In the midst of continuing geo political frictions with sharp moves in commodity prices, the USD strength has been a dominant feature in financial markets in the recent past. With the US economy facing the prospects ofsharp interest rate hikes over the year, as the FED attempts to bring policy levels to neutral and maybe restrictive zone, the moves have been quite sharp especially against currencies like the JPY where policy stance is expected to stay loose. Most EM currencies have weakened over the last month with the INR weakening by around 2.7%. With the expected tightening in global policy rates and resultant volatility in capital flows, the buffer provided by India’s stronger external sector balance sheet and foreign exchange reserves provide a degree of comfort, even as one needs to watch the incremental direction in the trade and capital flow accounts.

Equity Markets

Equity marketsstayed volatile in April with the benchmark indices witnessing intra month swings of over 7% to eventually end lower by over 2% and 2.5% respectively on the Nifty and the Sensex. Broader markets fared better with nearly 0.5% gain each on small cap and mid cap indices. One key headwind for the market in our view was the surge in 10- year bond yields by 30bps, from 6.84 at the end of March to 7.14 at the end of April. This has made equity valuations expensive on our preferred gauge that looks at the difference of earnings yield over bond yields. The rise in bond yields in turn was driven partly by rising global yields and partly by the RBI becoming more concerned on the recent inflation trajectory. Low bond yields around the world had been a key factor sustaining high valuations for equities. As that changes, equity valuations are bound to face gravity. This is evinced in the nearly 17% gain for the index over the past 12 months which is significantly behind the almost 35% earnings growth projected for Nifty in FY22 indicating compression in price to earnings multiple. With the rate cycle having commenced, both locally and across major global economies, valuations should continue to drift lower. Earnings growth against this backdrop will be vital to sustain markets.

While PE has moderated from recent highs, the sharp run up in bond yields has further reduced equity attractiveness

On earnings, the trajectory so far has been strong with six quarters of healthy growth. Corporate profits to GDP ratio has reversed its declining trend of 2008-2020 and is reverting higher. The consensus expects mid-teens earnings growth annualized over FY24-FY22. Aggregate economic activity on our in-house tracker is now 20% above pre-COVID levels suggesting a sharp improvement in demand post the Omicron scare earlier this year. However, the near-term outlook stays uncertain as commodity inflation is likely to weigh on corporate margins. Supply side disruption aggravated by prolonged geopolitical issues is leading to continued challenges on inflation. More importantly, if inflation challenge persists it may also cause a slowdown in demand. Last month we had highlighted how US Fed’s attempts to ward off inflation had resulted in the US yield curve inverting briefly. This is likely foretelling a slowdown in the US as well.

Investors would therefore do well to navigate the near term with caution and patience as markets await signs of a peak in inflation readings. In the interim, market upsides may be capped as earnings catch up and make valuations more reasonable. We however stay of the view that beyond the near-term turbulence, we are likely at the beginning of a new capex driven economic and earnings cycle and would therefore use any sell-off in pro-economy stocks to add from a midlonger perspective.

Fixed Income:

Providing explicit policy guidance has been a challenging proposition even in more sanguine times, notwithstanding the debatable effectiveness of such a practice. However, this has been mainstreamed even in India ever since the Inflation Targeting framework was established. With rapidly evolving macro developments accentuated by uncertain events such as the pandemic and recently, geo political frictions, central banks would probably be better served by keeping a higher degree of optionality or latitude on their policy actions to deal with uncertainties, lest market pricing drive policy actions in potentially sub optimum outcomes over time. This is more relevant as markets, conditioned to inactions by central banks, begin to quickly reprice as policy stance starts to diverge rapidly from consensus or prior guidance.

Over the last 3 months, the RBI policy guidance, statements and finally actions have undergone a rapid shift, with markets in the process of adjusting to the changing realities. More so, these changes need to be seen in the context of a distinct shift in most central bank policy actions, some of which have only accelerated in the recent past.

The February policy review saw the RBI turning out to be excessively dovish and downplaying all concerns on inflation with a projection of 4.5% CPI for FY23. As geo political pressures erupted in end Feb with commodity prices moving up further, the April Policy review was more nuanced and cautious with the CPI projection being marked up to 5.7% for FY23. The guidance shifted to prioritising inflation and the RBI effectively raised the floor for money market rates by introducing the Standing Deposit Facility as the floor at 3.75%. At the same time, the policy guidance had subtly shifted to removal of accommodation, though over a multi-year gradual process. In a surprise inter meeting move, the RBI yesterday hiked the policy Repo Rate by 40 bps to 4.40% with immediate effect. More surprisingly the central bank has announced a 50 bps hike in the CRR that would absorb durable liquidity of around Rs 870 Bn. While the policy stance remains accommodative, the focus stays on withdrawal of accommodation. While the last policy specifically mentioned a multi - year gradual process, the sequencing of the same may need to be dictated by macro realities. While no explicit reference to the time line was provided in the statement yesterday, one hopes that the central bank isn’t hamstrung by policy guidance in appropriately modulating excess liquidity consistent with the central mandate of maintaining price stability.

