Crude oil is up, the rupee is under pressure, and mid- and small-cap indices are trading at a premium. As the markets signal a structural shift away from easy money, we break down what every investor needs to know, to survive a prolonged consolidation phase.
After a confident march in April, markets have displayed indecisiveness in May, with the war prolonging. What are the worries today? Having seen a sideways market for quite some time since the September 2024 peak, how should you navigate this phase? Here are answers to top questions on your mind:
Why Are The Markets Nervous In May After Rallying In April?
The prolonging US-Iran war has made investors anxious.
March saw the initial nervousness on the war bring down the Nifty by 10 percentage points during the month. But the ceasefire announcement and hopes that the war would end soon, led the rally in April, with the Nifty gaining 7.5 percentage points.
Resolution of the war seems a slow process now and this is dampening sentiments. Crude oil is up 40-50% so far this year and even if the war ends, the ripple effects of oil prices shooting up – on government finances, industries, consumers and investors – will continue for a longer time.
Bond yields globally and in India have moved up stoked by fears of high inflation arising from passing on rise in oil prices, and the need for interest rate hikes to combat inflation and dollar outflows. In India, wholesale price inflation in April has already climbed to over 8%. Four rounds of petrol and diesel price hikes have been implemented in May so far and the impact will show up in consumer price inflation in the coming months.
The rupee has weakened by 6% so far this year against the US $ due to heavy dollar outflows. A weaker rupee in turn has made all imports including the already expensive crude oil imports costlier. Hence, the government’s move to increase import duties on gold, call to WFH to save fuel, use EVs etc.
All these factors ultimately lead to high input costs for industries, jump in retail prices for consumers and demand slowdown which puts the brakes on economic growth.
How Does High Inflation And Interest Rates Globally And Locally Affect Indian Equity Markets?
It triggers a ‘valuation reset’.
Foreign investors have continuously been pulling out money from our stock markets. Where is the money going? – Into other emerging markets and ‘safe haven assets’ like US Treasuries. Yields on US long-term bonds are hovering in the 4-5 % range now and there is less need for foreign investors to invest in ‘risk assets’ like Indian equities, where earnings yield (1/PE) ie (1/20 times) is hovering around the same 5%.
Domestically, companies will face margin pressures and price hikes can lead to demand cooling off. Besides, higher interest costs can pinch profits too. This means that earnings growth will take a hit.
All these factors demand a valuation reset in the markets to lower levels, marked by both price and time corrections. Hence, bouts of volatility and consolidation are expected to continue in Indian equities.
Are Mid And Smallcaps Attractive For Investments Today?
It is better to tread carefully in the smaller cap segments.
Usually, mid and smallcaps are expected to fall/rise more than largecaps. But they have been behaving a bit differently since the US-Iran war began for few reasons :
First, the smallcap indices had already been in correction mode from 2025 and the midcap index too posted only moderate gains compared to the Nifty last year. Hence, the impact of the correction so far on the mid and smallcap indices could have been lighter.
Secondly, continued FPI selling has also had a greater impact on the Nifty 50 index, given their ownership in index stocks.
Thirdly, mid and smallcaps have seen higher earnings growth post Covid and domestic investors have hence been using every dip to continue buying these stocks.
However, caution is warranted on two fronts. At 29- and 33-times trailing earnings, the Midcap 150 and Smallcap 250 indices respectively, continue to trade at a premium to the Nifty (20.7 times). Valuations of these firms can de-rate if their sales and earnings falter under marco-economic challenges discussed above.
Markets Have Been Range-Bound Since September 2024. How Should An Investor Navigate Such Conditions?
Post-Covid investors have become used to quick v-shaped recoveries after a negative event. But the sideways market since September 2024 shows that this need not always be the case. Markets can consolidate in a narrow range for longer than expected and may even move downwards after that.
Flocking to mid- and small-cap stocks at every dip or buying what you already own at a lower price may not be a good strategy. Investors need to take stock of the changed macro-economic conditions and their impact on stocks and sectors. A combination of top-down and bottom-up approaches to stock-picking can work better than a one-sided approach.
Mutual fund investors must not get impatient and stop SIPs or sell at lows. Do a review and replace fund choices, if necessary. But, continue your monthly investments.
Rising Bond Yields Are Making Debt Attractive. How Should Equity Investors Approach Asset Allocation?
If you find that you are under-allocated to debt or are looking to save for short-term goals, you can start looking for opportunities currently.
Yield on 10-year government securities (g-sec) in India hovers around 7% now compared with around 6 % levels a year ago. In the earlier cycle, it peaked at 7.6% in June 2022. Hence, debt as an asset class is beginning to look attractive today.
However, while debt throws up good investment options from time to time, many investors don’t make use of the opportunity due to unfriendly taxation rules or due to the assumption that they can make all their money in equities.
If you are young and don’t have dependents or near-term goals, having an all-equity portfolio is fine. But what works for most investors is proper asset allocation based on risk appetite and time-to-goal.
Floating rate bonds/ funds are an option to ride on expected rise in interest rates. AAA corporate bond yields and SDL (State Development Loan) yields are usually slightly higher than g-sec yields and the spreads have widened now. To invest here, use the mutual fund route (AAA bonds and SDLs) or the RBI Retail Direct platform (SDLs).
Keep in mind this is not a good time to take ‘credit risk’ in debt by loading on to instruments which promise high returns in return for high risk. When there is an economic slowdown and when there is pressure on margins and earnings, the company issuing the bonds may not be able to pay interest on the bonds or repay the principal. Don’t take ‘liquidity risk’ too by investing in a thinly traded bond, which you may not be able to sell when you want to.
If you wish to build a mutual fund portfolio which can navigate the current market challenges well, enroll with Milestones2Wealth now!
Read our previous article: Your Money, Your Rules: A Young Woman’s Guide to Saving & Investing
