What should the retail investor do in a market fraught with macro triggers?

HDFC Securities

By noon or late afternoon on Tuesday, the outcome of the Karnataka election will be known. Except in the case of a below-expectation (lower-than-average forecast) performance by the Bharatiya Janata Party (BJP), the market is unlikely to react much either way, after a brief round of initial knee-jerk reactions. Market reactions after assembly elections have been unpredictable, and present no clear trend if we look at the last few elections.

What will drive India's equity markets in the near term is not the outcome of this elections or any political issues, but the country's macros. As is known, India's macros have weakened considerably in the past few months – whether it is an increase in inflation, bond yields and crude oil prices, or the depreciation of the rupee, a deterioration in quarterly current account deficit, and the latest slowdown reflected in industrial production data.

This has unnerved foreign investors, who have withdrawn substantial sums from the debt and equity markets since February (when the rupee was trading at 64.50 to the dollar, the 10-year yield was at 7.5 percent, and Brent Crude had just crossed $60 a barrel). In April, we witnessed a temporary reversal of this, which did not last. From FIIs point of view, the multiple global tailwinds of the last nine years for the market, in the form of easy monetary policies, are waning.

So far, the impact of these outflows on the equity market (especially on the Nifty or the Sensex) has been minimal, as local funds' inflows have compensated for outflows by FIIs. The market has so far held its hopes of an earnings recovery, and largely ignored the deterioration of macros. This could hinder a further expansion of multiples, which are already at high levels.

Banks will contribute almost half of all incremental earnings in FY19 and FY20, as there is hope that they would no longer be required to make provisions for non-performing loans and interest reversals. Given the fluid environment with respect to the ongoing NCLT-1 and NCLT-2 resolutions, and the possibility of higher-than-expected provisions for hitherto non-NPL stressed assets, the earnings expectations for FY19/FY20 could dip.

While the Nifty continues to hit near-term highs (closer to the all-time high of 11,171 hit on January 29), the BSE Midcap has continued to drift lower after hitting its high on January 9. The index is down around 11 percent from its high, but thankfully, is yet to hit a new low below the one seen in March. So a vast majority of investors, who have a relatively large exposure to mid caps and small caps, feel that the market has already topped out. This also means that the turnover on the exchanges has fallen, owing to lower activity in mid caps, and the percentage of delivery has also reduced. From a sectoral perspective, we think it will be a bottom-up market. Some strategists prefer oil over metals, predicting that slowing demand growth in China will be a downside risk for iron ore and copper. Most stocks have corrected, irrespective of the outcome of their Q4 results.

While expensive sectors keeps becoming even more so (mainly consumer-facing sectors), a lot of other sectors could become attractive soon. Investors are facing the classic dilemma as to whether one should go for a margin of safety in relatively cheap sectors or stocks, with the accompanying uncertainty of the timing of re-rating, or throw caution to the winds and buy expensive stocks with the hope that they will remain in demand, even in a downturn. In such times, picking winning stocks proves to be even trickier.

We do not think that markets could witness sharp declines because of the above-mentioned reasons, as excesses in the current market are not extreme. Instead, the market may face modest declines in a choppy range.

The debt market have also not proved to be a good refuge in the recent past, with low single-digit returns over the past year due to interest rate volatility.

Retail investors could keep facing challenges in deploying funds over the next few quarters, after having enjoyed a period of relatively-easy money making. Contrary to the above thesis, our market may perform well over the next few quarters, due to a combination of a very good monsoon, revival in exports, crude oil prices reversing their trend, and early and lasting resolutions under the IBC. The possibility of more than two of the above working together seems less likely.