Wasn’t it just a few weeks ago when markets were concerned about disrupted supply chains, surge in commodity prices (subsequent to the conflict in Ukraine) and with how central banks would respond to the inflation challenge? How swiftly this narrative has changed!

Now, the attention has shifted to the risk of a recession in the US and in Europe, with their central banks targeting aggressive rate hikes to fight inflation.

The US Federal Reserve raised rates by 75 bps in June this year. The markets expect the Fed funds rate to increase by approximately another 175 bps over the next four policy meetings, to end the year above 3%. According to the so-called dot-plot forecast released by the US Fed, the midpoint of the target range for the Fed funds rate would go to 3.4% to be exact.

At the start of this year, in January, this rate was at 0.25%. Equity markets and bond markets have since been under pressure on account of the forward guidance from the US Fed and ECB (European Central Bank) of the rate hikes to come. However, commodities were insulated from this sell-off, aided by the disruptions caused by the Russia-Ukraine conflict. But that no longer is the case, as concerns shift to the likelihood of a recession in the western economies; and commodities have sold off.

The Bloomberg Commodity Index is still up 18.03% for the year as of June 30, 2022. But, this number camouflages the damage in the second half of June. The index at its peak in early June was up over 37% YTD. It has given back half of its gains as the narrative shifted to worries about a global slowdown.

The gains in the Commodity Complex are now primarily driven by the Energy Complex. The Bloomberg Commodity Energy Index is up 57.75% TYD. Metals such as aluminium and copper are down by 10% YTD; which is reflected in the 9.93% decline for the Bloomberg Commodity Industrial Metal Index. Agriculture crops such as wheat and corn are now up merely in the low teens YTD, which is reflected in the 12.66% YTD gain (versus peak +31% YTD) for the Bloomberg Commodity Agriculture Index.

With concerns about growth coming to dominate the markets, this has transmitted to the long end of the yield curve. Rising conviction that the US Fed will deliver sharp hikes in the short-term policy rate is also moderating future growth expectations. The change in narrative has led to a sharp rally in the US long bonds. Yields, which were at 3.4% for the US 10-year bond at the start of June, have slumped to below 3% in recent days due to the recession narrative.

And, there is a good reason behind this decline: it is the past track record of the US Federal Reserve. Out of US Fed’s 10 tightening cycles since 1960, seven of the episodes ended in a recession — a striking and less than impressive track record! Only thrice did the US Fed manage a soft landing. Although, nothing is predetermined, the markets are clearly pricing in this element of risk.

In India, the Reserve Bank of India's Monetary Policy Committee voted to hike the repo rate by 50 bps to 4.90%. The MPC maintained its “withdrawal of accommodation” stance while dropping the phrase “staying accommodative”, signalling a shift towards “neutrality”. The market is now discounting a terminal repo rate between 6 to 6.5% in the next 12 to 15 months. Similar to global markets, there has been a rally in the long-term bond yields in India as well. However, the magnitude is limited, given that our growth expectations are unlikely to pivot dramatically.

The Nifty 50 Index participated in a widespread sell-off in global equities, losing nearly 5% in June this year. This brings its losses from the peak in October 2021 to nearly 15%. Another way to crunch this is that the Nifty 50 Index is now unchanged over the period of a year. To be precise, the Nifty 50 Index has gained only 60 points from June 2021 to June 2022. During this period, the Nifty 50 trailing 12-month Earnings Per Share (EPS) (Source: Bloomberg) has climbed from Rs 620 to Rs 770; an increase of 24%.

In the process, the unchanged value of the Nifty 50 Index means that the market has derated in terms of P/E multiple. The Nifty 50 trailing P/E multiple is now below the long- term average and on a 12-month forward basis that is just above the long-term average.

As regards large cap stocks, we can now feel more positively disposed with valuations pulling back into the comfort zone. Of course, there are concerns about growth, rates and earnings, but these are now arguably reflected in the valuations. Mid cap stocks, albeit not as favourable as large cap stocks, have also pulled back into the comfort zone. The small cap segment of the market has witnessed a sharper sell-off this year. The Nifty Smallcap 100 Index is down 25.2% in the first half versus a 9.07% drop for the Nifty 50 Index. But, reflecting earlier valuation excesses, small caps are not in the comfort zone relative to large cap stocks.

In the latter part of 2021, when the Nifty 50 was trading in the expensive zone, it was not that every sector or industry was trading expensive. The same can be said of now, but in reverse. Not all segments of the market are in the comfort zone, even as the Nifty 50 valuation has moved into the comfort zone. Relative to bonds; comparing the earnings yield of equities to the yield on the 10-year Gilt, equities are not yet in the attractive zone.

Aggregate valuations serve as a reference point for asset allocation and combining the indicators we note that the pendulum has moved, albeit slightly towards equities.