Over the past one year, the up-way trajectory of the market has made equity investors richer significantly. After a good run thus far, our macro has turned for worse and market valuations are moderately expensive. This combination doesn’t augur well and its likely that markets will underperform investor expectations over next 12m.
I am not and haven’t been in the camp of calling equity market an ‘epic bubble’ or ‘mania like 2000’. In this note, my arguments are about market having up-corrected since March 2020, could be pricing growth and benign policy set up with far too much certainty. It is too convinced about lack of inflation or policy design of financial repression or of sharp earnings recovery or of a birth of new business cycle. Given that today’s market price is simply an expression of probability adjusted future outcomes and there exist significant risks to good outcomes, a balance of risk argument suggests going underweight equities at this juncture. In this note, I present my views looking at global and local macro, stock market valuations, technical data such as flows, retail interest in markets, and various other important variables that matter to markets. I see no sign of collapse in markets but detect that equities may have wasteful and volatile journey over next 2-4 quarters.
§ Developed world will grow out of Covid mess but scars will stay with EMs including India for longer:
I have argued for a V-shape recovery since April of 2020 (the definition of V-shape recovery = Output goes back to pre-Covid trajectory in couple of years). Both USA and China are on their way to achieve it in 2023. Other developed economies will take somewhat longer but will eventually get there. Most OECD countries will get to pre-Covid level of employment rate by end of 2023 (it may happen relatively earlier for USA). But the story for EMs (Emerging Markets), including India won’t be same. Slow vaccination, inadequate policy response and imminent withdrawal of easy policies in western world will mean shallower recovery for most emerging economies. This is perhaps a reason why these markets have continued to underperform US markets even though commodities have flared up so much (which tends to benefit EMs).
Two speed recovery in the world: Given the slow roll out of vaccination, we may end up experiencing multiple Covid waves in EM world that dampens both output as well as sentiments, though likelihood of the same is low in India (because of high level of sero prevalence). The bigger deal is that developed economies are likely to exit the Covid mess ahead of EMs. They will also do taper or some form of tightening in the next 12m which will leave no choice for EMs but to tighten rates prematurely. We have seen Brazil, Mexico and Russia tightening. Almost 40% of EMs have tightened in last 6 months. Others will follow soon. This also means that some of the output losses for the EMs will become more durable.
Sluggish recovery of India: Our country’s recovery has been painfully slow. Typical binding constraints of EM played out for us. Our orthodox fiscal policy with ultra-conservative lockdown policies have resulted in sharp output loss for our economy that are both substantial and durable. Don’t get swayed by high fiscal deficit of our country as most of it was simply driven by revenue slippage. True fiscal stimulus for India during past 16 months has been close to 3% of GDP. That’s one of the lowest amongst G20 economies. Though we are likely to grow at 10% growth in FY22, but that will still leave our economy 10% below pre-covid trajectory of output.
High Inflation may be transitory for developed world but will still drive tighter policy, and that will force EMs including India to tighten prematurely:
There are three types of views emerging on inflation’ outlook. One, the history will repeat type, which argues that last 40 years of disinflation will persist as demographics, tech development, high debt and rising inequality will continue to drive disinflation in developed markets. Second view is more topical (and pragmatic) one, which argues higher inflation for some time due to pandemic policies (fiscal transfers and supply dislocations) but return to the pre-pandemic regime in 1-2 years. Third view is of hyper-inflation which argues that commodity super-cycle, government guarantee programs during Covid and other fiscal transfers will result in massive inflation in the developed world.
Likely inflation outcome in developed world: I assign very high probability to the second outcome (near term inflation and then, return to old disinflation) and very low to the third one (hyperinflation). There is no evidence of easy money (2009-21) and commodity inflation (2000-10) resulting in hyper-inflation in developed world. But near term pressure on wages can certainly lead to high inflation for next 12-18 months. My view is that US inflation will persist at near 3%, well into next year, by when unemployment would have fallen significantly below 5%. This will drive fed to hint at tighter rate regime. Though dot plots hint at easy polices for long, it is Fed’s view, not a commitment (Fed changed the view dramatically in 2019, when they turned soft even though their dot plots conveyed opposite view for whole of 2018). Higher inflation outcome is likely for many other countries as well though I don’t think it will be beyond the comfort level of their central bankers. So, in this cycle too, I think US will be well ahead of most developed markets to tighten rates. That is key reason why I think, dollar will strengthen in near term.
