Is the market near capitulation? Here’s what 3 decades of data suggests

The stagflationary trends that began emerging in Oct’21 have deepened recently and are coalescing into collective headwinds of scaling down growth expectations, the elevation of inflation trajectory, and forced monetary tightening, increasing the risk of a recession in the US and other developed economies.

The Indian market has seen these headwinds resonating across asset classes, which is reflected in the bear flattening on the Gsec curve, weakening of the currency, and continued drag on the equity market.

There are discerning trends visible from how Indian markets have responded.

a) First, resonating with the collapse in the US Nasdaq index, the India IT index has eroded by 30%; the steep valuation expansion in the post-Covid era has also weighed heavily on the sector,

b) Small cap index has corrected by 35% for the peak, much steeper than the 18% decline in the Nifty 50 index, and

c) Cyclical sectors led by metals, reality, industrials, and capital goods have taken a huge knock.

What has held up relatively better are the domestic consumption theme, telecom, utility, and consumer staples, where the visibility of earnings trajectory is less volatile.

What is different from the earlier phases of capitulation is that both pharma and the technology pack have not provided shelter.

Amid this ongoing meltdown, the key question is whether we are anywhere close to the nadir?

The JM Capitulation monitor assesses how far we are from the ultimate capitulation against 10 macro-market components such as

a) economic surprises,

b) inflation surprises,

c) equity risk premium,

d) credit risk premium,

e) currencies (dollar index),

f) commodity inflation,

g) treasury term spreads,

h) index option spreads for high-yielding credit,

i) financial market conditions,

j) inflation expectations and real rates (TIPs).

Gauging markets using this monitor, we see that 30% of the characteristics of past capitulation are visible as of now, leaving further scope for adjustments.

So, what should we be looking out for?

a) Rundown of US Fed’s balance:

First, the rundown of the US Fed’s balance sheet is yet to start. A decline in the US money supply-GDP ratio is expected to have greater impact on asset prices than the 150bps US Fed rate hikes announced thus far.

As of now, the markets have only responded to the bond market meltdown. Indian market valuations tend to experience the impact of US tightening over a lag of several months.

b) Tightening Financial Conditions:

Second, while the risk-free rates have hardened, market risk parameters, including equity risk premium, volatility measures (VIX index, etc), and credit spreads are yet to reflect the maximum level of fear that typically emerge at the capitulation point. Further tightening of global liquidity can result in multiple implications for Indian markets, viz, tightening financial conditions, further hardening in Gsec yields, and weakening of the Indian rupee against the dollar.

c) Twin Deficit Problem:

Third, Indian markets will also have to grapple with the re-emergence of the twin deficit problem on the fiscal and external fronts.

The Centre’s fiscal measures undertaken till now to minimise the inflationary pain on Indian households by way of enhanced subsidies, under-recovery in the fuel sector, and rise in interest burden are estimated to add up to an additional spending burden of ~Rs. 5.0-5.5tn.

Thus, there potentially is an upside risk of 2 percentage points over the projected fiscal deficit/GDP of 6.4% for FY23BE, which can impinge upon capital spending. RBI’s latest study highlights that the fiscal position of many states (GFD/GDP) has deteriorated beyond acceptable levels.

d) Global Crude Oil Prices:

Fourth, sustenance of global crude oil prices above $100/bbl along with moderation in capital flows due to synchronous global monetary tightening could imply an elevated current account deficit (CAD/GDP) at 3.3-3.5%, which could remain unmatched by the capital account balance declining to 1.5-2%% of GDP. This could imply $40-50 billion further run-down in the RBI’s forex reserves on top of the $46 billion erosion since Oct 21 to the current $596 billion.

e) Earnings
Fifth, the earnings expectation of benchmark indices for FY23E and FY24E stands at an average of 15% growth on top of the abnormally high 41.5% in FY22. The 3-year CAGR real GDP growth till now is around 2%, and looking beyond the volatile element of the 7.2% projection for FY23, the terminal growth is around 4%.

A deceleration in global growth will also mean scaling down of both real GDP and earnings projections for India.

f) Valuation Correction:
Sixth, our assessment of valuation correction, especially in the mid and small caps still have some distance to run.

Relative small-cap index valuation (price to book) vs Nifty has declined to 69% from the mid-2021 peak of 81%; it will need to decline further to 50% as the retail participation moderates in response to negative price returns.

What can hasten the capitulation point is the possibility of a steep correction in global crude prices in line with the softening in metal prices.

But, can the market hope for a potential reversal of monetary tightening by the US Fed is an open question. The latest testimony of the Fed chair to the US Congress reflects the worry over entrenched inflation, which calls for continued tightening; high inflation is not just emanating from elevated commodity prices but a serious mismatch in labour market demand-supply.

Global crude price outlook will depend a lot on the ongoing Russia-Ukraine war, the lockdown in China, and a global slowdown or a recession in advanced economies.

What happens following a slowdown or recession-led capitulation will also need to be eventually priced in. A major compression in financial asset prices, correction in real estate prices, and major erosion in commodity prices will have a second-order impact on the system by way of credit defaults and the negative wealth effect. Also, as the economy moves from high to low inflation, the policy stance will also change.

Our study across the past three decades of multiple business cycles involving global inflections indicates that endogenous drivers, led mainly by household and corporate sector responses, will likely determine sectoral market performance.

Historically, segments that do well in the progression of the inflection point will be domestic themes in consumption, automobile, retail lending, technology, household products, personal products, hotels & restaurants, and durables.

In a scenario of volatile commodity prices and their impact on sales growth, it will still take some more time for private capex intent to revive in a significant way.

Agencies

(The author is MD & Chief – Strategist at Institutional Securities)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)