Two main issues investors are grappling with (i) Repricing of Interest Rates expectations and (ii) Recalibration of Earnings Expectations.
Is repricing of the year end Consensus on cards?
At the beginning of Dec-22, two views were gaining consensus in the markets:
Bullish Fed pivot;
Relaxation of Chinese Zero-COVID Policy leading to Chinese growth resurgence.
Both these aspects are expected to be supportive for the markets and global economy going into 2023.
Over the last fortnight, a cloud of ambiguity has surrounded these consensus views as we head into Jan-23.
Before the Dec-14th Fed meet, with two back to back inflation readings surprising positively, markets began to price in a bullish Fed pivot – growth supportive vs inflation fighting – for 2023. Widely broadcasted speech of Chair Powell in Nov-22 indicating a downshift in the pace of rate hikes, further entrenched these expectations, with markets even pricing-in two rate cuts in 2H-23. In the Dec 14th Policy meet and the ensuing Press Conference, Chair Powell categorically negated the dovish expectations. Powell reinforced the following messages – No Rate Cuts in 2023, Pace of Rate hikes matters less going forward than the Level of Terminal Rate, the Length of Terminal Rate and ongoing Quantitative Tightening. This led to a correction in stock markets.
In our view, if inflation readings continue to surprise positively in Q1-23, Fed could pause around 5%. From Q2-23, the base effect will come into play and inflationary readings should cool off substantially.
With the rapid surge of COVID among the Chinese population, the global scare surrounding the spread of BF7 variant of Omicron is creating uncertainty. This could also slow the pace of the Chinese reopening from its Zero-COVID policy. Despite the reopening, it will be important to monitor the nature and size of the stimulus which the Chinese Government administers.
What can such a recalibration of consensus mean for the earnings cycle?
While the macro indicators have been indicating the slowing global economy, the risks appear to be accelerating to the downside going into 2023. While sharply slowing inflation should temper the Central Bank hawkishness from Q2-23, the implication is less upbeat for Corporate Revenue growth amidst a demand slowdown. With supply chain constraints easing materially, rising inventory is likely to put pressure on end market pricing when demand is moderating.
As the negative operating leverage kicks in, during the course of 1H-23, we are likely to see earnings downgrades as the macro backdrop deteriorates further. With recession risks rising and earnings downgrade cycle continuing, Global equities are likely to run into rough weather in 1H-23. However, we are optimistic about the cycle trough coming through in Q2/Q3-23, with inflation largely in the comfort zone of Central Banks, material easing in China’s Covid restrictions in Q2, which could support a recovery.
Until now, consensus earnings downgrades were largely driven by margin compression rather than revenue weakness. In India, ex-financials, Q2FY23 margins have compressed by ~500bps. This means, until now, corporates have more cost issues rather than demand issues. If the recession turns out to be deeper than currently anticipated by markets, revenue revision will also turn negative.
What is our take on India?
As 2023 progresses, key investor debates will focus on falling commodity prices contributing to positive earnings revisions vs weakening demand weighing on revenue. Earnings environment is likely to get worse before getting better from 2H-23. In a hostile global environment, India should continue to benefit from its economic resilience and falling oil prices. Portfolio inflows over the last 6 months have pushed valuations higher relative to the World and Emerging Markets. Depending on how the cyclical upturn progresses, India’s valuation premium will evolve accordingly. Key risks for India remain – Oil Prices, Current Account and INR.
*The author, Vinay Jaising, is MD, Portfolio Management Services, Services)
