Why The Equity Bulls Will Take A Breather

After a three-year-long bull run, which started around the lockdown for the Covid-19 pandemic in March 2020, the stock markets are coming to terms with the United States Federal Reserve's (Fed's) jawboning of "higher for longer." Simply put, with key interest rates in the US likely to remain elevated at around five per cent – at least for the first half of the 2024 calendar year – the equity bulls will take a breather.

The reason is simple. As long as lending rates in the US remain high, there can be no bull run in stocks as elevated rates push up the equity risk premium, that is the gap between the borrowing rate and equity gains. Effectively, large institutional investors have to generate at least eight per cent to 10 per cent annual returns in the stock markets to beat the Fed rate, which is known as the risk premium. In the US, the earnings growth of S&P companies is around five per cent or lower than the Fed funds rate. Hence the equity bull run can only return when the US Fed begins to cut interest rates. India's stock markets are no exception to this phenomenon, since foreign portfolio investor (FPI) inflows will remain scarce as the US dives into a recession. Also, India's benchmark indices Sensex and Nifty have risen by 140 per cent from the pandemic lows to the recent lifetime highs and market valuations too need to adjust to the new reality. 

*Yield curve inversion 

"Due to the long duration of inversion in the US bond yield, the current leg of the global equity bull run is peaking. Probability of 10 per cent to 15 per cent market decline is high in India. In the US, the fall could be much deeper," says Rohit Srivastava, Founder, Strike Money Analytics and IndiaCharts.

What does a yield curve inversion mean? Investments in government bonds are considered risk-free. In an ideal scenario, long-term bonds (10-year maturity) carry a higher rate of interest payment, compared to a short-term bond (two-year maturity). The yield curve inversion, an extreme bond market scenario, happens when the two-year bonds start quoting higher than those of 10-year maturity. It is a double whammy, since it may offer charming risk-free returns for some investors in comparison to other risky asset classes but for the majority of the leveraged players, who had borrowed when the US interest rates were much lower, the yield curve inversion is a nightmare. It is primarily for this reason that FPIs have turned net sellers in India's markets for the past several months. In just three months between August and October, the FPIs have sold stocks worth nearly $10 billion in Indian stock markets in the cash segment. 

Nearly 88 per cent of the world economy and trade is still dominated by the US dollar, hence the Federal Reserve's fund rates are a deciding factor of global liquidity. In October, the US two-year bond yield touched a high of 5.25 per cent, surpassing the 10- year yield high of 5.02 per cent – a classic inversion – as the US Federal Reserve chief Jerome Powell remained focused on hiking interest rates throughout 2023 to manage inflation. 

*Wars keep US Fed Chief Awake?

Inflation is the most hated component in the long list of the vagaries of war. The fast galloping WTI crude oil price hit $139 per barrel on 6 March, 2022 – highest in a decade – less than two weeks after Russia invaded Ukraine on 24 February that year. Even as Russia was nearly a month away from invading Ukraine and still building troops on the border, the yield on the 10- year bond in the US jumped by 12 basis points to about 2.05 per cent on 10 February. It was the first time that the benchmark rate in the US had reached two per cent since August 2019. The yield on the two-year Treasury bond, the most sensitive duration to interest rates, surged 26 basis points to top 1.6 per cent. The surge marked the two-year bond’s biggest single day move since 2009.

Russia's invasion of Ukraine was just the beginning of the mountain of worries for the Fed chief, since the global crude oil prices and inflation are often the first casualty of a war. Although the U S has been imposing heavy sanctions on Russia for years and has debarred it from the global financial system, higher crude prices are Russia's 'manna from heaven,' that have averted a bankruptcy for the country. As much as Russia would rejoice higher crude oil prices, the US may abhor it in any form. A run-away inflation not only affects the Greenback’s purchasing power but challenges its status as the world's reserve currency and thereby the hegemony of the US and its financial system. 

