The market flight is 20,000 feet high in the air and investors seem to be in a dilemma whether it will go even higher or are there chances of an emergency landing caused by bad weather conditions. On the onset of year 2012, markets were struggling to hold up but contrary to the general perception, markets zoomed up. We have begun 2013 on a very positive note and now it remains to be seen if markets have a negative surprise in store for investors this time around. Well, it is anybody's guess at the moment. Let's take a pilots view on the market flight and look at different scenarios that may possibly play out in 2013.
A Flash Back...
Defying all negatives on the domestic front such as weaker rupee, persistently high retail inflation, anemic growth and deteriorating state of fiscal management, polluted political canvas; markets ascended in 2012 - and especially after the reforms were put at the forefront there was sharper impulse seen. There have been two main factors which have funneled the rally. One is global and the other is domestic. Monetary easing in Eurozone and in United States has induced rallies in risk assets asset including emerging market equities and India has been no exception to it. Moreover, markets have given thumbs up to the reforms initiated by Indian government since September 2012. In the winter session of the parliament, some important bills such as Banking Laws (amendment) Bill, enforcement of security interest and recovery debt laws, Prevention of Money Laundering (Amendment) Bill, Companies Bill and Quota in promotions were passed. The debate continued on allowing Foreign Direct Investment (FDI) in multi brand retail but by tailoring the responses to the surroundings, UPA II was successful in winning the vote for FDI in the end. General Anti Avoidance Agreement (GAAR) has been deferred by 3 years. Energy pricing has been rationalised and petrol and diesel pricing were hiked in order to reduce the subsidy burden. The Government has proposed to hike diesel prices further by 40 - 50 paise every month and given some leeway to oil companies to set prices and even raised the limit of subsidized LPG cylinders from 6 to 9. In order to meet the fiscal deficit target (of 5.3%) the Government has expressed optimism on meeting its disinvestment targets. All these actions are aimed at turbocharging the economic activities and attracting foreign capital to India and have thus far sent out positive signals to global investors and markets have rallied.
But would party continue on D Street?
Market valuations, corporate earnings, economic outlook, global economic conditions and the money flow are the main drivers of the market. Till economies in the developed world depend on monetary stimulus to revive growth, there will be slosh of liquidity in the global financial system which will be redirected to risk assets. When there is a supply of cheap money and all other factors are favourable, markets rally ferociously. We expect liquidity to remain favourable for market movement in 2013. However, to be able to make any judgment on the future market course; we need to analyse the each of the aforesaid factors in detail.
- Market Valuations:
Market valuation as measured by Price to Earnings Ratio (P/E Ratio) gives a rough idea as to how pricy the markets are. Lower the ratio cheaper is the market and vice versa. About a year ago (i.e. in January 2012) the markets were attractively valued and cheap money coming in from developed economies took advantage of discount in valuations compared to their historical averages.
Is Market Really Expensive?
Note: P/E ratio is calculated based on trailed earnings. Future earnings are not considered.
Now have a look at the chart displayed above. The first thing you would notice is that the market sentiment has been low post crisis. Prior to 2008, markets were betting on high growth. When markets peaked in January 2008, the P/E ratio of S&P CNX Nifty, calculated with trailed earnings, was above 25 which dropped below 10 when markets hit the rock bottom in March 2009. In pre-crisis bull market phase, markets often traded at premium valuations (high P/E multiple) despite of which S&P CNX Nifty kept rising which indicates that economy was vibrant and growing rapidly so did the corporate earnings. At present, the missing factor is confidence about the future growth. With P/E multiple of nearly 20, markets appear fairly valued now. From about 9.6% in 2006-07; growth of GDP has dropped to sub 6% levels this fiscal.
- Corporate Earnings
Corporate earnings have slackened, and that in a way reflects on the GDP growth rate clocked by India. Sectors such as Consumer Non-Durables and Pharmaceuticals have bucked the trend of slow growth so far. But these sectors are increasingly looking tired now. Some export oriented sectors are badly affected with muted growth in developed market economies. High crude oil prices and depreciating rupee are dampeners on industries which depend on imported raw materials. Even after considering the spate of reforms introduced by the Government in last few months; business environment is still not conducive for faster growth. The capex cycle appears limped (due to a yet high interest rate regime) and it is unlikely to show any significant recovery unless business outlook improves further and interest rates start to reduce. Earnings will only pick when macro- economic environment gets better.
