Marking out the markets as coronavirus makes economic recovery uncertain

Most commentators hope that agriculture will have a good year, countering contraction in services and manufacturing to some extent.
The economic outlook is hazy and investors don’t have a clear sense of market direction either as things stand. There’s consensus that gross domestic product (GDP) will contract substantially this fiscal, but estimates vary widely and there’s no visibility on the recovery timeline. ICRA, for example, assumes a 9.5 per cent contraction year-on-year for financial year 2020-21 (FY21) over FY20. Most commentators hope that agriculture will have a good year, countering contraction in services and manufacturing to some extent.


On the other hand, consumption is likely to be affected through the next six months, due to a rise in unemployment caused by the lockdown. The government is already running a big deficit, which is likely to increase further due to low tax collections. It doesn’t have space for counter-cyclical investment activity, or much money to disburse for aid and mitigation programmes. There could also be political tension due to problems with goods and services tax (GST) disbursal to the states.


In the financial economy, interest rates are low amid ample liquidity. The Reserve Bank of India (RBI) kept rates unchanged last week and may continue to do so, given the economic contraction and low inflation due to low demand. The central bank is also carrying out a programme of buying back bonds from the secondary market to ensure new government paper is auctioned at low yields. Other monetary-easing measures are also likely, and at some stage another bank bailout could become a reality. The RBI’s Financial Stability Report (FSR) says stress tests indicate gross non-performing assets (NPAs) could expand from 8.5 per cent of bank assets in March 2020 to 12.5 per cent in March 2021 in a baseline scenario, and to above 14.5 per cent in severe stress scenarios.


Contraction and recovery


High-speed indicators have showed sharp contraction of all activity from late March 2020 onwards. There could be a bounce if the economy reopens fully, but there may also be more lockdowns to contain the coronavirus pandemic, albeit not as stringent as seen earlier in 2020. There’s no visibility yet on vaccines and the pandemic case-load is growing. Base effects will make it hard to assess GDP growth, and corporate results, for the next fiscal and beyond. The sharp economic contraction in 2020-21 means that there could be a “V-shaped recovery” in 2021-22 YoY even if the GDP and corporate earnings remain well below the 2019-20 levels. On the trade front, low demand has led to a sharp contraction in imports but exports have also fallen. The current account is in surplus, which may help keep the rupee steady.


On the other hand, foreign portfolio investors’ (FPI) attitude since January 2020 as regards India as an investment destination has been net-negative (See table 'FPI'). However, they have been buying equity since May 2020, which has contributed to the market recovery. Domestic institutions (DIIs) were net negative in July, but they shored up the market with strong purchases earlier in calendar year 2020 (CY20).


The equity mutual fund segment has seen a cutback in inflows and assets under management (AUM) have also flattened. (See chart 'mutual trends') Retail investors have cut back on systematic investment plans (SIPs), but there has been direct retail investment in equities, which has helped keep mid-and-small caps buoyant. The SEBI decision to tighten margins norms has been pushed back to later this year, but the proposals may dent investors’ mood. However, retail investors are likely to continue playing the market in the absence of attractive returns from other asset classes.


Looking at the equity market, stocks across market-cap segments have very similar patterns. Led by the Nifty50, all stock indices hit record highs in late January 2020, followed by 35-40 per cent retraction to lows in late March once the pandemic triggered a nation-wide lockdown. Stocks have since rebounded considerably but are still well below January 2020 levels. (See chart 'indices normalised')


Over the past few months, however, there are clear trends in terms of sector preferences amongst investors. (See Table 'Sector') The 12-month performances of sectors such as pharma, information technology (IT), energy, auto, fast moving consumer goods (FMCG) and infrastructure gained. Most of these have done well in the past one month as well.


Volatility is likely to remain high over the next six months. However, ample liquidity and an absence of attractive returns from other investment channels will also mean continued interest in the stock market. We may even see an apparent paradox where money starts being pulled out of the stock market as and when the economy recovers and corporate demand for capital rises. However, poor economic performances and poor corporate performances could be a dampener. Also, there’s a real danger of a serious deterioration of bank and NBFC balance sheets, which could pull down the banking stocks, and in turn, the markets.


Too many variables


There’s a great deal of uncertainty about multiple variables. There’s no end to the pandemic in sight and no clarity about timeline of economic recovery. Public finances are stressed. Bank balance sheets are in trouble. The global economy is under pressure. Plus, there are geopolitical issues regarding the China relationship. Garnish that with political slugfest—elections in Bihar and the US presidential contest at the global level—and markets have a number of risky turns to manoeuvre. However, some of this is being discounted by markets but news flow on any of these fronts could be good or bad. That means investors and traders should brace for a continuation of high volatility, whichever direction the market trends.


At a fundamental level, market valuations are hard to justify. We have seen earnings contraction for the last two quarters (Q4FY20 and Q1FY21) and flat corporate performances for several quarters prior to that. The last two quarters also don’t offer a sense of where corporate performance could go. Base effects will complicate estimates and earnings hard to compare.


Technically speaking, the market trend is up right now, but there’s major resistance at about 10 per cent off the record highs, (corresponding to about 10,700-11,000 on the Nifty50). Trend followers will be more enthusiastic if the market breaks above that barrier.

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