Is there enough fear in markets that warrants investors be greedy?

Nifty has gone down by about 15% from its peak in October 2021. The decline of 15% to 20% in broad indices isfairly common and it has proven to be good levels to buy in normal market conditions, if we look at past history.

But,“in normal market conditions” is the key word here. The current market conditions are far from normal and even though there is fear circulating in the market, it is not yet extreme fear or panic.

The recent decline and ongoing downward pressure in the market have been led by liquidity factors rather than concerns about economic growth. The US Fed started to increase the interest rate in Mar-2022 and also announced a roadmap to reduce its balance sheet size. RBI followed suit soon after and has been more aggressive than US Fed. RBI has contracted its balance sheet by more than 5% while the contraction in US Fed’s balance sheet is still less than 0.5%.

The US Fed is likely to become more aggressive on this front as high inflation is expected to persist. The inflation in the USA was at 9.1% in June, coming ahead of expectations, while inflation in India also remains elevated at higher than 7%.

The mantle of high inflation has shifted from energy to food prices but the biggest elephant in the room remains wage hikes and labor shortages. Wage hikes tend to be sticky and irreversible leading to the wage-price spiral cycle and therefore central banks across the globe are likely to continue using all the arsenal available to them to keep inflation in control and they may like to do it quickly in this year itself. And guess what, in most likelihood, they are expected to overshoot as it is extremely challenging to optimize any policy response.

There is still quite a bit of optimism on the economic front and therefore the market is getting bought at dips. The risk is accelerated drying up of liquidity which will make the market fall more traversing from a fear stage to an extreme fear stage.

In addition, as interest rates move up, consumption takes a hit and corporates fail to pass on the increase in input prices to customers, their earnings will likely face downward pressure. So, equity investors may face the prospect of not only liquidity drying up but also an expectation of earnings decline. This piling up of bad news may trigger overreaction, warranting long-term investors to become greedy.

It's almost impossible to predict the timing when extreme fear takes over markets, but investors can look for signs. The most critical macroeconomic data today to watch out for and predict, if possible, is inflation, especially food inflation, and labor shortages. In spite of central banks’ aggressive actions, high inflation may continue to persist for a few quarters. It’s common knowledge that twin actions of a hike in interest rates and reduction in balance sheet always result in recessions.

The question is whether it will be a soft-landing leading to a short-lived recession or a hard landing leading to a longer time of recession. While central banks are trying to achieve a soft landing, but more often than not, it has proven to be very difficult to control. The complexity is even higher this time around, as the covid pandemic continues to linger along with the risk of continuing global geopolitical/military conflicts. The actions of the US Fed in this context are the most critical to watch out for as their impact on the global economy and market behavior is quite disproportionate.

So, in nutshell, there is still no panic in the market, but the risk is on the higher side. Currently, we are very cautious in the markets and while investors can continue to invest a smaller portion of their investible surplus selectively, it’s better to keep a larger part in cash or highly liquid equivalents. Two mutually exclusive events may happen from here. The risk may materialize, creating extreme fear and an overreaction warranting long-term investors to become greedy, giving them the opportunity to deploy the surplus cash they have been keeping aside.

The other probabilistic event is that the risk may not materialize and eases out. In this case, as well, the risk-reward framework of investing a larger portion of investible surplus in equities later, rather than now, appears to be favorable. This is a psychologically difficult period for equity investors but the gains can be highly rewarding and outsized. Happy Investing.

(Authored by Mohit Ralhan, Global CEO and Managing Partner at TIW Capital Group)