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Given that the equity market valuation looks richer, the confidence in asset class that has bought so much joy for investors over the past couple of years is bound to increase after a lengthy correction seen since October 2021.Yogesh Supekar discusses the market outlook while also highlighting the equity market’s performance in recent years

In spite of the recent recovery in the BSE Sensex, the key benchmark index that we all love to track is still down by more than 10 per cent since the beginning of the year. While those who prefer to invest aggressively and have gone overboard on Understanding the Current Situation
The reason why there has been a sell-off in 2022 is known to all. While recessionary fears have been doing the rounds in investing circles, the real villain has been inflation. The rise of inflation has been so sharp that the impact has been felt across the globe, leading to banning exports and policy changes and occasionally cancellation of supply contracts. All this is to secure supplies domestically and to control the rising inflation levels in respective countries. The western world (Europe) has never seen such a high level of inflation and uncertainties in commodity prices at least when there has been no tragic conflict in Europe.

In 2022, the European market displayed its worst bond market performance since 1980 and at the same time the biggest commodity outperformance since 1960. We can attribute most of the volatility to inflation this year. The geopolitical situation can also be said to be a strong reason for the inflationary pressure. However, the energy prices were headed northwards even before the Russia-Ukraine war broke out. The energy prices close to historic highs created a panic situation in the global equity markets which, aided with rising inflation and interest rate hike, led to a sell-off in global equities. In a nutshell, inflation, the geopolitical situation, rising interest rates and the resurgence of the corona virus scare in China has kept the bulls away from the markets in 2022 so far.

Road Ahead
We all understand that the equity markets are forward-looking. And it seems as if the markets have factored in all the negatives to a large extent. However, the bulls are still not in the game as amajority believe that the Federal Reserve’s machinations may ultimately decide whether the US economy heads into recession or whether there is a soft landing.

What is a recession?
Distinct signs of economic weakness such as volatile equity markets, raging inflation and regular hikes in interest rates are compelling investors to ask the daunting question: Have we entered recession? To answer the question – no, the Indian economy is not in a recession. Let us understand the precise meaning of recession as there are many ways in which recession can be defined.

As per the National Bureau of Economic Research (NBER) which is recognized as the authority that defines the starting and ending dates of US recessions, “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

In 1974, economist Julius Shiskin defined recession as two consecutive quarters of declining GDP. According to the economist, a healthy economy expands over time, so two quarters in a row of contracting output suggests there are serious underlying problems. This simple rule of thumb eventually became a popular standard over the years.

There are three scenarios that emerge based on US Federal Reserve’s decisions. If it decides to tighten rates aggressively and, in the process, overdoes the tightening, there is a high probability that the economic growth will be negatively impacted. There are already talks that the inflation, rising rates, war situation and supply chain issues may drag the economic growth in the US by 0.5 per cent.

It must be emphasised here that the US economy is expected to be least impacted by the situation emerging in the RussiaUkraine war. The European countries are expected to face a deeper cut in economic growth this year. If the US Federal Reserve gets it wrong and tightens rates that hurt the economic growth more than needed, we may have to deal with a US recession. The world markets may suffer in that case. Exportoriented stocks will also suffer in a recessionary environment.

IT stocks may be impacted if the IT industry in the US delays On a YTD basis, the Bank Nifty has relatively outperformed the Nifty 50 index. However, Bank Nifty is down by 5.5 per cent on a YTD basis. The index has immediate support in the zone of 32100-32300 as the prior two weeks is placed in this region, which also confluence with the March 2022 lows placed at the 32155 level. Talking about momentum oscillators, the RSI has formed a positive divergence in the last week. The formation of positive divergence is indicating receding downward momentum and could trigger a technical pullback in the coming weeks. On the upside, the level of 34500-35000 is likely to act as a hurdle.

expenditure (IT spends) fearing a recession.

We are in the most chaotic, hard-to-predict macroeconomic time in decades.
Morgan Stanley Economic Team

Even if the rupee depreciation may excite investors looking at IT stocks, a recessionary environment may not allow bulls to have their way. A recessionary environment may make it difficult for almost all sectors to achieve their corporate goals and hence profitability targets may not be achieved, thus leading to sell-off in equities. However, we may not see a major drawdown from the current levels as the markets have already corrected after factoring in all the visible negativities. In fact, the markets have a factored in a 50-50 chance of a US recession.

