. For instance, in January, February and March this year, FIIs adopted a strategy of ‘Sell India, Buy China’. But in May, June and July, this strategy was reversed to ‘Sell China, Buy India’. When economic conditions and expectations change, FII’s strategies change.
In contrast to the FII strategy, the Domestic Institutional Investor (DII) approach is focused on the domestic economy and fundamentals. The focus of DIIs will be the domestic economy’s performance and earnings prospects and macros like inflation and interest rates. The focus of the DIIs will be the Gross Domestic Product (GDP) growth, earnings growth, prospects for different sectors, and within sectors prospects for specific companies.
This divergence in the approaches of FIIs and DIIs explain the divergence in their investment strategies. This throws up opportunities for investors. When FII selling due to external factors causes market correction, investors can use that opportunity to buy high quality stocks which FIIs are selling. When the external environment normalizes, FIIs will buy the same stocks which they sold earlier. FIIs who sold heavily in banking/financial services in early 2023 bought these same stocks in May, June, and July. Investors who bought these stocks when FIIs sold are now sitting on handsome profits. The reverse strategy also can be tried. When FIIs buy aggressively due to external triggers, pushing valuations to excessive levels, some profit booking would be a good strategy.
Q1 results indicate divergent trends
There are important trends in sectoral performances as revealed by the just concluded Q1 results. The best performance, by far, has come from the banking sector which has reported excellent numbers. The profit after tax of the banking sector has shown spectacular growth of 67.5 percent. Credit growth is impressive, Non-Performing Assets (NPAs) and provisioning are declining, and profits are rising even though margins are likely to decline slightly in the coming quarters. From the investment perspective, banking stocks are fairly valued.
Capital goods sector is doing well. Profitability of the sector is steadily improving with rising order execution and falling input costs.
The automobiles segment is doing well on the back of strong domestic consumption. The auto sector is staging a comeback after stagnation of around five years. The domestic passenger vehicle segment is showing robust demand. In the case of two-wheelers, good domestic demand is neutralized by poor show on the exports front. The prospects for the sector appear bright.
Fast-Moving Consumer Goods (FMCG) sector presents a mixed bag with tepid volume growth but rising margins. Rural demand continues to be sluggish compared to urban demand. Decline in input costs have boosted the margins of the sector.
IT has been a poor performer with most companies reporting decline in revenue guidance. Sluggish demand from US and weak orders from banking, financials and insurance are near-term headwinds for the sector. But IT stocks have staged a comeback on the back of reasonable valuations after the correction. Some major deal wins by the leading IT majors have also helped boost the sentiments.
Pharmaceuticals have staged a comeback aided by rising sales, new launches, and declining price erosion in the US. Metals performed poorly due to steadily declining prices.
Oil and Gas sector saw margin improvement for Public Sector Undertaking (PSU) oil marketing companies. For Reliance Industries (RIL) their oil-to-chemicals (O2C) was impacted by tapering earnings, but this was compensated by good performance by the retail and telecom segments.
In brief, quarterly results indicate a recovery in growth and profitability. In Q1, Nifty EPS is up by an impressive 32 percent, thanks to the excellent show by banks/financials. FY 24 Nifty EPS has the potential to move up to around 980. This means Nifty at 19300 is trading at a forward PE of 19.70 indicating high but not excessive valuations.