Over the past year, even as the world has seen intermittent resurgences of the coronavirus disease, the outbreak of war in Europe and the start of an aggressive rate hike cycle in the United States, indices benchmark national stock markets have generated superior returns in the world.
This may no longer be the case.
The turmoil in the U.S. bond market and the knock-on effects it is likely to send to India are prompting stock bulls to take a step back and be more cautious about future returns, equity analysts said.
As US inflation remains at roughly 40-year highs, the Fed has signaled its intention to raise rates several times to rein in consumer prices.
As a result, the yield on 10-year US Treasury bonds, a global benchmark for fixed-income securities, hit near three-year highs, while the dollar strengthened to its highest level in two years approximately. Bond prices and yields move in opposite directions.
HOW IS DALAL STREET AFFECTED?
As the 10-year US Treasury yield nears the 3% mark – the yield was last at 2.81%, after soaring 82 basis points in a month, major stock indexes began to feel the stress.
So far this week, the BSE Sensex and the Nifty50 have both lost up to 1.9%, with the recent surge in US yields seen as the main culprit by equity analysts.
The clearest link analysts cite between rising US yields and falling stock prices is the inflow of foreign funds as investors head for the safety of the world’s largest economy.
“It will basically impact the flow of funds, the flow of REITs to India. Because if interest rates there continue to rise, they will think it is safer to invest in US bonds than to go elsewhere and invest at the risk of currency depreciation. , etc. So it will have an impact on REIT flows,” Deepak Jasani, Head of Research – Retail, HDFC Securities.
The offshore investment activity in Indian stocks is rather tricky at the moment. In the last three months of 2021 and the first three months of 2022, foreign institutional investors withdrew the largest amount of funds from Indian stock markets since the 2008 global financial crisis.
That selling pressure finally eased in April, but analysts fear the trend could reverse again if the Fed were to continue its 50 basis point rate hikes. FIIs have net sold Rs 1.03 lakh crore of shares so far in 2022, according to NSDL data.
The second knock-on effect of the US debt market relates to India’s domestic bond market. While US bond yields have climbed, they have also lifted their Indian counterparts to some extent as the interest rate differential between the two countries adjusts.
With the domestic bond market now also affected by the likelihood of the Reserve Bank of India raising interest rates at home, 10-year sovereign bond yields (which have jumped 73 basis points so far in 2022 ) are expected to increase further.
For the equity market, this means an erosion of valuations. Equity valuations are based on the prevailing risk-free borrowing rate in the country – the government bond yield.
“If domestic bond yields continue to rise, we are affected in many ways. Your business income will be impacted. Your availability of funds will also be reduced and your valuation standards will become more stringent in the sense that discounted cash flows will occur at a higher rate,” Jasani said.
Sovereign bond yields are the benchmarks used to calculate a company’s cost of capital, implying that when debt yields rise, equity valuations suffer. Rising bond yields therefore reduce equity returns.
“Many investors will try to shift their funds from equities to debt, or perhaps to a balanced or hybrid fund. The stock market is going to be very selective… in India, there were about 3,000 to 4,000 companies listed in India. The majority offered a fair return; the same cannot be expected now,” said Vinod Nair, head of research at Geojit Financial Services.
Jasani of HDFC Securities says the sectors that could be hit earliest would be those with leveraged buys, including auto loans, home loans and real estate.
Analysts say that in this environment, it is unwise to seek higher returns than the world. On the contrary, focusing on promising pockets of value and specific sectors would be a better strategy.
“If you look at the broader market, according to data released on March 31, if I look at the Nifty500, we can see that over 50% of stocks are trading very cheaply,” Nair said.
“If you look at the technical factors like average stock performance, it was below 200 and if I put it in the plus 5% range within 200 days; about two-thirds of the stocks were in this bracket… The main indices are very expensive, however. They were about 20x.