On financial repression? I don’t agree with the prognosis that ‘Inflation-istas’ are making that Government guarantee driven credit growth will fuel high inflation over rest of the decade. Western economies have done nothing so far to suggest a China styled, state directed capex funding. Most guarantee measures which were undertaken during pandemic are on their way out. Fed and other central bankers along with governments will turn restrictive once they begin to sight inflation. The only key change in policy regime in US and EU is that they aren’t likely to tighten in anticipation of inflation but only react as they sight it. Since inflation pressures are already there and that they are likely to persist for 12-18 months (more on this in the next note), the base case should be a tighter policy regime in 2021-22.
India inflation is an easier case to make: Even over last two years, our average inflation has been close to 5.5%. In the same period, WPI has been just 2%. So it’s the local factors (not the usual imported ones) which drove the consumer inflation higher. Now we have 12% WPI meeting recovering demand conditions. All the pre-conditions of high CPI, sharply higher food prices and industrial commodities, supply shortages or dislocations and somewhat complacent monetary policy are in place. It’s very likely that India will experience tightening over next 12 months, though output conditions would require loose polices for longer. That’s the predicament of a typical EM and is the reason they never recover from crises early enough (Unlike in 2009-11, when RBI kept rates too loose but allowed the bond markets to get repriced, we are practicing a soft yield cap also. My fear is that this experiment may not end well if market forces RBI to do a knee jerk tightening at some point in next 12 months).
Implications of high inflation for investors: Inflation is a tax on all financial instruments. If inflation is imminent, it’s best to hide in assets which tend to benefit from high inflation such as real estate. Corporates should be careful of unhedged foreign debt now. Both taper and local inflation will hurt INR. Debt investors should stay in low duration funds. While curves are steep, they won’t compensate for losses that you are likely to witness in months to come.
What about stocks? It’s empirically proven that low and stable inflation is the best for stock markets. The equity risk premium tends to fall in such periods. We have experienced good 40 years in which most of the developed world, and most importantly US has experienced low inflation and therefore secularly lowering rates (both nominal and real).
In near term, some inflation could be actually good for developed markets’ stocks as long as it coincides with committed central bankers to keep interest rates (and thereby real rates) low. But this template of market isn’t available for EMs as these economies don’t have a luxury of such financial repression. A combination of ‘high inflation’ locally and ‘moderate to low inflation’ in the world isn’t a good outcome for Indian markets (and other EMs) which rely so heavily on outside risk capital.
§ Valuations are moderately expensive but aren’t bubbly
Though different metrics suggest different views on valuations but I side with ‘moderately high valuation’ argument for most of the stock markets. Once you account for low real rates and low capital investment requirements of mags firms, the argument that stocks are bubbly falls flat. Even at current valuations, available risk premium is substantial in most developed world.
Here too, Indian markets case is weak. In India’s case, available ERP is lower and therefore our markets are more expensive than most developed and emerging markets.
The bear argument in US is that an ongoing earnings expansion of its firms (profit to GDP, profitability margins) or bullish rate cycle (lower for longer, disinflationary environment) may reverse. Possible but there is nothing in policy and economic construct that suggest that the ongoing trend would reverse any time soon. On the other hand, In India’s case, our corporate earnings growth has struggled over past decade (7% growth for Nifty firms) and unless earnings expansion mean reverts to previous two decade’s average (10%+), our markets look expensive. So the bear argument for US stock markets is about reversal of ever rising earnings whereas in India’s case, more of the same will result in lackluster markets.
CAPE, PB & Buffet ratio suggest that markets are very expensive, but these don’t account for real-rate regime shift: Cyclically adjusted PE ratios in India as well as US are near 30. Market cap to GDP is 230% in US (average of last century is 100). Indian market cap to GDP (116%) too is high once it is contextualized to history (only briefly in 2007/08 and 9/10 this was higher than 100%). It’s also very high compared to other EMs (Russia, Brazil, and China near 50s). Even other matrices such as PB look stretched at 4.3 times for Nifty. Only during 2006-08, P/B were higher than where they are today. But back then, ROEs of Indian firms were in mid 20s. It’s never been above 15 in past 5 years. So paying 4 times for this sort of ROE appears excessive. If valuation metric like market cap to GDP had to mean revert by end of the decade, the US would deliver negative returns and Indian market would too deliver low single digit. Will it happen? Most likely no. All the ratios which hint at market being exuberant make a critical assumption that real rates will mean revert. Will they- most probably no.