US recession is possible under the circumstances that the Federal Reserve increases interest rates by a margin that impacts the economic growth of the country. Hence, taking a call on equity markets is dependent on what the Federal Reserve does. So far what the market hears is that the focus on US Federal Reserve is bringing back inflation to a neutral level of 2-2.5 per cent. With such inflation levels it is perceived by experts that the economic growth is not negatively impacted. Fixed income may outperform equity in such case.

However, if the economic data is conducive and inflation remains in control without the need to raise interest rates, thus avoiding a recessionary environment, the equity markets may stabilise and prepare a firm ground for a strong bounce-back from the lower level. Any positive news on the geopolitical situation along with softening energy prices may end up unleashing the bulls. Says Omkar Bhalekar, a long-term investor who believes in fundamental analysis and adopts top-down research approach to equities, “The way I see this market is that we all will suffer if the US Federal Reserve and the Reserve Bank of India along with other central banks get the equation wrong.”

“We have seen synchronous decisions been made across economies to raise interest rates recently. What if all the central banks are wrong and they end up neither taming inflation nor achieving the economic growth targets? All the central banks, including RBI, should not tighten too much resulting into a recession nor should they tighten too little resulting in out-of-control inflation which is even more dangerous in the long term. The best outcome will be if the central banks somehow are able to balance the equation and raise rates enough to not hurt the economy. Factoring in the worst case scenario I have built a portfolio that can provide me stable returns. I am banking on sectors that are inflation-proof and defensive in nature,” he adds.

Jigar Trivedi,
Research Analyst- Commodities & Currencies Fundamental, Anand Rathi Shares & Stock Brokers.

"Indian Rupee spot notched a fresh record low of 78.5963 against dollar index on 28th June, owing to continued sell-off in equity markets coupled with elevated crude oil prices, which might weigh down on the net importer's fiscal balance. Rising crude oil prices once again bring back concerns on the inflation front, which might prompt the central banks to be very aggressive in hiking rates and thereby inducing a recession.

Going forward, we expect the Rupee spot to depreciate towards 80/81 levels by the year-end as twin deficits add to pressure on the emerging market currency. The Fed is expected to hike rates by 75 bps in the July meeting, while the RBI meeting is not due until August, which could narrow the yield differentials between India and US, and might further weigh down on Rupee."

The first five months of the year marked the worst start for the S and P 500 since 1970 and the sixth worst back to 1928. The average earnings drop in prior recessions was 13 per cent with the global financial crisis (GFC) skewing the results. Blackrock

Valuation and Earnings
Corporate India has been in a sweet spot when it comes to earnings’ growth and profit margins if we consider the performance of the past two years. In a challenging environment we saw that corporate India was able to deliver strong operating profits and net profit growth. However, after factoring in the inflationary pressures leading to higher input costs and rising interest rates, the growth momentum for corporate India may not be sustained. It can be argued that the earnings may disappoint in the coming quarters owing to rising input costs. However, the market has not factored in completely the pain that may arise from poor earnings’ growth.

According to Suman Chowdhury, Chief Analytical Officer, Acuite Ratings and Research, “The performance of the corporate sector has clearly surprised on the upside given the severe impact of the prolonged pandemic on lives and livelihood and has been instrumental in the economic recovery seen in FY22. Some of the businesses, particularly in the manufacturing sector, have been fairly resilient and actually strengthened their financial performance during this period while many others staged a significant recovery by the end of FY22.”

We are in a bear market!

A bear market occurs when the majority of stocks fall by more than 20 per cent owing to pessimism and remain down for at least a couple of months. Indeed, we have seen a bulk of the stocks from the broader markets fall by more than 20 per cent from their respective 52-week highs. We are still in a bear market and the current rally can be said to be a bear market rally at least in the US markets. BSE Sensex was down by 17 per cent from October 2021 highs. In US markets, typically, the bear market has lasted for two to three years whenever it has been induced by rising inflation which then translated into higher interest rates. Also, all the biggest market days have been in the bear markets as well. For investors, it becomes extremely crucial to distinguish between a relief rally within a bear market and a bull market rally.

