The last few weeks have proved conclusively, if indeed such an obvious fact needed to be proved, that while there may well be a debate on the economy decoupling from the US, the markets are completely incapable of steering an independent course. Despite all the brave talk about domestic money, FII inflows remain the most important driver of our markets. So what’s the outlook for FII flows?
Brokers have used the aftermath of the market crash to draw attention to the more reasonable valuations now prevailing in the Indian market. Motilal Oswal Financial Services, for instance, in a strategy report on 11 February, says that “we believe that valuations are a lot more reasonable now”. The broker expects FY09 Sensex earnings per share at Rs1,056, which means that, at around 18000, the Sensex FY09 P-E multiple is 17, which looks reasonable, viewed against the earnings growth forecast of 20.9% for FY09 and 28.9% for FY10.
Much depends, of course, on whether those forecasts are correct. A note by Kotak Institutional Equities Research on strategy, dated 8 February, assumes EPS (earnings per share) growth for the MSCI India index at 20.8% in FY08, 23.3% for FY09 and 28% for FY10. On that basis, it then computes the PEG (P-E to growth) ratio, or the price-earnings multiple divided by expected earnings growth in the next year, at 0.8 for FY08 and 0.6 for FY09.
The rule of thumb is that a PEG number of less than 1 is attractive. You could, of course, question the earnings growth numbers, especially when the economy is showing clear signs of slowing while earnings growth too is much lower. For instance, the Motilal Oswal report points out that Sensex (excluding DLF Ltd) net profit growth was 17.4% in the December quarter compared to the year-ago period. Excluding oil and gas, the 117 companies researched by the broking firm saw a rise of just 16.5% in their net profits last quarter. Seen in that perspective, the forecasts appear too optimistic. And as for the Indian economy’s much-vaunted immunity to external factors, here’s a sobering assessment by Credit Suisse: “In India, external borrowing reached $35 billion in 2007, and that combined with portfolio debt and equity inflows of more than $25 billion pushed external financing to over $60 billion (6% of GDP) in 2007, almost double the level of 2006. This exposes India to a greater slowdown than is currently reflected in Credit Suisse’s and the Indian government’s real GDP growth forecast of 8.5% for FY2007/08.”
But even if we assume that analysts are prone to being over-optimistic, then that should be true for forecasts for other markets as well. In other words, let’s compare what could be over-optimistic forecasts for the Indian market to similar forecasts for other emerging markets. The Kotak report, citing data from Thomson Datastream, says that the MSCI Emerging Markets Asia index has a PEG ratio of 0.9 for 2008 and 1.0 for 2009, which makes the Indian market comparatively cheap.
Taking the 2008 numbers, the PEG ratios for Russia, Taiwan, China, Thailand, Malaysia and Brazil are all higher than India’s. And if we take the 2009 numbers, practically all emerging markets look more expensive than India. The underlying assumption, of course, is that Indian outperformance in earnings growth will continue, which may not hold true.
But regardless of valuations, the short-term outlook for foreign portfolio inflows is not rosy, because of rising risk aversion. Here’s a startling fact: in the US, corporate bonds rated Baa by Moody’s (a medium-grade rating) had a yield of 6.81% on 13 February. On 7 September 2007, these bonds had a yield of around 6.5%. The irony is that between 7 September and today, the US Federal Reserve has cut its policy rate by 225 basis points and that has had no impact on the rate for medium-grade corporate credit. AAA-rated corporate bonds, the very best credit, have fared slightly better, their yields falling from 5.7% at the beginning of last September to 5.4% on 8 February. Conventional mortgage yields have fallen from 6.4% to 5.6% over the same period. The point is that for riskier assets, such as the Baa-rated corporate bonds, the Fed rate cuts have had no effect at all. That shows the extent of risk aversion. On the flip side, yields on two-year US treasurys have fallen from around 4% in early September to around 1.9%—a clear indication that money has rushed to the ultra-safe haven of short-term government bonds. All the liquidity released by the Fed rate cuts is being parked in US government securities. This is the reason why some observers have said that the stock markets have been oversold and a short-term bounce is likely, a bounce that could be seen in emerging markets as well.
But the credit markets in the developed countries continue to be under severe strain—the i-Traxx crossover index which tracks the European credit default swap market is much higher than what is was three months ago. More worrying is the fact that the crisis seems to be spreading to new entities such as the bond insurers, and new products such as municipal bonds. And although banks have been asked to be pro-active and make provisions upfront for all their losses, the truth is that the losses will depend on the extent of defaults in mortgages and banks have no way of predicting that in advance. Till clarity emerges on the extent of the damage, liquidity is unlikely to flow to emerging markets, although short rallies will continue.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.