Ample and cheap liquidity could soon be a thing of the past as global central banks claw back to the normal interest rate regime and start unwinding their heavily loaded balance sheets.
The US Fed is expected to ease its quantitative easing (QE) by March 2022 and an American economist from the global brokerage house Jefferies believes that seven rate hikes of 25bps each are likely in 2022, followed by four next year.
A report from Jefferies also suggests that the US Fed may shrink its balance sheet by possible active sale of its book in addition to the run-off (securities worth $80-100 billion maturing every month won't be replenished). If the Fed allows for a 'run-off' model, it would imply about $100 billion per month of balance sheet reduction. If the Fed decides to sell assets, the pace could be higher.
The highest ever inflation in the Eurozone has pressured ECB to initiate QE in the union.
What does it mean for India
The talks of rising interest rates pushed the US treasury yields beyond 2 percent on February 16. The shift towards investment in safe haven government bonds has seen massive foreign portfolio investment (FPI) outflows from India. The FPIs have been net sellers for the past few months and since April 2021, they have pulled out $20 billion from the secondary market.
Jefferies in its report suggests that unwinding of the global liquidity calls for mean reversion on valuations. “Our 10 mean reversion scenarios put Nifty December 2022 target at an average of 17,500 with the range being 16,500 to 18,500,” it said.
The LIC public issue amid continued foreign selling, and a perception that the RBI might be behind the curve amid the twin deficit concerns, are the two key near-term risks that Indian markets face.
India is still expensive
The Nifty trades at a 12-month forward PE of 19.8x, which is at a premium of 6.6 percent to five-year average and a premium of 19 percent the 10-year average.
“On our favoured yield gap parameter (earnings yield less 10-year government bond yield), the current gap of 161bps is 33/44 bps higher than the 5-year/10-year average,” the report said.
Compared to other regional markets, Indian markets are trading much above their historical highs. As per the report, Nifty PE is at a premium of 69 percent, compared to other emerging markets, while it trades at a premium of 53 percent over Asian markets, excluding Japan.
Risk of higher Fiscal and Current Account Deficit (CAD)
India is seeing a broad-based surge in imports (non-oil, non-gold rising at 20 percent at a two-year CAGR now). The recovery in domestic demand along with high commodity and crude prices will in all likelihood keep the current account under pressure.
“We estimate CAD at 2.5 percent of GDP in FY23 ($80/bbl assumption for high) which is at 10-year high,” Jefferies said in its report.
The bond market is already feeling the fritters from the government’s fiscal deficit target of 6.4 percent for FY23.
Central bank falling behind the curve
Countries like Brazil, Russia and Mexico have revised their interest rates upwards by 7.25 percent, 4.25 percent and 1.5 percent, respectively, from their two-year lows. South Korea and South Africa have implemented 0.75 and 0.5 percent hikes in their interest rates.
Reserve Bank of India (RBI) maintained the status quo on key headline rates and continued with its accommodative stance to support growth. “We note that effective policy rates have already been moved 50bps higher than the 3.35 percent reverse repo rate,” the report said.
“The RBI's continued pause on headline rates and a surprisingly low CPI forecast for FY23 has bought the RBI a few months of time.”
The recent surge in crude oil prices which are inching closer to $100 a barrel could result in the government increasing the fuel prices by Rs 6 to 8 per liter once the crucial state elections are over.
The rise in domestic fuel prices would flare up the inflation further and may force RBI to revisit it accommodative stance in the next one or two quarters. CPI for January 2022 came at 6 percent, however, the RBI is forecasting the same to glide down to 4 percent over the year.
The saving grace for Indian markets so far has been that the heavy foreign selling has been absorbed by strong domestic buying which has smoothen the market impact to a large extent. “Potential LIC IPO (estimated at $5-7 billion) can disrupt this balance,” the brokerage said.
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