The actions by the RBI marks the first decisive action to unwind the crisis era policy of excessive liquidity accompanied with policy rate cuts. Given that the effective policy rate was anchored around the Reverse Repo rate for a long period, policy settings have remained far easier than that implied by the headline Repo Rate. The CRR hike, which remains the most blunt, though effective tool in the absence of MSS, probably reinforces the RBI’s changed stance of addressing the issue of excess liquidity in a more decisive manner. As we have stressed in the past, VRRR auctions are ineffective tools to address durable liquidity and the signalling effect of high VRRR cut offs also get diluted by excess system liquidity and its uneven distribution across the financial system. A transition to more neutral levels of liquidity would be in order and is likely to happen over the coming months as the RBI policy focus has decisively shifted to inflation control and to anchor inflation expectations.

The surprise inter meeting hike could be a result of the very likely possibility of the CPI breaching the 6% upper band for 3 consecutive quarters. With the March CPI printing closer to 7% and the reading for April likely to be even higher, decisive policy actions were probably warranted. Recent uptick in food prices and continued impact of higher input price and passthrough also warrant attention. This leads us to be cautious on the evolution of CPI in the coming months with material upside risks to the RBI projection of 5.70% CPI for FY23. We expect this number to undergo further upward revision, which would warrant more policy actions and durable liquidity absorptions. Given the evolving uncertainties, we would not hazard a guess on the terminal rate in this cycle, though we remain hopeful that adequate adjustments to liquidity in a timely manner may keep the policy hiking cycle to be relatively moderate, given the challenges on durable growth.

To some extent, the RBI has broadly followed the pattern set by the US FED, which espoused the narrative of transitory inflation until Q3 of CY21, subsequently accelerated the pace of taper (though shockingly continued to buy bonds in reduced quantities even as late as March 22), moved ahead with a modest hike in March and subsequently has conditioned marketsfor larger actions which has been followed up with a 50bps hike in the May 22 FOMC meet. However, it must be admitted that the RBI stopped injecting primary liquidity by H2FY22 and looks likely to remain so for a while. The impact of eventual QT that has been announced by the US FED starting June with a natural run- off process and how that plays out remains uncertain.

Given the challenging external backdrop and more importantly, the shift in RBI stance and actions, the preference for a lower duration stance with focus on adequate liquidity has been broadly appropriate. We would continue to prefer the same stance as the process of adjustment plays out. We would expect opportunities to take strategic long term investments to open up over the coming months as the market repricing continues.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

In the midst of continuing geo political frictions with sharp moves in commodity prices, the USD strength has been a dominant feature in financial markets in the recent past. With the US economy facing the prospects ofsharp interest rate hikes over the year, as the FED attempts to bring policy levels to neutral and maybe restrictive zone, the moves have been quite sharp especially against currencies like the JPY where policy stance is expected to stay loose. Most EM currencies have weakened over the last month with the INR weakening by around 2.7%. With the expected tightening in global policy rates and resultant volatility in capital flows, the buffer provided by India’s stronger external sector balance sheet and foreign exchange reserves provide a degree of comfort, even as one needs to watch the incremental direction in the trade and capital flow accounts.

Equity Markets

Equity marketsstayed volatile in April with the benchmark indices witnessing intra month swings of over 7% to eventually end lower by over 2% and 2.5% respectively on the Nifty and the Sensex. Broader markets fared better with nearly 0.5% gain each on small cap and mid cap indices. One key headwind for the market in our view was the surge in 10- year bond yields by 30bps, from 6.84 at the end of March to 7.14 at the end of April. This has made equity valuations expensive on our preferred gauge that looks at the difference of earnings yield over bond yields. The rise in bond yields in turn was driven partly by rising global yields and partly by the RBI becoming more concerned on the recent inflation trajectory. Low bond yields around the world had been a key factor sustaining high valuations for equities. As that changes, equity valuations are bound to face gravity. This is evinced in the nearly 17% gain for the index over the past 12 months which is significantly behind the almost 35% earnings growth projected for Nifty in FY22 indicating compression in price to earnings multiple. With the rate cycle having commenced, both locally and across major global economies, valuations should continue to drift lower. Earnings growth against this backdrop will be vital to sustain markets.

While PE has moderated from recent highs, the sharp run up in bond yields has further reduced equity attractiveness

On earnings, the trajectory so far has been strong with six quarters of healthy growth. Corporate profits to GDP ratio has reversed its declining trend of 2008-2020 and is reverting higher. The consensus expects mid-teens earnings growth annualized over FY24-FY22. Aggregate economic activity on our in-house tracker is now 20% above pre-COVID levels suggesting a sharp improvement in demand post the Omicron scare earlier this year. However, the near-term outlook stays uncertain as commodity inflation is likely to weigh on corporate margins. Supply side disruption aggravated by prolonged geopolitical issues is leading to continued challenges on inflation. More importantly, if inflation challenge persists it may also cause a slowdown in demand. Last month we had highlighted how US Fed’s attempts to ward off inflation had resulted in the US yield curve inverting briefly. This is likely foretelling a slowdown in the US as well.