Very high BOND PEs = High Stocks PE: Bonds PE is reverse of yield. US rates (10 year bonds) averaged at 6% in 1995-2000, 4.35% in 2003-08 and 2% in 2016-21. So US bonds average PE were at 17 and 22 in 2000 and 2008 (this is 100/average yield of previous 5 years). The same is 50 today because US bond has averaged at 2% in last 5 years. This has to be kept in mind whenever one compares US stock markets PEs of today vs that of 2000 or 2008.
US rates aren’t likely to go to 6% (as they were then in 2000). Even if one imagines US rates to settle at 3% over next 5 years, the corresponding PEs of the bond will be 33. That’s twice of 2000. If one is bullish and think that UST will settle at 2% only (last 5-year average = Next 5 years’ average) then US bonds PEs will average at 50 (vs 5-year average of 17 in 2001). Most investors who call stock markets are in bubble, either ignore this fact or simply argue that bond market is bubblier. The reason rates have settled lower in the whole of the developed economies is simply driven by long term forces which aren’t going away any time soon. That, this 40-year disinflation would end is an ideological argument and may not serve much to investors until we see a glimpse of reversal. I do not see it. Net net, once you look at equity markets through the lens of bonds, they don’t look terribly expensive for developed economies.
Falling interest rate argument doesn’t hold good for India: Our past 5-year average of 10-year bond yield has been close to 7%, same as it was in 2008 (it has averaged at 7.5% over last 10 & 20 years). Unlike in US, our interest rates haven’t shifted downward in last 10-12 years. To be sure, they did in early 2000s as India’s 10-year bond averaged at 12% in 2000 (1995-2000). So one can argue that 2000’s Nifty PEs will never return because it corresponded with high rates. But since today’s interest rate regime is somewhat same as it was in 2008, we can compare the PEs of these two periods. During the bull market of 2003-07, trailing PEs peaked at 26 in Dec 2007. We are at 29 right now and have been above 25 for past 3 years. So purely on interest rate movement basis, one can argue that Indian equities don’t deserve a lift in PE as one can argue for US & other developed nations.
Equity risk premium is low in India: Equity risk premium is excess return that stock markets offer vs risk free rate. Historically, Indian market ERP = US historical ERP @4.7% + country risk premium due to excess volatility in our markets (0.2) + inflation premium (2-3%) = so about 7-8% over US risk free. For Indian investors, it’s been close to 4.5% (during 2005-20, based on RBI paper, calculate basis FCFE). It gives us a hint of what an average investor should expect.
What is the current premium available in markets? The difference between equity yield, subtracted by real bond yield gives us a good hint of ERP available at current valuation. This is about 5.5% for the US (forward PEs at 22 therefore earning yield of near 4.5%, real bond yield at -1%). In India, given that we are trading at 22 times next 12 earnings, our earning yields are at near 4.5%. I think our real bond yield will be close to 1% (10-year bond yield at 6.25% - expected CPI @5% over next 10 years). Therefore, available ERP in India is 3.5%. If you assume that bond yields are artificially depressed and are likely to settle at 7%, the available ERP is further lower. This is clearly lower than what one would expect once it is referenced to US markets. The only way to justify the current valuation will be to either keep bond yields depressed or orchestrate higher inflation. So if we want to match US’ -1% real yield, the expected inflation should be 7% over next decade or bond yields should fall to 4%. Can it happen? Very unlikely.
Another problem with valuation is the steep climb in earnings that is expected by markets. The trailing EPS of Nifty is 550 and markets believe that we will get 750+ over next 12 months. Possible, but it requires a steep climb. The room for disappointment is certainly higher when the ask is so high (This is true for S&P 500 as well, where earnings are expected to rise from 145 to 200 over next 12 months).
