Market downside seems limited

Global equity markets have been buoyant in recent weeks in anticipation of additional monetary actions from both the Federal Reserve and the European Central Bank (ECB). It is ironic that the market has cheered even the weak economic data from the western world as it expects a monetary action. Ben Bernanke’s statement at the Jackson Hole meeting clearly indicates his readiness for quantitative easing if economic data continue to be weak. So, markets are almost waiting to see rounds of monetary policy actions anytime soon. However, if the central banks’ actions in the coming weeks do not deliver on market hopes, a big disappointment might follow.

Domestically, political developments have not only dimmed the hopes which emerged post recent portfolio reshuffle, but is also taking a scary direction leading to a prolonged economic slowdown. All these suggest the economy is unlikely to get any repair it needs desperately from policy makers, failing which we are heading for only a worse vicious cycle. Many political pundits are predicting early polls. If it does happen, policy paralysis will find its legitimacy till election gets over and a new government is formed.

The Reserve Bank of India is unlikely to cut interest rates in the absence of fiscal consolidation and political clarity. The banking system which has so far been hoping to avoid a severe non-performing assets cycle will eventually give up the hopes. I strongly feel markets currently are underestimating the impact of the economic downturn on the banking asset quality. The upcoming two to three quarterly results from the banking sector could be very bad on the asset quality front. Recently, we have seen large defaults by some corporates and many more could follow. This could lead to poor performance by the banking sector, which accounts for over a quarter of the weight in the Index.

Market polarisation is clear, as all the defensive sectors and stocks have done well, whereas interest rate sensitive, high beta, leveraged sectors have performed poorly. This may continue. Banking is one sector, which will decide the market direction in the medium term. It can lead to an 8-10 per cent market correction.

Another big risk looming large on the macro front is credit rating downgrade by rating agencies. Any such downgrade is likely to impact fund flows in the short term and will increase the cost of capital. Foreign currency reserves and current account deficits are not giving any comfort towards affordability of any further downward pressure on the rupee. Any sharp downward movement in rupee can lead to panic selling in the markets.

On the positive side, market downside seems to be limited in the medium term to 8-10 per cent as a lot of support is likely to come from inexpensive valuations, decent corporate earnings growth (15-16 per cent), easy liquidity, expectation of monetary action from global markets and expectation of commodity price correction. Being an optimist, I feel post-monsoon session the government will have an opportunity to do certain things which can boost market sentiments. All these factors would limit the downside.

In a nutshell, at the global level, central banks’ actions will be the key factor shaping the market performance in the near-term. But at the domestic level, the fading hopes of administrative action only point towards the downside risks. Market volatility is likely to be high in such a scenario. I believe that equity as an asset class might not perform for some more time. Till then safety is the best policy.

The author is president and co -head, wholesale capital markets, Edelweiss Financial Services