UP election results: The day after
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Yes, Narendra Modi’s impressive Uttar Pradesh election victory has generated a lot of euphoria and will boost investor sentiment. Yes, it’s likely to help the benchmark market indices take out their previous highs. Yes, it’s likely to expand valuations.
That said, as the party winds down and the exuberance wears off, we need to take stock of the market in a more sober light. Let’s try and keep the optimism rational. And if we’re talking of rational expectations in equity markets, we must talk about corporate earnings.
But first consider the macro picture. The investment cycle shows no signs of revival. With capacity utilization still stuck at sub-par levels, it would be astonishing if it did. Many corporate balance sheets are still stretched to their limits. With the banking sector in a mess, getting credit growth off the ground is going to be tough. The central government doesn’t have enough money to fund infrastructure—it is reliant on private-public partnerships that have had a mostly underwhelming track record. State governments will have to contend with demands for pay hikes to their employees as a fallout of the seventh pay commission largesse at the centre, and will find it difficult to spend on infrastructure.
Export growth has revived a bit, but it’s nothing spectacular. Nor can it be, in a global environment where growth is still tepid, albeit improving.
That leaves the economy flying on only one engine—consumption. True, consumption demand is likely to be better, on the back of a good monsoon and the impact of lower interest rates. Do not forget, though, the drought in the south. The introduction of the goods and services tax may also act as a drag on consumption, particularly if the rates are higher but also because of the possible adverse impact on the informal sector. Also, unless the construction sector recovers, which is difficult given the plight of real estate, jobs for the masses and hence consumption growth will continue to be tepid.
As Pranjul Bhandari, chief India economist at HSBC Securities and Capital Markets (India) Pvt. Ltd, said in a recent note, “We expect growth recovery to be U-shaped in FY18, as opposed to V-shaped that markets are expecting.”
That brief, if rather dismal macro tour, sets the stage for the outlook on corporate earnings. Although not as bad as feared, the December quarter corporate financial results did not provide any robust signs of an earnings revival. On the contrary, consensus estimates continue to see downgrades. Here’s what IIFL Institutional Equities said in a research note dated 8 March: “Earnings downgrades have accelerated in the last couple of months despite the perception that 3QFY17 results were better than expected, or not as bad as feared. On aggregate basis for the BSE200 companies, FY18 profit estimate has seen a 3% downgrade from January with all consumer facing sectors seeing a downgrade of 2-10%.” According to IIFL, the consensus pegs the 2017-18 profit growth estimates of BSE 200 companies (excluding metals and public sector banks) at 16%. Though down from 17% in December 2016, the profit growth forecast is almost double growth estimates for the current fiscal year.
True, a lower base may aid next fiscal year’s earnings growth. But many doubt if the strong earnings forecasts will materialize. Bank of America Merrill Lynch warns about downside risks to consensus earnings estimates. Kotak Institutional Equities says it is “not confident” about a strong economic recovery.
The recovery in global commodity prices may help improve profits of energy, metals and commodity companies. But the rise in commodity prices could hit profitability and weigh on earnings in general if the much-anticipated demand growth doesn’t happen. “Companies have benefitted enormously from the fall in commodity prices and are thus enjoying record high margins. With commodity prices increasing in recent months, cost pressures are building. Unless growth picks up adequately, the companies may struggle to pass on the entire cost increase. Thus, margins face headwinds in FY18,” adds IIFL.
And then, of course, there are the rate rises by the US Federal Reserve looming ahead, probably as early as 15 March and perhaps two more to follow this year. Globally, central banks seem to be moving away from their easy money stance.
We finally come to the elephant in the room—valuations. With earnings growth tepid, the recent market rally has been largely on account of an expansion in price-earnings multiples, or valuations. Small wonder that a Kotak Institutional Equities note, brilliantly titled La La Land, pointed out, “We struggle to find meaningful value in our coverage universe with very few stocks offering meaningful upside to our 12-month fair valuations based on FY2019E earnings.” And further, “The broad Indian market looks fully valued at 17.6X March 2018E ‘EPS’.” In other words, earnings growth needs to catch up fast if the market goes up further.
Of course, markets are rarely fully rational and often overshoot deplorably. That is why, while keeping a wary eye on valuations, investors must also not forget the old warning from John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”