Global mkts fully pricing in Fed hike to 5.5%; Indian equities at risk: UBS

Indian equity markets appear expensive and face a downside risk if the US Federal Reserve (US Fed) hiked rates to 6 per cent to tame inflation, wrote analysts at UBS in a recent note. Global equity markets at the current levels, UBS said, are fully pricing in three further Fed rate hikes to 5.5 per cent.

India, according to them, is among the more sensitive markets to US rates, and demonstrates the most sensitivity to local rates given higher influence of domestic flows into the market.

“We believe Indian equities have further downside risk on valuations, as support from domestic flows has room to weaken further with rates going up / staying higher, particularly if more sticky US inflation is fanned by rising oil prices amid China reopening. It is not helping that corporate earnings are showing signs of weakness: leverage levels back to pre-pandemic highs, working capital at 8-year high, inflation creeping into sticky costs,” the note said.

Meanwhile, over the next few days, the focus will shift to the February jobs report (scheduled for Friday) and then Fed Chair Jerome Powell's testimony to congress on Tuesday and Wednesday. Analysts expect the US central bank to hike rates by 25 bps in the meeting next week, in continuation of a similar hikes done in the last two meetings. The Fed has hiked interest rates eight times since March 2022, including four consecutive 0.75 percentage point increases during this period.

"Modest increases in US 10-year nominal yields, of 10-30 basis points (bps) on a rolling 3-month basis, have typically been easy for emerging markets (EM) to digest. 'Pain thresholds' have typically set in above 30bps for EM forex, and above 40bps for equities and fixed income. These levels began to be tested in recent days, and would likely be forcefully breached if a 6 per cent (or higher) terminal Fed rate were to be priced in," the UBS note said.

Relative to the sharp up-move in US real rates over the last 12 months, equity valuations, according to UBS, have held up remarkably well. 

“Equity risk premia is at post-global financial crisis (GFC) lows. We’ve also seen strong foreign flows this year: largest monthly flows into China equities on record in January; strongest start to the year for Korea and Taiwan equities on record. In this context, further US yield gains appear a threat to EM,” UBS cautions. 

That said, their analysts expect Chinese equities in particular to outperform historical sensitivities to US yields amid an improving economic cycle, a likely acceleration in retail flows, and undemanding valuations. 

“EM ex-China equities appear more vulnerable to a scenario of Fed tightening without a commensurate lift in global trade/ commodities. The negative hit to EM forex and equities from a 50bp rise in US real yields would only be offset by a 25% rise in oil and copper prices. Subdued US and Chinese housing and capex, alongside a continuing rotation towards services may also keep EM export volume growth subdued in the next one-two quarters,” they said.