The equity market has topped 20,500 and is close to its all-time high, an enormous increase in value considering that just a few months ago naysayers were predicting a downslide. Three months ago, the Sensex was around 18,500 levels, and experts predicted the worst.
Revenue and profit growth figures of the latest quarter have cheered the equity market. Revenue growth came in double digits while profit increased in line with analyst estimates.
Now the equity market is factoring in a growth rate of approximately 14 per cent in the current fiscal - with consensus estimates for the Sensex at around 1,310 for FY14. With the first half growing at roughly 50 per cent of that, we have to achieve a 20 per cent year-on-year growth rate in the second half of the year in order to attain to that figure. That seems quite incongruous with the prevailing macro outlook.
In other words, the consensus is likely to scale down closer to an earnings of Rs 1,290. This would imply that the Sensex trades at 16 times current-year earnings, not particularly cheap. However, when looking at FY15 estimated figures, valuations drop closer to 14 times (assuming next year will register a 15 per cent growth rate in earnings), which is attractive.
Sure enough, corporate India continues to be faced with challenges in the months ahead. The government has announced a cut in Plan expenditure to meet its fiscal-deficit targets. This means that GDP growth will be lower to that extent. After all, greater government expenditure leads to economic growth. Rural programs will be cut the most. This could mean curtailed spending power in rural India, the one engine that has driven demand in recent months. Coupled with the smaller rise in minimum support prices, it appears that growth in rural incomes over urban India has peaked.
While this may lay the foundation for inflation shrinking, it would also mean that real interest rates are likely to rise. This removes the stimulus provided in the past several years to the Indian corporate sector, that of negative real interest rates for the past five years. The upside to markets is likely to be contained, with foreign flows playing an overwhelming role in determining market levels.
Capex may have bottomed out
A recent note by IIFL Research has pointed out that the capex cycle has touched a nadir. The note points out that, while Gross Fixed Capital Formation (GFCF) is at a decade low, under-implementation projects continue at 2x the level at the start of the decade. Companies are less leveraged now than they were a decade ago. The reason for the slowdown in investments, therefore, appears to be slow government decision-making. The note goes on to argue that the capex cycle is likely to revive soon.
Assume that projects begin to move forward in the next six months, though this is not an easily digestible argument given the context of an election year and consequent likely de-focus on economic concerns. Even then, it appears unlikely that such a recovery would also revive corporate profits. Typically, a capex cycle ends with fresh capacity and diminished pricing power by producers. Profits are highest when production capacity is fully stretched and pricing power is maximised. This usually happens at the trough of a capex cycle, and just before a new cycle is initiated. In 2003, the capex cycle began. It has not yet ended. As further capacities come on-stream, it is unlikely that this will result in further pricing power for producers.
Banks will, of course, benefit from a resumption of stalled projects, since many of these would have turned NPAs or are threatening to become such. It remains to be seen how many delayed projects would be profitable since cost and time overruns would inevitably reduce profitability. Alternatively, end-user prices will trend higher, leading to persistent and debilitating inflation.
Knowing is not the same as preparing
The joker in the pack is the "taper". The "sometime on-sometime off" commentary from the US Federal Reserve has been enough to set the cat among the pigeons and has induced significant volatility in emerging markets. The latest FOMC minutes suggest that the tapering down of US Federal Reserves asset purchases may begin as early as next month, though most commentators think that highly unlikely. Despite uncertainty regarding the timing, it is almost certain that balance-sheet expansion of the U.S. and the European central banks has to stop some time. The market impact then is uncertain, though it appears that it would result in, at least, a short-term fall in emerging markets, including India.
Many commentators, including the Reserve Bank of India Governor, have mentioned that, since this is known, markets are prepared. This argument is disingenuous. Knowing is not the same as being prepared. No visible steps have been taken to insulate India from the volatility that a tapering must inevitably lead to. However, with the timing uncertain, waiting out such a tapering is not feasible at least for institutional investors. One is left with almost no option but to look beyond it and sail over the fall whenever it occurs.
Beaten-down sectors appear inexpensive
Beaten-down sectors offer better value. It is better to assess those companies that would benefit from a revival of the capex cycle. The capital-goods sector would be a case in point. Additionally, this sector benefits from a weaker rupee, as a depreciated rupee renders it more competitive against imports. Other sectors that would benefit from a weak rupee-textiles, IT services, autos, pharma-will continue to do well. Telecoms and utilities will do better as policy concerns are clarified.
Sectors that have held up the markets last year would underperform; banks and FMCG figure at the top of the list. Despite all this, downside volatility is a real possibility given the dependence on foreign inflows. Patient investing and the willingness to "look beyond the valley" is the clarion call now.
ON THE BETTER ROAD
* Markets are trading at lower valuations if earnings for the next financial year are factored in
* Investment cycle may have bottomed out as infrastructure spending may pick up next year
* Relative to the broader market, many companies are trading at premium valuations
* Beaten down sectors such as capital goods could revive faster on economic recovery
* Give enough time for investments in undervalued sectors to rebound and make money.