No place to hide as Indian market gets a much-needed reality check

Asian equities slipped on Thursday on worries that a stronger US economy will result in interest rate hikes, and make emerging market assets even less attractive for foreign investors. Investors in Indian equities have a lot more to worry about. Not that anything materially new has emerged in terms of information, but the liquidity squeeze has forced investors to finally acknowledge the cracks in the India story. For quite some time now, the markets have been afloat using either the “earnings aren’t growing, but the macro is great” argument or its counterpart, “there are worries on the macro-economy, but earnings are growing”.

There is no place to hide now, with earnings being downgraded at the same time when macroeconomic worries, such as a widening current account deficit and the need to slow down the economy, are causing investors to flee. It’s the proverbial perfect storm.

The rupee hit a fresh low of 73.80 against the US dollar on Thursday, despite the government’s desperate measures to curb the currency’s free fall. In a double-whammy, the price of Brent crude rose to $86 per barrel. In short, the country’s current account deficit will worsen further.

Consequently, the yield on benchmark 10-year bonds hardened, adding to the panic in the equity market. Expectations that the Reserve Bank of India will adopt an aggressive monetary policy stance on Friday also eroded the risk appetite.

The fear gauge, National Stock Exchange’s India VIX (volatility index) rose 9.65% to an intraday high of 19.68. But it’s still far below its peak of 20.015 in February.

What’s been different about the correction in the past few sessions is that market heavyweights such as Reliance Industries Ltd, Tata Consultancy Services Ltd and the HDFC twins were also punished. Earlier, a correction in other stocks would lead to a flight to safety in the above-mentioned counters. But this had resulted in bizarre valuations in sectors such as IT services and a few other stocks. As such, they were ripe for a correction.

It’s interesting that the IT and pharmaceutical stocks were the biggest losers on Thursday, despite the continuing slide in the rupee. Finally, the markets seem to have given up silly props such as “buy shares of exporters whenever the rupee falls, regardless of where valuations are”.

Investors have also been forced to reckon with the fact that earnings are under pressure. Hopes of a revival in corporate earnings have dimmed, thanks to input cost pressures. Besides, worries of a liquidity crisis in the NBFC (non-banking financial company) sector still loom. Public sector banks are still struggling to get rid of their bad loan baggage. What’s more, subdued sales of automobiles in September could well mean that the consumption story is faltering.

While all of this has led to a much-needed reality check on Indian stocks, valuations of Indian equities remain expensive. As the chart shows, the one-year forward price-to-earnings multiple of MSCI India Index is much higher than that of its Asian peers, excluding Japan. While the gap has narrowed a bit compared to early September, it remains wide. And the India VIX suggests there is a fair bit of complacency in the markets.

But given the rapidly deteriorating situation on the macroeconomic front, the downgrade in corporate earnings and the liquidity shock, it shouldn’t be surprising if the markets continue in correction mode.