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

MUMBAI : While Indian stock markets have outperformed the developed and other emerging markets year-to-date, the odds of a correction over the next 12-15 months have shortened, given the rising interest rates and slowing growth scenario. This is being reflected by the gap between the next 12 months’ Nifty earnings yield and the 10-year G-sec yield falling to minus 2%. Such an occurrence has been seen only a handful of times since the global financial crisis and has presaged a 15-20% correction over the next 12-18 months, Abhiram Eleswarapu, chief executive and head of India equities, BNP Paribas, said in an interview: Edited excerpts:

How does an investor gauge the current market setup?

The two key monitorables globally today are inflation and growth, or the lack of it. What drives stocks from a long-term perspective are valuations relative to these factors. In the short term, what seems to explain stock movements better is investor positioning in risky assets. Global markets are down about 20-30% on the back of high inflation, a trend not seen in decades. In India’s case, the current level of inflation, while being high, is not as unusual for an emerging market, which along with predictable growth, has led the Nifty to outperform quite significantly.

But if you really see, the market has gone nowhere on an absolute basis, even for India. It has just been flattish this year. That said, we have seen exaggerated up and down movements in the index based on investor appetite for risk fluctuating between extremes.

Today valuations aren’t very supportive of a sustainable rally, but investor positioning globally is also very light in equities. This sets us up for continued volatility.

Inflation is here to stay…

In the first couple of months of the year, investors were still digesting the narrative of inflation being transient. What’s turned out is that high inflation has proved to be structural, and investors are coming to terms with the higher rates needed to combat it. Furthermore, higher inflation (and higher rates) tends to slow growth. Thus, investors are also gradually factoring in lower growth over the next two to three years. This process is still ongoing, and earnings expectations and terminal rates in the US, India and most other countries remain moving targets with each incremental data point.

Do you expect more correction in stocks?

At this point, the question that one should ask is how attractive stocks are relative to bonds and other asset classes in a dwindling liquidity scenario. Relative to bonds, one of the more commonly used metrics is the yield gap, which is the forward earnings yield minus the 10-year bond yield. India’s earnings yield is slightly above 5% today, but the bond yields are upwards of 7.4% and may slightly rise further, given we are expecting another 50 bps hike in repo rate this year. Thus, the yield gap is lower than minus 2%.

This kind of differential has been seen only a handful of times since the global financial crisis, and the markets corrected 15-20% over the next 12-18 months following those episodes. In other words, conditions are supportive of either a significant price or time correction.

What’s your expectation from Q2 earnings?

In Q1, earnings surprises versus consensus estimates were more or less in line with that seen in the previous seven to eight quarters. But earnings increased by 15-20% on a three-year compounded basis for corporates, making India stand out relative to peers. In Q2, we would look for this trend to continue, but we will also watch out for slowing growth in globally linked sectors and whether domestically-oriented companies can pass on the full impact of higher input costs to consumers.

Would fixed income be a better bet at the current juncture?

If one takes the view that interest rates are on the verge of peaking globally, then bonds appear to be more attractive than equities, especially Indian equities. Another risk for equities comes from the Fed running down its balance sheet at a faster pace than that seen in the past few months, which in turn could reduce risk appetite.

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