A host of factors conspired to sharply change sentiment in global markets on Friday, with European Central Bank chief Jean “Tricky” Trichet, living up to his sobriquet, hinting he’s very likely to raise interest rates next month. That sent the dollar hurtling down and commodities moving up, but the most spectacular action was reserved for crude oil, which spiked to a record high. Simultaneously, a weak jobs report in the US and a re-surfacing of concerns on banks pounded US stocks. Monday in Asia promises to be bloody.
(SIGNS OF STRESS) There’s little doubt that the price of oil is being influenced by a number of factors, including high demand from Asia, supply problems, the weaker dollar and speculation. But according to testimony by hedge fund manager Michael Masters before the US Senate, “Annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, index speculators’ demand for petroleum futures has increased by 848 million barrels. The increase in demand from index speculators is almost equal to the increase in demand from China!”
Citigroup economist Rohini Malkani predicts that with oil at $135 (about Rs5,760) a barrel, India’s current account deficit will be 3.9% of GDP and it will rise to 4.7% of GDP if oil goes up to $150. She predicts that with oil at $150 a barrel, the rupee will weaken to the 44-45 per dollar levels. The less said about what it will do to inflation and interest rates the better.
So will the market go down to this year’s lows? On the positive side, the credit crisis, while it may not have one away, has eased and the US markets are no longer “priced for Armageddon” as they were after the Bear Stearns collapse in March. The Dow Jones Industrial Average is now 4.8% higher than the low it reached in March. In India, the Nifty closed at 4,627.80 on Friday, 3.5% above its March low of 4,468 and a bit more above the January low of 4,448. But both the growth and inflation outlook have worsened considerably since March and will worsen further if oil prices continue to climb. Interestingly, the Nifty trailing price-earnings multiple was at 19.7 last Friday, just a touch above the low of 19.62 it hit on 17 March. The valuation multiple had already fallen below the March low on 4 June.
IT: a shift in capital allocation
Software stocks are in a sweet spot. Not only has the rupee depreciated considerably, but even factors such as high inflation and interest rates that are weighing down the markets don’t affect most IT stocks. So, while the National Stock Exchange’s Nifty index is close to the lows it hit on 17 March this year, the exchange’s CNX IT index has risen 34% from that date.
(A STEP AHEAD) When the rupee had appreciated sharply last year, the worst hit stocks were small- and mid-cap-IT stocks. These companies operate on relatively lower margins and hence the rupee impacts their profit growth more. By the same logic, these stocks should gain the most from the current depreciation in the rupee. But that hasn’t happened.
Large companies such as Infosys Technologies Ltd and Wipro Ltd have led the rally in IT stocks, with gains of 49% and 43% respectively. Mastek Ltd, a much smaller firm, has gained more (55%), but that’s little to do with the depreciation in the rupee as the company gets a majority of its revenues from Europe. The company’s shares have gained more mainly because of better-than-expected results for the March quarter. Some small companies, such as Subex Ltd, have even lost value since March. Yet, there are some exceptions to the rule—NIIT Technologies Ltd has gained about 43% and Zensar Technologies Ltd 40%, while in the large-cap space, Tata Consultancy Services Ltd has gained just 22%. But, by and large, it’s large-cap shares that have benefited the most from the rally.
According to an analyst, there has been a major shift in capital allocation towards the IT sector, and since large flows are involved, it’s natural that large stocks have gained more. In any case, the markets are likely to wait to see if the rupee holds at current levels and if the benefits of the rupee depreciation are visible in companies’ results.
In this regard, it’s important to note that the rupee depreciation may be seen as an opportunity to release more funds towards selling and marketing and other investments. The gains from rupee depreciation will not entirely end up in the profit. Besides, some analysts believe that the worst is not over in the US market, where software vendors get a majority of their revenues from. Earnings growth, therefore, could continue to be under pressure, although it will still be higher than what analysts had assumed at the beginning of the year. Given this backdrop, valuations of some IT stocks already look stretched. Infosys now trades at 25 times trailing earnings, which tilts the risk-reward ratio against investors.
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