Sustainable uptrend unlikely until credit spreads narrow: CRISIL Equities

A study by CRISIL Equities suggests that a sustainable bull trend is unlikely in Indian equity markets, until the currently high spreads of 199 basis points (bps) between yield on corporate AAA bonds and treasury bonds slip back to its historical mean range of 110 bps.

Historical data reveals a strong inverse correlation between the movement in credit spreads and performance of equity markets. Credit spread is a leading indicator of macroeconomic business conditions and often marks turning points in the business cycle. It functions counter-cyclically, narrowing during business expansions and widening during contractions.

Historically, credit spreads narrow when the fundamentals and credit quality of companies show an improvement across the board. CRISIL Equities has observed a strong inverse correlation between the movement in credit spreads and performance of equity markets, with the equity markets showing a time lag of 9-12 months.

To elaborate, during June 2001 to August 2002, when the average spread was above the historical mean at around 156 bps, equity markets remained range bound with a negative bias and the S&P CNX NIFTY delivering around 7 per cent returns. Thereafter, CY2003 to CY2006 was marked by lower average credit spreads of around 63 bps.

Correspondingly CY2003 marked commencement of the bull trend that continued until early CY2008. During this period S&P CNX NIFTY yielded a return of 37.60 per cent CAGR. The spreads then started showing an upward trend from January 2007, with the average spread for CY2007 being 154 bps.

In keeping with the lagged inverse relationship, the stock market peaked in January 2008, before declining sharply. According to the CRISIL Equities analysis, since March 2009 the credit spreads have declined by 24 per cent from 260 bps to 199 bps, indicating an improvement in the risk appetite of the investors. However, the current spreads are still 88 bps higher than their historical average of around 110 bps, reflecting a degree of scepticism of fundamentals.

CRISIL expects the spreads to remain around 200 bps in CY09 before declining to around 110-120 bps in CY10. Commenting on the correlation, Chetan Majithia, Head-CRISIL Equities, said, ''We have observed a similar correlation between the movement in credit spreads and the equity market performance in various international markets such as Dow Jones Industrial Index in the United States, FTSE in the United Kingdom and emerging markets like Hang Seng of Hong Kong. The combination of larger spreads and sceptic investor participation in the market strengthens our view that the current equity market rally may not be sustainable.''