‘Fancied’ midcaps & ‘narrative’ stocks at risk as D-Street adjusts to new reality

NEW DELHI: The US Fed commentary last week was clear -- tapering of $120 billion a month bond-buying program is on the discussion table and that it is natural for ‘interest rates’ to rise in coming years.

Back home as well, there could be a shift in RBI’s accommodative stance sooner or later. What would matter the most to the domestic market will be the interplay of corporate earnings and bond yields, analysts said.

Two scenarios
The base case scenario, as Kotak puts it, will be strong earnings growth and a gradual increase in bond yields.

A low-probability outcome but a high-impact scenario could be of strong growth, but a sudden and sharp spike in bond yields due to negative inflation surprises. The two scenarios may impact largecap and smallcap stocks differently.

In the base case, largecap stocks can deliver modest returns and hold up better in the second scenario, Kotak said, as they have more predictable and visible cash flows, especially companies in sectors such as consumer staples, IT, and pharmaceuticals, and their valuations are a lot more palatable.

“We expect ‘fancied’ midcaps and ‘narrative’ stocks to struggle in the second scenario as the market will recalibrate the ‘narratives’ behind the re-rating of the stocks. In fact, a number of midcaps have seen significant re-rating without any change in their fundamentals but a change in their narratives. We do not suggest ‘blanket’ apathy towards midcaps — many have superb business,” Kotak Institutional Equities said in a note.

For now, the 12-month forward earnings yield stands at 4.6 per cent and bond yield, as suggested by 10-year government bond yield at 6 per cent. The beer ratio, defined as bond-equity earnings yield, stands at 1.3. A value above 1 suggests equities are no cheap.

Rising bond yield a headwind
Kotak analysts said higher bond yields will act as headwinds to the market through higher cost of equity but higher earnings will offset some of the negatives of higher bond yields.

“The performance of the market will depend on the interplay of earnings and bond yields. The current yield gap (earnings yield less bond yield) is reasonable by historical standards, but is predicated on strong earnings growth,” the brokerage said.

Market veteran Prashant Jain of HDFC AMC told ET NOW capital markets can take in their stride some increase in the cost of capital because India reasonably is a fast-growing economy and the outlook for profit growth importantly is quite positive.

What lies ahead?
Analysts said if inflation data surprises on upside, central banks will have to realign their current ultra-loose monetary policies at a faster pace through lower bond purchases and higher policy rates. Markets will have to adjust faster to the ‘new’ reality, they said.

They see RBI to likely cut the quantum of bond purchases by end-2021 and rate increases in 2022.

Porinju Veliyath of Equity Intelligence, whose PMS delivered a 153 per cent return in FY21, said that when there is a trend of every stock going up, one should be extremely careful and cautious.

“We are at that kind of a point of time now and the leveraged investors should be very careful because whatever money made in the last one year or one and a half years can be lost very fast,” he said.

S Naren CIO at ICICI Prudential AMC said no pocket in the market can be considered extremely cheap at this point in time but believes the Indian business cycle looks very attractive in the long term. He said it is only the business cycle in the US that has picked up and felt that the domestic business cycle would pick up sooner than later.

“Credit growth has not picked up, corporates have not undertaken big capex, power demand has still not grown, and neither we have seen the business cycle in India pick up. It is only the US business cycle that has advanced. The Indian business cycle never really took off,” Naren said.