“Higher for a bit longer” on policy rates was the hard, though obvious message that came out of the much awaited Jackson Hole Symposium speech by the US FED Chairman. Ever since the inititation of QE post the 2008 Financial crisis, financial markets have been conditioned to factor in weaker economic data as “Good data” for asset prices given the disposition of Central Banks, especially the US FED to provide backstop support. Whether this points to excess financialisation or the overreliance on softer interest rates, the fact remains that Central bank policy actions continue to remain a key factor in the evolution of market trends. At the same time, given the recent policy failures it is quite likely that as the dust settles, policy mandates, operating frameworks as well as the broader topics of central bank independence and accountability mechanisms would undergo a relook. This has already been set in motion at an operational level with most central banks eschewing the practice of giving specific forward guidance. The decision of the Australian Government in July 22 to review the role of Reserve Bank of Australia’s Monetary Policy framework and operations could well be the first among many other similar steps in other jurisdictions in the developed world.

With the FED promising to “be at it until the job is done on inflation” , financial markets have repriced expectations on the peak FED rates back higher. The expectation of modest easing towards the end of CY23 still remains difficult to fathom in the current circumstances. At the same time, bond yields across most of the developed markets have substantially retraced the easing seen since July22, in a flattening trend. The key recession indicator , i.e the steepness of the 2/10Y US treasury yield curve still remains inverted at around -23bps.

Source: Bloomberg, SBIMF Research

Equity

Indian equities continued with the up move off their June lows with the Nifty and the Sensex gaining 3.7% and 3.6% respectively for the month of August. This was a strong outperformance to the rest of Emerging Market (EM) complex that was broadly flat for the month as well as to the US market with the S&P500 declining 4% for the month. On a YTD basis, India has outperformed EMs by over 14% in 2022 after already outperforming strongly in CY21. Since the beginning of 2021, Indian equities have outperformed the EM index by over 38%. This has in turn led to India’s valuation premium to EMs swelling to near historical highs. While this may be reflective of India’s rising prominence in the global economy, from a near term standpoint it could also mean that further upsides may be capped till the valuation argument improves.

India’s valuation premium to Emerging Markets near historic highs

Source: Bloomberg, SBIFM Research

On a standalone basis too, Indian equity valuations are on the expensive side, as measured by our preferred valuation gauge- yield spread of earnings yield over bond yields (please refer the chart below- the lower this spread, the more expensive equities are versus bonds).

Equity valuations expensive versus bonds

Bloomberg, FactSet, SBIFM Research

Valuations are expensive at a time when global macro uncertainties continue to persist. Even as inflation may be peaking for good, headwinds on global growth stay. With the Fed chair having decisively declared fighting inflation as the priority even if it comes at the expense of growth, China continuing to struggle and Europe potentially staring at an energy crisis in the winters, we believe we may still not be out of woods. For valuations to support further upsides, either a meaningful decline in bond yields must materialize, or else markets need to consolidate till earnings catch-up.

Beyond the headline index however we find decent dispersion in stock valuations and hence stock specific opportunities. Our measure of market sentiment has turned neutral over the past few months after pointing to euphoria in second half of 2021. This is suggestive of the froth in broader markets having been cleared thanks to the price action of the past many months. This in turn has opened bottom-up, stock specific opportunities.

Equity market sentiment has cooled off over the past few months

Bloomberg, FactSet, SBIFM Research

We therefore stay bottom-up and stock specific. On the other side of the potential near term turbulence however, we stay optimistic on the prospects of a manufacturing and investment activity driven earnings expansion over the next few years.

Fixed Income:

The domestic bond markets have surprisingly remained insulated from the repricing of overseas yields and expectations. Stable currency and softness in crude prices alongside newsflow pertaining to inclusion in the JP Morgan Bond Index led to a softening trend in yields. Crude prices have remained lower than the RBI estimate of USD 105/barrel , but prone to swings based on newsflow including China lockdowns, Iran nuclear deal resolution as well as demand data. This is likely to sustain in coming months as the war in Europe drags on even as other sanctions on Russian oil take effect alongside the scheduled end for the Strategic reserve drawdowns which have been supplying additional barrels of oil to the markets so far.

Bloomberg, SBIMF Research

The issue of Index Inclusion has been triggered by the routine review expected around September and certain research reports and news stories surrounding it. While the same was considered imminent around the Union Budget, this has been on the backburner for a while as the Government remains unwilling to provide preferential taxation benefits or enable overseas clearing. The immediate trigger seems to be the exclusion of Russia from the indices and the concern of Index trackers on increasing concentration within the index. Alongside similar worries around China, the issue of non-inclusion of a large market like India has been raised again in the routine investor feedback reviews. While we believe that a policy decision to be part of indices has been taken with a more open framework for debt flows such as the Fully Accessible Route (FAR securities), there is no evidence so far of any additional measures to immediately accelerate the process. Hence, we remain sceptical of any immediate inclusion, though the same can be accelerated if the Index providers climb down in their preconditions to accommodate the second largest EM Debt market within Asia. At the same time, index inclusion announcement in the current year would be sentimentally positive and less likely to result in any large flows given the global backdrop as well as the process of staggered inclusion that the indices follow.

