Markets can hit highs only after inflation peaks abroad: Taher Badshah

The latest surge in the markets is driven by change in inflation expectations, says Taher Badshah, chief investment officer, Invesco Mutual Fund. In an interview, Badshah tells Samie Modak that some of the most-talked-about headwinds such as growth slowdown and high inflation might not be fully neutralised. Edited excerpts:

We have seen a sharp revival in market sentiment. What is driving the current optimism?

There are several reasons that can be attributed for the improved market sentiment in the last couple of months. Inflation has been the biggest bugbear in recent times. Easing of commodity prices and global supply chain pressures – presumably led by moderating Covid-19 and gradual re-opening of important Chinese cities – has clearly been the most important factor.

Actual inflation data, at least in the US and in India, has seen some retreat, too, led by cooling of energy prices along with certain policy interventions. This has had the salutary effect of even keeping medium-term inflation expectations relatively better anchored, thereby, raising the market’s confidence in global central banks’ ability to achieve faster normalisation of monetary policy.

Can the market revert to June levels or are new record highs on the cards?

The battle against inflation in developed markets may be quite prolonged due to significantly above-average negative real rates of interest, though the recent growth-inflation dynamic drives hopes of a faster return to neutrality. Even there, while the US has seen a modest drop in inflation, much of the Eurozone and the UK continue to see very elevated inflation. Notwithstanding this, we reckon the current rate of inflation in India is only marginally higher than its 20-year average, with real rates modestly positive, and, hence, should have lesser impact on domestic consumer behaviour and growth.

India’s monetary and fiscal policy coordination will likely allow the Reserve Bank of India (RBI) to reach neutral territory sooner, thereby, taking the risk of structurally higher inflation and significant deterioration in growth outlook off the table. However, the recent recovery in the market, and given that most of the known risks cannot be said to have been fully neutralised, makes the risk-reward now relatively balanced with valuations once again having crept back to above long-term averages from some nominal discount until a few weeks ago. In our view, Indian markets would stay relatively resilient but would need to clearly see peak inflation in developed economies and the risk of recession meaningfully abate before new highs can be scaled in 2022.

How has the Q1FY23 earnings season panned out so far? Do you think the Street’s earnings estimates for FY23 and FY24 are achievable?

Overall, the Q1FY23 earnings season can be described as a mixed bag.  Headline Nifty earnings have missed expectations moderately due mainly to the shortfall in heavyweights like Reliance Industries, Tata Motors, and State Bank of India, leading to a cut in estimates by about 2 per cent for the full year. But at a broader level, the spread of earnings has been good with nearly 70 per cent of companies having met or exceeded expectations according to some estimates. India’s aggregate earnings profile looks resilient in the face of commodity challenges this year. This may lead to some more downdraft in earnings for balance of FY23 but could likely abate materially in FY24.

What are the key risks at this juncture? How is the correlation between oil and Indian markets?

The key risk for the market at this juncture, especially after this strong comeback, is the resurgence of the known risks of recent times, namely the rebound of inflation and geopolitical tensions. Commodity prices, after a very sharp correction, are threatening again while the Russia-Ukraine war has not yet seen closure. Also, as discussed above, important parts of the global economy like the UK, the Eurozone, and China are not out of the woods and the US growth path in this phase of still rising interest rates over the next couple of quarters is not fully clear. Some of these risks can likely revisit us in the near future.

Is the worst of the FPI (foreign portfolio investor) selling seen earlier this year behind us?

Foreign flows to India gyrate depending on the overall global risk-on and risk-off environment and, generally, oil prices in a band of $60-80 provide the best backdrop for our markets. For emerging economies like India, the growth outlook, interest rate cycle, direction of commodity prices, particularly oil, and valuations provide an additional overlay. At this point, the growth outlook for India remains relatively strong and recent easing of commodity prices with oil below $100 has clearly stemmed outflows. But the interest rate and global growth cycle will determine the extent of inflow hereon. On aggregate, however, the worst of outflows at least seems behind us.

How do valuations compare between large-, mid- and small-caps? Which sectors and themes are looking attractive at this juncture?

At present, we are somewhat agnostic to market cap with regard to our investment choices as we do not see a meaningful economic rationale or valuation disconnect that strongly favours large or mid-caps. After a brief hiccup due to the Russia-Ukraine conflict, our much-favoured preference towards sectors and companies that are users of commodities versus producers of commodities is finally playing out well and is expected to extend itself for some more time. While globally exposed sectors like IT and metal/oil commodities have turned a lot more palatable in recent weeks on valuations, we remain watchful and wait for probable moderation in earnings expectations before turning incrementally constructive. Meanwhile, banks, industrials, and parts of consumption remain our ‘go to’ sectors for additional allocation.

Will the pace of flows into equity schemes sustain?

Intensity and direction of flows, whether global or domestic, is always difficult to predict in the short run. Domestic flows have been resilient through the recent market softness and suggest that structural drivers of low equity penetration and a more mature long-term investment orientation are still at play. They can be safely said to grow at a decent pace in the long term, though the very strong growth of the last two years can regress to trend.