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Risk-off; 2022 begins on a stormy note!

Fed raises inflation pitch; equities adjusting to higher cost of capital

* 2022 has kicked off on a corrective note for the global markets, with concerns around inflation and potential rate hikes driving risk-off sentiment in equities. FOMC Chair Jerome Powell signaled the Fed’s intention to raise rates and fight inflation. The Nifty has corrected by 8% from its previous highs in Oct’21, with FII outflows of ~USD13.5b since Oct’21 in India.

* The modest correction in the Nifty has masked the severe price dislocation in some of the expensive buckets in the market – viz. Technology and New-age Digital / Consumer Tech companies – as valuations adjust to the new reality of potentially higher cost of capital.

* In this note, through some key exhibits, we highlight the correction in global and domestic markets, relative price damage in different segments of the market, valuation trends vs. average, flows and relative rolling outperformance of Mid/Small-caps.

* We prefer bottom-up stories where the earnings visibility remains solid, the earnings revision has been stable, and the recent correction has moderated the valuation multiples

Inflation and anticipated rate hike drive risk-off sentiment

* Global risk-off: The global equity markets have seen a sell-off in Jan’22 on the back of concerns around rising inflation and potential interest rate hikes. The US FOMC meeting on 26th January raised the risk-off sentiment as Fed Chair Jerome Powell’s speech hinted that the high inflation may be prolonged (and not transitory), along with the continued risk that it could move even higher. The Fed chairman further indicated that the Fed would proceed with the balance sheet reduction; this would potentially reverse the ultra-loose monetary expansion followed by the Fed since the pandemic. The US 10-year bond yield has spiked to above 1.8%, while India’s 10-year yield has jumped to above 6.7%, the highest in more than two years – clearly underscoring the risk-off sentiment and elevated volatility.

* Sharp FII outflows in India: Concerns on inflation / higher bond yields / potential rate hikes have sparked a risk-off globally, leading to elevated FII outflows in India (USD13.5b in FII outflows in the secondary markets since Oct’21). Domestic equities have also borne the brunt of rich valuations after a relentless rally post the bottom in Mar’20. While the Nifty-50 has corrected just 8% from its Oct’21 peak thus far, it is hiding the stress in the broader markets. Concerns around the cost of equities going up has taken a brutal toll on highgrowth stocks belonging to the Tech domain, with recently listed Digital IPOs coming off 25–50% off their recent highs. The spike in crude oil prices to ~USD90/barrel has further soured sentiment in India.

* Corporate earnings resilient: Meanwhile, the third COVID wave has led to a spike in cases in India, with an average of more than 200k new cases being reported in Jan’22 – the highest since the second wave (Apr–Jun’21). However, most of the cases have been mild in nature and have not resulted in any spike in hospitalization. Moreover, state governments have now begun to reduce the restrictions imposed at the start of the third wave. Also, corporate earnings for 3QFY22 have remained broadly in-line, with sales/EBITDA/PBT/PAT growth for the 19 Nifty companies that have reported thus far coming in at 32%/16%/23%/18% v/s the expectation of 31%/18%/24%/18%.

* Elevated volatility here to stay; earnings visibility to acquire premium: Notwithstanding the recent correction, the Nifty trades at 20x 12M forward P/E. The earnings yield / bond yield is hovering at 0.8x, higher than the 10-year average of 0.74x, despite the increase in G-sec yields. With the ultra-easy monetary policy set to reverse the course globally and in India, we expect the equity markets to remain volatile as they adjust to the higher cost of the capital environment. This, in our view, would keep testing the expensive valuation multiples enjoyed by a section of the market in question. This is truer for companies that lack profit/cashflow visibility in the near future – as rising interest rates would suppress the valuations of companies where positive cash flows have been modeled in only into the distant future. Given this backdrop, we prefer bottom-up stories where the earnings visibility remains solid, earnings revision has been stable, and the recent correction has moderated the valuation multiples.

Preferred ideas

* Largecaps: ICICI Bank, SBI, Axis Bank, Reliance, Bharti Airtel, Infosys, HUVR, L&T, Titan, Hindalco

* Midcaps/Smallcaps: Gujarat Gas, Ashok Leyland, Oberoi Realty, ABFRL, Indian Hotels, Devyani International, Zensar Tech, Indigo Paints, Orient Electric, Transport Corp.

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