Investors would therefore do well to navigate the near term with caution and patience as markets await signs of a peak in inflation readings. In the interim, market upsides may be capped as earnings catch up and make valuations more reasonable. We however stay of the view that beyond the near-term turbulence, we are likely at the beginning of a new capex driven economic and earnings cycle and would therefore use any sell-off in pro-economy stocks to add from a midlonger perspective.

Fixed Income:

Providing explicit policy guidance has been a challenging proposition even in more sanguine times, notwithstanding the debatable effectiveness of such a practice. However, this has been mainstreamed even in India ever since the Inflation Targeting framework was established. With rapidly evolving macro developments accentuated by uncertain events such as the pandemic and recently, geo political frictions, central banks would probably be better served by keeping a higher degree of optionality or latitude on their policy actions to deal with uncertainties, lest market pricing drive policy actions in potentially sub optimum outcomes over time. This is more relevant as markets, conditioned to inactions by central banks, begin to quickly reprice as policy stance starts to diverge rapidly from consensus or prior guidance.

Over the last 3 months, the RBI policy guidance, statements and finally actions have undergone a rapid shift, with markets in the process of adjusting to the changing realities. More so, these changes need to be seen in the context of a distinct shift in most central bank policy actions, some of which have only accelerated in the recent past.

The February policy review saw the RBI turning out to be excessively dovish and downplaying all concerns on inflation with a projection of 4.5% CPI for FY23. As geo political pressures erupted in end Feb with commodity prices moving up further, the April Policy review was more nuanced and cautious with the CPI projection being marked up to 5.7% for FY23. The guidance shifted to prioritising inflation and the RBI effectively raised the floor for money market rates by introducing the Standing Deposit Facility as the floor at 3.75%. At the same time, the policy guidance had subtly shifted to removal of accommodation, though over a multi-year gradual process. In a surprise inter meeting move, the RBI yesterday hiked the policy Repo Rate by 40 bps to 4.40% with immediate effect. More surprisingly the central bank has announced a 50 bps hike in the CRR that would absorb durable liquidity of around Rs 870 Bn. While the policy stance remains accommodative, the focus stays on withdrawal of accommodation. While the last policy specifically mentioned a multi - year gradual process, the sequencing of the same may need to be dictated by macro realities. While no explicit reference to the time line was provided in the statement yesterday, one hopes that the central bank isn’t hamstrung by policy guidance in appropriately modulating excess liquidity consistent with the central mandate of maintaining price stability.

The actions by the RBI marks the first decisive action to unwind the crisis era policy of excessive liquidity accompanied with policy rate cuts. Given that the effective policy rate was anchored around the Reverse Repo rate for a long period, policy settings have remained far easier than that implied by the headline Repo Rate. The CRR hike, which remains the most blunt, though effective tool in the absence of MSS, probably reinforces the RBI’s changed stance of addressing the issue of excess liquidity in a more decisive manner. As we have stressed in the past, VRRR auctions are ineffective tools to address durable liquidity and the signalling effect of high VRRR cut offs also get diluted by excess system liquidity and its uneven distribution across the financial system. A transition to more neutral levels of liquidity would be in order and is likely to happen over the coming months as the RBI policy focus has decisively shifted to inflation control and to anchor inflation expectations.

The surprise inter meeting hike could be a result of the very likely possibility of the CPI breaching the 6% upper band for 3 consecutive quarters. With the March CPI printing closer to 7% and the reading for April likely to be even higher, decisive policy actions were probably warranted. Recent uptick in food prices and continued impact of higher input price and passthrough also warrant attention. This leads us to be cautious on the evolution of CPI in the coming months with material upside risks to the RBI projection of 5.70% CPI for FY23. We expect this number to undergo further upward revision, which would warrant more policy actions and durable liquidity absorptions. Given the evolving uncertainties, we would not hazard a guess on the terminal rate in this cycle, though we remain hopeful that adequate adjustments to liquidity in a timely manner may keep the policy hiking cycle to be relatively moderate, given the challenges on durable growth.

To some extent, the RBI has broadly followed the pattern set by the US FED, which espoused the narrative of transitory inflation until Q3 of CY21, subsequently accelerated the pace of taper (though shockingly continued to buy bonds in reduced quantities even as late as March 22), moved ahead with a modest hike in March and subsequently has conditioned marketsfor larger actions which has been followed up with a 50bps hike in the May 22 FOMC meet. However, it must be admitted that the RBI stopped injecting primary liquidity by H2FY22 and looks likely to remain so for a while. The impact of eventual QT that has been announced by the US FED starting June with a natural run- off process and how that plays out remains uncertain.

Given the challenging external backdrop and more importantly, the shift in RBI stance and actions, the preference for a lower duration stance with focus on adequate liquidity has been broadly appropriate. We would continue to prefer the same stance as the process of adjustment plays out. We would expect opportunities to take strategic long term investments to open up over the coming months as the market repricing continues.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.