§ Retail participation & equity supply are flashing risks to markets:
I see frenzied retail participation and historic equity supply as flashing risks to the market (Both of these are markers for upcoming difficult time).
Most volume indicators suggest that retail participation is at near all-time high across major markets. In India, prop and retail together, contributes more than 80% of trading volume. We have had three episodes of this sort of hyper-activity in past two decades. 2004-5, 2010 and 2017 saw the volumes in small and mid-caps rise dramatically with respect to large caps. Those episodes coincided with sharp increase in valuations of such stocks. At such elevated valuations (small-caps and mid-caps are trading at premium to large caps today) and with low probability of take out from institutional investors (because of 2018’ scarring is still fresh in their mind), it’s very likely that there is going to a disappointment ahead for these stocks. As such, retail investors’ financial savings and time to speculate in market (Covid lockdown related) may have peaked in most parts of the world, including India. As businesses re-open and lockdown give way to open economies, we will see reduced interest, time and money in stock markets.
Big supply of equities: India saw $24bn supply of equities in FY21. And the current pipeline hints at $35bn+ worth of supply in FY22. That’s huge. I don’t see a commensurate demand from traditional sources of funds. FIIs have slowed over past 2 quarters given the macro narrative of EMs and concerns around valuations. In this financial year, I expect FII flows to be close to average of past 5 years, which is near $10bn. Mutual funds saw sustained redemption throughout last year and are beginning to see flows trickle again. But I don’t expect more than $10bn equity flows (this is just a feel being an institutional fund manager). So there could be a gap between demand and supply of equities. (I have worked in Indian bond markets for more than two decades and know the value of this gap. Bond supply in Indian markets have persistently been higher than demand over past decade, posing a big resistant to bond rally even in wake of good data)
I also think that the current one is an ‘old bull market’ (which began in 2009 for US and in 2012 for India) instead of a new one. Elevated valuation, in a mature bull market, is a recipe of big disappointment. Investors should be cognisant of that.
§ Probabilistic distribution of various outcomes and long term assessment
What we see is that while many advanced nations and some EMs like China will grow out of Covid crisis, India will struggle for longer. Also, India’ inflation will be stickier and will cause a premature policy tightening. In this macro backdrop, our stocks offer low ERP and are more expensive than most other major stock markets. That’s the key reason why I am going underweight Indian equities.
Whole of last year, I have argued for a possibility of a glorious decade for India. Low Oil prices, China+1 policies of the international firm and a few important initiatives such as GST, PLIs and tax cuts were reasons I had been bullish for India’s prospects. To a certain extent Indian market performance has reflected it. But I am afraid, markets are far too certain about it now. As a market participant, my job is to evaluate all the probable outcomes and value markets based on them. I feel markets have strayed in believing the positive outcome as the only probable one and are dismissive of many risks to the same. The belief that crude will stay low, Covid won’t turn endemic, inflation will prove transient, monetary policy will remain accommodative and the cost cuts by the firms will be durable are not assumptions that we can entirely trust. Markets are smart. They will correct this anomaly in months to come.
But an important reminder here, it is a fact that stocks almost always do better than bonds, gold and real estate. There is no argument of being out of stocks for long, so once markets adjust to more nuanced form of probable realities, I should dial market risk again. And I will write here before I do it.
Maneesh Dangi, July 23, 2021
I know that it’s a conventional wisdom to not try to time the stock markets. But I have always tried to time it (often successfully in entering, but somewhat early in exiting). Since most markets correct recurrently and crash sporadically for some random reasons, having dry cash to invest, when markets are crashing has been a key reason why I have compounded well over past 15 years. In my experience, it’s fine to leave some upside on table if that secures an opportunity to dive again in stressful times. I initiated this reflation trade in the last week of March 2020. Though valuations started to look stretched a couple of months ago, I waited for macro to turn worse to time the closure.
My macro template that when even mildly stretched valuation meet weak macro, stock markets don’t deliver expected returns. We are living in such times. I am not professing a crash in markets. Just expecting volatile and wasteful year.
Finally, this isn’t an advice to anyone. It’s simply an attempt to express my views on public forum and attract alternate views so that I can identify mistakes in my thought process and course correct.
Look forward to knowing your thoughts on the views expressed. You can reach me at: firstname.lastname@example.org