A near-record Indian equity valuation premium to peer markets as well as to domestic bonds, indicates a kind of decoupling for Indian bonds as well as equity markets, foreign brokerage, CLSA said in a report.
"We do not expect this to be sustainable and regard it as indicative of a very low margin of safety. A simple valuation mean reversion anchored on bond yields indicates fears of 30 per cent downside in the Nifty," CLSA said.
The difference between a 10-year Indian and US GSec yields has fallen to a 13-year low of 3.3ppt.
India is the only market other than the US where equity valuations are extended versus domestic bonds.
At about 2ppt, the difference between India's 10-year GSec yield and the Nifty's earnings yield is at a point at which negative equity returns usually ensue.
The Nifty's absolute PE is at levels where positive equity returns are usually not forthcoming. At the 98-99th percentile, India's relative valuation to EMs and Asia ex-Japan is also near record highs. A simple mean reversion could drive a deep pullback, the report said.
The historical average difference of 1ppt vs earnings yield would take the Nifty's fair earnings yield to 7.7 per cent, implying 13x PE, 30 per cent below the current 12M forward PE of 18.3x.
The 10-year GSec yield in the US has spiked by 150bps in less than two months to about 4 per cent, an almost 14-year high. In comparison, the Indian 10-year GSec yield has risen only 25bps from its recent lows to 7.3 per cent. At about 3.3ppt, this is the thinnest yield differential between US and Indian 10-year GSec yields in 13 years.
"Simply put, this is the highest relative valuation that Indian bonds have commanded versus US bonds in 13 years. Many factors determine relative bond valuations, but for this extended relative valuation of Indian bonds to remain in place, investors would need to at least be sanguine that annual INR depreciation vs USD will be less than 3 per cent. With forex cover of imports falling to nine months and geopolitical and commodity risks not fully behind us, we find it difficult to rule out much higher currency volatility," the CLSA said.