Although peculiar (at this point), the fallout from Silicon Valley Bank (SVB) and Credit Suisse raises the possibility of a banking catastrophe. The present one differs from the previous one (Global Financial Crisis, European debt crisis). Today's problem is more a result of high interest rates than it is of bad debt. In reality, the western world's private sector and core banking balance sheets are robust, which has limited the severity of the crisis. However, the growth backdrop is much adverse.
Contrary to 2022, there is no longer an excess of liquidity, and domestic consumption is weak. Cashflows must take priority over valuations.
Knowing when markets truly bottom out during crises is useful given the impending crisis. Nuvama Wealth Management Ltd says there are four key factors for the markets to bottom. These are not sacrosanct figures, but rather benchmarks. Dynamic changes will determine the actual movements. Let's look at them now.
Even before the credit event, the brokerage was worried about the earnings outlook. The credit incident only makes the situation worse. One of the strongest lead predictors for Nifty earnings is Global M1. (given the strong global interlinkages). It implies that the Nifty earnings have sharply moderated. This might fall short of consensus estimates of 18–20% earnings increase.
"Historically, during global financial crisis or European debt crisis, Nifty earnings have been cut by 10-15% before markets have bottomed. So far, we are far from that and hence earnings cuts need to happen. Hereon, expect demand led earnings downgrades. In such an environment, falling input prices alone are not enough to support margins," said the brokerage.
According to the brokerage, for markets to turn attractive, valuations need to cheapen below 1 standard deviation above mean (1SD) on forward price-to-earnings (PE) and market cap to Gross Domestic Product (GDP).Typically, in the past, markets have bottomed when market cap to GDP has been around 60-70% and Nifty PE was of 12-13 times. Currently, market cap to GDP is 90% and Nifty PE is 18 times.
Additionally, India's valuation premiums relative to the rest of the world usually contract during global slowdowns. They are currently at very high levels, largely as a result of the notable outperformance in 2022.
US Treasury (UST) rally
The brokerage claims that the UST rally has only just started. Compared to their high, they are down 50 basis points. However, they should ideally be at least 200 basis points lower given the outlook for global growth. It expects the US 10-year treasury (US10Y) to decline even further as the growth outlook is likely to deteriorate as a result of the fallout from global banks. This may not augur well for equities initially.
"The rally in USTs initially happens due to risk aversion, but later due to reversal in Fed’s stance. The rally has to be of such magnitude that it eventually cheapens equities," said the brokerage.
Historically, according to the report, Nifty earnings yield premium soars as high as 7% over US10Y. However, presently, the premium is only up by 2%. Therefore, there's a long way to go.
"Expect this premium to widen owing to both rising earnings yield as well as falling bond yields," added the brokerage.
Finally, the most important variable to calm the markets is policy response. The Fed's response in terms of policy is crucial for the financial markets. Markets historically correct during Fed pauses or early rate cuts. Markets can only feel comfortable once the reaction hits a critical mass.
This time, the ammunition of other agents, including the US government and China, is much lower, making the Fed's response even more crucial. At a time when it is no longer enjoying the 'exorbitant privilege', the US government has record debt. (Emerging markets are no longer large buyers of USTs.)
Therefore, financing significant deficits may be problematic unless the Fed uses quantitative easing. If the Fed doesn't get ready for a change in policy shortly, things could get significantly worse.
In addition to the Fed, the Reserve Bank of India's (RBI's) acts will be crucial. The shock to the balance of payments (BoP) in 2022 might enable the INR to gradually depreciate without harming the domestic financial system. This is because there was a huge liquidity surplus at the beginning of the banking industry. As a result, its INR defence only used up that surplus and had no adverse effects on domestic financial circumstances.
However, that surplus has now vanished. An aggressive intervention by RBI will plunge the system into deficit. This could now weigh on domestic credit creation, as has been the case in the past crisis.
"This is even more important in the context that India’s fiscal room is much limited this time. We are entering the crisis with much higher fiscal deficit and debt and consumption still being 10% below pre-covid trend. Hence, in that context unlike global financial crisis (GFC) a large domestic oriented stimulus is unlikely. Thus, RBI’s actions become even more critical in this context," said the brokerage.
Overall, it is still some time before the market bottoms out.
"A quick and aggressive intervention could prevent the downside, else volatility is likely to continue for longer. Hence, to that extent, we remain cautious and argue that the current market correction, isn’t enough to make equities attractive," added the brokerage.
Also Read: Explained: The impact of US Fed rate decisions on the Indian market