Inflation to vaccines: Factors that will guide markets as economy recovers

India is battling a second Covid wave as its economy recovers from last year's devastation. And the RBI is unlikely to change lending rates. How will these factors influence stock markets in FY22?

The outgoing fiscal year was marred by the onslaught of the Covid-19 pandemic. Indices hit four-year lows on March 23, 2020, a day before India locked down to contain the spread of Covid-19. Sensex and Nifty closed at 25,981 and 7,610, after crashing 33 per cent in just 13 trading sessions. Market capitalisation dropped from Rs 160.6 trillion in mid-January to Rs 102 trillion on March 23.

Recovery has been swift since then. Stimulus measures announced by the government and the central bank helped markets to soften the fall and then to rebound. Such was the liquidity that the one-year rolling return for benchmark Nifty and Sensex stood at about 90 per cent on March 23, 2021.

The last time benchmark indices had a higher one-year return was in 2010, when domestic equities bounced off sharply from the global financial crisis. Market recovery then and now have one common factor: pump priming by global central banks, mainly the US Federal Reserve.

Abundant liquidity, Covid-19 vaccines and signs of economic recovery helped the rally in FY21, but as we enter FY22 the market is choppy again. A second Covid-19 wave and rising bond yields owing to supply shocks and inflationary concerns have capped gains at the bourses. From their record peak levels of 52,517 and 15,432, the Sensex and Nifty have corrected over 6 per cent and 5.7 per cent.

Here are the key factors that are likely to guide the markets in fiscal 2021-22 (FY22).

Covid-19 and vaccination: A spike in coronavirus cases in India and other countries poses a near-term risk to markets. India’s daily case count is now as high as in November 2020. Several European countries have extended lockdowns or announced restrictions till mid-April as a third wave of the pandemic sweeps the continent.

Bond yields: US Treasury yields have surged to their highest from record lows in 2020, as a low interest rate regime and potential demand recovery encourage investors to bet on economic growth.

“Rising bond yields is the major concern in the market right now and would be closely monitored. If it continues to rise, it could result in a higher interest rate and suck liquidity from the equity market,” said Siddhartha Khemka, head, retail research, at Motilal Oswal Financial Services.

According to a March 19 note by BofA Securities, US 10-year Treasury yields could rise to 2.15 per cent by the end of calendar year 2021 (Q3FY22) on the back of a "much more aggressive" US fiscal stimulus impulse and rapid vaccinations in that country. The bank also raised its target for German 10-year Bund yields, the benchmark for the euro area, to -0.25 per cent from -0.40 per cent previously. It forecasts 10-year Gilt yields at 0.95 per cent in the UK, balancing a positive near-term economic outlook against a cautious medium-term outlook.

Inflation and rate cut cycle: Another factor that may put brakes on the market uptrend is reversal in the low interest rate regime. Central banks have assured the market of accommodative monetary policy till economies normalise. However, if they change their stance, it can hurt economic recovery and trigger a risk-off environment. Prices of key commodities such as copper and oil have seen a sharp rise, which could result in higher inflation for FY22. Thus, how long do the monetary policies continue to be accommodative and support economic revival holds key.

Fiscal measures and economic recovery: The accommodative monetary policy of central banks, especially the US Federal Reserve, will be key to how emerging markets (EMs), including India play out in FY22. Hope of a $1.2 trillion fiscal stimulus package kept Indian markets buoyant though rising yields and commodity prices played spoilsport.

India’s economy revival: Markets will track the momentum in FY22, with the government's focus on fiscal expansion and capex spending holding the key for the revival of the long-anticipated private investment cycle. India's GDP growth could surprise on the upside in FY22. Agriculture and manufacturing will continue growing as the service sector, which is still struggling, due to the pandemic may improve as more people are vaccinated.

Corporate earnings: A sustained momentum in earnings is also key to give markets the necessary fillip in FY22. Despite concerns over economic recovery due to the sudden rise in Covid-19, earnings momentum, experts believe, is likely to continue. However, sustenance of demand recovery and maintenance of operating margins and profitability in light of rising commodity prices and inflation would hold key.