The resilience of markets also should be seen in the context of reasonable appetite and probably space available in Bank Held to Maturity Book for sovereign securities. In the current FY till date (Aug 12, 2022), scheduled bank’s incremental investments in SLR securities have remained robust at Rs 3.43 trillion as against Rs 1.50 trillion in the corresponding period in the previous FY. Alongside healthy investor demand from long term investors and lower issuances of SDL as against the calendar, SLR securities have remained well bid so far. SDL issuances in this FY till end August have been around 67% of the indicated calendar for the same period. At the same time, as second half supply meets the reality of better credit growth as well as less favourable domestic liquidity and overseas cues, we could witness episodes of volatility in yields.

Corporate Bonds continue to be supported by pending demand for mandated investment quotas, despite glaring disconnect in valuations. AAA PSU/PFI bonds continue to trade lower than SDL’s and almost in line with Government securities across most tenors. Spreads on liquid AAA PSU/PFI bonds over government securities range from zeroto 17bps across various benchmark tenors. These spreads provide no compensation for either credit or liquidity/ impact cost. Similarly, other credits priced over an overvalued AAA curve remain an equally non attractive propositionon a relative basis. A gradual unwinding of excess liquidity and repricing of the existing favourable terms on External benchmark linked Bank loans should set the stage for a gradual unwinding of the excesses seen in credit spread pricing. Sovereign securities provide the best space currently to position for a medium-term positive view on the interest rate cycle.

SBIFM research, Bloomberg. As on 06/09/22

From a monetary policy perspective, while India seems to be in a much better shape as compared to developed economies, the influence of a strong dollar would continue to impact outcomes. Effectively, EM central banks getting complete “operational independence from the policies of the FED”, would remain a challenge given the dynamics of capital flows. However, we expect that the RBI could well resort to smaller adjustments incrementally in the Repo rate in the journey towards a near term pause zone of between 6.00% - 6.25%. The path towards this potential end point is unlikely to be smooth and unidirectional as seen in recent weeks.

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

“Higher for a bit longer” on policy rates was the hard, though obvious message that came out of the much awaited Jackson Hole Symposium speech by the US FED Chairman. Ever since the inititation of QE post the 2008 Financial crisis, financial markets have been conditioned to factor in weaker economic data as “Good data” for asset prices given the disposition of Central Banks, especially the US FED to provide backstop support. Whether this points to excess financialisation or the overreliance on softer interest rates, the fact remains that Central bank policy actions continue to remain a key factor in the evolution of market trends. At the same time, given the recent policy failures it is quite likely that as the dust settles, policy mandates, operating frameworks as well as the broader topics of central bank independence and accountability mechanisms would undergo a relook. This has already been set in motion at an operational level with most central banks eschewing the practice of giving specific forward guidance. The decision of the Australian Government in July 22 to review the role of Reserve Bank of Australia’s Monetary Policy framework and operations could well be the first among many other similar steps in other jurisdictions in the developed world.

With the FED promising to “be at it until the job is done on inflation” , financial markets have repriced expectations on the peak FED rates back higher. The expectation of modest easing towards the end of CY23 still remains difficult to fathom in the current circumstances. At the same time, bond yields across most of the developed markets have substantially retraced the easing seen since July22, in a flattening trend. The key recession indicator , i.e the steepness of the 2/10Y US treasury yield curve still remains inverted at around -23bps.

Source: Bloomberg, SBIMF Research

Equity

Indian equities continued with the up move off their June lows with the Nifty and the Sensex gaining 3.7% and 3.6% respectively for the month of August. This was a strong outperformance to the rest of Emerging Market (EM) complex that was broadly flat for the month as well as to the US market with the S&P500 declining 4% for the month. On a YTD basis, India has outperformed EMs by over 14% in 2022 after already outperforming strongly in CY21. Since the beginning of 2021, Indian equities have outperformed the EM index by over 38%. This has in turn led to India’s valuation premium to EMs swelling to near historical highs. While this may be reflective of India’s rising prominence in the global economy, from a near term standpoint it could also mean that further upsides may be capped till the valuation argument improves.

India’s valuation premium to Emerging Markets near historic highs

Source: Bloomberg, SBIFM Research

On a standalone basis too, Indian equity valuations are on the expensive side, as measured by our preferred valuation gauge- yield spread of earnings yield over bond yields (please refer the chart below- the lower this spread, the more expensive equities are versus bonds).

