Chances of a quick end to the military conflict between Russia and Ukraine seem to have receded after discussions held in Belarus between the warring nations ended in a deadlock.
Western countries have slapped tough economic sanctions against Russia, with the European Union (EU) directly targeting individuals and companies involved in the Russian aggression, as well as banks that finance the Russian military apparatus. The US is punishing Russia by freezing the assets of Russian banks in the US and banning fundraising by Russian state-owned enterprises.
A coordinated freeze of Russian financial assets by G7 countries and an export ban on advanced technology to Moscow will hurt Russia. The Russian ruble has already declined 41 percent, people of the country are confronted with a severe cash crunch, and prices of commodities including crude oil and gas are escalating at a rapid pace. All this is happening at a time the world had been hoping for an early end to the war so that the global economy that's trying to recover from the effects of COVID-19 is spared more pain.
According to a report by JM Financial Institutional Securities, "the flows to emerging markets are significantly dependent on a) direction of expected Fed rate trajectory (~26 percent probability), b) quantitative easing and size of the Fed’s balance sheet (46 percent), c) market risk premium (14 percent) and d) EM-specific factors, including EM-AE (advanced economies) growth differential (14 percent)".
The impact of global liquidity normalization is already visible on Indian equities with foreign portfolio investors taking out funds every month since October 2021 and the pace of outflows only accelerating. Out of the $10 billion of outflows since March 2021, $8.6 billion worth of retrenchment has taken place over the past two-and-a-half months. This may only be a trailer before the whole picture unfolds as the US Federal Reserve embarks on its liquidity normalization journey.
Experts are now predicting foreign portfolio investors’ retrenchment of $7 billion in fiscal year 2023 from the Indian markets, higher than the earlier projection of $4 billion.
"Unlike the US, India’s Mcap/GDP (market capitalization to GDP) has risen to an all-time high of 115 percent from 56 percent in Mar’20 but corporate profit to GDP remains low even after rebounding to 2.6 percent from the all-time low of 1.1 percent in FY20 but is still much lower than 7.5 percent peak in FY08," JM Financial wrote in its report.
This makes Indian equities susceptible to volatility in global liquidity, rising market risk premium and growth slowdown.
There has been a lot of talk doing the rounds that India stands to benefit from the ongoing crises and India’s exports to the EU may get a boost amid the sanctions on Russia and shift towards a "China plus one" strategy.
In its report, JM Financial held out a contrarian view and cautioned that the benefits for India from gaining market share in EU imports may be outweighed by rising energy prices and an economic slowdown in the EU and US.
The sanctions on steel exports from Russia can create some legroom for countries like India. But Indian exports may face competition from Russia in other parts of South-East Asia and Africa.
Indian exports to EU mainly comprise non-petroleum components like specialty chemicals, pharmaceuticals, engineering goods, auto components and textiles.
However, "the stagflationary impact of high inflation and the resultant economic slowdown in both US and EU can impact several of these components, both because of the sanctions and the pre-existing surge in inflation, which at 5.1% in Jan’22 reached the highest in 30 years", JM Financial warned.
JM Financial believes that Indian company earnings estimates are likely to be scaled down by 20 percent as the current "earnings expectation for FY23E-FY24E for the Nifty at 18 percent on average appears considerably high given the macro headwinds of slowing real GDP, which is projected to decelerate to sub-4.5 percent in H2FY23 and our assumption that India’s GDP will at best align to the pre-COVID trajectory of 4-5 percent."
Indian corporate earnings will also be hurt by the moderation of global trade on the back of the economic weakness in China, and a potential steep decline in growth in the US and Europe because of stagflation. The Russia-Ukraine conflict will reinforce the trend.
Most companies are facing the impact of increased raw material prices. This is despite gaining considerable market share from smaller and unorganized businesses in the aftermath of the COVID-19 pandemic and earlier macroeconomic shocks.
Based on these, "we see downscaling of earnings projections emanating from both sales growth deceleration and lower margins. Thus, there is strong possibility of a relapse to the earlier trend of consistent earnings downgrade that we saw during FY09-FY19,"JM Financial cautioned.
"Thus, assuming that India’s real GDP slows to sub- 4.5 percent in H2FY23 and 4.5-5 percent trend subsequently, there is a fairly high chance of at least 20 percent downgrade over the next 12-24 months," the report said.
As seen in past cycles of high crude oil prices, margin pressure and growth deceleration poses a higher earnings vulnerability to sectors like industrials, infrastructure, cement, public sector banks, autos, real estate and telecom.
"We would consider metals to be vulnerable to global factors emanating from the Chinese slowdown, the fallout of stagflation in US and Europe and the spillover impact of the Russia-Ukraine conflict," JM Financial wrote in its report. "Sectors that are less vulnerable are private banks, consumer staples, pharma, utilities, upstream oil & gas and IT".