A note on the Indian equity markets

The Indian equity markets have rallied inline with most global markets from the lows of March 2009. The key indices like the Nifty and Sensex have gained by 79 per cent and 95 per cent respectively from their lows. The various factors that drove the rally are:



A surge in global risk appetite driven by liquidity on account of expansive fiscal and monetary policy adopted by all major central bank and governments alike across the globe.

So far, India has attracted USD 7.6bn of FII inflows in 2009 as compared to an outflow of USD 6.6bn for the same period in 2008.

Semblance of return of economic activity in the Indian economy, by way of increased sales of automobiles, steel and cement, which are traditionally regarded as lead indicators for the economy.

An unexpected electoral mandate in favor of the incumbent government sans the Left parties, which has fanned renewed hopes of reforms in the economy including insurance, banking, retail and disinvestments.

The renewed expectations and liquidity surge has led to the market getting ahead of fundamentals. Currently, the market is trading at valuations of 18xFY10 EPS, which is at a premium to the long term average and other emerging markets in Asia.

Further, the correlation amongst global markets has increased in the recent past which leads to the fact that global macro factors will have significant influence on the way the Indian markets will perform, in the months ahead. Although there have been spurts of good news in the global economy, we believe we have a long way to go for sustained recovery. This will impact equity markets in the near term.

The Union Budget was on expected lines, with a stress on infrastructure. Rural spending also shared the limelight with the Government doling out huge relief packages to the rural masses. However, the Budget failed to enthuse the market as it lacked in major reformist statements, like disinvestments and FDI.

The market will look for cues from the Government on these reform issues, which will be a key for market re-rating, in the near future.

The below-average monsoon could also dampen the recovery process in the economy, as it severely affects the rural demand which has been the mainstay for the economy over the last few months.

The cumulative deficit as of July 24 is 19 per cent, with certain key states in the north reporting deficits of 45 to 50 per cent. This would put substantial pressure on food grain production and rural incomes, thereby curtailing any positives one can see on the macro front.

Earnings growth for the Q1FY10 quarter has been better than expected. If we observe the performance of the Sensex companies, most of them have shown more than 15 per cent growth in revenues on YOY basis, but the net income for the Sensex on aggregate basis is down 5 per cent, but still above street expectations.

Sectors like cement, automobiles, technology and financials have performed better than energy, commodities and real estate.

The marginally better-than-expected results and some encouraging macro numbers in the recent past, has led to a series of earnings upgrades by a number of brokers. However, we feel that the upgrades are not substantial for a near term market rally as despite the upgrades, the market valuations appear to be rich.

As per consensus, the Sensex EPS estimates for FY10 and FY11 are in the range of Rs. 875 and Rs. 1025, respectively. This leads to a valuation of PE of 18FY10 and 15xFY11.

Inflation
With the government fiscal expansion being funded by massive borrowings to the tune of Rs. 4trn (USD80bn), the fiscal deficit is projected to reach around 6-7 per cent for FY10.

This, coupled with a relatively benign interest rate environment, could lead to a surge of liquidity. Interestingly, unlike in the rest of the world, the domestic liquidity has not found its way to the consumers or asset markets as banks have been reluctant lenders.

Albeit, with increasing global commodity prices and a likely poor food production due to weak monsoon, inflation could be a factor in the next 3-6 months. In fact, the RBI recently increased its inflation expectations for the year to about 4 per cent. This is definitely not a good development for the equity markets as interest rates could inch up.

Supply
With the markets having rallied, a number of companies are expected to raise fresh equity from the market in FY09-10.

Apart from the new issues, a few PSU’s could also be disinvested. It is estimated that approx USD 12.9bn of fresh paper is expected to hit the market and this does not account for government disinvestment.

Equity issuance could be through QIP’s, private placements or public issues. We suspect that increased supply of paper will also have a negative effect on the markets.

Short-term outlook
Based on the following observations, we believe that the market for the near term looks fairly valued, with a number of stumbling blocks like reform progress, monsoon, inflation and new issuances.

These factors would cap the near term upside, but improving economic conditions and an expectation of GDP growth reviving to about 7-8 per cent over the next two years, will also restrict the downside and any correction could see fresh buying interests.

We believe that the markets are likely to remain range bound, barring any positive or negative macro surprises, which could lead to adverse effects on liquidity conditions, and pose to be the biggest risk to our premise.

Long-term outlook
With the economy already showing some early signs of recovery and the Government continuing on its spending program, we strongly believe that India will rebound to its recent growth trajectory of 7-8 per cent GDP growth by FY11-12.

This would lead to improved corporate performance. Considering that India is among the fastest growing economies in the world, it will attract capital flows. We hold a reasonably bullish view for the long term prospects for the Indian equity market and would advice investors to buy well-run, good quality companies with a 3 to 5year view, to benefit from another Indian bull market.