End Of Irrational Exuberance: Five reasons why markets are tanking In the middle of a bull run

• With oil on the boil ($90/barrel), the risk of inflation is back on the table. Inflation rates continue to trend above RBI’s comfort zone.
• Market could further lose momentum if investors start rotating money out of small and midcap stocks to largecap ones.
• US Treasury yield of 4.5% could pose a risk to India’s market rally as the US greenback offers a risk free opportunity to global investors.

India has been the best performing market in the region ever since the pandemic started in 2020. Not surprising that most global investment banks have changed their stance on India to overweight, despite the fact that valuations are richer than they have historically been. So, what’s spooked the market and is this the end of the bull run?

HSBC Global Research thinks we are only midway through the bull run but there will be bouts of risk on and risk off phases. In a note, Amit Sachdeva, India Equity Strategist at HSBC, writes: “Our long range cycle analysis suggests that we are still mid-way into a bull run; in general, a momentum once set does not go away that easily unless broken by a major global crisis or large swings in crude and inflation.”

It is not just rich valuations – something that Kotak Institutional Equities seems to flag off every few weeks – but several macro risks that can have a spillover effect on corporate profits. With oil on the boil ($90/barrel), the risk of inflation is back on the table. Making matters worse is the sharp rise in bond yields and the Dollar Index (DXY), which has risen to 107. A stronger dollar is bad news for India because it continues to be a net importer and the effect is already visible in the current account deficit figure for the first quarter of the current fiscal year. India’s CAD widened sequentially to $9.2bn in the June quarter against $1.3 bn in the preceding quarter.

The risk of rising raw material prices is negative for corporate earnings too. According to Kotak Institutional Equities, “The Nifty index looks 10% overvalued when we model the index’s earnings yield as a function of the index’s expected growth, profitability, VIX and 10-year yield. Moreover, the last quarter of the calendar year has been seasonally the weakest in terms of equity market returns in the past 40 years.”

Return expectations of the equity research house over the medium horizon (3-6 months) are muted based on these headwinds. In addition, data from more than forty years show that the October-December quarter has been the weakest for corporate profits. As a result, valuations and seasonality are headwinds for the near-to-mid term.

Crude oil has risen to $95/barrel on supply constraints and any further rally in crude will trigger a selloff as investors will take risk off the table. What makes this highly possible is the risk free return that global investors can look at with the US Treasury yield hitting 4.5%, which is the highest since 2007. According to HSBC Global Research, “The US bond yield has risen to 4.5% and the stronger-for-longer Fed rate narrative has weighed on flows to India and other emerging markets (EM) as well.”

Not surprising that the RBI has maintained its hawkish stance on policy rates, as the battle against inflation has not been won. Inflation continues to run above the central bank’s comfort zone, although lower food prices should help ease inflation in September and beyond. The patchy monsoon this year could also put some pressure on agricultural commodity prices.

Another risk to markets is the sharp rally in small and midcap indices of late because of the bulky capital flows into mutual fund schemes that invest in these stocks. The small and midcap stocks have rallied 40% but they account for 30% of India’s market cap. In any bull run the performance of large and midcap indices tend to diverge but this time it is way more than historical levels. Large cap valuations are more attractive now than midcaps. Strategists believe that rotation is likely after the outperformance of small and midcap stocks. This could contribute to the overall momentum of the market.