Equity market at a fair price, here is what can work well for investors; Relief rally after Fed meeting to benefit emerging markets
By Unmesh Sharma
The FOMC policy statement and press conference had enough material for pessimists and optimists alike. The 75 basis point hike was clearly communicated and therefore well expected and priced in. The commentary and indeed the press conference that followed was once again a master class in communications by the US Fed. The market’s reaction in the following two days can be seen as a collective sigh of relief. Indeed, there was a risk that the rate hike was more pronounced or that the comments were more hawkish. Neither happened.
At the same time, there was also a clear acknowledgment and even an implicit promise that there was an eye on growth risks. Essentially, markets are seeing the re-emergence of the “central bank put” at an appropriate time. And the fact that the next step will be “data-dependent” gave participants enough hope that things won’t at least get worse from here. Moreover, even as the room to maneuver and achieve a “soft landing” has narrowed, the worst-case scenario could be a shallow recession. This would imply that any bursting bubble would be localized and an almost zero probability of widespread economic dislocation. Indeed, if the data prints do not worsen, this signals a neutral to benign environment until the next policy meeting in September. The resulting rally in risk assets should benefit emerging markets and even India.
So is this finally the time when we reverse our cautious stance on the market and go “All In”? Not yet! We think there are three big factors – none of which are comforting.
3 worrying factors for equity markets
Inflation: On inflation, even if the headline starts to come off due to the base effect, a drop from 9% to 6% will still be well outside the Fed’s comfort zone. Numerous problems on the supply side and labor market data seem to indicate that the Fed’s fight against inflation will be long and arduous. Meanwhile, the current market rally indicates that market participants expect the next rate cycle to be similar to the previous one. In this case, we saw rates rise rapidly and then fall in an inverted V-shape as the Fed retreated. We don’t think this is likely to happen again. The Fed Chairman has made it clear that price stability is the foundation of price stability. If he invokes the inner Greenspan, which we believe will because the policy is aligned to that, then we expect a long grind. This would lead to high volatility and therefore a sideways movement in the markets until at least the start of next year.
Flows: Anecdotally, the pace of REIT sales has slowed. So far, the selloffs have been absorbed by national retail and institutional funds. However, we may see this pace pick up again as we experience the unprecedented phenomenon of “Quantitative Tightening”. Remember that 2013 is fading and the current group of market players have not experienced this cash outflow in their careers. We don’t know which way this will fall, but there is a more than equal chance that risk assets will see another leg down with profit booking over the next 6 months, even if the comments from the Fed are starting to become less hawkish.
Estimates: The market is reasonably priced at best. The usual rule of thumb we use is that valuations should be 1 standard deviation below the long-term average. We are nowhere near that.
What works in this situation for investors
We believe that active strategies work in this environment. The HDFC Securities Institutional Equities (HSIE) research team’s model portfolio is value oriented – we continue to pick stocks on relative value (low vs. high PE stocks). This is reflected in our preference for large banks, real estate, cement and pharmaceuticals over non-bank lenders, consumer staples, energy and materials and most IT names. We would use the rally to lighten positions at the high-risk end of the duration curve (such as new-age technology) and add positions in longer-term themes (e.g. financial inclusion – insurance and markets of capital). The big call for the next 12 months is “manufacturers over consumers”, given the direction and will of the government.
(Unmesh Sharma is the Head of Institutional Equities at HDFC Securities. The views expressed in the article are those of the author and do not reflect the official position or policy of FinancialExpress.com.)