The probability of a sustainable bull trend is less in Indian equity markets till the spread between corporate AAA bonds and treasury bonds does not fall from the present 199 basis points (bps) to a mean range of 110 bps, according to a report by Crisil Equities.
Historical data show a strong inverse correlation between movement in credit spreads and performance of equity markets.
Credit spread is an indicator of macroeconomic business conditions and often shows turning points in the business cycle.
Chetan Majithia, head, CRISIL Equities, said, “We have observed a similar correlation between movement in credit spreads and performance of equity markets in various international markets.”
There is a strong inverse correlation between the movement in credit spreads and performance of equity markets, with the equity markets showing a time lag of 9-12 months, the report said.
During June 2001 to August 2002, when the average spread was above the historical mean at around 156 bps, equity markets remained range bound with a negative bias and the S&P CNX NIFTY giving around 7 per cent returns.
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After that, in the 2003-2006 period there was lower average credit spreads of around 63 bps. And year 2003 saw commencement of the bull trend which continued till the start of year 2008.
During this period S&P CNX NIFTY gave a return of 37.60 per cent compounded annual growth rate. The spreads then started showing an upward trend from January 2007, with the average spread for year 2007 at 154 bps.
According to the analysis, since March 2009 the credit spreads have declined by 24 per cent from 260 bps to 199 bps, showing an improvement in the risk appetite of the investors.
“Huge government borrowing is sucking liquidity which is leading to wider credit spreads. This signalled unavailability of funds in the near term,” said a head of a brokerage house.
However, the recent spreads are around 89 bps higher than their historical average of around 110 bps, showing a degree of skepticism of fundamentals. CRISIL expects the spreads to remain around 200 bps in year 2009 before going down to around 110-120 bps in year 2010.
“The combination of larger spreads and sceptic investor participation in the market strengthens our view that the current equity market rally may not be sustainable,” the report added.