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Omicron leads to a risk-off; volatility to remain elevated

* After touching a record high on 18th Oct’21, the Nifty has corrected 8%, led by global factors: Fed’s taper announcement, rising bond yields, higher crude oil prices, and strengthening of the US Dollar Index. A big fundraise in the primary market also put some pressure on the secondary market. Sentiments were battered across global equity markets on 26th Nov’21 with the detection of a new COVID-19 variant – Omicron – in South Africa. This resulted in risk-off sentiment, with markets correcting by 2-3% globally, easing bond yields, and an 11% fall in Brent Crude prices. India’s VIX rallied 25% to 20.8.

* Since these are early days for the new variant, limited information regarding its transmission and impact on hospitalization, mortality, etc. is available. Several countries have raised restrictions around international travel. In India, some states (Maharashtra and Karnataka) have issued fresh guidelines on travel and COVID-19 testing. We expect the Centre and state governments to remain proactive, given their experience from the second COVID wave in Apr-May’21, and guidelines to evolve as the trajectory of the new variant becomes clearer. We expect the market to witness elevated volatility in the near term.

* On the domestic front, the economy is witnessing a sustained pick-up post the opening up and festive season, with several high frequency indicators crossing preCOVID levels. Primary market activity remains intense, with issuances at INR964b in FY22 YTD, with several new-age digital plays listing (Paytm, Nykaa, Policy Bazaar, Zomato, etc.) and several more lined up ahead.

* Despite the pullback, India remains among the top performers in CY21, with the Nifty up 21% in CY21 YTD v/s a flattish performance of the MSCI EM Index. Corporate earnings in 2QFY22 were better than our expectations, despite sharp input cost inflation impacting several sectors. Earnings estimates for FY22/FY23 are stable and haven’t seen any downward revision, strengthening our belief in the resumption of a new earnings cycle. Valuations, after the pullback, at 23.3x/19.5x FY22E/FY23E Nifty EPS are relatively reasonable now. India managed the second COVID wave in AprMay’21 with local restrictions and without implementing any national lockdowns, unlike the first wave in early CY20. We expect a similar approach should the need arise going forward. We highlight for our preferred ideas to buy in this pullback.

Global factors drive pullback; new COVID-19 variant results in risk-off

* The Indian market has taken a breather after touching a high of 18,477 in Oct’21 led by several factors: Fed taper, rising yields, higher energy prices, and elevated primary market supplies. The detection of new COVID-19 variant, ‘Omicron’, in South Africa aggravated further risk-off sentiment on 26th Nov’21 as news reports suggested faster transmission of this variant as compared to Delta. This led to a sell-off in equities and commodities on 26th Nov’21. The Nifty corrected ~3%, Brent Crude declined by ~11% to USD72/bbl, and US 10-year bond yield eased 12bp to 1.48%. While the impact of the new variant on hospitalization, mortality, etc. remains unknown and is still undetected in India, we expect the elevated volatility to continue till more clarity and data emerges on this variant’s trajectory. The medical fraternity is far better prepared today than during the first and second COVID waves to deal with the implications of new variant, with overall vaccination crossing 1.22b (0.79b/0.44b Indians partially/fully vaccinated) in India as of 28th Nov’21.

* Primary market activity in India remains quite elevated, with a bunch of new age companies (Zomato, Nykaa, Policy Bazaar, Paytm, etc.) raising capital. Around INR964b has been raised in FY22 YTD, which is higher than INR909b raised in FY18 (Exhibit 13). While the primary market has seen net FII investments of USD7.2b in CY21 YTD, the secondary market saw net outflows of USD1.77b.

* Inflation (CPI), despite the multitude of supply-side challenges on the global supply chain front, has remained within RBI’s comfort range (4.48% in Oct’21). Rising fuel prices necessitated the Centre and state governments to reduce excise and VAT on petrol and diesel in Nov’21.

* Corporate earnings delivery continues to remain robust (link) as 2QFY22 earnings were above our estimates, led by strong growth in Metals, Oil and Gas, and PSU Banks. While RM inflation suppressed margin for Specialty Chemicals, Consumer Staples and Durables, Autos, Cement, etc., companies have resorted to price hikes to pass on the cost inflation. Earnings projections for the Nifty remains stable so far at INR730/INR873 for FY22E/FY23E, a growth of 35%/19%, after delivering 15% growth in FY21.

Index corrects 8%, but constituents see more damage

* Among NSE500 constituents, 44% have declined by over 10%, while ~10% (47 companies) fell by more than 20%. Over the same period, the Nifty has declined by 8%. Around 19% of companies have gained in the same period.

* Metals (-15%), Private Banks (-11%), FMCG (-10%), Realty (-9%), and Auto (-9%) have seen a major correction among indices, while IT (-4.7%) and Pharma (- 5.5%) have remained relative outperformers.

* While the Nifty is 8% shy of its fresh high, 70 constituents in the NSE500 are down more than 20% from their recent highs.

Elevated volatility to continue; defensives may see greater acceptance

* COVID-19 cases continue to remain under control, despite the festive season. The total active cases are currently at 0.11m v/s a peak of 4m in May’21. The decline in active cases has led to an increase in economic activity and mobility. While the new variant – Omicron – adds to the uncertainty, we expect more clarity to emerge in the next few weeks as additional data comes out. So far, this variant has not been detected in India.

* This will mar sentiment in Travel, Tourism, Hospitality, and Retail, which has seen significant outperformance in the last few months on the back of opening up of economy, a good festive season, and a broad-based demand recovery. Even sectors/stocks exposed to markets with rising COVID-19 cases/greater prevalence of the Omicron variant may underperform.

* We expect sector rotation in the market to continue and defensives like Pharma, IT, and Consumer to make a comeback till sentiments improve.

* Equity valuations, after the pullback, at 23.3x/19.5x FY22E/FY23E Nifty EPS are relatively more reasonable now. India managed the second COVID wave in AprMay’21 with local restrictions and without implementing any national lockdowns, unlike the first wave in early CY20. We expect a similar approach should the need arise going forward. We highlight our preferred ideas to buy in this pullback.

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