Wisely Adjust Your Portfolio in a Costly Market

The global rally, recovering from the aftermath of the yen ‘carry trade’ issue, is strengthening due to the recent positive economic data including prospects of global rate cuts. However, this momentum could be tested in the medium term due to concerns about a slowing global economy and signs of weaker domestic earnings growth, as observed in Q1. 

It is prudent to churn your portfolio to value stocks from growth stocks, which rallied in the last 4 years. Going forward, shuffling to defensive stocks will be the key to generating stability in the equity portfolio. Sectors that are presumed to be safe are FMCG, Consumption, Pharma, IT, Pvt Banks, and Telecom, as the market lacks steam in growth stocks due to elevated prices. 

While stock-specific opportunities remain, particularly in manufacturing-based sectors that play a crucial role in India’s long-term growth story, it’s important to consistently review business models and valuations due to their elevated levels. Sectors holding strong growth prospects, like industrials, electronics, IT, renewables, healthcare, e-commerce, infra, agriculture, and consumption, remain attractive, suggesting that premiumization will stay in the medium to long-term. However, broad market is expensive, so it is crucial to focus on stock fundamentals, avoid overvalued stocks, and adopt an accumulation strategy. 

Yen ‘carry trade’ effect on the world market…  

“Yen Carry Trade,” is a global financial strategy where investors borrow in Yen and invest those funds in risky assets such as equities and bonds, including cross-border investments for arbitrage opportunities. The yen is favoured in this strategy due to its status as one of the world’s most liquid currencies, its reliability as a currency from a developed economy, and the low interest rates available. The global sell-off which started in July was sparked by a reversal of this strategy, where investors squared off their investment positions and repaid their yen loans.  

This shift occurred as Japan’s interbank interest rate rose from 0.07% to 0.28% in June and further to 0.45% in July, driven by a hawkish monetary policy, which led to an appreciation of the yen. The yen appreciated by roughly 12%, with the USD/JPY exchange rate dropping from 162 to 142 between July and August. These factors made lending expensive in Yen. And since the valuations of Japanese and global markets were elevated, it deepened the issue.  

Between July and August in a span of just 25 days, Japan’s Nikkei 225 index dropped by over 1/4^th from the peak. This drop triggered a ripple effect on nearby markets, causing corrections of around 1/5^th in both Taiwan and South Korea. In the US, the S&P 500 saw a 1/10^th decline, with the tech-heavy Nasdaq dropping by 1.6/10^th. In contrast, the Nifty 50 corrected by only 0.5/10^th, beating the global clampdown. The Indian stock market displayed strong resilience during the global sell-off.  

The issue is grounded in the short term… 

Now the global market is experiencing a relief rally. This rally can continue in the near-term, as there is a presumption that the carry trade issue is over. However, given the huge size of the global strategy and plausibility of yen to appreciate in the long-term, led by hawkish monetary policy the risk is elevated. Market expects BoJ to raise the rates in 2025 to control inflation and stabilize the currency, which has depreciated by ~40% over the last five years, from 106 USD/JPY. 

Given the differing policies of the FED and the BoJ, the interest rate spread between the US and Japan may narrow. This change could influence medium to long-term carry trade positions and the yen-denominated inflows. FED is expected to cut the rate from 5.5% to 3.85% in CY25, while BoJ is expected to increase from 0.25% today to 0.5%.  

The Indian market was relatively unaffected by the issue. However, data indicates that India did benefit from the carry trade, which bloomed from January 2023 as Japanese currency depreciated from 127 to 162 to USD. The forecast is that India received 23% of the yen-denominated inflows, of which 25% went into midcaps. It would make India vulnerable if yen-based sales comeback in the future. However, the impact is likely to be limited as Japanese FPI holdings in India are low at 3%. Influence on midcaps may be high, but the key factor for India is that the trend of the global stock market and inflow from domestic investors, both institutional and retail, should sustain.  

Other factors governing the ongoing rally 

India’s outperformance coincides with the substantial inflows from domestic investors, including mutual funds and retail participants. It is absorbing the selling pressure from FIIs. Recently, FIIs have been net sellers in the equity market. 

The global rally is being supported by the view that the FED will implement interest rate cuts from September. The BoE has already started the rate cut with a small cut of 25bps to 5% bank rate. More than that, it will be essential that the degree of rate cuts be high, and the trend continues. Otherwise, it will be a challenge for the stock market to maintain the buoyancy as the slowing economy and corporate earnings will affect the mood.  

Over the last 4 years, the global economy was supported by the loose fiscal policy; government expenditure increased enormously leading to a high fiscal deficit. Basically, the stock market was supported by the twin engine of low interest rates and high public expenditure. Now that high inflation has increased interest rate, and government expenditure is forecast to reduce, the loose fiscal policy must reverse as governments cannot sustain high deficit for a long time. This is expected to trigger a slowdown in the economy and earnings growth. We cannot expect the market yield to reduce substantially given high inflation and the fiscal deficit. Hence the rate cut is forecast to be slow.  Since markets are trading at high valuations, a time and price correction is due in the short to medium-term. 

It is sensible to bring your investment pattern in-line with the change estimated in the market mood… 

The domestic market is striving to break through the psychological level of Nifty 50 at 25,000. However, the sustainability of this rally is in question due to limited upside potential from a slowdown in earnings growth. Nifty 50’s PAT growth is 6%, down from 13% in the previous quarter. The key requirement is that growth should revert in Q2. 

It is wise to exercise caution in the medium-term market outlook. To safeguard the capital, sector-wise rotation is a proven strategy. Shifting exposure from the outperformers to value sectors is the way forward. Further, the improvements in rural consumption, agriculture, and government expenditure are anticipated to benefit sectors connected to the domestic economy, such as staples, FMCG, fertilizers, telecom, cement, private banks, consumer durables, and non-durables.  

The government’s emphasis on enhancing rural consumption and capital expenditure will benefit these sectors. Efforts to improve agriculture income through increasing production and supply chains will expand demand, mitigate inflation, and lower consumer sector input costs, which will benefit corporates in these sectors. The government’s continued focus on aquaculture, through measures to cut customs duty, reduce input costs, and extend financial support to double seafood exports in the long-term, is a major boost for aquaculture companies. As the market approaches a potential peak in the short to medium term, investing in defensive sectors such as IT and Pharma could also be a strategic approach.