Markets at record highs on rate cut hopes, but are high valuations justified?

Benchmark stock market indices hit lifetime highs again on Thursday as record-low inflation and a sharp dip in factory output growth spurred investor expectations of a rate cut by the Reserve Bank of India (RBI).

Supportive global markets, which gained after Federal Reserve chair Janet Yellen said the US central bank will hike rates gradually, also helped. Still, some analysts cautioned that valuations had leapt ahead of fundamentals.

The Sensex breached the 32,000-point mark for the first time and closed the day at 32,037.38, up 0.73% from Wednesday’s close. The Nifty closed just 8.3 points short of 9,900.

Retail inflation eased to 1.54% in June from 2.18% in May and factory output growth slowed to 1.7% in May from 3.1% in the previous month, data released on Wednesday showed. Chief economic advisor Arvind Subramanian said in an implicit message to RBI that the data was “something that, I am sure, all policy makers will reflect upon very, very carefully”.

“A combination of slowing growth and low inflation has stoked expectations of an interest rate cut by the RBI next month,” said Karthikraj Lakshmanan, senior fund manager, equities, at BNP Paribas Mutual Fund. Yellen’s statement also spurred a “risk-on” sentiment in the market, he said. Markets such as Hong Kong (1.16%) and Shanghai (0.67%) also gained.

June retail inflation in India was about 50 basis points below the lower band of RBI’s mandated target of maintaining inflation within the 2-6% band. One basis point is one-hundredth of a percentage point.

The Sensex and Nifty have gained 20% in the year to date, propelling the value of Indian equities above $2 trillion. The country’s stock market is now the world’s ninth biggest by that measure and is closing the gap with Germany and Canada, Bloomberg reported on Wednesday.

Still, there are enough disquieting factors—anaemic industrial output growth, disruption of supply chains by the implementation of the goods and services tax and muted corporate earnings expectations for the first half of the financial year.

The premium valuations of Indian stocks are still a concern for analysts.

The Sensex is trading at 18.48 times expected earnings for this fiscal. That makes it the most expensive among peers. The MSCI Emerging Markets index, for instance, trades at 12.44.

“The market is susceptible to reversal of global tide. Stay cautious in the near term,” Sanjay Mookim, India equity strategist at Bank of America Merrill Lynch wrote in a 12 July report, setting the December Sensex target at 30,000.

“This premium is not driven by higher expected growth but likely by comfort that Indian companies can sustain growth and higher return on equity (ROE) for longer, given India’s strong long-term potential.”

Indian stocks appear expensive even if one looks at other yardsticks such as India’s contribution to global stock market capitalization and cyclically adjusted price-earning ratios, said Ankit Agarwal, fund manager, Centrum Broking.

Not everyone buys the expensive stock explanation, though. Morgan Stanley, for instance, believes that India is entering a new growth cycle in which earnings could compound annually at about 20% for the coming five years.

“So far, as the global bid on stocks is intact, Indian stocks will probably outperform given India’s superior macro environment. Of course, this also represents the biggest risk to the current rally,” said a 5 July report authored by equity strategists Ridham Desai and Sheela Rathi.