The Sensex has declined by 6% year-to-date (YTD) in 2011. Net foreign institutional investor (FII) flows were a negative Rs 2,930 crore in the first quarter of 2011. However, the sell-off in emerging markets witnessed a reversal around the end of March, leading to strong inflows into most of Asia, including India. With $1.5 billion of inflows in March as well as in April, the YTD figure on FII flows into India has turned positive at around Rs 4,098.74 crore. As a result, the Sensex has rallied by 10% from its February low of 17,296.
Domestic institutional investors (mutual funds and insurance companies) have been net buyers of over $2 billion YTD as per exchange statistics.
We expect Indian equities to trade in the range of 17,500-20,000 until crude oil prices cool off and drop below $100 per barrel. Earnings revisions are expected to be marginally negative, leading to heightened volatility during the April-May results season. Consensus earnings estimates stand at 18% year-on-year (y-o-y) for FY11. However, we conservatively estimate 15% y-o-y growth, factoring in the likely 2-3% downgrade in earnings over the next few months. Our one-year target for Sensex, at 22,000, represents 15% upside in line with earnings growth.
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While valuations remain reasonable, what would drive the direction for equity market returns in the second quarter are the March quarter results, brent crude prices and global liquidity and emerging market flows.
Expectations for earnings growth are somewhat muted and the earnings upgrade cycle has reversed. High commodity prices and resultant margin pressure have been largely factored into estimates. However, the risk of crude prices remaining elevated for a longer period of time and its impact on global growth is not yet factored into consensus numbers. The negative revision of earnings is likely to be led by a slowdown in global recovery, which would impact earnings expectations of companies and sectors that are driven by global factors.
The markets could see a rally in May if the low probability event of “no earnings downgrades” plays out.
A potential source of uncertainty for the financial markets is the end of the second phase of quantitative easing. Considerable uncertainty exists regarding the impact of further quantitative easing, if any, on asset prices globally. Indications from the Federal Reserve in terms of their monetary stance will have significant relevance for equity market momentum over the next 2-3 months. The environment for global equities and commodities is therefore expected to remain challenging and volatile, given the multiple headwinds such as political uncertainty in the MENA (Middle East North Africa) region, still high oil prices, peaking of lead indicators, topping of growth momentum in developed economies, and the expected turn of the interest rate cycle.
Indian equity markets saw a sharp 12% correction in January, a range consolidation in February and early March, followed by a 10% March end rally. The trend in FII flows during first quarter of 2011 (outflows of $1.4 billion in January and $826 million in February and an inflow of $1.6 billion in March) corroborate the fact that direction of the FII flows remains the single-most important factor driving shorter-term movements in Indian equities. The recent rally in India in the face of several near-term fundamental concerns on spiralling crude prices and sticky inflation (and their long-term impact on growth and fiscal situation), political and corporate governance issues, etc, reinforces the view that investment strategies increasingly need to take cognizance of the direction of global investors’ allocations and flows.
Our structural view on Indian equities remains positive, with earnings growth driving our one-year Sensex target of 22,000. Our cautious near-term view drives our shorter-term trading band expectation of 17,500–20,000, given the macro headwinds that India faces. We would, therefore, advise investors to add to their equity exposure closer to the lower end of our trading band as valuations become appealing at those levels. Also, given our expectations of high volatility in the market, an absolute return-oriented approach and active profit-taking on part of the portfolio would help generate better returns compared with a passive buy-and-hold approach.
Edited excerpts from a report by Credit Suisse. Your comments are welcome at firstname.lastname@example.org