Welcome - the new year

This article is rather delayed - I had written it for Wealth Insight Jan edition.

The equity market sentiment has suddenly turned bullish over the past few months. Unrelenting foreign inflows have pushed the nifty to deliver a >25% gain in the current calendar year. Readers of this column will recall that I had laid out a framework in the mid year which had pointed to a set-up for a rally despite the all pervading gloom. It is time now to bring out the crystal ball again.

One of the problems with gazing at a crystal ball is that it soon begins to reflect the thinking of the watcher. Since forecasting depends on the assumptions made, it is important to lay out the assumptions and the consequent possible outcome. Let us therefore start with the bull story – which, as I said, is the pervading sentiment.

The “Bull”

The bullish argument is predicated on two important hypotheses – (a) a lower interest rate (b) lower commodity prices, including that of energy.

The RBI in its last two policy statements has hinted towards being more open to lowering policy rates to boost growth. This, despite the fact that inflation has remained steadfastly high and above RBI’s stated “comfort zone” of less than 7%. Expectations are that with growth slowing to sub 5% in the last quarter (projected) of the current fiscal, policy emphasis will shift from controlling inflation to propping up growth. If interest rates were to fall, asset markets including equity markets will rise.

The second argument is also linked to the first. China has been witnessing slower growth. With China becoming slightly less dependent on exports and more on domestic consumption, it is expected that commodity intensity of its economy will reduce. Additionally, in many cases, production of commodities has increased with increased investments in production capacities across the globe over the past few years. 

Consequently, with the world economy not recovering, a weaker Chinese economy, and fewer production constraints, commodity prices will remain under pressure. This too will play into lower inflation. Lower commodity prices are generally good for the Indian economy which is still a consumer of basic materials, and a large importer of petroleum.

1 yr forward P/E

If both the above were to materialise, we are looking at a consensus earnings growth of 15%-16% , taking the sensex eps to higher than Rs1410 (march 2014). At that level, sensex valuation (@19350) is lower than 14x, much lower than trend level of 16x-18x. Additionally, with lower interest rates, valuations can rise, yielding a sensex target of 22560 or higher – a growth of 16%. The other factor in our model is liquidity – and the postulate here is that with Japan joining the band wagon of countries willing to print money, and Europe having given up its earlier prudery in being “modest” about loose monetary policy, liquidity will not be a constraint. The “bull” seems to be alive and kicking – or is it??

The “Bear”

The bear too seems to have sharpened claws. Let us start with inflation. Despite the best efforts of the officials (the Indian economic data is extremely prone to manipulation), inflation that a consumer sees is still above 9%. Government economists therefore tend to focus on the WPI (whole sale price index). Unfortunately, this too remains stubbornly high – and above 7%. In addition, various government officials have mentioned in passing that in the next year, there will be increases in price of diesel, railway fares (including freight), power, fertilizers and perhaps an increase in service tax and excise rates. All or any of this will be inflationary. There may be a temporary fall in inflation in Jan, but anyone willing to push the figures will see that this is not going to last even for one quarter.

RBI may succumb to the enormous pressure it is being subjected to by the government and industry and cut policy rates. In such a scenario – depending on which inflation number you look at, the real interest rate will be either negative or just marginally positive. The impact on the credibility of monetary policy will be large and negative. This in itself will be inflationary.

A cut in interest rates is not a given, and even if it were to come through, has to be restricted to a marginal cut to get hawks off the back of RBI.

As mentioned above, with rising costs, it is very difficult to believe that corporate margins can improve. Passing on further price increase to customers is going to be really difficult. Consequently, a 16% growth in earnings against a single digit growth expected till March 2013 seems to be extremely optimistic, and will likely result in a lowering of consensus estimates over the next few quarters.

The fiscal deficit has been alarming and given that we enter an election year next fiscal, is likely to remain so, government protestations to the contrary notwithstanding. The current account deficit is also high – hovering around $20 bn for the past couple of months. With oil prices showing signs of increasing again, India has only 14 months of cover for our net imports. The rupee will likely remain under pressure and this pressure will be further exacerbated if interest rates were to be cut.

