Deeper correction

Geo-politics & monetary policy have increased market risks

Investor sentiment has changed for the worse, leading to the end of a long bull run. Ironically, stock valuations are falling, even though an economic recovery is still in progress and the pandemic is easing its grip. India, which was among the best-performing markets of 2021, could experience one of the more extreme corrections as sentiment changes. Rupee equity valuations are the highest among emerging markets and the rupee itself may be under pressure, given heavy foreign portfolio investment (FPI) selling and a rising trade deficit. The downturn is partly due to geopolitical tensions in Ukraine. But investors have also turned cautious in the face of higher inflation, and threats of tightening liquidity. The Russia-Ukraine situation could affect crude oil and gas supply, even if it doesn’t result in an armed conflict.

Sanctions targeting Russia would impact one of the world’s largest energy exporters, and key gas pipelines supplying the European Union run through the potential conflict zone. Hence, fears of potential supply disruption have led to spiking energy prices, even though global supply is in surplus over demand. High energy costs are adding an impetus to global inflation. The Fed started making hawkish noises in September. It has since accelerated tapering off its bond-buying programme, reducing hard currency liquidity. In its latest policy, the Fed has signalled a series of rate hikes. Some investment advisors are betting there could be up to seven hikes of the Fed funds rates in calendar 2022. Any Fed hike will most likely induce tightening by the European Central Bank and other large central banks. The drop in liquidity has led to “risk-off” trading attitudes with global traders moving to safer hard-currency assets, such as government treasuries. Foreign portfolio investors have sold Indian stocks worth over Rs 66,000 crore since September when the Fed started making hawkish noises and the Nifty is down by 8 per cent from its record highs. Even the Dow Jones Industrial Average and the Nasdaq 100 — America’s premier stock indices — are down significantly, indicating high levels of caution on the part of investors.
 

Given India’s own higher inflation rate, with the increase in the wholesale price index in double-digits and consumer price index at a five-month high, the Reserve Bank of India may also have to hasten the policy normalisation process. This would impact already fragile domestic sentiment, given the impending Assembly elections. The upcoming Budget will also have to walk a tightrope. It needs to encourage economic activity but cannot ignore massive increases in government debt and deficit. Corporate India is feeling the inflationary pressure. A look at the October-December 2021 quarterly results of a sample of 507 listed companies indicates that, while revenues are up 24 per cent year-on-year compared to October-December 2020, operating margins have fallen from 35 per cent to 31 per cent. Expenses have mounted sharply, with power and fuel costs up 67 per cent and raw material and component costs up 43 per cent. Investors would have to hope for the Ukraine crisis to end quickly without conflict or sanctions. In that case, inflation may moderate somewhat as energy prices normalise. However, lower liquidity and higher policy rates will mean a downgrade for risky assets and could lead to a deeper correction.