Market Looking For Macro Cues

The markets continued to be strong with the Nifty rallying 3% in August, and the improved breadth evident in NSE Midcap (up 7.8%) and NSE Small cap (up 11.5%) both outperforming. Despite the markets looking through the 1Q GDP contraction of 23.9%, macro trends and earnings visibility will be the key to how markets hold up from here. We remain selective and cautious and focus on three key pillars of our investment philosophy – focus on leaders and strong businesses, keep the portfolio diversified and be selective with banking stocks.

The GDP print

The markets looked through the unprecedented 1QFY21 GDP contraction of 23.9% for a number of reasons:

• The GDP print is backward looking, and the manifestation of the weak growth has already been seen in corporate earnings – this was not new information to the market.
• The 1Q earnings trends had already captured this information. Ex-financials, Nifty companies reported a topline contraction of 34%, though aggressive cost control resulted in EBITDA contraction of just 28%. The markets are looking through these weak numbers and valuing stocks on a more normalised FY22 outlook.
• The linkage between GDP growth and corporate earnings has been weakening over time. Index weights are now skewed towards market leaders and strong businesses which gain market share in bad times. 
• Liquidity flows into the market continue to be strong, aided by supportive monetary policy from the global central banks and the RBI.

Going forward, however, growth and earnings recovery will play more important role, as the relief rally that began in March starts to flag.

Progress on normalisation. In the short-term, the market will track the progress on normalisation of economic activity. There was positive momentum through June and July but the pace slowed during August. September is likely to be tepid due to lockdowns in parts of the country. It is also notable that the progress in smaller towns and rural areas have stalled because of the rapid spread of CoVid-19 in the hinterland. The continued spread of the virus remains a major worry and a hindrance to the normalisation of the economy – that is one metric we will continue to watch.

Some positives emerging. There is a sharp bounce-back in wholesale auto sales with some companies reporting growth over last year. This is, however, dispatches to dealers and not retail sales, but reflects the confidence that manufacturers have in a strong festive season after two years of weakness. Consumer durable sales have also been strong, though some of it has been a manifestation of pent-up demand.

Financial stability. The RBI’s timely measures has ensured that financial stability has been unaffected by the overall macro turmoil. Public finances, however, is emerging as a risk. The weakness in revenues has put both central and state government finances under pressure, and states now must resort to market borrowings to make up the GST shortfall. The RBI has managed to cap bond yields with direct intervention via “Operation Twist”. Their firepower, however, is finite and continued pressure on the deficits could create challenges for financial stability, which would spill over to the equity markets at some stage. This is a risk we have to be vigilant about. 

In summary, we see the broader markets taking a pause till growth trends become clearer. There will, however, continue to be opportunities in select sectors and are focusing on bottom-up stock-picking in this environment. An additional challenge is that quality names have seen strong valuation expansion in this rally. We, however, believe that quality companies with strong businesses and balance sheets could enjoy unprecedented premium valuations given the low interest rates, strong liquidity and lack of options for investors.