Mumbai: The factors that dictated the fortunes of Indian equities in 2010 go into the New Year. Despite the positive signals in recent months and subsequent upgrades, growth in advanced economies could still disappoint. While a double-dip recession is a fear of the past, the risk of a euro zone country default is real.
Prices of commodities, especially rising crude oil, that would feed inflation are likely to remain bullish as well thanks to a US decision to buy back bonds worth $600 billion (Rs26.88 trillion) until June. Inflation in India, which some economists are now calling structural, remains a key local risk that could crimp growth and shrink earnings multiples.
Still, expectations of 8% plus growth in the local economy and 20% likely growth in company earnings mean that the outlook for Indian stocks is optimistic.
Also See | How they fared in 2010 (Graphic)
Some argue these expectations have already been priced in, pointing to the stoic reaction of the markets to the better-than-expected September-quarter gross domestic product (GDP). Thus, analysts are divided about the degree of bullishness with their calls ranging from a 5.6% (21,650 for the Sensex) return in 2011 from Credit Suisse AG to 17% (24,000) forecast by BNP Paribas SA.
In 2010, the Bombay Stock Exchange benchmark, Sensex, gained 17% to end at 20,509. In comparison, the MSCI Emerging Markets Index rose 16%.
Earnings revisions have stabilized and “a significant downside risk to consensus earnings estimates no longer exists”, wrote Clive McDonnell of BNP Paribas Securities (Singapore) Pte Ltd in a 22 November report. Still, “highvaluations and a low ROE (return on equity) are factors that limit us from maximum turning bullish on the market in 2011”.
The Sensex now trades at nearly 16 times its forward earnings for fiscal 2012. Indian markets have traditionally traded at an average 20% premium to emerging market peers. However, with recent growth upgrades to advanced economies that would benefit export-oriented East Asian economies such as Taiwan and South Korea more, the fight for foreign fund inflows is going to be a lot more difficult this year, analysts said.
In 2010, foreign institutions invested more than $28 billion in Indian stocks, a record high. However, there has been “a substantial decline since late November in India’s share of total Asia-bound flows—to just 14% of the latest four-week sum, vs. roughly 50% during September–October”, wrote analysts at Macquarie Bank Ltd in a 16 December note to clients.
“The best case for India is a ‘muddle through’ world. Any extreme outcome, either that of risk aversion or surging commodity prices, can hurt Indian growth and, hence, equities,” wrote Ridham Desai of Morgan Stanley India Co. Pvt. Ltd in a 1 December note.
The reasoning is that better-than-expected growth in advanced economies could see funds flow back to Western stocks, and a euro zone shock or some other negative event could see investors flying to the safety of US treasuries or gold.
While the year-to-date returns of the Sensex as well as the MSCI Emerging Market Index have been higher than their western peers, both the FTSE 100 as well as the S&P 500 have generated returns of over 5% in the past two months. In the same period, the Sensex has declined by 1.6% while the MSCI Emerging Market Index rose 1.5%.
The International Monetary Fund has forecast the world economy to grow by 4.2% in its October World Economic Outlook report after an estimated growth of 4.8% in 2010.
A reversal of fund flows or even a slowdown could not only prove a dampener for Indian equities, it could have a detrimental effect on the larger economy as well.
“With a large and deteriorating current account deficit, the reversal of external flows is the biggest risk to Indian markets in our view,” wrote Ashish Gupta, head of India research at Credit Suisse Group AG, in a 23 November report. India’s current account deficit is likely to expand to at least 3% of GDP this year, the largest since 1991.
Another key risk that could dampen growth is inflation. While headline inflation measured by the Wholesale Price Index has fallen to 7.48% in November, concerns still remain with even the finance minister calling it “real” and not due to the “base effect”.
India’s inflation could be structural due to “rising incomes, changing dietary patterns and stagnant (crop) yields”, wrote Rohini Malkani, an economist at Citigroup Inc., in a 29 November note. She also noted that “possible rises in fuel costs on the back of a liquidity-driven global commodity price rally” could fuel inflation.
Thirdly, as analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd noted, a labour shortage across industries is pushing up wage inflation and this “would mean that the pass-through in output prices would push inflation higher”.
This could lead the Reserve Bank of India to hike policy rates in 2011 in an environment where liquidity is already tight, thus creating another fetter to growth.
“The average returns expected in 2011 are typical of how markets behave post a crisis or slowdown,” wrote analysts at Citigroup in a 30 November report. The first year, markets bounce back as “multiples expand to factor in an earnings recovery” (77% in India’s case in 2009). In the second and third years, (markets) “grind higher…with multiples tending to hold and markets tending to follow earnings. Years four and five are usually the years of multiple expansion and stronger market returns”.
India’s long-term potential and growth prospects are undisputed. Citigroup reckons that the Indian economy will overtake those of the US and France by 2015, earlier than expected. The fact that India’s share of world market capitalization is just about equal to its share in world GDP means that money would flow to the economy as it expands.
So what does this mean for investors? To use a market expert’s favourite and oft-repeated cliché: Buy the dips.
Graphic by Yogesh Kumar/Mint