Indian markets have been on an upward trend since July with the frontline indices rising around 14 percent since then. The rally in the broader markets has been sharper with the midcap index advancing 22 percent since July. However, post the recent rally, brokerage house Jefferies has turned cautious on Indian equities. The brokerage believes that the current uptrend in equities may not continue for long.
According to the brokerage, the information technology (IT) sector remains at significant risk of sell-off if the Nifty started to correct. Hence, as a tactical strategy, they have decreased their weightage in the IT sector making it underweight and increased the same in staples. It expects the consumer staples sector to prove to be a good defensive bet in case of a market correction. Jefferies has also replaced Godrej Properties (more volatile) with Macrotech developers in their model portfolio.
Let's take a look at the key reasons for their cautious approach for the Indian markets despite the rally:
Bond yield, earnings yield gap: According to the brokerage, expensive valuations is not a new phenomenon for Indian markets. However, the bond yield, and earnings yield gap exceeding 2 percentage points (ppt) makes the brokerage uncomfortable, especially as bond yields could move higher, putting further pressure on the markets.
Also, in the last one year, the Nifty has corrected by over 10 percent three times from a similar yield gap when the index was around the 18,000 mark, noted the brokerage. It sees a strong chance of a repeat given the clues from the US Federal Reserve (US Fed).
Global rates on the rise again: Secondly, the brokerage noted that the US 10-year treasury rates are up around 70 basis points (bps) month-on-month (MoM) to 3.25 percent, with the dollar index (DXY) has appreciated by nearly 4 percent. Consequent to this, the US markets have moved within 7 percent of their year-to-date (YTD) lows. Jefferies believes that the US Fed has much more tightening ahead than priced in as the low unemployment rates are causing inflation to run much higher than the 2 percent target. It further noted that the US unemployment rate needs to double from the current 3 percent so as to achieve the inflation target - which implies more/continued rate hikes.
India's forex position: The brokerage also pointed out that India's trade deficit has trended at record levels recently and the current account deficit (CAD) is on track to hit a decadal high of 3.5 percent in fiscal 2022-23 (FY23). Jefferies believes this needs close monitoring. "The FX reserves (including forward cover) are down around $100 billion now from peak and import cover has fallen below 9-month levels. The GDP deflator has hit a decadal high, implying broad-based inflationary pressures," the report said.
What happened in the past three corrections?
The brokerage highlighted that from the October 2021 peak, the Nifty has had three declines of over 10 percent with a total decline of 17 percent to the June bottom. Among the larger sectors, Autos, Industrials and FMCG have outperformed, while information technology (IT), healthcare and materials have underperformed, it added while banks have been broadly market performers.
Any potential market correction will likely emanate out of the hawkish stance of the Fed and the likely stagflation worries. That could hit the IT sector,” Jefferies cautions.
A key positive for the Indian markets is the turnaround in FPI inflows in equity markets. That and the rising expectations of India's inclusion in global bond market indices have led to a stable rupee and resilient bond markets over the last month noted Jefferies. Also, the benchmark 10-year G-sec yields are down 40 bps from their June 2022 peak, as against the trend of the rising yield seen elsewhere globally, it noted.
Also, Jefferies pointed out that the broader economy in India is holding up well.
"We do note that India's economy continues to hold well. Recent data shows strength in overall consumption, property sales, manufacturing, passenger vehicles/two-wheelers sales and credit growth," stated the brokerage.
Also, after India's outperformance of most major global peers in August, Chris Wood of Jefferies recently raised India's weightage in his Asia Pacific ex-Japan asset portfolio to 16 percent from 14 percent.
“Recent market movements, and the renewed lockdowns in China, prompt GREED & fear to make asset allocation changes in the Asia Pacific ex-Japan relative-return portfolio. With the Indian overweight having almost become Neutral, the allocation in India will be increased by two percentage points with the money raised by shaving the weighting in China,” Wood said in his GREED & fear report.
Wood added that he had expected Indian markets to consolidate in 2022 after recording strong gains in the previous year and the commencement of a monetary tightening cycle by global central banks, especially the US Federal Reserve (US Fed). He believes India is by far the best structural story in Asia.