Is the Sensex up against a wall of worry? That is the question doing the rounds of the market. It is hardly surprising because the Sensex journey has been rapid, especially, if you look at the last 15% appreciation in the index.
Sensex virtually did nothing in the first four months, despite the volatility. However, since mid-May this year, the Sensex has been on a one-way journey upwards. From a level of 48,254 in mid-May, Sensex rallied to 55,583 in just 3 months. That is a 15.2% return on the Sensex in just 3 months.
One concern has been that the impact of COVID 2.0 may have been underplayed or ignored. However, the bigger question have been on the macro front. IIP and core sector numbers are still short of 2019 levels, indicating two lost years in the India growth story. If you look at the Jun-21 quarterly results, sequential growth in sales and profits have been negative; reflecting COVID 2.0 pressure.
What then explains the relentless up-move of the Sensex. It is tough to call the levels of the Sensex, but there are 4 factors that actually give comfort even at these levels of the Sensex.
1. Interest rates are at all-time lows
If you look at the RBI repo rates at 4%, it is the lowest sustained rate that India has maintained in its entire history. But it is not just the repo reference rate that is the issue. Rates for all kinds of loans ranging from home loans to auto loans to personal loans are at their lowest levels. In the latest monetary policy statement, the RBI underlined that 87% of the rate cuts since January 2019 had been passed on to end borrowers in the form of lower weighted average lending rates. Due to this high transmission, the weighted average lending rates are also at their lowest levels.
Why are low interest rates so critical? On the one hand, they make borrowings cheaper, but that is just part of the bigger story. The bigger reason is the way they impact valuations positively. There are two ways this happens. Firstly, when interest rates fall, the future cash flows are discounted at lower rates of WACC (weighted average cost of capital). Even assuming normal growth in earnings, this sharp fall in rates makes equity valuations attractive. Secondly, fall in interest rates has subdued bond yields and hence, the earnings yields have fallen. The higher P/E ratio is more an outcome of lower earnings yield. In short, despite the P/E at an all-time high of 31.9X, there is no wall of worry.
2. Five-Year average oil prices are lowest in memory
In the last five years, oil prices have been alternatively influenced by supply and demand. The net result is that in the last five years, the average prices of crude oil have been the lowest in last 25 years. India still imports ~80-85% of its daily oil needs, so this is material. Since mid-2014, there has been a massive wealth transfer running into trillions of dollars from oil producers to oil importers. India, along with Japan, EU and China; has been among the key beneficiaries.
3. Liquidity has been robust, and will remain so
Over the last few months, there have been concerns that the US Fed tightening monetary policy may have an adverse impact on liquidity. That is unlikely to happen immediately, and even when it happens, it is likely to be calibrated. The US Fed has been talking about a 2% hike in interest rates by end of 2023. However, Jerome Powell of the Fed has assured that these decisions would be subject to growth and labour conditions normalizing.
There are two things to note here. Firstly, RBI may try to avoid monetary divergence but its decisions will be purely driven by internal factors. Secondly, today liquidity is not just about FPIs but there is substantial liquidity support from domestic mutual funds and even retail investors. In short, liquidity is likely to remain robust.
4. Above all, Indian companies are deleveraging
This is a trend not yet fully appreciated. When we talk of deleveraging, the prominent names that come to mind are frontline stocks like Reliance Industries, Tata Steel, Tata Motors and DLF. However, this trend has been rampant. Consider these numbers! In FY21, the BSE-500 companies pre-paid debt to the tune of Rs160,000cr, a record compared to any other year in history. Secondly, average debt-equity ratio of BSE-500 companies has fallen from 0.73X in FY20 to 0.51X in FY21. In the midst of falling rates and rising uncertainty, Indian corporates have gone aggressive in winding down debt.
One can argue that commodity costs are up, but companies have cut on discretionary spending in last 2 years. Sensex may be higher, but it appears to be more of a catch-up with the market reality than a wall of worry. That is the good news!