Time for caution

Higher valuations will not support a sustained rally

Indian equities have seen a correction over the past one month, which has, so far, pulled the benchmark Nifty down 5.7 per cent from its record peak. This follows up on a remarkable rally, which pushed the markets up by 130 per cent from a panic low in late March 2020 during the first lockdown. In addition, there has been frenetic activity in the primary market with a multitude of issues getting over-subscribed and listing at a premium. The rally was backed by easy money conditions, with most central banks including the Reserve Bank of India (RBI) maintaining a combination of high liquidity and low interest rates. It was also marked by a sharp improvement in corporate profitability starting from the second half of 2020-21. This is due to low base effects, low interest rates, and tax cuts, despite weak consumption demand. The recent correction, however, carries signs that it could be the harbinger of a deeper trend reversal. Foreign portfolio investors (FPIs) have been heavy and consistent buyers through the last fiscal year, with most of their advisories signalling “overweight” on Indian equities. They bought over Rs 2.75 trillion worth of equities in the last fiscal year.

However, a few days ago, various FPIs indicated a reversal of attitude by downgrading India to “neutral” or “equal-weight”. They all cited similar reasons. India valuations are far higher than other comparable markets; India is impacted by inflation, which may force the RBI to hike interest rates by February 2022; and higher energy prices are leading to elevated costs. This change in attitude could translate into lower FPI investment or even some net selling. Indeed, this fiscal year has seen net selling of about Rs 3,447 crore by FPIs. The global economy is also seeing growth downgrades, with several red flags cited by bears. The Fed has started to taper its bond-buying programme and indicated that it might accelerate the pace of tapering, and some investors believe that rates will rise earlier than expected, given inflationary trends. Meanwhile, Europe’s economic recovery has been impacted by a fresh wave of Covid cases, which has led to a downgrade of growth prospects across the European Union.
 

Most worryingly, China’s real estate sector seems to be over-leveraged. Evergrande is only one of several players teetering on the edge of debt default. Since real estate and associated construction activities and financial services contribute 29 per cent of China’s gross domestic product, this is certainly cause for global concern. It has already led to corrections in commodity markets, with every industrial metal falling substantially over the last month. Even energy prices, which were high on a global demand overhang, are softening now on projections of likely over-supply from January 2022. Returning to India-specifics, the base effect has worn off. Many firms are approaching pre-Covid levels of activity. While growth is expected to remain strong through 2022-23, the market is also valued at 24 PE for forward earnings, which is historically high. According to the Goldman advisory, India is valued 60 per cent higher than comparable economies. Hence, investors may consider most of the positives are already reflected in the prices. Market direction is always unpredictable. But a combination of high valuations, smart money pulling back, and the end of base effects should induce a degree of caution among domestic individual investors.