The curious case of all Indian markets - Sanjeev Prasad, Co-head and Managing Director - Kotak Institutional Equities

The curious case of all Indian markets. We struggle to understand the divergent reactions of India's bond, currency and equity markets to the sharp deterioration in India's macro-economic position over the past three months. The bond market seems to be rightly worried about the downturn in India's macro-economic conditions but the currency and equity markets appear to be fairly nonchalant about the same. The Indian markets may have discovered their own version of 'conscious uncoupling'!

Bond market is worried about weaker macro, high inflation and interest rates

The sharp increase in bond yields in India over the past few weeks reflects the bond market's concerns about (1) likely higher inflation over the next few months and upside risks to the same, and (2) likely higher fiscal deficit and government borrowing on sluggish government revenues.

Currency markets seem calm about weaker macro and higher CAD, which is quite strange

The recent strength in the INR against most currencies is quite mystifying as India's macro-economic conditions have deteriorated meaningfully with (1) higher inflation (lower real interest rates) and (2) weaker BoP on the back of higher crude oil prices. We note that a US$1/bbl change results in a US$1.5 bn impact on India's CAD/BoP; Our base-case BoP projections and BoP scenarios at higher crude oil prices. As such, the INR has been in the over-valued zone on REER basis for some time. We can understand the strength in other currencies versus the USD; for example, stronger recent economic data in the Eurozone may have led the markets to recalibrate their expectations about continued loose monetary policy of the ECB.

Equity markets seem nonchalant about weaker macro, which is equally odd

The continued strength of the Indian equity market despite higher bond yields, inflation and BoP suggests that the market (1) has very high confidence about earnings recovery, which will offset the weaker macro-economic factors and/or (2) is simply willing to overlook these factors based on some misguided view about earnings and macro-economic factors being irrelevant or less relevant for the equity market versus 'liquidity' (whatever it may mean). The general euphoria in global markets may be rubbing off on India too (India's performance is similar to other major markets) but other major economies are seeing strong signs of economic revival whereas India's macro-economic position has deteriorated significantly.

High valuations and 'strong' currency are 'bad' starting points for the equity market in CY2018

(1) A de-rating of multiples (on higher domestic and global interest rates and/or earnings disappointments) and (2) sudden weakness in the INR (the INR has periods of inexplicable strength, only to give up all the gains and more during periods of crisis) can hurt the performance of the Indian market. The 37% US$ return in CY2017 has to be seen in the context of (1) 29% local currency return, which in turn was helped by 12% increase in multiples from the beginning of CY2017 and (2) 6.4% appreciation in the INR. The Indian market's 12-month forward multiple has been quite steady over the past few months despite the steep increase in bond yields (see Exhibit 14 for bond and earnings yields).

Source : Equity Bulls

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