Equity valuations expensive versus bonds

Bloomberg, FactSet, SBIFM Research

Valuations are expensive at a time when global macro uncertainties continue to persist. Even as inflation may be peaking for good, headwinds on global growth stay. With the Fed chair having decisively declared fighting inflation as the priority even if it comes at the expense of growth, China continuing to struggle and Europe potentially staring at an energy crisis in the winters, we believe we may still not be out of woods. For valuations to support further upsides, either a meaningful decline in bond yields must materialize, or else markets need to consolidate till earnings catch-up.

Beyond the headline index however we find decent dispersion in stock valuations and hence stock specific opportunities. Our measure of market sentiment has turned neutral over the past few months after pointing to euphoria in second half of 2021. This is suggestive of the froth in broader markets having been cleared thanks to the price action of the past many months. This in turn has opened bottom-up, stock specific opportunities.

Equity market sentiment has cooled off over the past few months

Bloomberg, FactSet, SBIFM Research

We therefore stay bottom-up and stock specific. On the other side of the potential near term turbulence however, we stay optimistic on the prospects of a manufacturing and investment activity driven earnings expansion over the next few years.

Fixed Income:

The domestic bond markets have surprisingly remained insulated from the repricing of overseas yields and expectations. Stable currency and softness in crude prices alongside newsflow pertaining to inclusion in the JP Morgan Bond Index led to a softening trend in yields. Crude prices have remained lower than the RBI estimate of USD 105/barrel , but prone to swings based on newsflow including China lockdowns, Iran nuclear deal resolution as well as demand data. This is likely to sustain in coming months as the war in Europe drags on even as other sanctions on Russian oil take effect alongside the scheduled end for the Strategic reserve drawdowns which have been supplying additional barrels of oil to the markets so far.

Bloomberg, SBIMF Research

The issue of Index Inclusion has been triggered by the routine review expected around September and certain research reports and news stories surrounding it. While the same was considered imminent around the Union Budget, this has been on the backburner for a while as the Government remains unwilling to provide preferential taxation benefits or enable overseas clearing. The immediate trigger seems to be the exclusion of Russia from the indices and the concern of Index trackers on increasing concentration within the index. Alongside similar worries around China, the issue of non-inclusion of a large market like India has been raised again in the routine investor feedback reviews. While we believe that a policy decision to be part of indices has been taken with a more open framework for debt flows such as the Fully Accessible Route (FAR securities), there is no evidence so far of any additional measures to immediately accelerate the process. Hence, we remain sceptical of any immediate inclusion, though the same can be accelerated if the Index providers climb down in their preconditions to accommodate the second largest EM Debt market within Asia. At the same time, index inclusion announcement in the current year would be sentimentally positive and less likely to result in any large flows given the global backdrop as well as the process of staggered inclusion that the indices follow.

The resilience of markets also should be seen in the context of reasonable appetite and probably space available in Bank Held to Maturity Book for sovereign securities. In the current FY till date (Aug 12, 2022), scheduled bank’s incremental investments in SLR securities have remained robust at Rs 3.43 trillion as against Rs 1.50 trillion in the corresponding period in the previous FY. Alongside healthy investor demand from long term investors and lower issuances of SDL as against the calendar, SLR securities have remained well bid so far. SDL issuances in this FY till end August have been around 67% of the indicated calendar for the same period. At the same time, as second half supply meets the reality of better credit growth as well as less favourable domestic liquidity and overseas cues, we could witness episodes of volatility in yields.

Corporate Bonds continue to be supported by pending demand for mandated investment quotas, despite glaring disconnect in valuations. AAA PSU/PFI bonds continue to trade lower than SDL’s and almost in line with Government securities across most tenors. Spreads on liquid AAA PSU/PFI bonds over government securities range from zeroto 17bps across various benchmark tenors. These spreads provide no compensation for either credit or liquidity/ impact cost. Similarly, other credits priced over an overvalued AAA curve remain an equally non attractive propositionon a relative basis. A gradual unwinding of excess liquidity and repricing of the existing favourable terms on External benchmark linked Bank loans should set the stage for a gradual unwinding of the excesses seen in credit spread pricing. Sovereign securities provide the best space currently to position for a medium-term positive view on the interest rate cycle.

SBIFM research, Bloomberg. As on 06/09/22

From a monetary policy perspective, while India seems to be in a much better shape as compared to developed economies, the influence of a strong dollar would continue to impact outcomes. Effectively, EM central banks getting complete “operational independence from the policies of the FED”, would remain a challenge given the dynamics of capital flows. However, we expect that the RBI could well resort to smaller adjustments incrementally in the Repo rate in the journey towards a near term pause zone of between 6.00% - 6.25%. The path towards this potential end point is unlikely to be smooth and unidirectional as seen in recent weeks.

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