Portfolio flows may not be as robust towards emerging markets as we have seen this year.        

Country Performance
MSCI Index (20th Dec 2012)	3MTD	YTD	1 Yr	3 Yr	5 Yr	10 Yr
TURKEY	16.1%	57.5%	54.8%	8.1%	-2.7%	18.4%
PHILIPPINES	11.2%	43.6%	45.2%	22.7%	7.1%	19.8%
EGYPT	-8.5%	48.2%	45.1%	-7.2%	-12.1%	24.9%
POLAND	13.2%	33.8%	33.3%	2.1%	-8.9%	10.4%
MEXICO	6.8%	28.8%	30.3%	12.4%	4.1%	17.0%
THAILAND	5.6%	30.6%	29.3%	24.3%	11.5%	19.0%
COLOMBIA	9.3%	28.1%	26.5%	18.4%	16.3%	34.2%
INDIA	0.5%	24.2%	25.4%	-1.3%	-7.2%	16.4%
KOREA	4.7%	20.0%	23.9%	10.7%	0.3%	12.1%
CHINA	12.3%	18.4%	21.0%	0.2%	-5.3%	15.7%
CHINA 50	11.3%	18.3%	20.6%	2.0%	-5.2%
TAIWAN	0.3%	12.0%	19.3%	2.9%	-0.3%	5.2%
SOUTH AFRICA	4.1%	13.3%	17.1%	8.7%	3.4%	14.3%
MALAYSIA	1.8%	9.5%	14.7%	12.4%	4.6%	11.7%
RUSSIA ADR/GDR	2.3%	9.9%	8.8%	0.9%
RUSSIA	2.4%	10.0%	8.7%	1.2%	-11.9%	11.8%
CHINA A 50	7.9%	7.7%	8.0%	-6.8%	-11.6%
INDONESIA	-0.4%	1.3%	3.0%	11.7%	6.1%	24.6%
CZECH REPUBLIC	-5.0%	-4.3%	-3.4%	-7.6%	-12.2%	15.3%
BRAZIL	3.1%	-2.7%	-4.2%	-7.3%	-5.8%	21.0%
BRAZIL ADR	3.5%	-5.9%	-5.6%	-8.9%	-6.9%
MOROCCO	5.5%	-13.0%	-17.1%	-7.2%	-8.5%	10.1%
EM (EMERGING MARKETS)	5.0%	14.9%	16.9%	3.5%	-2.5%	13.3%

 Source : www.msci.com

Sitting in India, we tend to forget that our markets too move in tandem with global markets. A look at the table above reveals that performance of Indian indices not extraordinary. It is in line with other emerging markets. More importantly, the last three months of so called “reforms” have yielded far less (see 3 mtd returns) than is being attributed to it.

Money is chasing emerging markets on the basis that there is “growth”. However, with slower growth, and a possible rebound in larger markets say the US where the low price of energy seems to suggest a resurgence in manufacturing activity (theme for another column) could make asset allocation shift back to developed markets

In summary, persistent inflation, expectations of higher prices of administered goods, an out of control fiscal deficit and a persistent current account deficit put various pressures on the Indian economy. It is reasonable to expect that consensus earnings will fall. A 5% cut in consensus could imply that the market is fully priced for next December. With no expected returns from the current level, markets will have to first fall and then rise to deliver nil returns over the year.

Chose your scenario and watch the assumptions

 Investing is not about being brave or even being optimistic. It is about taking a view on the possible scenarios, and positioning oneself on the basis of what is the most likely outcome. Since the outcome is based on a probability, it is important to be clear on the assumptions being made, and to see if they still hold as time passes. It is very likely that two people given the same set of data will plump for completely different outcomes. There is NO “expert” view here – only one which you are comfortable with. I currently favour the second view – chose your own – and a very happy new year ahead.