Rational expectations

Evolving conditions would lead to adjustment in markets

Financial markets are correcting in response to changing economic trends and the emergence of mutant Covid-19 strains. The US economy has just received a big stimulus, combined with the ongoing easy monetary policy. A Supreme Court judgment in India could lead to a surge in the declared non-performing assets (NPAs) of banks. There are also fears that a fresh wave of Covid-19 cases will lead to more economic disruption. Taken together, this has triggered a correction across equity markets. The Nifty has dropped 6 per cent from the record highs it registered in mid-February. It is still very richly valued at a trailing PE ratio (last four quarters’ earnings) of 39.5.

The Joe Biden administration’s $1.9-trillion Covid relief package is among the reasons why the US economy is expected to rebound strongly but while this will encourage consumption, it could also trigger inflation. The US Federal Reserve has said it is comfortable with the inflation rate climbing to 2 per cent. US treasury yields have risen. Money is moving into the US, and there is more caution regarding Third World assets. Foreign portfolio investors have been consistent sellers of rupee debt through calendar 2021, though they continue to be net buyers of rupee equity. The Reserve Bank of India declared a moratorium on bank loans between April and August last year. In September last year, the Supreme Court stayed the classification of NPAs for any bank loans that had not been declared NPAs before August 31. This stay was lifted in March, when the court also clarified banks could not charge interest on interest racked up in the moratorium.

Officially, gross NPAs in the banking system amounted to Rs 7.4 trillion as of December 2020. They are expected to surge to Rs 8.7 trillion by end-March. The bulk of these fresh bad loans will be held by public sector banks (PSBs). Net NPAs are expected to rise by Rs 1 trillion. Bank balance sheets will be under stress, and the 2021-22 Budget allocation of Rs 20,000 crore for the recapitalisation of government-controlled banks will be insufficient. The strategic sales of two public sector banks as announced in the Budget would become more difficult, and the merger ratios for the planned consolidations of PSBs will need to be reviewed as valuations are likely to drop. The NSE’s PSU bank index is currently valued at an astronomical PE of 65.5. A sharp correction is on the cards once fresh NPAs are declared. The Nifty’s private bank index is trading at a PE of 33.6. Private banks are also likely to declare rising NPAs but they will have fewer severe problems than PSBs.

Value investors may argue that even a deep correction could be healthy. The economy is expected to grow quickly in 2021-22 but nowhere near quickly enough to justify current valuations. The financial sector’s problems may cause economic deceleration. If a fresh wave of Covid-19 cases also causes disruption, growth expectations would be substantially pared. A combination of easy money and expectations of a strong V-shaped recovery have helped to keep stock markets buoyant through the pandemic. As conditions start to normalise with the advent of vaccines, investor expectations must be dialled down to more rational levels to reflect the reality of an economy that may not rebound all that fast. The market seems to be entering this phase of revaluation.