The Indian markets faced a significant sell-off on Friday, with the Nifty down 2 per cent and the mid-cap and small-cap indices dropping by more than 3.5 per cent. The mid- and small-cap indices are now already down almost 10 per cent for the year. With the overnight decline in global markets, there was continued selling on Monday as well. Why are markets selling off in India? Is it the Budget, global issues, or something else altogether?
As for the Budget, there is the issue of the long-term capital gains tax. Frankly, I do not think this 10 per cent tax will fundamentally alter flows into India. Yes, expected realised returns will reduce, and this can hurt flows on the margin, but investors allocate capital to make money. If India and our companies can deliver strong cash flows and growth, with good capital efficiency, then money will come. A 10 per cent tax on the gains will not be enough to derail the long-term India story. The pain point in the short term is more around the paperwork of filing tax returns and accrual of taxation, etc. You have thrown some sand into the flywheel and created greater friction to invest into India, but investors will not walk away, not till such time as the underlying growth convergence story holds. Once the fundamentals turn, the pain of this move will be felt more.
A second fear is linked to local bond yields. Ten-year g-sec yields went up 18 basis points on the Budget day to 7.61 per cent. This, despite the Budget maths being credible, and a reduction in net government borrowings by Rs 600 billion. The markets seem to have taken the finance minister’s word on raising minimum support price (MSP) on crops seriously. This statement combined with some of the duty changes on edible oils etc. show a determination to raise incomes for rural India. Farmer distress is linked to low realisations received for their crop. If the government is determined to raise farmers’ incomes through higher prices, then food inflation is inevitable. A bout of food inflation, and the Reserve Bank of India will raise rates for sure. This is concerning, as higher rates are corrosive for valuation multiples, and the relative attractiveness of equities. There is the risk of a negative circular loop coming into play. Bond yields rise, global investors pull capital from our debt markets, the rupee weakens as this capital flows out, inflation rises due to weaker rupee, and the RBI has to tighten. The cycle feeds on and reinforces itself. This can create market dislocations. I do not think we are in this negative loop yet, but we must be aware and careful. The government has to convince bond markets about the Budget arithmetic, its focus on inflation, and the RBI has to ensure liquidity does not tighten beyond a point. Given that banks are already excess statutory liquidity ratio, new buyers have to be found for the government paper, either through greater limits for foreign portfolio investors or changes in investment pattern for domestic long-term investment institutions.
Illustration by Ajay Mohanty
A related concern is around US 10-year Treasury yields. They have also spiked and at 2.84 per cent, are perilously close to the 3 per cent level commonly seen as being critical. US yields have spiked as the average hourly wages went up by 2.9 per cent in its latest reading. Could this be the long-awaited resurrection of the Phillips curve? Has unemployment finally reached such a low level that it is causing wages and thus inflation to spike? Could the Fed be behind the curve? It could be these fears of an accelerated Fed tightening cycle, or it may simply be the markets testing the new Fed Chair Jerome Powell. Markets may be testing his inflation-fighting credentials and his belief in the Greenspan put. Given where valuations are in the US, any surge in yields will hurt markets for sure. The risk-off sentiment in the US will hurt all markets globally. If you believe that the Fed is behind the curve, the inflation genie is out of the bottle, and we have an accelerated tightening cycle ahead of us, then it would make sense to be cautious on markets globally.
The reality is also that we have been lulled into complacency both in India and globally. A 10 per cent correction is par for the course in any bull phase. We have not seen that in India for the past 15 months; in America, this is the longest period ever for the markets to not see even a 3 per cent correction. Any sell-off feels exaggerated because of the calm of the past year.
In India the sell-off is more focused on the small- and mid-cap stocks. Here, there were pockets of excess, both in valuation and even sentiment. These stocks had outperformed the broad market continuously. It was inevitable that we would see a period of distribution and consolidation for these stocks. The new Securities and Exchange Board of India guidelines ensuring consistency of portfolio with mandate has only precipitated the correction.
I remain convinced that we will see a strong acceleration in corporate earnings. The goods and services tax has been a positive for the larger corporate entities and their margins. The economy is clearly recovering and multiple real economy data points show the acceleration. There will be a tricky hand-off, as rising rates will force some multiple compressions, but surging earnings should allow markets to move up despite the multiple fade. This hand-off between multiples and earnings is always tricky and creates volatility. We must be prepared for this. If one does not believe in the earnings story, then they should sell and exit the markets. The macro does not support any further multiple expansion.
My sense is that we should be braced for a correction. It has already begun in the mid-caps for the past month, and will now spread to the larger stocks as well. A pause which refreshes is healthy for markets. I do not think this is a trend reversal. That will happen if the negative macro spiral alluded to above were to come into play. Use the correction to upgrade the quality of your portfolio.