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The detection of the Omicron variant of coronavirus in the last week of November led to a bloodbath in global equities, catching complacent equity market investors by surprise. Key markets of US, Japan, India, Russia, Korea, Brazil ended November on a negative note, down by around 1.5-4%, showed Bloomberg data.

While the severity of Omicron is still unclear, it has surely dampened sentiments of global equity market participants, who were gearing up for a Santa Claus rally. With the rising pace of vaccinations worldwide and gradual reopening of borders, there were expectations that global equities would rally towards the end of year—a trend usually referred to as a Santa Claus rally. But hopes are fading fast and fear is setting in.

The fear factor
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The fear factor

In the past one month, fear gauge, the CBOE Volatility Index (VIX) has risen by 53%. In comparison, India’s NSE VIX has seen a milder increase of around 23% in the same span. But that doesn’t mean all is well. Analysts caution of increased volatility in global and Indian equity markets going ahead.

An expensive bet
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An expensive bet

“Speculation that Omicron might prove more contagious than previous variants, and perhaps resist vaccines, has seen a sharp deterioration in risk appetite," Thomas Mathews, markets economist focusing primarily on emerging markets at Capital Economics said in a report on 3 December. And Omicron is not the only factor that is likely to drive the markets down. A loose and accommodative monetary policy, generous fiscal support and muted inflation are all turning from tailwinds to headwinds.

According to Mathews, Omicron could increase inflation in the medium term and pave the way for rate hikes. “After all, supply chains are much more stretched than they were even during the Delta wave, and any further restrictions would only hinder them further. Meanwhile, we already thought expectations for terminal policy rates looked too low, and Omicron-related inflation in the medium term might well be a catalyst for them to rise."

With inflation rearing its ugly head, many central banks have started to hike interest rates. For instance, Brazil has raised its policy rate for the sixth time since March and by a massive 150 basis points in October. One basis point is one hundredth of a percentage point. Russia, Hungary and Chile are other examples. As far as the key US Federal Reserve is concerned, the central bank has already indicated that it will soon withdraw stimulus measures and start hiking rates by mid-2022. For Indian investors, the upcoming monetary policy meeting of the Reserve Bank of India (RBI) on 8 December is crucial in-terms of interest rate decision as well as commentary on inflation.

“The jury is still out on whether RBI will follow in the footsteps of emerging market peers with its interest rate decisions. Given that inflation is wreaking havoc on corporate balance sheets, we feel, RBI may not be in a position to maintain status quo on rates for long. So, volatility is bound to rise in the coming weeks," an analyst with a domestic brokerage said requesting anonymity.

Simply put, the downside risks to equities are on the rise. Yet, valuations remain expensive, especially in the case of India.

The MSCI India index is trading at a one-year forward price-to-earnings (PE) ratio of around 22 times. This is at a steep premium over the MSCI EM index which is trading at a PE multiple of 14 times, showed Bloomberg data.

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