US Fed's taper talk likely to keep the bulls in check on Dalal Street

This is expected to suppress valuations in India; decline in P/E may nullify gains from rise in corporate earnings

The US Federal Reserve’s (US Fed’s) decision to quicken the pace of monetary tapering and raise interest rate sooner than planned to fight inflation is likely to keep the bulls in check on Dalal Street.

Historically, there has been a positive correlation between changes in the US Fed’s balance sheet and the movement of the Indian benchmark indices such as the BSE Sensex and the Nifty50. And, this correlation has been especially strong since the pandemic’s outbreak. (See the adjoining chart).

According to analysts, the transmission of US Fed’s action will largely occur through changes in stock valuation. “There would be a contraction in key stock valuation ratios such as the price-to-earnings (P/E) multiple and price-to-book value (P/B) ratio. Investors might become risk averse as liquidity conditions tighten after the latest US Fed action,” says Dhananjay Sinha, managing director and chief strategist at JM Institutional Equity.

This could either fuel a further decline in the broader market or a range-bound market if corporate earnings continue to grow.

In lockstep

The BSE Sensex, for example, has risen 21 per cent since the beginning of 2021, closely tracking the 18 per cent expansion in the US Fed’s balance sheet. 

The US Fed’s balance sheet has doubled since March 2020 and the Sensex has seen a similar rise. Likewise, the recent weakness in the Indian equity market coincided with an announcement by the US Fed in early November that it would taper its bond buying programme from December. As a result, the US Fed balance sheet shrank by $17.2 billion in the first week of December, for the first time since July 2020.

Under the asset purchase programme, the US Fed bought nearly $80 billion worth of US govt bonds and $40 billion worth of mortgage-backed securities every month. This suppressed interest rates and provided additional liquidity to global financial markets. This is also called quantitative easing (QE).

Analysts say QE raised the demand for riskier assets such as Indian equities. “The US Fed’s action led to an expansion in valuations and as a result equity prices rose much faster than the underlying growth in corporate earnings in the last few years,” says Sinha.

The Sensex’s trailing P/E multiple expanded from around 17x in 2012 to around 27x just before the pandemic’s outbreak, and to a record 35x this March. It is currently trading at 27.1x. This rise in valuations resulted in a much faster rise in stock prices than what was warranted by corporate earnings growth.

For example, the Sensex has risen 274 per cent in the last 10 years against 134 per cent growth in the underlying earnings per share (EPS). While the index has rallied from around 15,450 at the end of December 2011 to close at 57,837 on Thursday, the index only grew from Rs 913 to Rs 2,134 during the period. This process is now expected to reverse, creating uncertainty.

“Unlike in the past, earnings growth will be the accelerator while P/E contraction will be a market decelerator. The market level will be decided by the balance of these two opposing forces,” says Shailendra Kumar, chief investment officer of Narnolia Securities.

Brokerages expect a 30 per cent growth in corporate earnings over the next two years. They don’t see any material change in corporate earnings due to the US Fed’s action.

However, the taper could hit corporate earnings if it sparks a significant rise in interest rates. This will further muddle the picture for equity investors.