The Nifty was up 1% last week, reaching all-time highs! And while the markets seem to be in an upswing, other than valuations, there seem to be more indicators signalling elevated risks at current levels.
The valuation premium for India has been at an all-time high, and that stands as a risk. But it may not be a factor to sell on. After all, India is also the fastest growing economy, and that would prompt global funds to be massively overweight India.
As long as the growth premium continues, the valuation premium can be justified. However, if growth falters (and it can give rise to increasing macro headwinds), there is no reason for valuations to stick around at the peak.
Currency and flows
The rise in the US dollar has been a major concern. While India has been one of the less-depreciated currencies, aggressive rate hikes in the US do pose a threat to the Indian Rupee. Why? When the US Fed hikes rates, investors get better risk-reward by investing in the US - higher yield at lower risk.
Moreover, for any foreign investor the required rate of return in US dollars, increases when the rupee depreciates. If an investor made 10% in India and then had to take it back to the US, they would take nothing if the Indian Rupee depreciates by 10%.
If a currency has the potential of eating into returns, it also has the potential to stop flows into India.
The rising yield gap
When the spread between earnings yield and the yield on a government bond (say the 10-year G-Sec), increases, it’s time for caution! Earnings yield is how much earnings you’re getting for the price you’re paying for stocks (earnings/price).
For Nifty 50, the earnings yield is at 4.5%. However, bond yields are currently at 7.3%. With valuations at their highs, and given the rising rate scenario, this gap has the potential to expand from here, unless the markets fall.
💡 Our View: Valuation indicators have been increasingly raising risks. In a rising rate environment and a slowing global economy, we’d not be rooting for the upswing to continue sustainably. We’d be buyers when the markets fall instead.