There is lot of steam left for the stock market in the coming months. Whether this is just another ‘risk on’ trade or the start to a new bull market is open for debate. Nevertheless, the current situation presents a tactical opportunity for equities, not to be missed. Here’s why…
Reforms and money supply: There’s more to come
Indian equities rallied in September after global easing coincided with the Indian Government getting into action on the policy front. Compelled by the fear of a downgrade of the country rating to junk status, the UPA shrugged off the lethargy and announced a slew of measures from diesel price hike and capping of subsidies to opening up of foreign investment in many sectors.
The Congress‐led UPA has managed the numbers in Parliament and is likely to go ahead with more reforms. This is because downgrade fears may have subsided for now, but they have not been dispelled completely. The ruling Government is also looking for an image makeover. The Winter Session holds the key here. Even in the low probability event of an early election (anyways may just be a few months before the due date), the Government may be seen as martyr of sorts, rather than an under‐achiever.
The timely action from global central banks helped equity markets immensely. On September 13, 2012, the US Federal Reserve announced another quantitative easing programme, the third of its kind. But this time it was different. The Fed’s easing focuses on mortgage‐backed securities and not Government bonds and is an open‐ended programme, both in terms of time duration and amount involved. The ECB and the Bank of Japan also convened similar monetary action. What’s more, the Fed promised to keep interest rates low till 2015. We read this as a sign of abundant liquidity flow, largely favouring equities. To call this a bull market would be premature with trouble still brewing in many parts of the world. Unless Governments take concrete measures, economies could easily head back into a recession. But one thing is clear; money flow will remain upbeat in countries with decisive Government action, till the ‘risk on’ trade lasts. Already, net FII flows into Indian stock market have been $18bn year‐to‐date and $5bn since QE3 in September till date.
Low risk of commodity price bubble
Unlike the previous rounds of quantitative easing, the risk of a speculative bubble in commodities is low due to excess global capacity and a slowing Chinese economy. Softening commodity prices augur well for emerging market economies like India and will boost margins of many corporates.
Improvement in current account deficit likely
The INR depreciated 18.4% from 46.7 to a low of 57 v/s the USD and is currently trading at ~53.5 levels. The worst may be over for the Rupee. The current account deficit can be expected to correct to 3.5% of GDP from 4.2% currently on account of lower crude oil price, drop in gold imports and higher exports growth trajectory. The Rupee carry trade favours portfolio flows into India. A stronger INR will also help taming inflation.
Rate cut on the anvil
The consensus is that the interest rate cycle has peaked and rates can only fall from current levels. Already, rates on deposits, home and auto loans are on a downward trajectory. Although system liquidity has eased considerably, our banking analyst expects another CRR cut in the next policy meet on account of festive season. Drop in food inflation as revealed in the recent release is a big positive. We expect the central bank to cut repo rates in the first month of the new calendar year. This is the beginning of the downtrend in interest rates.
ROE at trough; P/E expansion on the cards
India has historically enjoyed a significant valuation premium over other emerging markets due to its low cost of capital and high return on equity (ROE) differential. But the ROE premium significantly narrowed from an average of 5 percentage points during 2004‐2008 to a low of ~2 percentage points. FY11 onwards saw a big fall in the ROE differential. Although premature to predict a ROE reversal to 2004‐08 levels, it appears that a trough may have been hit. With interest rates set to fall, relief on the margin front for corporates and cyclical improvement in certain sectors, the situation appears improved. Even though GDP growth has been downgraded, the analyst community will wait for clarity to emerge before making significant changes to Nifty and Sensex earnings estimates. With improvement in business sentiment and money flow into equities, there is a case for expansion of the market trading multiple, currently at 13.5‐14x FY14E earnings, to 15‐odd times. This would translate into a Nifty and Sensex target of 6,300 and 20,000 respectively.
Bottom up approach key; a time for midcaps
While the medium term outlook for equities looks upbeat, many frontline sectors and stocks are facing headwinds. Metals, Capital Goods, Automobiles, Utilities, Telecom, Real Estate and PSU banks are sectors grappling with uncertainty. Among the large index names, the likes of Reliance, L&T, BHEL and Infosys are rated market performers at best. In our view, a bottom‐up approach, tactically targeting good quality midcap names is the way to go to boost portfolio returns in the medium term. While the target for leading indices mentioned above suggest a 10% upside possibility, many midcap names can deliver relatively higher returns. In stock selection, business and earnings visibility, good governance and cashflows need to be kept in mind.
Risks to our call
- Adverse developments in the global economy
- Political backlash in India, parliamentary clearance not received
- Welfare measures in upcoming Union budget worsens fiscal deficit situation