Falling yield gap a sign of worry for markets: BNP Paribas’ Eleswarapu

MUMBAI : Although Indian equity markets have outperformed developed and other emerging markets year-to-date, the chances of a correction over the next 12-15 months have diminished given the rising interest rates and slowing growth scenario. This is reflected in the gap between the next 12-month Nifty earnings yield and the 10-year G-sec yield, which falls to minus 2%. Such an event has only been seen a few times since the global financial crisis and has predicted a 15-20% correction over the next 12-18 months, said Abhiram Eleswarapu, chief executive and head of India equities, BNP Paribas, in an interview: Edited excerpts:

How does an investor assess the current market situation?

The two most important monitors around the world today are inflation and growth, or the lack thereof. What drives stocks from a long-term perspective is valuations relative to these factors. In the short term, investors’ positioning in risky assets appears to better explain stock moves. Global markets have fallen about 20-30% due to high inflation, a trend not seen in decades. In the case of India, current levels of inflation, while high, are not that unusual for an emerging market, which combined with predictable growth has meant the Nifty has outperformed significantly.

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But if you really look, the market has gone absolutely nowhere, even for India. It was only flat this year. However, we have seen exaggerated ups and downs in the index based on investor risk appetite oscillating between extremes.

Today’s valuations aren’t very supportive of a sustained rally, but global investor positioning is also very thin on equities. This prepares us for continued volatility.

Inflation is here to stay…

In the first few months of the year, investors were still digesting the temporary inflation narrative. It turns out that high inflation has been structural and investors are reconciling the higher interest rates needed to combat it. In addition, higher inflation (and higher rates) tends to cause growth to slow. Investors are also gradually calculating lower growth over the next two to three years. This process is still ongoing, and earnings expectations and terminal interest rates in the US, India and most other countries remain moving targets with each incremental data point.

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Do you expect another correction in stocks?

At this point, one should ask how attractive stocks are relative to bonds and other asset classes in a scenario of diminishing liquidity. When compared to bonds, one of the most commonly used metrics is the yield gap, which is the expected earnings yield minus the 10-year bond yield. India’s earnings yield is slightly above 5% today, but bond yields are above 7.4% and could continue to rise slightly as we expect another 50 basis point hike in the repo rate this year. This puts the yield gap below minus 2%.

This type of difference has only been seen a few times since the global financial crisis, and markets corrected by 15-20% over the next 12-18 months following these episodes. In other words, conditions support either a significant price or time correction.

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What do you expect from the Q2 results?

In the first quarter, earnings surprises compared to consensus estimates were more or less in line with those of the previous seven to eight quarters. But profits grew 15-20% on a three-year cumulative basis for companies, setting India apart from its peers. In Q2, we expect this trend to continue, but we will also be alert to whether growth in globally connected sectors is slowing and whether domestically focused companies can pass the full impact of higher input costs on to consumers.

Would fixed income be a better choice at this point?

With global interest rates close to peaking, bonds look more attractive than equities, particularly Indian equities. Another risk for equities is that the Fed is trimming its balance sheet at a faster pace than it has in recent months, which in turn could reduce risk appetite.

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