India Inc. has put up a good show for the 2QFY22 earnings season and the street witnessed more earnings upgrades than downgrades. Yet, Indian markets are down around 5 percent, while global markets continue to be strong.

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Why so?

Inflation is one of the main culprits. It not only hits the purchasing power of consumers but also, impacts the demand and margins of corporates; leading to a double whammy for earnings. Inflation, after an inflection point, leads to long term demand destruction and is severely detrimental to markets. It leads to decreased risk appetite, leading to outflows from equities, which are basically risk assets. The world has taken the notice of increasing inflation and supply-side issues are being resolved gradually. We believe that this might pose a short term threat to the markets, but medium/long term prospects still remains robust. And unless a wave-3 hits hard, any deep correction will open up buying opportunities. Has this risk-off trade started?

Rising bond yields is the first sign of flight to safety. While the emerging market (EM) bond yields haven’t moved much, US bond yields have inched up to over 1.6 percent (since August 21 lows of 1.2 percent). Unless the bond yields are arrested at the current levels, we may see ugly risk-off trade. India has been the biggest beneficiary of equity money moving out of the US in 2020 and China in 2020/2021. And that’s what led to Indian markets move ahead of fundamentals. This money flow helped corporates raise capital, through the flurry of IPOs and a large number of QIPs, at right time to survive the tough times in pandemic and keep the fundamentals intact.

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How is the change in dollar strength impacting markets globally?

The dollar index (DXY) is a strong indicator for money flow. Since the outbreak of the pandemic in Mar’20, the DXY dropped from 102 to 90 within a year – indicating money flow from the US to EMs. During this period, Nifty outperformed the US markets by a whopping over 50 percent. Over the last one month, DXY has inched up from 93.5 to 96. During this period, Nifty has underperformed Dow by 4.3 percent. We believe this is the start of emerging markets (EM) to developing markets (DM) trade. Historically, such events lead to underperformances of ~15-20 percent.

Fed bond purchase tapering, opening of economies

Simultaneously, tapering of bond purchases by the US Federal Reserve and a return to normalcy in economies across the world will lead to an outflow of both FII and retail investor money. Idle money flowing into the market so far will now move to real consumption in terms of discretionary spends, travel, etc. While this will lead to stronger earnings growth, this outflow into actual consumption will lead to selling pressure and hence stocks prices will fall (as we believe stock prices are reflecting the earnings expectations).

Within EMs, how does India fare?

On a YTD basis, Nifty has massively outperformed other indices – Nifty up 28.7 percent vs. Dow up 18.1 percent and Kospi & Shanghai (which witness similar fund allocation as Nifty) are up 4.3 percent and 1.4 percent, respectively. However, over the past one month, none of the EMs is positive compared to US equities. Nifty/Shanghai/Kospi are down 1.9 percent/1.4 percent/0.6 percent while Dow/Nasdaq are up 2.5 percent/7.2 percent. Among the EMs, Nifty is the worst performing month-on-month (MoM). No incremental negative news from China could trigger increased flow to these Asian markets and could impact Nifty negatively.

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What we are seeing is a technical correction (Nifty down 3.3 percent MoM) as investors are taking some chips off the table and re-allocating the investments into other markets, other asset classes like real estate, unlisted/IPO space and the likes.

What should investors do?

We expect companies that need or depend on external capital to grow see more pain in the short term than those that have recently raised capital and/or have a stronger balance sheet. We, as long-only asset managers, continuously assess the market dynamics and focus on the earnings potential of companies under our radar; so that we can buy into the correction at the right time for stocks with strong earnings tailwind. A few names on our radar are Bharti Airtel, ICICI Bank, Maruti, Page Industries, Reliance Industries and SBI.

The article is authored by Mridul Jalan and Sweta Jain, co-founders of Senora Advisors

(Edited by : Priyanka Deshpande)