Volatility High Across the Board

The obvious worries about the ongoing rally in equity markets is the heightened volatility across asset classes. However, the bigger concern could be the spike up in volatility in underlying fundamentals. Put another way, markets are only reflecting the increased volatility in economic and fundamental indicators. For the rally to sustain, we believe it is important that the volatility in macro variables subsides, which could happen if the government were to follow up with strong policy action.

The absolute realized volatility of the BSE Sensex is slightly below a 29-year high.Fundamental variables are exhibiting very high volatility. Thus, the volatility in inflation rate and industrial production growth are at multi-year highs. The volatility in economic fundamentals reflects the unprecedented macro environment of the past 12 months. The increased volatility in macro variables has also translated into more realized volatility in the bond markets with the 10-year treasury yields oscillating much more than they have in the past 10 years.

The median 12-month forward volatility BSE-200 is expected to rise slightly from 80% to 87%. [Volatility is the difference between the bull and bear case for the stock divided by its current share price.]

Markets are clearly running ahead of fundamentals and in our view it is unlikely that the budget will meet the expectations across the board as expected by the market.