Investors accepting lower risk premium as economy recovers; growth upgrades needed to sustain valuations

Key domestic stock market indicators are now signaling that investors are willing to accept lower equity risk premium, domestic brokerage and research firm ICICI Direct said. The brokerage firm highlighted that with uncertainty over economic recovery reducing, investors are willing to accept lower returns. Meanwhile, for any upside from current levels listed companies need to continue on the earnings growth trajectory. meeting or beating growth estimates to sustain current levels of valuations. Domestic equity markets have scaled fresh high today with the Nifty 50 breaching 16,500 while BSE Sensex has crossed 55,400.

Investors ready to accept lower equity risk premium

Further, analysts at ICICI Direct highlighted that key indicators such as low earnings yield of Nifty 50, India VIX below 13, and high Nifty 50 index returns in the recent past are hinting at acceptance of lower equity risk premium by investors. “Corollary of lower equity risk premium is that investors are willing to accept lower returns as uncertainty of economic recovery reduces,” they said. The forward earnings yield of the NSE Nifty 50 relative to bond yield has been dipping recently and so has the earnings yield spread of midcap, smallcap and microcaps.

Having exited one of the highest one-year rolling returns period in history, prospects of a sharp upside from equities in the near term have been diminished unless growth surprises meaningfully, they added. Currently on a 5 and 10-year rolling basis, returns of domestic equity markets stand at 12-13% and do not indicate euphoria as earnings growth trajectory continues to be in-line with strong growth expectations especially from cyclicals. This reduces expectations of any significant returns. 

Earnings growth crucial to sustain valuations

Although equity markets are expensive and equity risk premium is low, ICICI Direct said that it does not imply that corporate earnings growth outlook will falter, which typically is the key driver of stock price corrections amongst other factors. “However, it does imply that margin of safety is much lower in case growth falters; hence, we believe that the continuation of earnings growth meeting or beating estimates is crucial for the market to sustain current levels of valuations,” they said. 

Analysts highlighted that so far corporate earnings in the first quarter of the current financial year indicate that the economic impact of the second wave of covid on organised corporate players is marginal. Out of the 35 Nifty 50 constituents that have reported their results so far, only 12 have beaten estimates while 6 have reported results in-line with expectations.