From China to liquidity withdrawal, here are key risk factors for the markets

A smaller risk at this point is an excessive monsoon resulting in destruction of crops, property

Market valuations have risen considerably over the past few quarters both in the frontline indices like Sensex or Nifty and in the midcap/ smallcap indices. The current equity market valuations are factoring in a robust recovery in earnings growth. Retail investors are worried whether the valuations would sustain at current levels. This depends on how soon and robust the earnings recovery is and how sustainable it will be.

While optically, the markets may seem to be expensive going by historical standards, bulls say that price-to-earnings (P/E) multiples are inversely correlated with the cost of capital. 

Further, markets typically top out at times the economy is overheated and there is a general euphoria in the markets. Index composition/changes and index earnings composition (losses by some large companies offset profits by others depressing the index earnings) are other parameters to check whether the markets are really overvalued or not. The truth lies somewhere in between. If the economy is close to a bottom and corporate earnings are slated to recover soon, then the P/E ratios will look reasonable going forward. 

However, in the case of earnings recovery being delayed, the markets may be expensive and may remain sideways for an extended period, if not fall. 

Earnings growth over the last three years has been lacklustre, with flattish Nifty EPS over FY14-17. Earnings growth was constrained by the lack of revival in private investment cycle, two consecutive droughts, asset quality stress at public sector undertaking (PSU) banks and corporate private sector banks, deceleration in credit growth, among other reasons.

Markets also dislike geopolitical risks or conflicts, although the impact of this is large only if the issue is prolonged. Currently, while India could face issues with China and Pakistan based on current skirmishes/posturing, globally also small regional conflicts may become large involving multiple nations. Any such development could lead to paring down of risk on sentiments and withdrawal of funds by foreigners and even locals as they are sitting on wide profits. This could lead to downward volatility in the markets. 

A smaller risk at this point is an excessive monsoon resulting in the destruction of crops and other infrastructure. Going by current trends, the India Meteorological Department (IMD) has said that the monsoon has been 5 per cent above normal between 1 June and 26 July. Though breaks are expected in August and September, if it doesn't happen, excess rainfall could lead to crop shortfall, infrastructure damage, health epidemics, among other problems. This could mean some damage to the prospects of growth and to valuations. 

One big risk for the markets is the swift unwinding of the balance sheet by the central banks. If this happens, liquidity which is floating across the world will be withdrawn and come back into the original countries that could create turbulence in the debt and equity markets across the globe. 

If global bond yields were to move up from current levels on the back of global economic recovery, this process of rerating would come under threat and reversal. 

Liquidity withdrawal and its strong signs by the United States, Japan, the euro zone and lately the United Kingdom could create jitters among equity investors who have entered into an arbitrage trade. 

We need to watch as to how serious these central bankers are about ending easy money policies and beginning to shrink balance sheets of the respective countries’ central banks. 

The author is Deepak Jasani, head-retail research, HDFC Securities