Will secular growth trends delimit scope for deeper equity corrections?

The equity market has continued its good run with a surge in the largecap indices in the recent past. But the action in the last two to three fortnights shows that the process of normalization of returns to lower levels has started happening. The corrections seen in midcaps and smallcaps were not very deep but the corrections in some of the individual scrips have been quite substantial. This drives home the truth that the easy liquidity conditions that facilitated the expansion of the price earnings multiple and the market capitalization could re-orient itself as normalization of liquidity starts and as interest rates start edging higher.

Needless to say, the domestic market has the advantage of a positive corporate performance which has been sustained over the last four quarters. This performance is the result of strong fundamental factors which have a basis in stronger economic growth, faster than expected recovery from the pandemic, the reopening of most businesses post the lockdown, the fiscal support especially the special support extended through the RBI, the PLI Scheme etc, apart from the lower corporate tax rate instituted for corporates. The recovery in the US and Europe has helped businesses which have export orientation.

GDP growth is picking up and the fact that it has been rising over the last two years, brings in greater optimism. The GDP growth number for Q1FY22 was reported at 20.1% as compared to contraction of 24.4% in the first quarter of FY21. The GVA number for Q1FY22 came in at 18.8% as compared to -22.4% during the year ago comparable period. The record growth rates have largely been a function of a low base effect. The pandemic induced restrictions were not as severe this time around and more localised in nature, it still led to a slowdown in the growth momentum.

If quarter-on-quarter sequential growth is considered, the effects of the second wave come to the fore. The GVA for Q1FY22 has contracted by 13% as compared to the last quarter (Q4FY21). The slowdown in momentum has led to economic activity, when gauged through GDP numbers, not yet crossing the levels recorded during the pre-pandemic period. The GDP number for Q1FY22 is lower by 9.2% as compared to Q1FY20 and the GVA is still lower by 7.8%. Growth rate which was at 6.10% in Dec 2018 and 4.20 % in Dec 2019, has come up after the major fall to 7.90% in Dec 2021, and much higher for the latest quarter.

This should instil greater confidence in the coming quarters on further improvements in the earnings profile. This is what the market is busy discounting at this juncture. Also, the corporate profits as percentage of GDP dwindled from 6.50% in FY10 to 1.80% in FY20. This was from a peak share of 7.80% in FY 08. The third wave being weaker than expected and the cost of funds remaining easy, provided there is a pick-up in aggregate demand, there is no reason why the corporate profitability should not rise with economic growth. There is a strong positive correlation between the growth rate of the economy and the rate of growth in earnings.

While the broad-based growth may benefit all the major segments of the market and sectors, the movement in market capitalization may indicate a more scientific basis to anchor investor expectations. The market capitalization expansion was positive for large caps in six out of seven periods since 2018, while in the case of midcaps and small caps, for the same time period it was three and two events respectively. Therefore, any saturation in market capitalisation in the latter two segments may shift the further expansion into specific stocks rather than the index. This should be borne in mind while fresh investments are considered for the portfolio. Manage investments either through well managed funds or portfolio management schemes including AIFs should be looked at to optimise the portfolio returns over longer time horizons.

(The author is Joseph Thomas, Head of Research, Emkay Wealth Management. The views are his own).