Why valuation compression will be the biggest risk to the equity investors – Blue Barrows

During the recent Jackson Hole Economic Symposium, the realistic Federal Reserve articulated the current inflation challenges, indicating that its inflation-containing measures will continue for some time. The Federal Reserve Chair Jerome Powell said, “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance”. This rules out an early easing environment and indicates the likelihood of another 75bps rate hike soon.

Tightness in the labor market – A major challenge

The specter of global inflation is complicated, and regardless of the source of inflation, it is incumbent on central bankers around the world to contain it. However, with the challenges of prevailing inflation soaring at levels not seen in the last 40 years, the central bankers have their work cut out. The current structure of inflation in the western world is driven by supply-side pressures and demand-side challenges. While supply-side pressures still contribute to inflation, demand-side challenges are inflicting a significant impact. Amongst the supply-side pressures, the labor shortage is a major problem, with the labor participation rate in the western world decreasing significantly, post the pandemic period. Successfully addressing the labor shortage is an uphill task, as it generally takes longer than expected to improve the labor participation rate.

Labour Participation rate

Apart from these, the other supply-side challenges induced by the war in Europe or drought in other parts of the world will also impact the prevailing inflation. Amidst this environment, where the chances of inflation remaining elevated throughout the year are high, central bankers across the globe face the daunting challenge of managing interest rates without sacrificing growth.

Demand destruction could be painful

While it is the role of central banks to manage inflation, their tools primarily aim at managing the demand, wherein they try to manage the expectations on inflation, which in turn, help in changing consumption patterns. These changing consumption patterns, in turn, help to manage inflation. In the present circumstances, as inflation levels continue to remain elevated, the central bankers will have to respond by raising interest rates, and at times, these may turn out to be sharper than expected.

It is no secret that a change in interest rate impacts the economy with a lag. Consequently, the effect of higher interest rates on demand could have a more adverse impact than perceived by central bankers or economists. The current pace of interest rate hikes has been steep, and it could continue to remain steep in the short term. However, its effects would be accentuated by the continued supply-side pressures, which may result in significant demand destruction in the western markets. This phase could be rather painful as the markets will have to adjust to a higher cost of funds and a slower economy. While the markets have adjusted to a higher cost of funds to some extent, further adjustments are still on the cards, with real interest rates continuing to remain in the negative territory.

Inflation in India is still manageable.

While global inflation remains a challenge, inflation in India seems manageable. Labor market challenges in India are not as significant as the global scenario, but challenges related to crude continue to linger. Most other commodities have declined, and the monsoon season, too, has been good. Thus, food inflation is likely to be under control. India’s inflation has moved in line with expectations, and the RBI is also managing the expectations very well.

Valuation Compression to be the Biggest Risk to the Markets

The NASDAQ correction till Jun’22 was a bear market correction but this was followed by a typical bull market run-up in Jul’22 and Aug’22. Nonetheless, many subject matter experts opine that the run-up in the global equity markets was a bear market rally, and the market will correct soon. Indeed, the correction on 26th August after the Jackson Hole speech by the Federal Reserve Chair does indicate that the market could be set for further correction. While corporate profitability remains high, changes in corporate profitability trajectory over a longer time frame are still difficult to predict. In any case, the markets expect this to come down, and hence, the correction over the short to medium term will be led by compression in valuations.

India is well placed; Valuation risks pose challenges

India’s valuation premium over the other emerging markets has expanded in the last 12 months. This can be attributed to its resilient earnings growth and improvements in the quality of the balance sheet of India Inc. However, sustained inflation pressures in the western world and rising chances of a recession could mean further outflows, keeping the pressure on valuations. In this environment, quality companies at reasonable valuations will continue to perform well. Sectors such as Banking, Industrials, Autos, and Domestic Consumption plays will perform well.

Nonetheless, inflation will continue to dominate the headlines around the world. While the solutions to world problems are seldom simple, economies and markets adjust to these challenges over time. Inflation challenges are not new for the Indian markets and have indeed navigated the global challenges quite well in the last year while delivering an encouraging outperformance. We believe this outperformance will sustain but sector selection and focus on valuations will remain critical for investors.

(The author is CIO, Axis Securities)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)