In just around a year since September 2022, the key interest rates in the US rose by a whopping 500 basis points as the Fed embarked upon the fastest interest rate hike cycle in recent history. Despite the brutal rise in US interest rates that set the ball rolling for inversion of the bond yields, the stock markets have been hanging on the bare thread of hope that the Fed would halt before it was too late and start cutting rates. The iron hand of the Fed had put inflation on a downward spiral in the US and it has declined to around 3.6 per cent from nine per cent sometime in 2022. It, however, still remains way higher than Powell's comfort zone of less than two per cent. And the elephant in the room – the Russia-Ukraine war – is showing no signs of simmering down, which keeps the threat of a spike in inflation alive for the Fed. The Israel-Hamas conflict that has the potential to keep West Asia on the boil for long is that proverbial fuel to the fire. There is a view that the US may not cut interest rates in a hurry, which is something that will keep the bond yield inverted for a long time and hit the equity bulls hard. 

In a 3 November report titled War and Signs of Soft Landing, the Danish Danske Bank said, "Further uncertainty was added to the global economy with the Hamas attack on Israel and breakout of war. In itself, Israel is only a relatively small producer of natural gas but given the strained gas market in Europe, there was an initial reaction in the form of higher prices. Oil prices were also modestly higher, driven by the risk that the conflict will escalate further and for example lead to tightened sanctions against Iran. Potentially, higher energy prices could give both a positive impulse to inflation and a negative impulse to growth, creating a dilemma for central banks, which would normally not react strongly to such supply chocks but might have to now, given that inflation is already too high. The situation clearly adds to the already large geopolitical tensions and creates further uncertainty and risk aversion among investors, although the global economic impact for now is not large."

The Danske Bank’s contention only vindicates the apprehension that the two conflicts would influence interest rate policies of large central banks and thereby, affect the entire financial market ecosystem. Till the US economy throws up strong numbers and as long as wars rage on, the Fed chief is unlikely to relent on interest rates or start lowering it in a hurry. This will keep markets on the edge, experts say. It is little wonder that the S&P 500 retreated by 4.2 per cent in September, on pace for its second straight losing month and its worst month since December 2022.

*The India Picture

High household savings rates in any country are the lead indicator of an impending long-term bull run. But this factor too seems to be weakening for India. In a report titled Midnight Approaches for India’s Retail Lending Boom by the research firm Marcellus, analysts Saurabh Mukherjea and Nandita Rajhansa detail the threat of a sharp rise in borrowings by the retail population. India’s savings rate, on a net basis (i.e., savings, less borrowings) has touched a 40-year low. For the first time ever, Indian households are borrowing more than they are saving through bank deposits, the report says.

"This fall in the net savings rate is a by-product of three structural trends: (a) the youthful demography of the nation; (b) the strong employment prospects of creditworthy Indians working in the knowledge economy; and (c) the rise of digitization and the India Stack which is allowing lenders to assess the creditworthiness of hundreds of millions of borrowers who were formerly transacting primarily in cash. Given the underlying drivers of the fall in net savings, it is unlikely that this trend will reverse until economic growth throttles off and unemployment starts rising. When that happens, those who are currently lending abundantly will face their day of reckoning," the Marcellus analysts say.

Interestingly, not only is such a low net savings rate unusual in the Indian context (given that India has been accustomed to seeing a high net savings rate over the past few decades), but it is also unusual when compared to the East Asian Tiger economies that have financed their high investment rates through high savings rates, says Marcellus. 

To put this remarkable surge in household borrowing in context, in FY2023 households made bank and non-bank deposits of Rs 11 trillion, but took out loans for Rs 15.82 trillion i.e., FY2023 was the first year when Indian households 'crossed the Rubicon and became net borrowers from the financial system,' the report sums up. Stressed household savings do not suggest a situation where the Indian retail investor will turn adventurous. Even so, it may not be wise to assume that the bull run on Indian bourses is all but over.