The quantitative tightening (QT) cycle, which is a monetary policy tool used by major central banks to reduce the money supply in the economy, is approaching its peak. As a result, the downward pull on equity valuations that have been seen in recent times is expected to wane, said brokerage firm ICICI Securities.
The impact of increasing interest rates on equity valuations has been significant in recent times. The effect of growth over the past 1.5 years has been eaten away due to the downward pull caused by rising interest rates.
Since the fear of a QT cycle started in October 2021, the one-year forward earnings of the NIFTY50 index have increased by around 20%. However, the index has declined by 8% since then as the forward P/E multiple has contracted significantly from 23 (x) to marginally below 18 (x), currently reflecting the downward force of rising interest rates on stocks, said the brokerage.
Similarly, the GDP has advanced by 24% since October 2021. However, the aggregate market cap has declined by 7%. This resulted in a fall in the market cap to GDP ratio to 97%.
Further, the earnings yield for the NIFTY50 over the next one year is relatively attractive at 5.6%, while the price-to-book ratio has dipped below the long-term average, the brokerage added.
The recent turmoil in the US banking system triggered by run-on deposits at a few banks and subsequent ripple effects on other banks globally has brought forth the risks of an aggressive rate hike cycle by the U.S Fed.
The banking crisis has caused a decrease in the anticipated frequency of aggressive rate hikes. Furthermore, the recent headline CPI (consumer price index) reading in the US was in line with the consensus estimate of 6%, while wage growth was low, ICICI Securities noted.
The QT cycle in the US is probably in its last leg, with smaller further rate hikes contingent on incoming data. Also, the recent bank failures have increased the prospects of QE later in the year on the fear of the economy falling into a recession, it added.
Moreover, equity markets typically discount such events well before they actually play out. Hence, as the most aggressive QT cycle in recent times nears its end, the brokerage expects equity valuation contraction, in general, to slow down from hereon, except for areas that are still extremely expensive.
ICICI pointed out that India is currently in the early stages of recovery for both its domestic capex cycle and credit cycle. This recovery coincides with the lowest level of non-performing assets in a decade and a profit after tax-to-GDP ratio at a ten-year high of 4.5%, it says.
The real estate industry in India is playing a significant role in the capex cycle, making it a major contributor to household income growth. The industry is also the largest employer in the country after agriculture.
In the past, manufacturing activity has thrived during capex upcycles in India, and government policy initiatives, such as the PLI schemes for various sectors, will further boost the sector, as per the brokerage.
“We anticipate that stocks with strong earnings growth prospects and reasonable valuations will outperform as the P/E valuation contraction ends and stock prices begin to track earnings growth. If the Fed pivots towards QE later in the year, then valuation expansion is likely, which could trigger a bull market,” said ICICI Securities.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of MintGenie.
