Breaking the pattern: A downcycle without macro stress?
The degree of stress differed across cycles, but the direction was the same: macro fundamentals were under pressure during every downturn.
What makes the current phase rather distinct is that, despite the severe crack in the stock prices, the broader macro remains relatively resilient. Indicators such as current account balance, forex reserves, fiscal trajectory, and the health of corporate and banking balance sheets are, by and large, in a far better shape compared to past downcycles.
In that sense, this is perhaps the first meaningful market downturn in India unfolding without an accompanying macro slump. This nuance is extremely important to keep in the backdrop while assessing the investment opportunities that the markets are presenting. At the same time, one should not forget that sustained stress in crude and gas prices can lead to deterioration in the macro metrics in its own way via the fiscal, current account and banking channels. At this point in time, the probability for that looks low.
More importantly, when markets undergo a sharp correction without an accompanying macro stress, the nature of the recovery tends to be far more constructive, often resembling a V-shaped or, at worst, a shallow U-shaped, rather than a prolonged grind. This, in turn, makes the current phase a fertile ground for building high-conviction positions.
That said, the approach needs to remain highly selective and bottom-up. Despite the correction, broader market valuations at the index level continue to hover above long-term averages, which limits the scope for indiscriminate buying. The opportunity, therefore, lies not in the market as a whole, but in stock-specific dislocations where the mispricing has been maximum when viewed in comparison with the growth prospects.
Coming back to the current downcycle, understanding the shape of the recovery requires a closer assessment of risks across key macro variables like the current account, forex reserves, banking system stress (NPA cycle), government finances, corporate balance sheets, and the interest rate–inflation dynamic. More importantly, these need to be viewed in contrast with the 2018–19 deleveraging cycle to draw meaningful insights into how the present downturn might evolve.The choice of the 2018–19 cycle as a reference point is a fairly straightforward one. It was arguably one of the most severe and prolonged downturns in the past two decades, both in terms of severity and duration. Triggered by the IL&FS crisis, the macro backdrop deteriorated deviously and, in many ways, magnified the market stress.
In a span of less than a year, the currency depreciated sharply by 15–17% (Rs 63 to Rs 74). The current account deficit, already elevated at 1.8% of GDP, widened further to 2.1% at the peak of stress. Fiscal slippages emerged, with the deficit inching to over 3.5% of GDP. Most importantly, the banking system was under significant strain, with gross NPAs rising to 11–12%, one of the highest in history. This, coupled with highly leveraged corporate balance sheets, created a vicious self-fulfilling feedback loop that weighed heavily on the overall macro environment.
Contrast this with the current phase, and the divergence is quite stark and striking. In one of the most potent shifts, both the banking and corporate sectors have moved from being the epicentre of stress to a position of strength. Gross NPAs are now at multi-decadal lows of 2-2.5%, while corporate balance sheets are significantly deleveraged, with cash surpluses with the corporates exceeding $110 billion, nearly doubling over the past five years.
On the external front, the current account remains well-contained, aided by robust services exports, with the CAD-to-GDP ratio currently around 1%. While rising crude and gas prices could push this towards 1.3-1.4% if geopolitical tensions persist, it will remain well below the stress levels seen in 2018.
From a fiscal standpoint, while headline deficit numbers may appear comparable at first glance, the underlying quality is materially better today. Government capital expenditure has increased meaningfully to over 3.1% of GDP, compared to 1.6% in 2018, indicating a far healthier fiscal stance with a reasonable headroom for fiscal adjustment in case of exigencies.
Taken together, unlike the 2018 cycle, where multiple macro variables deteriorated simultaneously, the current environment reflects far stronger underlying resilience, a distinction that is critical in assessing the potential trajectory and shape of the ensuing recovery.
However, on the currency front, the picture is relatively less comforting compared to other macro variables. While the depreciation has been far more contained than in the 2018 cycle (closer to 10% versus 15-17% then), the rupee does appear somewhat vulnerable in the near term, particularly in the context of elevated crude prices and persistent FII outflows.
That said, the broader macro backdrop today is significantly stronger and better equipped to absorb any such pressures. As a result, any currency-led volatility is unlikely to translate into a prolonged macro dislocation and, in our view, should still allow for a relatively swift recovery in equities, provided the ongoing Middle East tensions do not escalate into a prolonged conflict.
Importantly, the probability of a sustained escalation appears limited at this stage, given the political pressure from both the US mid-term polls and from the surging bond yields in the US.
In this context, the current market dislocation presents a compelling opportunity for selective, high-conviction, bottom-up portfolio construction. That said, navigating this phase would require the ability to withstand sharp bouts of near-term volatility with a disciplined and patient approach.
