The search for the much awaited and elusive Fed Pivot continued in the run up to the FOMC November meeting. With some segments of the markets having interpreted the last EBC rate action as a Dovish hike, expectations centred on the FED indicating a softer approach by downsizing to more modest hikes in its meetings from December. This led to yields softening and equity markets moving up in the weeks leading up to the FOMC meet. The message from the FOMC eventually was simple and in hindsight the obvious, which certain segments of the markets have been repeatedly failing to internalise. The pace of incremental hikes matter less and what is more relevant is "how high the policy rates go" and "how long it needs to stay high". With a rapid increase in rates over the last 6 months from 0 to 4% and considering the lag effects of earlier hikes, the requirement to downshift at some stage is obvious. However, given the extent of overshoot on inflation, the tight labour markets as well as stronger near term data, the FED was more likely to stay hawkish.The market expectations on the peak FED Funds Rate accordingly has shited further post the FOMC.

Equity:

The month gone by was a risk-on month with global financial assets faring well. Sentiments were helped by hopes that the US Fed may signal a reduced pace of incremental rate hikes, which in turn bought some stability to US Bond yields as well the dollar index. Indian equities performed well in October along with global markets with the Nifty and the Sensex rising 5.4% and 5.8% respectively. However, there was a marked deterioration in market breadth as the Nifty 100 Equal weight index significantly trailed at 2.2% gains. Nifty MidCap 150 and Nifty SmallCap 250 indexes lagged as well at 1.8% and 1.9% gain, respectively.

The up move materialized even as there was little cheer from macro data. CPI data showed inflation moving up to 7.41% in September, a 5-month high, while IIP data pointed to an 0.8% contraction in August, an 18-month low. The INR depreciated 1.8% against the dollar for the month while 10-year bond yield inched by 5 bps. The uptick inequity indices even as bond yields ticked higher has meant that the valuation argument has swung further in favour of bonds and against equities on a relative basis, as measured by earnings yield to bond yield spread.

The Q2 earnings season so far has been a mixed bag too. The key challenge for economy and corporate earnings so far has been the continued weakness in various consumption categories. This suggests that the recovery so far has been tepid and two-track. While businesses stay optimistic, consumer sentiment is still weak. The strength in business sentiment can be attributed in part to the global opportunity driven by better western demand especially from the US as well as optimism around the China plus one opportunity. On the other hand, inflationary pressures have led to an erosion in real disposable incomes contributing to weak domestic consumer demand. Even within consumption, while urban high-ticket consumption has held up, it is mass consumption that has suffered the most thus pointing to a continued K in the recovery.

Business sentiment at odds with consumer confidence

Source: CEIC, RBI OBICUS, SBIMF Research

Indeed, while consumer perception for income and employment is improving, that for prices has been deteriorating underlining inflation as the key challenge for consumption. The following chart based on the RBI consumer confidence survey amply demonstrates this point.

Inflation primary concern for consumers

Source: RBI consumer confidence survey, SBIMF Research; NB: CSI refers to Current Situation Index

In an environment where the external sector is slowing reflecting a slowdown in global economy, and with local rates rising and liquidity shrinking, it will be critical for domestic consumption to recover for the sustenance of economic and earnings momentum. And for that to happen, inflation trajectory will be crucial. The sharp deceleration in global money supply growth which is now in contraction zone and a sustained war against inflation by global central banks augur well for inflation trajectory, even as this is bound to have adverse economic implications on other parts of the economy. Yet a correction in the current K shape of the recovery is, in our view, necessary to make the economic trajectory more balanced and hence eventual recovery sustainable.

Overall, we stay of the view that equity market volatility may persist given continued macro uncertainty amidst valuations that suggest equities are expensive relative to bonds. Sticking to the long-term asset allocation plan, following diversification,and keepinga longer investment timeframe should help investors in this environment.

Equity valuations expensive relative to bonds

Source: Bloomberg, SBIFM research

Fixed Income:

Emerging markets, have so far navigated the raging storm trigerred by aggressive monetary policy moves in key developed markets in a relatively sanguine manner. The larger deviations in inflation targets and significantly loose monetary policy settings as a starting point has ensured larger adjustments in market prices in developed economies. At the same time, rapid reset in asset prices could potentially have financial stability implications as hidden faults emerge such as the pressure faced by UK pension funds with Liability driven Investment strategies. The adjustments in the currency as well as yields in key EM’s have been much muted as compared to the developed markets. Bond yields in India have also remained range bound in the recent weeks even as overseas yields continued to adjust higher. After the repricing trigerred by the lack of Bond Index inclusion, the benchmark 10y yields have traded in a narrow range between 7.40%-7.50% for the most part.