- Macro-Economic Indicators
Inflation is a much discussed macro-economic variable that has been hindering growth. In order to curb inflationary pressure, RBI has so adopted its anti-inflationary stance, which has kept interest rates still linger high. In the year 2012, we have witnessed only a 50bps (0.50%) ease in repo rates. Higher cost of borrowing has been delaying the pick-up in the capex cycle of India Inc. However, in the recent times RBI has indicated that its focus may now shift towards aiding growth provided inflation cools down further and settles lower. The inflation measured by movement of Wholesale Price Index (WPI) has mellowed out in 2012. But there is a catch, have a look at it.
Inside Story of Inflation
In the graph above, it is clearly visible that inflation in manufacturing (which accounts for almost 2/3rds of the movement of WPI) has been flagging high. It is one constituent of WPI where the monetary policy can be the most effective tool to curb inflationary pressures. However, fuel and power inflation, and more importantly inflation in primary articles has been chronic and monetary policy can help little in an effort of easing inflation in these fields.
Rising dollar and stubbornly high crude oil prices is the double whammy for Indian economy. The weakness in Indian rupee is getting increasingly difficult to deal with. Despite inflows to the tune of USD 24 billion in 2012, Indian Rupee continued to slide against US dollar. India's current account deficit has come in at 5.4% in the 2nd quarter of the current fiscal. Besides, RBI has incessantly sold dollars to smoothen the movement of rupee. Rising trade imbalance is difficult to do away with. Shrinking growth in European economies and edgy recovery in US has made it difficult to maintain pace in export growth. On the other hand, import bill is constantly rising due to depreciating rupee. The government is expected to overshoot its fiscal deficit target of 5.3% set for FY 2012-13. This, when coupled with higher inflation in primary articles and fuel prices, limits the scope for monetary easing. Also, factory output measured by the Index of Industrial Production (IIP) is repeatedly failing to maintain consistency in growth and needs a boost in the form of accommodative monetary policy. We expect 75bps-100bps cut in policy rates in 2013. Rapid growth in bank credit is often considered as an indicator of high growth expectation and robust business sentiment. Growth in bank credit in the year 2012 is expected to be one of the weakest in last 3 years. Asset quality concerns still linger. In 2013, we expect a slight uptick in bank credit. As per the World Bank estimates, India's GDP would grow at 6.4% in FY 2013-14 as against the growth of 5.7% expected to be achieved in the current fiscal.
How investors should approach equities?
After the recent rally, markets now factor in most of the positives including probable rate cuts, expected rise in GDP, possibility of revival in industrial growth and positive impact of reform measures initiated recently by the government. Now it remains to be seen whether corporate earnings catch up.
Would Large Caps Outperform Midcaps?
The chart above reveals that midcaps have become pricy and discount in valuation of midcaps over large caps has gone down significantly. In the past, whenever the valuation differential has reduced or midcap valuation has become dearer to that of large caps; in the subsequent time periods, midcaps have underperformed large caps. Considering this we expect large caps to outperform midcaps in 2013. Having said this, large caps too are unlikely to stage any significant rally from current levels. Markets may continue to remain volatile and range bound.
Those who already have exposure in equity should take advantage of the current market rally to bring their equity exposure (in overall asset allocation) back to predetermined levels by booking profits. On the other hand, those who intend to take fresh exposure in equities should stagger their investments across time periods.
To summarise
After rallying in excess of 20% in 2012; Indian markets are expected to take a breather and year 2013 is unlikely to be as good a year as 2012. Money supply in the global financial system is expected to remain firm. Indian macro-economic data too may remain supportive. But now the market valuation is not as cheap as it was at the beginning of 2012. Furthermore, reforms introduced by the government are already in the prices as a consequence markets will rise only if corporate earnings catch up and rise above the expected level. Any unexpected positive news flow in the form of a policy action may trigger rallies.
On the global front, nothing much may change on ground since it appears that developed world economies would continue to rumble under pressure and growth may become increasingly difficult to achieve. Indian market would take cues from their global peers and any weakness in global markets would have amplified effects on Indian markets as valuation is not cheap and expectations are high. Investors should not try to play the momentum as odds against the bulls have increased. We are 20,000 feet above the ground level and therefore must care to look for a parachute in case we need it.
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