Can growth trump the spike in bond yields and inflation?

Stock markets have an uncanny ability to surprise – both on the upside and downside. Also, markets overreact, that too in both directions. The market crash of 32 per cent in March 2020 and the subsequent incredible recovery of around 100 per cent from the March lows reflect ‘Mr Market’s’ famed mood swings.

Investors have to react cautiously between these mood swings to minimise the loss from crashes and to optimise the returns from rallies. This needs clarity on two factors: How the markets are positioned in a given context and how it is likely to trend, going forward?

Let’s try to get the issue in perspective.

It is important to appreciate the fact that the current bull run in equity is global. The primary drivers of the rally are the abundant liquidity available in the global financial system, historically low interest rates and the new trend of hyper investment activity by retail investors – the so-called ‘Robinhood phenomenon’. A runaway market without adequate valuation support needs only a trigger for correction and recently that came from the bond market.

It is important to understand that the US 10-year bond yield is the single most important financial indicator that can move all markets – bond, equity and currency. And, when inflation fears emerged, the bond bears pressed the ‘sale’ button pushing up yields. On February 25, the 10-year yield spiked to 1.61 per cent in the US, leading to a selloff in US equities. In emerging markets, FIIs sold heavily spreading panic and the bears charged in to exploit the opportunity. Nifty crashed 568 points on February 26.

But the power of liquidity is so strong that when the yields cooled off a bit, the equity markets bounced back.

Is this rally similar to the 2003-07 bull market?

A much-debated issue now is whether the current bull run is a repeat of the 2003-07 bull run, which took the Sensex from 3,000 in May 2003 to above 20,000 by December 2007. There are some similarities and some stark differences. The 2003-07 bull market, too, was characterized by huge FII inflows, which continued in spite of a steady rise in US bond yield from 3.4 per cent in May 2003 to 4.3 per cent by the end of 2007.

But the stark differences cannot be ignored. When the 2003-07 bull run started, valuations were very low with Nifty PE quoting at around 12. So, there was room for PE expansion to take the market higher. More importantly, the 2003-07 period witnessed record GDP growth of around 8.4 per cent annually and corporate earnings grew by an impressive 30 per cent CAGR. This impressive earnings growth provided the fundamental support to the market. This was in sharp contrast to the current situation where the trailing Nifty PE is excessive at around 40 and FY22 Nifty forward PE is very high at around 22.

For this rally to sustain, GDP and earnings growth should sustain for a few years. There is no clarity on this. FY22 growth – GDP growth at 12 per cent and earnings growth at above 30 percent – will be impressive, thanks mainly to the base effect. But beyond that? The capex expansion cycle can sustain the growth rate. The bold Budget 2021 that focussed on privatisation can turn out to be a trigger. The jury is still out on this.

The inflation threat

The major known threat to this bull market is inflation. Bond bears believe a combination of ultra-loose monetary policy and the $1.9 trillion US fiscal stimulus will trigger inflation and a sustained rise in bond yields, leading to a market crash. The market has a clear logic: bond yields and stock prices are negatively correlated.

That’s why Warren Buffet famously said that “interest rates act like gravity on stock prices.” So when interest rates reverse direction, equities have to decline, because higher interest rates can support only lower PEs.

Rising bond yields indicating growth recovery?

But there is another interpretation of the rising yields. US Fed Chairman Jerome Powel was quick to explain that rising yield is an indication of growth recovery. The bond market is discounting an imminent rebound in growth. The Fed chief went on to emphasize that the Fed rate will be kept near zero through 2023 and that the Fed will tolerate higher inflation, if need be.

In brief, if inflation continues to remain subdued and growth makes a smart recovery, markets can remain buoyant, globally. In this favourable global construct, if growth and earnings accelerate in India, this rally will sustain. On the other hand, if inflation suddenly spikes pushing the US 10-year bond yield higher, say beyond 1.8 per cent, there can be a selloff in equity markets. Let’s keep our fingers crossed.