Analyst expects cautious investment pattern in short to medium-term amid ongoing rally, here’s why

Over the past 3 weeks, the Indian market has benefited under the protective shelf of global rally & domestic inflows. Domestic economic data have not been very encouraging this month, aside from the robust inflows from DIIs and retail investors. These inflows have counterbalanced the selling pressure from FIIs, who have been net sellers this month, allowing the market to reach new highs. The domestic economic data, Q1 corporate results, and RBI policy actions this month have generally met or slightly fallen short of expectations. Although earnings growth has been weak, the influx of domestic capital and the global positive sentiment, supported by anticipated rate cuts, have heightened equity market interest. Other than this, a positive bias is the subdued crude price, which is trading below the 80$ mark, helping the domestic sentiment.

Global equities have recovered about 75% of the losses incurred during the sell-off in July 2024. Indices such as Nifty50, Dow Jones, and Dax have reached new highs. However, it may be too soon to interpret this rally as a sign of sustained growth. The ongoing net selling by FIIs in markets like Japan, South Korea, and Taiwan—some of the hardest hit—indicates that the uncertainty continues. This short-covering rally could merely be a dead cat bounce, driven by the cessation of Yen 'carry trade'-based selling after the Japanese stock market's 25% correction, presenting a short-term buying opportunity.

Recent reports indicate that FIIs continue to be a net seller in the Japanese market. Domestic players are also cautious other than buying noticed by Institutional players. The BoJ provided a support to the financial market indicating no further rate hike and stability to the financial market including currency market. A similar uptick has happened across the global market. However, the critical question remains: is this recovery sustainable? It’s highly probable that this ongoing rally is a short-term rebound triggered by the market reaching an oversold position. The underlying issues that led to the sell-off remain unresolved and could resurface in the medium term, particularly the yen's appreciation and rising Japanese interest rates. The economist consensus is that the BoJ will increase rates in 2025 to combat inflation and control the yen carry trade, which has exceeded the central bank's threshold. Hence, we can presume that the number of Yen denominated, and arbitrage trades will reduce in the future, which has been a key part of the global liquidity in recent years.

Secondly, the global market has been rallying under the bliss of a change in the interest rate from the rising to the reducing cycle. It is good for the stock market and will bring positivity in the long-term. However, it is essential to assess the extent and timing of these rate cuts. We need to acknowledge that the Fed rates are currently at two decades high of 5.5% in the US. A 25bps Fed rate cut in the month of Sept will not change the side effects of a high interest rate on the world economy.

Long term overview

In the long term, economists generally agree that the Fed is expected to cut rates to 3.75% within the next year, to remain above the long-term average. Bond yields are projected to trade above the long-term average interest rate in the medium term, which could dampen future spending and consumption. Simultaneously, central banks around the world are reducing their balance sheets by either cutting back on bond purchases or selling bonds, which will decrease liquidity in the financial sector. This reduction in liquidity is likely to impact market yields and slow economic growth due to a moderation in spending. Additionally, since the slope of inflation and fiscal deficit is on the higher side, the ability of market yields to reduce in the short to medium term will be modest.

Adopting a cautious perspective on the current rally in the short term is wise. This cautious stance is reflected in the market's trend, with notable shifts between sectors and a transition from growth to value stocks. In the last month the best outperformers are Pharma, Consumer and IT. While weak stocks are new growth areas of PSUB and Reality. We expect such a cautious investment pattern to prevail in the market in the short to medium-term.

The author Vinod Nair is the Head of Research, Geojit Financial Services.

Disclaimer: The views and recommendations provided in this analysis are those of individual analysts or broking companies, not Mint. We strongly advise investors to consult with certified experts before making any investment decisions, as market conditions can change rapidly and individual circumstances may vary.