Looking ahead, as developed market central banks, primarily the US FED tightens monetary policy further to restrictive levels, the spillover effects are unlikely to completely escape EM’s including India. While country specific macro factors could potentially lead to some divergence, the process of adjustment would essentially have to be borne with the Fx markets likely to be channel in India’s case. Even as domestic monetary policy rates would be guided by the growth-inflation dynamics, external factors would continue to exert a material influence. The process of adjustment is effectively 3 pronged encompassing policy rates, Fx as well as liquidity. We expect that the adjustment in policy rates should largely be done as rates move up towards 6.50% ( which provides a 1%+ real policy rate based on 1y ahead expected CPI ), while Fx and liquidity adjustments may be ongoing.

From a valuation perspective, bond yields remain attractive both on an absolute as well as relative ( to equity ) perspective. Market yields at the end of CY21 with effective overnight rates anchored below the reverse repo rate of 3.35% and 3 year yields around 5.30%-5.75% for sovereign and AAA bonds provided a steep curve. Playing the curve steepness was the only way to generate additional carry, though with extremely unfavorable valuation given the potential risks. The current curve settings , though provide a higher degree of comfort given the process of adjustment/ repricing that has played outover the last 6 months. With an expected 1 year ahead CPI which as per most estimates range around 5.20%, the yield curve currently provides a 1 year ahead positive real return. This is in contrast to the realised outcomes over the last 3 years.

Source: RBI , SBIMF Research

At the same time, apart from spillover effectsfrom globalevents, risk factors include demand –supply dynamics for Government securities in anenvironment of tightening liqudiity.Robust credit growth has led to widening gap between Credit-Deposit growth as well as increaseinbulk deposit rates as well as rising CD issuances . Corporatebonds where demand –supply equation seems fairly positive do not however provide comfort from valuationperspective, more so as Bank benchmark linked loans get repriced higher. While inflation is expected to moderate going forward, the volatility in food prices and the broad based nature of items in the CPI basket with 6% inflation and above needto be watched.Wideningdeficit on the current account alongside muted capital flows could have feedback effects with respect to currency trends and domestic liqudity and rates.

Source: RBI , SBIMF Research

The argument to consider Fixed income investments remain very compelling currently, based on valuation. Current market pricing largely incorporates someof the potential risks, even as one should stay alert to potential additional repricing in the near term. Recognising near term potential headwinds a gradual increase in duration could be optimal. Fixed Income products based on current market yields, currently offer sufficient options to investors across the risk spectrum with respect to their interest rate risk tolerance.

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

The search for the much awaited and elusive Fed Pivot continued in the run up to the FOMC November meeting. With some segments of the markets having interpreted the last EBC rate action as a Dovish hike, expectations centred on the FED indicating a softer approach by downsizing to more modest hikes in its meetings from December. This led to yields softening and equity markets moving up in the weeks leading up to the FOMC meet. The message from the FOMC eventually was simple and in hindsight the obvious, which certain segments of the markets have been repeatedly failing to internalise. The pace of incremental hikes matter less and what is more relevant is "how high the policy rates go" and "how long it needs to stay high". With a rapid increase in rates over the last 6 months from 0 to 4% and considering the lag effects of earlier hikes, the requirement to downshift at some stage is obvious. However, given the extent of overshoot on inflation, the tight labour markets as well as stronger near term data, the FED was more likely to stay hawkish.The market expectations on the peak FED Funds Rate accordingly has shited further post the FOMC.

Equity:

The month gone by was a risk-on month with global financial assets faring well. Sentiments were helped by hopes that the US Fed may signal a reduced pace of incremental rate hikes, which in turn bought some stability to US Bond yields as well the dollar index. Indian equities performed well in October along with global markets with the Nifty and the Sensex rising 5.4% and 5.8% respectively. However, there was a marked deterioration in market breadth as the Nifty 100 Equal weight index significantly trailed at 2.2% gains. Nifty MidCap 150 and Nifty SmallCap 250 indexes lagged as well at 1.8% and 1.9% gain, respectively.

The up move materialized even as there was little cheer from macro data. CPI data showed inflation moving up to 7.41% in September, a 5-month high, while IIP data pointed to an 0.8% contraction in August, an 18-month low. The INR depreciated 1.8% against the dollar for the month while 10-year bond yield inched by 5 bps. The uptick inequity indices even as bond yields ticked higher has meant that the valuation argument has swung further in favour of bonds and against equities on a relative basis, as measured by earnings yield to bond yield spread.

The Q2 earnings season so far has been a mixed bag too. The key challenge for economy and corporate earnings so far has been the continued weakness in various consumption categories. This suggests that the recovery so far has been tepid and two-track. While businesses stay optimistic, consumer sentiment is still weak. The strength in business sentiment can be attributed in part to the global opportunity driven by better western demand especially from the US as well as optimism around the China plus one opportunity. On the other hand, inflationary pressures have led to an erosion in real disposable incomes contributing to weak domestic consumer demand. Even within consumption, while urban high-ticket consumption has held up, it is mass consumption that has suffered the most thus pointing to a continued K in the recovery.

