There was a strange divergence between the economy and the markets last week. While the news about the economy kept getting better, the Sensex kept going lower.
More than four months after the first “green shoots” of recovery appeared in the Indian economy, everybody seems to be convinced we’re seeing a recovery.
Last week, the International Monetary Fund (IMF) raised its projections for India’s gross domestic product (GDP) growth by 0.9 percentage points both for 2009 and 2010. IMF now says India will grow 5.4% this year and 6.5% the next. The Index of Industrial Production (IIP) also saw a nice bounce, which too was forecast by the Purchasing Managers’ Index quite a few months ago.
That’s not all. Non-food bank credit increased significantly in the month to 26 June, a much better performance than the fall in credit in the previous one month.
True, credit growth compared with last year is still very low, but then nobody is arguing that the current GDP growth rate is near the growth rates notched up at this time last year. Also, we need to remember that oil companies had to borrow heavily last year.
Yet another encouraging signal about the economy last week was provided by the OECD Composite Leading Indicator (CLI) for India, which came in at 96.7 for May, compared with 95.3 for April. The CLI for India has been improving steadily since February this year. The Organization for Economic Cooperation and Development (OECD) says the CLI indicates that the Indian economy is now in a “possible trough”, compared with the “slowdown” it was in earlier.
This graphic shows the price-earnings multiples of different Asian nations. Graphics by Sandeep Bhatnagar / Mint
Which sectors are growing? Quite clearly, the economy is being held up by domestic demand, since exports aren’t doing well at all. It’s the consumer sector that’s supporting the economy, with consumer non-durables showing a year-on-year growth of 12.4% in May according to the IIP.
With so much excess capacity in manufacturing globally, it would be a brave entrepreneur who would risk expanding capacity at present. That’s why the capital goods index is still in negative territory. Of course, government spending on infrastructure should spur a recovery in capital goods, but it may take a while for that to happen.
The market, however, completely ignored all these encouraging signals from the economy last week. Instead it continued to fall, even after its nose-dive on the Budget day. The MSCI India Index has performed worse that the MSCI World Index this month, besides significantly underperforming the MSCI Emerging Market and Emerging Market Asia indices.
That underperformance could mean either disappointment over the Budget, or it could merely be that investors are booking profits because the market did much better than the others earlier. It’s probably a mix of both. The Bombay Stock Exchange (BSE) Capital Goods Index, the Power Index, the Bankex and the Realty Index have been the worst performers last week, losing far more than the benchmark Sensex. There’s no particular reason for disappointment in the capital goods and power sectors, as the government has made it amply clear it wants to spend a lot on infrastructure. But the reason the market did not respond to the improvement in the economic data is perhaps because it was already pricing in a V-shaped recovery and earnings growth arising out of thatrecovery.
Here’s what the equity strategists at HSBC Holdings Plc. say in their latest Asia Insights Quarterly, “In every market except Australia, analysts are forecasting double-digit growth next year. Korean analysts, most notably, expect 48% EPS (earnings per share) growth in 2010, after 11% this year. We are not saying that all these forecasts are necessarily too high: 18% growth for China, 21% for India and a doubling in Taiwan from a very low level are probably about right. But it is hard to see how they could surprise significantly on the upside from these levels.” Simply put, the reason the market did not respond to the good news about the economy last week is because a lot of good news is already expected.
In fact, the chief argument for markets such as India and China doing better than others is that their GDP growth is higher. IMF and the World Bank both agree that while India and China will continue to grow reasonably well, the mature economies will contract this year.
This has several implications. One, low global growth will mean that the cost of raw materials should be low this year. That should hold true even if China grows rapidly, because the US accounts for a quarter of world GDP and China around 8%. That should be good for sectors that face robust domestic demand, such as infrastructure. Two, sluggish global growth will mean that monetary policy will continue to be easy. That will provide support to liquidity and to capital flows.
But higher GDP growth may not necessarily mean a more attractive market. For instance, around two-fifths of the Indian market is linked to commodities and if global commodity prices stay low, these stocks won’t do well. Companies in the export sector too face a difficult time. So, the obvious choice is investing in companies that look to the domestic market. But the weak monsoon clouds the prospects for several of these stocks as well, particularly those dependent on rural consumption.
Does that mean it’s time to invest in other domestic plays such as banks and capital goods? Unfortunately, there’s the little matter of valuations being rather high. As the HSBC report says, “Even if we use 2010 P-Es (price-earnings), most markets in Asia have already exceeded the 2002-06 average. Asia ex-Japan, for example, is on 13.6 times next year’s earnings, a level it didn’t reach in the last bull market until December 2006. That compares with an average 12-month forward P-E of 11.4 times earnings in 2002-06.” According to HSBC, India’s 2010 P-E is at 14.6, 19% above its average for 2002-06.
The HSBC strategists put it admirably: “Is there any reason why multiples should be higher now than for the first three years of the last bull market? We can’t think of one.”
The wild card, of course, is global liquidity. Nobody expected the rush of money to our markets between March and May. There’s still plenty of money lying in US money market funds, which, as CLSA strategist Chris Wood has said, could lead to another bubble in Asia.
Morgan Stanley economists believe that central banks will continue to pump in liquidity and, combined with low growth in the real economy, that could mean high asset prices. But with valuations so high, the odds are that liquidity will cushion the downside rather than lead to a bull run.
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