Market Reflections: Assessing the Second Half Amidst Market Rally and Lingering Doubts

Dear readers,

With the first half of the year behind us, it's time to reflect on the current state of the markets and anticipate what lies ahead. Benchmark indices across major markets have witnessed substantial gains since the beginning of the year. In India, the Nifty has been reaching new heights, capturing investors' attention.

A closer look at the MSCI country indices provides valuable perspective. As of June 27th, 2023, the MSCI India index in dollar terms has risen by 2.7 percent year-to-date. Comparatively, Korea has surged by 16.2 percent, and Mexico by 26.6 percent. However, the performance of MSCI China leaves much to be desired.

The question arises:

Are the markets rallying due to high expectations for the remainder of the year? 

Inflation is on a downward trajectory, and rate hikes have either occurred or are nearing their peaks. Systematix Institutional Equities notes that the markets are factoring in a "hyper goldilocks scenario," assuming that high inflation in the US and other advanced economies will normalize without triggering a recession. Consequently, market risk premium has dropped to historically low levels associated with an ultra-easy monetary policy. These presumptions have driven up valuations and reinvigorated portfolio flows into emerging markets, including India, which had previously underperformed due to rich valuations.

However, the Bank for International Settlements warns that the next phase of disinflation will be more challenging. Mid-year outlook reports reveal significant doubts. Morgan Stanley's report, titled 'Soft Landing, Hard Choices,' Barclays' 'Managing the Slowdown,' and Allianz's concerns about high inflation and an impending economic downturn indicate a potentially bumpy second half of the year, necessitating adjustments in market expectations. JPMorgan's report even goes so far as to question whether current market conditions are too good to be true.

Naturally, these reports could be inaccurate, as exemplified by Credit Suisse's note at the beginning of the year, which predicted a "Fundamental Reset" but ultimately experienced its own fundamental reset instead of impacting the markets.

Interestingly, KKR and Citi Global Wealth view the current market doubts as favourable. Citi suggests that the current poor investor sentiment creates potential opportunities, noting that bearishness, measured by short equity interest, has reached multi-decade highs. Investors are waiting for market indices to decline before reallocating assets into equities. This anticipation of a bear market, which is highly anticipated, serves as an argument against successful market timing. If everyone is waiting for a decline, any downturn may be brief and difficult to trade. However, caution regarding the US markets has prompted a call to diversify into emerging markets.

High valuations in the US contribute to this diversification trend. In May, the Fed's Financial Stability Report highlighted that equity price growth had outpaced growth in earnings forecasts, leading to a forward price-to-earnings ratio significantly above its historical average. Moreover, a chart in the RBI's Financial Stability Report illustrates that the US market is currently less expensive than India, which stands as the second most expensive market globally, trailing only Japan. As the famous quote attributed to Lord Keynes suggests, "The markets can remain irrational longer than one can remain solvent." Bears recovering from market losses will undoubtedly agree.

Beyond valuations, there are additional reasons for caution. The RBI report, although generally positive, acknowledges emerging constraints such as moderation in real wages, tempered private consumption, weakening external demand, and their potential impact on export prospects. Our Monsoon Watch column indicates ongoing worries despite a narrowing rain deficit. However, the Indian Ocean Dipole effect could alleviate the potential El Niño impact on India. A Motilal Oswal strategy report raises concerns about an anticipated consumption and/or residential real estate slowdown in FY24, which could disrupt credit growth in the country. Their thesis suggests that the rise in consumption was driven by a decline in net financial savings, representing pent-up demand. Going forward, this tailwind may no longer be present.

Analysts in developed nations have made similar arguments, emphasizing that the reduction of "excess savings" accumulated during the lockdown period will eventually impact the US economy. Although the US economy is currently performing well, the impact of rate hikes is expected to surface. The June Flash PMIs indicate a slowdown in growth across developed economies.

For the Indian markets, a CLSA note expresses concerns about rich valuations, eroding margins and return on equity, and unrealistic EPS estimates. Additionally, it's unlikely that the central bank will cut rates in the near future. As mentioned in a previous article, bringing down inflation from 7 percent to 5 percent was relatively easier as the impact of supply chain shocks and temporary price jumps tend to fade over time. However, reaching 4 percent will require a significant change in pricing behaviour from economic participants. As the RBI governor has stated, "It is always the last leg of the journey which is the toughest."

Ultimately, the future depends on whether central banks in advanced economies can adhere to their objective of withdrawing liquidity. Analysts point out that The Goldman Sachs Financial Conditions Index reached its current level of restrictiveness over a year ago and has significantly eased since last autumn. The Chicago Fed's Adjusted National Financial Conditions index currently stands at a level similar to April 2022, when rate hikes were just commencing. After all, the exponential growth in liquidity has fuelled asset prices and economic growth in developed economies for decades. Those who have benefited from this expansion may resist its withdrawal. While Jerome Powell intends to maintain a tight monetary policy, the upcoming US elections next year could introduce additional variables.

Economists have often highlighted the contrast between the slowing global economy and the resilient Indian economy. However, it's worth considering whether it is the decelerating global economy and declining oil and commodity prices that have contributed to the relative resilience of the Indian economy. If, as widely predicted, the global economy continues to slow in the second half of the year, it may prove advantageous for India, as long as it doesn't plunge into a severe recession.

Highlights:

• Benchmark indices in major markets are significantly higher than at the beginning of the year, with India's Nifty scaling new heights.
• MSCI India index has risen 2.7% YTD, while Korea and Mexico have experienced stronger gains.
• Markets are rallying on the expectation of a "hyper goldilocks scenario," assuming inflation will normalize without triggering a recession.
• Mid-year outlook reports express doubts, with titles like "Soft Landing, Hard Choices" and "Managing the Slowdown."
• High US valuations and concerns about the global economy prompt calls to diversify into emerging markets, including India.
• Reasons for caution include rich valuations, moderation in real wages, tempered consumption, weakening external demand, and potential monsoon-related worries.
• Analysts highlight the challenge of achieving further disinflation and the impact of withdrawing liquidity in advanced economies.
• Concerns about unrealistic EPS estimates, eroding margins, and rich valuations in the Indian markets are raised.
• Central bank rate cuts are unlikely, and the journey to reducing inflation further is expected to be tough.
• The future depends on whether central banks can maintain their liquidity withdrawal plans.
• The contrast between the slowing global economy and the resilient Indian economy raises questions about India's potential advantage.
• The US elections and the upcoming slowdown in the global economy may impact market conditions.