BackA welcome reality check for Dalal Street
Next rally will have tobe based on strong earnings growth to be sustainable
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There is a palpable sense of disquiet in the financial markets. The government’s tax demands have shaken investor confidence. The first corporate results have been disappointing. The possibility of higher US interest rates later in the year continue to cast a shadow. Equity prices have retreated. Foreign investors have been selling Indian debt. And the rupee has drifted down a bit.
The magnificent rally that began a few weeks before the general election in May 2014 has already run out of steam. Equity returns have been close to zero since the beginning of the year. Other markets such as Russia that were beaten down over the past few quarters have seen confidence rallies that have pulled in global smart money.
It is not hard to understand why the Indian equity market has stuttered. The bulk of the increase in stock prices over the past year has come from an expansion of earnings multiples, or valuation improvements. Actual earnings growth has been muted. It is also clear that the next round of increases in stock prices will have to be based on strong earnings growth if the rally is to be sustainable. The latest corporate results show that this is some way off.
There are several risks here. The growth in nominal gross domestic product will be muted because of the dramatic fall in inflation. The deflation in wholesale prices shows that corporate pricing power continues to be weak. The ongoing problems in the farm sector will weigh on rural demand. Add to this the fact that the Indian corporate sector is highly leveraged, and is especially at risk from its foreign currency debt exposures at a time when the dollar is rallying. And the less said about the state of the banking sector the better.
The next few months will almost definitely test the commitment of investors. Money—both domestic and foreign—has been pouring into Indian equities on three hopes: the Indian economic recovery will strengthen; the Narendra Modi government will push ahead with the overdue structural reforms that are needed to take India to the next level; and India will continue to be what the International Monetary Fund has described as a bright spot in a gloomy world economy. And India, for all its troubles, looks in better shape than many other large emerging markets such as China and Brazil.
The recent developments have cast a long shadow over these fond hopes. But most investors continue to believe that India is a good bet over the medium term. It is also useful to remember that the recovery from the previous slowdown in the early years of this century was a slow one. Companies had to deleverage. Banks had to clean their asset books. The Reserve Bank of India had to slash interest rates. Fiscal profligacy had to be checked. The Atal Bihari Vajpayee government had to push through important reforms. The turn in the profit cycle, the improvement in return on equity, and the boom in corporate investments came over a period of time.
However, there is one ingredient that will be missing this time around: a robust world economy. Central banks have flooded the world with excess liquidity but real economies are still struggling. Several economists are now asking whether the world has reached a new normal of mediocre economic growth. What this means is that India will have to depend on domestic demand recovery for its earnings growth—or at least more than it did during the previous cyclical recovery.
The past few months have been something of a reality check on the extreme bullish case about India. Such a check should be welcomed because of the tendency of markets to otherwise run ahead of reality—to the point when valuations are so steep that the only corrective is a crash that scares investors off the markets for several years.
What explains the poor performance of the markets? Tell us at views@livemint.com
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