What’s leading to increased volatility in India’s markets?

India has been among the best performing emerging markets. Nifty has given a return of 30.98 percent this year to date; the Nifty 500 an even better 36.79 percent while the MSCI Emerging Markets Index shed 1.8 percent. However, in the last month, the rise in Indian stocks has been accompanied by an increase in volatility. Since 14 October, the India VIX, that measures the market’s expectation of near-term volatility, has surged 18.6 percent compared to the Nifty’s 4.5 percent.

What is causing this volatility?

There are global factors affecting all other markets and India is not immune. These include rising oil prices, bond yields and a risk-off sentiment because of the Evergrande crisis. Also, historically October has been the most volatile month, according to a 3 October HDFC Securities Monthly Strategy Report.

 “The month remains at the top of the volatility rankings even if we remove 1929 and 1987 from the sample — the years in which the two worst crashes in stock market history occurred, both in October,” it said. 

India is particularly vulnerable to rising oil prices because it is dependent on crude oil imports to meet rising energy needs. Also, this will lead to rising inflation. Although near term inflation appears to be trending down (as the September CPI number of 4.35 percent shows), it could still trend up over the medium term. There is an energy crisis on and some pundits see high fuel prices prevailing for some time.

“Inflation continues to remain high and the component that is coming down is food inflation, which is the most volatile component,” said Dharmakirti Joshi, chief economist at Crisil. “With core inflation [a measure of inflation that excludes food and fuel] likely to remain sticky, the inflation pressure will remain.”

Rising inflation and increased interest rates also make equities less attractive. Note that the markets are finely balanced, because valuations are pretty high which translates to a low-earnings yield. Motilal Oswal’s India Strategy report noted that the market-capitalisation-to-GDP ratio had touched 115 percent (FY22E GDP), above the long-time average of 80 percent. The report added that the number was the highest since 2007, when it had touched 149 percent during the 2003-2008 bull-run. This ratio, also called the Buffet indicator, says that a reading above 100 percent means a market is overvalued.

 The Motilal report also noted that Nifty 12-month forward price-earnings (P/E) multiple of 22.1 times was at a premium of 22 percent over its long-time average of 18 times. It added that IT and consumer staples were trading at 15-year high valuation multiples, and metals, oil and gas, and auto were trading at 6 percent - 8 percent premium over their long-term averages.  

At these high valuations, investors are becoming sensitive to any adverse global cue and more so because earnings season is here.

 “At these valuations, markets don’t leave much room for disappointment, so every now and then people will book profits,” said Harsha Upadhyaya, chief investment officer, Equity, Kotak Mahindra Asset Management.

“Valuations are higher than the last ten-year average, and people have made profits, so when global headwinds come, there will be some nervousness. Also, as we get closer to the earnings season, the nervousness will increase,” he added.

What's the way forward?

Fund flows will be crucial. So far, they have been strong and therefore volatility has not run too deep, lasting only a few days. FII inflows have been strong in August and September, but in October so far, they have been net sellers with outflows of Rs 1030 crore while DIIs have been net buyers with inflows of Rs 1299 crore. If this trend continues, it can put pressure on valuations.  

The way forward also depends on earnings and whether they meet expectations. According to Kotak Securities’ India Strategy report, Nifty is trading at 21.4 times the earnings estimate for FY23.

“We expect earnings of the Nifty-50 Index to grow by 31% in FY2022 to Rs.718, by 14.3% in FY2023 to Rs.822 and by 19.1% in FY2024 to Rs.930,” said the report.

The report listed the key risks to the market expectations: impact on the economy and earnings from a possible COVID-19 third wave and increase in crude oil prices; rising inflation leading to central banks rethinking their easy monetary; and elevated commodity prices that could affect the manufacturing sectors’ earnings in particular.

Industry watchers believe that it will be crucial to watch if earnings expectations are met in the next few quarters. This is because, until the June 2021 quarter, there was a favourable base effect.

 “March 2020 and June 2020 [quarters] were affected by the COVID-19 first wave, but by September 2020 things had started to normalise even if there was not a complete recovery. Therefore, for September 2021, the favourable-base effect will be weaker,” said Upadhyaya. “Also, with higher commodity prices, there will be some impact on the margins.”  

Kotak Securities’ India Strategy report said that there could be a pullback in the market, with or without modest returns for a ‘longish’ period of time. But the analysts have ruled out a severe correction in the market, “as potential bad news in the form of earnings downgrades (from global factors) and/or higher bond yields may not be bad enough.”