One way to understand the market is to study its breadth. In case we have a majority of stocks recovering by more than 20 per cent from their 52-week lows we can say the market is coming out of bear market zones.

What Is A Bear Market?
When a broad stock market index experiences a 20% or more decline from recent highs for at least two months it's considered a bear market.

Since 1928, the S&P 500 has had 26 bear markets, according to Hartford Funds. the average duration of an S&P 500 bear market since the 1920s has been 289 days, or about nine and half months. (The shortest, in March 2020, during the onset of the COVID-19 pandemic in the US, lasted just one month.) On average, the S&P 500 declined about 36% during those bear periods.

But more recently, the 14 bear markets since World War II have averaged 359 days, or close to a year, according to Bespoke Investment Group.

Indian markets have shown resilience and have indeed outperformed their global peers. US markets are showing relative weakness and that is why one needs to track US markets to understand their potential impact on the Indian markets. In the US, we have seen 12 recessions since World War II, out of which we have witnessed 9 bear markets. However, in 26 bear markets since 1928, only 15 recessions were experienced. Interestingly, according to a study by US Hedge Fund the bear markets lasted for an average of 495 days whenever the economy was faced with a recession. The bear markets without recessions have on average lasted for 198 days. As the bear markets in a recessionary environment tend to cause higher turbulence in the stock market and usually tend to last longer, the pain for equity investors is exacerbated.

Even though the Indian economy is expected to be strong, and the equity markets are showing resilience a turbulent equity market in the US may not allow Indian equities to enter a bull phase. 

Conclusion
The real risk may be at its minimum when the perceived risk is at the maximum. One of the ways to understand the perceived risk in equity markets is through India VIX. In June, India VIX was at least 30 per cent lower from the 52-week high VIX levels even when the BSE Sensex made a fresh 52-week low. Thus, a falling market without a falling VIX is a good sign for the bulls. This is exactly what has happened in June in the Indian markets which have shown some recovery from their 52-week low levels even as the India VIX refused to tumble while the markets fell.

While the recovery has pushed several stocks out of the bear market territory, especially small-caps, it is too early to call it a market bottom both for near-term or for the medium-term. The reason why we may not have tested the bottom yet is because the known risks have not totally disappeared. While inflation and rising interest rates continue to bother bulls, one of the key concerns for markets is that of earnings’ disappointment by corporate India. Besides disappointment in earnings, what may impact the global markets negatively is the price of crude oil.

The upside risk in crude oil prices remains very high and India may suffer the most amongst the large economies if crude oil prices jump closer to their recent high of USD 140 per barrel. The recent pull-back in crude oil prices may be temporary and could threaten the prospects of any decent recovery. In such uncertain times one needs to manage the portfolio actively. Active portfolio management allows investors to position the portfolio in such a way so as to benefit from the developing situation. In the current situation, energy stocks can be part of your core portfolio along with banking stocks. Banks and financials have proven to be market outperformers during recessionary periods. Also, defensive stocks can be added to the portfolio.

While IT stocks come under the aegis of defensive stocks, they may continue to suffer a little bit more on account of the recessionary environment in the global equity markets. Pharmaceutical stocks may come into the limelight owing to their relative underperformance in recent periods and attractive valuations. Pharmaceutical companies are also expected to report healthy earnings’ growth. So do not be surprised if these stocks are suddenly chased by the bulls. The portfolio should be built in such a way that it should provide resilience and cushion from the recessionary environment if it hits us and at the same time should protect us from the inflation environment. Several studies have found that the energy and financial sectors along with the pharmaceutical sector have managed to perform relatively better during times of recession.

Investors can use these research findings and construct a portfolio to protect from inflation and the recessionary environment. Equity as an asset class can be expected to outperform other asset classes especially fixed income if a US recession is averted. History tells us that times of pain can be ideal moments to position for future gains. That said, one must remember that the markets may see a sharp downside if the attempts to tame inflation fail by the US Federal Reserve. The same can be said about RBI’s decisions. In case the inflation is not tamed and the growth rate is negatively impacted owing to rising interest rates, we will face a stagflationary situation.Investors will not want this situation to exist either in India or in the US.