Business sentiment at odds with consumer confidence

Source: CEIC, RBI OBICUS, SBIMF Research

Indeed, while consumer perception for income and employment is improving, that for prices has been deteriorating underlining inflation as the key challenge for consumption. The following chart based on the RBI consumer confidence survey amply demonstrates this point.

Inflation primary concern for consumers

Source: RBI consumer confidence survey, SBIMF Research; NB: CSI refers to Current Situation Index

In an environment where the external sector is slowing reflecting a slowdown in global economy, and with local rates rising and liquidity shrinking, it will be critical for domestic consumption to recover for the sustenance of economic and earnings momentum. And for that to happen, inflation trajectory will be crucial. The sharp deceleration in global money supply growth which is now in contraction zone and a sustained war against inflation by global central banks augur well for inflation trajectory, even as this is bound to have adverse economic implications on other parts of the economy. Yet a correction in the current K shape of the recovery is, in our view, necessary to make the economic trajectory more balanced and hence eventual recovery sustainable.

Overall, we stay of the view that equity market volatility may persist given continued macro uncertainty amidst valuations that suggest equities are expensive relative to bonds. Sticking to the long-term asset allocation plan, following diversification,and keepinga longer investment timeframe should help investors in this environment.

Equity valuations expensive relative to bonds

Source: Bloomberg, SBIFM research

Fixed Income:

Emerging markets, have so far navigated the raging storm trigerred by aggressive monetary policy moves in key developed markets in a relatively sanguine manner. The larger deviations in inflation targets and significantly loose monetary policy settings as a starting point has ensured larger adjustments in market prices in developed economies. At the same time, rapid reset in asset prices could potentially have financial stability implications as hidden faults emerge such as the pressure faced by UK pension funds with Liability driven Investment strategies. The adjustments in the currency as well as yields in key EM’s have been much muted as compared to the developed markets. Bond yields in India have also remained range bound in the recent weeks even as overseas yields continued to adjust higher. After the repricing trigerred by the lack of Bond Index inclusion, the benchmark 10y yields have traded in a narrow range between 7.40%-7.50% for the most part.

Looking ahead, as developed market central banks, primarily the US FED tightens monetary policy further to restrictive levels, the spillover effects are unlikely to completely escape EM’s including India. While country specific macro factors could potentially lead to some divergence, the process of adjustment would essentially have to be borne with the Fx markets likely to be channel in India’s case. Even as domestic monetary policy rates would be guided by the growth-inflation dynamics, external factors would continue to exert a material influence. The process of adjustment is effectively 3 pronged encompassing policy rates, Fx as well as liquidity. We expect that the adjustment in policy rates should largely be done as rates move up towards 6.50% ( which provides a 1%+ real policy rate based on 1y ahead expected CPI ), while Fx and liquidity adjustments may be ongoing.

From a valuation perspective, bond yields remain attractive both on an absolute as well as relative ( to equity ) perspective. Market yields at the end of CY21 with effective overnight rates anchored below the reverse repo rate of 3.35% and 3 year yields around 5.30%-5.75% for sovereign and AAA bonds provided a steep curve. Playing the curve steepness was the only way to generate additional carry, though with extremely unfavorable valuation given the potential risks. The current curve settings , though provide a higher degree of comfort given the process of adjustment/ repricing that has played outover the last 6 months. With an expected 1 year ahead CPI which as per most estimates range around 5.20%, the yield curve currently provides a 1 year ahead positive real return. This is in contrast to the realised outcomes over the last 3 years.

Source: RBI , SBIMF Research

At the same time, apart from spillover effectsfrom globalevents, risk factors include demand –supply dynamics for Government securities in anenvironment of tightening liqudiity.Robust credit growth has led to widening gap between Credit-Deposit growth as well as increaseinbulk deposit rates as well as rising CD issuances . Corporatebonds where demand –supply equation seems fairly positive do not however provide comfort from valuationperspective, more so as Bank benchmark linked loans get repriced higher. While inflation is expected to moderate going forward, the volatility in food prices and the broad based nature of items in the CPI basket with 6% inflation and above needto be watched.Wideningdeficit on the current account alongside muted capital flows could have feedback effects with respect to currency trends and domestic liqudity and rates.

Source: RBI , SBIMF Research

The argument to consider Fixed income investments remain very compelling currently, based on valuation. Current market pricing largely incorporates someof the potential risks, even as one should stay alert to potential additional repricing in the near term. Recognising near term potential headwinds a gradual increase in duration could be optimal. Fixed Income products based on current market yields, currently offer sufficient options to investors across the risk spectrum with respect to their interest rate risk tolerance.

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